Why no Canadian, Australian housing busts?

Here’s a chart to ponder from the peer review of residential mortgage practices, just published by the internationally-coordinated Financial Stability Board:

Set aside Switzerland and the Netherlands. We’ve no idea (right now) what’s going on there, and we want to focus on two areas that have been in our thoughts lately.

Canada and Australia.

Both these countries have had rather high mortgage debt to GDP ratios and there have been some rumblings about frothiness in the two markets for a while now. There’s even a whole website dedicated to Canada’s (nascent?) housing bubble.

Should we be concerned? Some people — like Bank of America Merrill Lynch’s Sheryl King and Ryan Bohren think not, at least when it comes to the Canadian market.

Here’s why, from a Monday note:

Although we believe Canadian housing is in bubble territory, and down-side risks remain despite an accelerating economy, we find that the structure of the Canadian mortgage market greatly reduces the probability of a US style housing melt-down. In the US excessive risky lending left financial institutions vulnerable, a housing market vastly over supplied and subsequently created a recordbreaking foreclosure crisis.

When we look at the four key features of the Canadian mortgage market:

1. 1. We find government guaranteed mortgage insurance mitigates risk to financial institutions. Unlike the US where financial institutions were clearly over exposed and the solvency of insurance providers were questionable. 75% of mortgages in Canada are fully insured with Government guarantees and all mortgages with an LTV higher than 80% must be insured by regulated lenders.
2. 2. Legal recourse laws reduce the risk of households walking away from their mortgage and implicitly improve lending quality, unlike the US where reports of abandoned vacant homes were and remain rampant. By our estimation around 90% of mortgages are full recourse in Canada, creating a more lender-friendly environment.
3. 3. About 30% of the mortgage funding market has a federal government guarantee, which likely reduces the risk of a US style funding freeze. Indeed during the height of the credit crisis, the Government of Canada initiated a very effective Insured Mortgage Purchase Program which essentially kept the Canadian mortgage market functioning.
4. 4. Canadian’s have historically held lower leverage ratios than their US counter parts and tend to gravitate to more conservative mortgage options. Canadian household balance sheets have deteriorated and have been treading into more risky areas like variable rate mortgages, but sub prime lending remains a virtually non-existent market in Canada.

Now mortgage insurance’s role in housing booms and busts is an interesting one, and there’s also a mention of the industry in its past and current form in that FSB review.

In some countries, like Canada and the US, mortgage insurance is legally required on mortgages with high loan-to-value ratios. In others, like Australia and also Canada, it’s incentivised through capital weightings. In Australia and Canada mortgage insurance also covers 100 per cent of the loan balance.

But is that a strength?

Call us crude perma-bears but we still remember what happened to US mortgage insurers during the subprime meltdown. Once housing losses went viral, losses at mortgage insurers mounted. Some of them went KABOOM!, pressuring the banks.

The FSB has a handy rundown:

The effectiveness of mortgage insurance depends on the financial strength of the provider. In particular, because default risk in mortgage portfolios is inherently correlated, the value of this risk mitigation can decline in times of crisis precisely when it is most needed. The mortgage insurance industry was severely affected by the recent global financial crisis. In Australia, only six mortgage insurers remain, down from 16 in 2004, but it should be noted that most of the exits occurred after the Australian Prudential Regulation Authority (APRA) significantly tightened capital requirements for mortgage insurers in 2005, and thus not as a direct consequence of the crisis … Canada has a well-regulated mortgage insurance industry, consisting of one public insurer (Canada Mortgage and Housing Corporation) and a small number of private firms. The government of Canada back-stops mortgage insurers through guarantee agreements that protect lenders in the event of default by the insurer …

Canada and Australia’s mortgage safety blankets may be thicker than most but they won’t necessarily shield the financial system if a bust does come to pass. To quote the FSB, “the recent crisis has shown how deceptive risk transfer … can be.”

Now admittedly, there’s one big difference between Canada and Australia insurance — in Canada the government is already backstopping some mortgage losses.

In Australia it’s not. Yet.