## 1. Non-Interest Rate Mortgage Cost Comparisona ## Source details **Canonical URL:** [1. Non-Interest Rate Mortgage Cost Comparisona](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09130.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09130.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09130.pdf.json) --- ### I. INTRODUCTION - Canadian banks often characterized as “too conservative” or “not dynamic enough” relative to the United States, particularly in mortgage product variety. - Past research (Klyuev (2008)) found the Canadian market for housing finance highly advanced and sophisticated, but financing options somewhat limited at terms longer than five years. - Paper’s central argument: scarcity of longer-term loans is caused by: - a five-year maturity cap on government-guaranteed deposit insurance, and - a prepayment penalty limit on residential mortgage loans in the Interest Act. - Paper compares availability and cost of residential loans for prime borrowers in Canada and the United States, describes key features of the Canadian system, discusses prime-borrower mortgage accessibility, and concludes with policy suggestions. ### II. KEY FEATURES OF THE CANADIAN HOUSING FINANCE SYSTEM - Origination and holdings - Deposit-taking financial institutions held 69 percent of outstanding Canadian residential mortgage debt at end-2007. - Chartered bank share stands at 56 percent (end-2007), up from 10 percent in 1970. - By contrast, U.S. depository institution share of residential mortgage loan holdings declined from 75 percent to about 30 percent over 1970–2007. - At end-2008, of $906 billion outstanding residential mortgage loans in Canada, $566 billion (62 percent) are held by deposit-taking institutions, of which $452 billion were held by chartered banks. - Mortgage securitization and instruments - Only $267 billion (29 percent) of Canadian residential loans have been securitized, compared to about 60 percent in the United States. - $245 billion of securitized mortgages are held by special purpose vehicles that issue mortgage-backed securities (MBSs) guaranteed by Canada Mortgage and Housing Corporation (CMHC) under the National Housing Act. - $142 billion of NHA MBS were held by the Canada Housing Trust, funded by the CMHC-guaranteed Canada Mortgage Bonds (CMBs). - Only $24 billion were held by “private label” securitization vehicles. - OSFI has imposed issuance restrictions on covered bonds expected to limit their importance to about 10 percent of outstanding mortgages. - Role of mortgage insurance - Federally-regulated deposit-taking institutions, including all chartered banks, can only hold “high ratio” loans (i.e., those with loan-to-value (LTV) ratios greater than 80 percent since April 20, 2007, up from 75 percent) if they are insured against default. - About 45 percent of all chartered bank-held mortgages are insured. - All mortgages that back NHA MBSs must be insured. - CMHC accounts for about 70 percent of all outstanding insurance. - Two private insurers, American International Group and Genworth Financial, account for almost all of the rest. - Since 1988, the federal government has been providing a 90 percent guarantee to private insurers. - Insurers are required to contribute to a guarantee fund and set aside reserves; the 10 percent guarantee differential recognizes costs associated with CMHC’s mandate to serve all parts of the country and other housing forms. ### III. PREPAYMENT RIGHTS AND MORTGAGE TERMS - Prepayment classification - Open mortgages: full prepayment rights similar to most U.S. prime mortgages. - Closed mortgages: allow borrowers to prepay a certain percentage of their mortgage (usually 15–20 percent of the original loan balance) annually, but impose penalties on prepayment amounts that exceed this. - Typical penalty calculation on a closed mortgage - If prepayment is in the “closed period” (e.g., the first three years of a four- or five-year mortgage), the penalty equals the greater of: - (a) three months of interest on the prepaid amount, or - (b) an interest rate differential (the contractual rate minus the [text truncated in source]). - Open mortgage offerings beyond the one-year term are rare. - Example fragment in source: 4.00 percent in mid-March 2009, versus 7.00 percent on the open counterpart. ### III. TYPICAL FEATURES OF CANADIAN RESIDENTIAL MORTGAGES - Most Canadian residential mortgages have recently been rollover loans that amortize over a 25-year period but reset the terms every six months to five years. - The typical mortgage loan has recently been a five-year fixed-rate loan amortized over 25 years. - Trends: terms shortening, amortization periods lengthening, and adjustable rates recently more popular. - Mortgage insurers, including CMHC, started to insure 40-year loans in 2006; in July 2008 the government announced it was pulling the maximum term back to 35 years and introducing a minimum five percent down payment. These changes became effective on October 15, 2008. - CDIC only guaranteeing retail term deposits out to five years increases cost of retail funding beyond five years. - Section 10 of Canada’s Interest Act effectively gives homeowners the right to prepay mortgages with a term to maturity greater than five years after five years of payments for a fixed prepayment penalty (i.e., the three months interest). - Prepayment penalties during the “closed period” equal three months of interest on the prepaid amount; a “reinvestment fee” starts at about $500 in the first year, sliding down to $300 in the third year, and zero thereafter. Penalties may be lower if refinancing with the same bank. - Portability of Canadian mortgages offsets some prepayment cost differences. - Lenders pass higher cost of hedging longer mortgage prepayment risk into higher interest rates; combined effect of CDIC five-year cap and prepayment penalties produces a gapping up of rates past the five year point. - Data limitations: time series of fixed-term mortgage rates beyond five years and of term deposits and guaranteed investment certificates beyond five years are spotty; evidence is anecdotal. ### A. Canadian Mortgage Interest Rates - Comparison approach - Canadian five-year fixed-rate mortgage rates against five-year swap rates; U.S. 30-year rates against 10-year swap rates, to reflect likely prepayment activity. - Period averaged: end-month September 1999 to January 2009. - Key findings - On average during the plotted period the Canadian five-year conventional rate was about 110 basis points above the U.S. thirty-year conforming rate. - Canadian posted rates overstate transacted rates typically by more than 100 basis points; example on February 20 five major Canadian banks were posting 5.79 percent, but four were offering “specials” at 4.49 percent. - CAAMP estimate: recent posted rates have exceeded transacted rates by 159 basis points (CAAMP, 2008). - U.S. thirty-year conforming rate series reflect payment of upfront points; example on February 19, 2009 the posted conforming rate was 5.04 percent with 0.7 points upfront, equivalent to about 5.34 percent (plus 30 basis points) with zero points. - Conclusion: after accounting for posted-versus-transacted discounts and U.S. upfront points, Canadian fixed-term rates on prime mortgage loans are quite competitive with U.S. counterparts. ### B. Origination and Prepayment Costs - Need to factor higher origination costs and upfront “points” charged on U.S. mortgage loans when comparing effective prepayment costs. - Definition: a point is one percent of the loan amount. - Example on a $240,000 loan - Typical origination fees for both new loans and refinancing in the U.S.: $1,000 to $3,000. - Settlement and closing costs and fees: about $1,000. - Various state and local government taxes: about $1,000. - Canadian borrowers pay about $1,800 in upfront fees and taxes for purchase, but only about $1,100 on refinancing. - Table 1 summary (costs pertain to a $240,000 mortgage at a five percent interest rate for Canadian prepayment penalty calculation) - Canada (Purchase): Settlement Costs $1,700; Recordation Taxes $100; Prepayment Penalty n/a; Total Cost $1,800. - Canada (Refinancing): Settlement Costs $1,000; Recordation Taxes $100; Prepayment Penalty $500 + $2,500; Total Cost $4,100. - United States (Purchase and Refinancing): Origination Fees $1,000 to $3,000; Settlement Costs $1,000; Recordation Taxes $1,000; Prepayment Penalty n/a; Upfront Points varies; Total Cost $3,000 to $5,000 plus points. - U.S. points example: on a $240,000 30-year fixed mortgage on February 14 AimLoan.com offered: (i) 5.25 percent with zero points; (ii) 5.00 percent with 0.5 percentage points; (iii) 4.75 percent with one percentage point. - Rate lock-ins: U.S. lenders may charge for rate lock-ins, whereas they are generally free of charge in Canada; Canadian lock-ins typically give benefit of any rate declines between commitment and settlement. - Net conclusion: effective prepayment penalties in the United States and Canada seem comparable; extra costs of refinancing in the U.S., plus upfront points, equate, or maybe even exceed, the three-month interest penalty paid by Canadian borrowers. ### C. Mortgage Insurance - Mortgage insurance (MI) plays a big role in setting mortgage lending standards in Canada. - Prior to 1967 Bank Act amendments federally-regulated depository institutions were not permitted to hold uninsured conventional mortgages; until 2007 such mortgages were subject to a 75 percent LTV ceiling (it is now 80 percent). NHA MBS are also bound by same criteria. - Most Canadian MI is underwritten by CMHC; several private-sector firms compete. The federal government covers 90 percent of private insurer losses. - Differences between Canada and U.S. MI regimes - In Canada MI covers the full amount of the loan; entire premium is paid upfront by the borrower. - In the United States MI covers only losses that exceed the LTV ceiling (e.g., 20 percent for an 80 percent ceiling); part of the premium is paid upfront by the lender and part paid monthly by the borrower; borrower can cancel insurance when LTV drops through the ceiling. - Comparative NPV example - For an 80.01 to 85 percent LTV mortgage at a five percent per annum discount rate, the NPV of the U.S. 32 basis point annual premium is less than the Canadian 175 basis point upfront premium up to seven years. - For more leveraged mortgages, the breakeven point occurs at five years. - Table 2: Comparison of Canadian and U.S. Mortgage Insurance Premia on Prime Loans - LTV 80.01 – 85%: Canadian - paid upfront 175 bps; United States - paid annually 32 bps. - LTV 85.01 – 90%: Canadian 200 bps; United States 52 bps. - LTV 90.01 – 95%: Canadian 275 bps; United States 67 bps. - Note: U.S. premia do not include recently introduced upfront loan-level price adjustments and adverse market delivery charges for borrowers with FICO credit scores below 720. ### IV. PRIME BORROWER MORTGAGE FUNDING ACCESS - Payment affordability criteria - To qualify for mortgage insurance, gross debt service should usually not exceed 32 percent of gross household income, and total debt service cost should usually not exceed 40 percent (versus 31 and 43 percent to qualify for U.S. FHA insurance). - Approval criteria for adjustable-rate loans - Canadian practice: usually based on the three-year fixed-term rate, which is usually the highest fixed rate inside of the five-year term. - U.S. practice: use the current floating rate (though some Canadian lenders have started using current floating-rate loan rates). - Credit score requirements for CMHC MI - To qualify as a prime borrower for CMHC MI purposes, the borrower or guarantor must have a minimum credit score of 620 (it was 600 prior to October 15, 2008). - If insuring a loan with an LTV between 60 and 80 percent, the credit score must be at least 580. - No minimum credit score required for loans with LTVs below 60 percent. - Three firms offer credit scoring services in Canada: Equifax, Trans Union and Experian, based on FICO formulas. - Down payment and loan limits - Federally-regulated deposit-taking institutions have been able to underwrite insured mortgages with LTVs as high as 95 percent since 1992. - No limits to individual loans that CMHC and other mortgage insurers will insure; by contrast Fannie Mae and Freddie Mac MI is only available on loans up to the conforming limit ($417,000), which in 2009 was raised to $625,500 for loans in “high-cost” areas. - Market structure differences - Lower securitization rate in Canada than the U.S. - Far fewer loans are initiated by brokers in Canada (about 30 percent versus 70 percent in the United States). - Canadian brokers act as middlemen; most non-prime loans are brokered. - Banks service their own mortgage portfolios; non-bank lenders usually retain sub-servicers. - Features keeping delinquency rates in check - Lenders have recourse to all the borrower’s other assets and income if the loan goes to foreclosure (unlike typical U.S. practice). - Virtually all mortgage payments are made via auto debit from a borrower's bank account. - Canadian borrowers can opt for weekly, biweekly, semimonthly, or monthly payment schedules; almost all U.S. mortgages require payments at the beginning of the month. ### V. SUMMARY AND POLICY SUGGESTIONS - Comparative assessment - Prime Canadian homeowners are well served by their mortgage finance system, with accessibility and costs roughly in line with those in the United States. - Although Canadian mortgages impose what seem to be hefty penalties on prepayments, when all costs of originating and refinancing are considered, the effective penalty is comparable, if not smaller, than those paid by U.S. homeowners. - Interest rates on fixed-rate mortgages are comparable after accounting for Canadian deep discounts of posted rates and U.S. buying of points upfront. - Homeownership rates: virtually identical in Canada and the United States at about 68 percent of all households. - Policy recommendation - Policymakers could consider eliminating barriers to development of a more vibrant market for fixed-rate mortgage loans longer than five years embedded in the Interest Act and CDIC deposit insurance; until that happens, rates on fixed-term residential mortgages beyond the five year term will remain uneconomical for most borrowers. - Longer fixed-rate terms would help households better manage financial risks. - Notable policy developments and counterpoints - In 2008 the Canadian government expanded the CMB program to include a ten-year maturity that may contribute to availability of longer-term mortgages in Canada. - Counterpoint: policymakers may prefer to keep mortgage terms short to reinforce counter-cyclical impact of short-term interest rate swings. - Historical note: from 1984 to 1997, CMHC offered mortgage rate insurance to help households manage interest rate risk, which undermines argument that the effective term cap is designed as a macroeconomic stabilizer. ### Box 1. Canadian Covered Bond Issuance - Definition and structure - Covered bonds are backed by identifiable and legally “ring-fenced” pools of loans. - In issuer insolvency bondholders have an unsecured claim on the issuer plus a priority claim over other unsecured creditors on the pool. - Assets remain on the issuing bank’s balance sheet; issuing bank retains ultimate credit risk. - Covered bonds contrast with traditional securitization vehicles where the issuing bank has little if any “skin in the game”. - Covered bonds do not provide the capital relief associated with securitization. - OSFI regulatory framework and limits - OSFI includes an issuance cap of four percent of the institution’s total assets, which implies $95 billion of potential issuance (versus total outstanding mortgages of about $800 billion). - The cap limits size of claims this preferred class of claimant would have on the institution’s balance sheet. - Canadian covered bonds are “structured” covered bonds with bilateral contract terms, unlike many European covered bonds whose terms are defined in country-specific legislation. - Motivations for banks to issue covered bonds - Help banks diversify market-based funding sources beyond the MBS market. - Represent cheaper funding than unsecured senior debt because they carry credit ratings higher than those on the issuing bank. - Offer advantages over Canada Mortgage Bonds (CMBs), including greater flexibility around assets and simpler asset-liability matching. - Canadian issuers and program details (examples) - Royal Bank of Canada (RBC): issued €2.0 billion five-year bonds in October 2007 and €1.5 billion ten-year bonds in June 2008; maximum program size €15 billion, about two percent of RBC’s total assets; cover pools comprised only conventional uninsured residential mortgages. - Bank of Montreal (BMO): established a €7 billion program; issued €1.0 billion five-year bonds; cover pools comprised a mixture of insured and uninsured mortgages. - Canadian Imperial Bank of Commerce (CIBC): set up an €8 billion program; issued €2.324 billion two-year bonds; cover pools comprised only insured mortgages. - Bank of Nova Scotia: set up a €15 billion program but had yet to issue any bonds. - Market functioning and 2008 challenges - European covered bond markets remained functional through most of 2008, while most private-label MBS markets were shut down. - Since late-2008 banks’ ability to issue covered bonds was severely impaired by government guarantees, rating changes, and de-leveraging of the financial sector. - Government-guaranteed bonds undermined demand for covered bonds because government-guaranteed bonds are eligible for a zero risk weight under Basel II and the European Capital Requirements Directive, versus a 10 percent risk weight for covered bonds. *Content derived from _wp09130 - 1. Non-Interest Rate Mortgage Cost Comparisona* ### 1. Non-Interest Rate Mortgage Cost Comparisona....................................................................8 ### 1. Non-Interest Rate Mortgage Cost Comparisona ### I. INTRODUCTION - Canadian banks are often characterized as “too conservative” or “not dynamic enough” relative to the United States, particularly in mortgage product variety. - Past research (Klyuev (2008)) concluded the Canadian market for housing finance is highly advanced and sophisticated, but financing options were somewhat limited, particularly at terms longer than five years. - This paper argues that the scarcity of longer-term loans is caused by: - a five-year maturity cap on government-guaranteed deposit insurance, and - a prepayment penalty limit on residential mortgage loans in the Interest Act. - The paper compares availability and cost of residential loans for prime borrowers in Canada and the United States, describes key features of the Canadian system, discusses prime-borrower mortgage accessibility, and concludes with policy suggestions. ### II. KEY FEATURES OF THE CANADIAN HOUSING FINANCE SYSTEM - Shift in origination and holdings: - Deposit-taking financial institutions held 69 percent of outstanding Canadian residential mortgage debt at end-2007. - Chartered bank share stands at 56 percent (end-2007), up from 10 percent in 1970. - Much of the bank share growth followed the 1992 Bank Act revision allowing banks to own trust and loan companies. - By contrast, U.S. depository institution share of residential mortgage loan holdings declined from 75 percent to about 30 percent over 1970–2007. - At end-2008, of $906 billion outstanding residential mortgage loans in Canada, $566 billion (62 percent) are held by deposit-taking institutions, of which $452 billion were held by chartered banks. - Mortgage securitization and instruments: - Only $267 billion (29 percent) of Canadian residential loans have been securitized, compared to about 60 percent in the United States. - $245 billion of securitized mortgages are held by special purpose vehicles that issue mortgage-backed securities (MBSs) guaranteed by Canada Mortgage and Housing Corporation (CMHC) under the National Housing Act. - $142 billion of NHA MBS were held by the Canada Housing Trust, funded by the CMHC-guaranteed Canada Mortgage Bonds (CMBs). - Only $24 billion were held by “private label” securitization vehicles. - Canadian banks have started using covered bonds, but the Office of the Superintendent of Financial Institutions (OSFI) has imposed issuance restrictions expected to limit their importance to about 10 percent of outstanding mortgages (see Box 1). - Role of mortgage insurance: - Federally-regulated deposit-taking institutions, including all chartered banks, can only hold “high ratio” loans (i.e., those with loan-to-value (LTV) ratios greater than 80 percent since April 20, 2007, up from 75 percent) if they are insured against default. - About 45 percent of all chartered bank-held mortgages are insured. - All mortgages that back NHA MBSs must be insured. - CMHC is the dominant mortgage insurer, accounting for about 70 percent of all outstanding insurance. - Two private insurers, American International Group and Genworth Financial, account for almost all of the rest. - Since 1988, the federal government has been providing a 90 percent guarantee to private insurers. - Insurers are required to contribute to a guarantee fund and set aside reserves to absorb losses; the 10 percent guarantee differential recognizes costs associated with CMHC’s mandate to serve all parts of the country and other housing forms. ### III. PREPAYMENT RIGHTS AND MORTGAGE TERMS - Prepayment classification: - Open mortgages: have full prepayment rights similar to most U.S. prime mortgages. - Closed mortgages: allow borrowers to prepay a certain percentage of their mortgage (usually 15–20 percent of the original loan balance) annually, but impose penalties on prepayment amounts that exceed this. - The typical penalty is at least three-months of interest on the amount being prepaid. - Typical penalty calculation on a closed mortgage: - If prepayment is in the “closed period” (e.g., the first three years of a four- or five-year mortgage), the penalty equals the greater of: - (a) three months of interest on the prepaid amount, or - (b) an interest rate differential (the contractual rate minus the [text truncated in source]). - Open mortgage offerings beyond the one-year term are rare. - An online rate aggregator (RateSupermarket.ca) was showing three-year fixed-term closed mortgage rates of about [text truncated in source]. *Italic: Content derived from _wp09130 - 1. Non-Interest Rate Mortgage Cost Comparisona* ### 4.00 percent in mid-March 2009, versus 7.00 percent on the open counterpart. The rate ### _wp09130 - 4.00 percent in mid-March 2009, versus 7.00 percent on the open counterpart. The rate ### III. TYPICAL FEATURES OF CANADIAN RESIDENTIAL MORTGAGES - Most Canadian residential mortgages have recently been rollover loans that amortize over a 25-year period but reset the terms every six months to five years. - The typical mortgage loan has recently been a five-year fixed-rate loan amortized over 25 years. - Trends: terms have been shortening, amortization periods lengthening, and adjustable rates have been recently more popular. - Mortgage insurers, including CMHC, started to insure 40-year loans in 2006; in July 2008 the government announced it was pulling the maximum term back to 35 years and introducing a minimum five percent down payment. These changes became effective on October 15, 2008. - Conservative credit culture and the popularity of five-year retail term deposits, plus banks’ asset-liability gap management, help explain attractiveness of five-year mortgage terms. - CDIC only guaranteeing retail term deposits out to five years increases cost of retail funding beyond five years. - Section 10 of Canada’s Interest Act effectively gives homeowners the right to prepay mortgages with a term to maturity greater than five years after five years of payments for a fixed prepayment penalty (i.e., the three months interest). - Prepayment penalties during the “closed period” (e.g., the last two years of a five-year term) equal three months of interest on the prepaid amount; a “reinvestment fee” starts at about $500 in the first year, sliding down to $300 in the third year, and zero thereafter. Penalties may be lower if refinancing with the same bank. - Portability of Canadian mortgages offsets some of the prepayment cost differences. - Lenders pass higher cost of hedging longer mortgage prepayment risk into higher interest rates; combined effect of CDIC five-year cap and prepayment penalties produces a gapping up of rates past the five year point. - Data limitations: time series of fixed-term mortgage rates beyond five years and of term deposits and guaranteed investment certificates beyond five years are spotty, so evidence is anecdotal. ### A. Canadian Mortgage Interest Rates - Comparison approach: Canadian five-year fixed-rate mortgage rates against five-year swap rates; U.S. 30-year rates against 10-year swap rates, to reflect likely prepayment activity. - Period averaged: end-month September 1999 to January 2009. - On average, during the plotted period the Canadian five-year conventional rate was about 110 basis points above the U.S. thirty-year conforming rate. - Posted versus transacted rates: Canadian posted rates overstate transacted rates typically by more than 100 basis points; example on February 20 five major Canadian banks were posting 5.79 percent, but four were offering “specials” at 4.49 percent. - CAAMP estimate: recent posted rates have exceeded transacted rates by 159 basis points (CAAMP, 2008). - U.S. thirty-year conforming rate series reflect payment of upfront points; example on February 19, 2009 the posted conforming rate was 5.04 percent with 0.7 points upfront, equivalent to about 5.34 percent (plus 30 basis points) with zero points. - Conclusion: after accounting for posted-versus-transacted discounts and U.S. upfront points, Canadian fixed-term rates on prime mortgage loans are quite competitive with U.S. counterparts. ### B. Origination and Prepayment Costs - Need to factor higher origination costs and upfront “points” charged on U.S. mortgage loans when comparing effective prepayment costs. - Definition: a point is one percent of the loan amount. - Example on a $240,000 loan: - Typical origination fees for both new loans and refinancing in the U.S.: $1,000 to $3,000. - Settlement and closing costs and fees: about $1,000. - Various state and local government taxes: about $1,000. - Canadian borrowers pay about $1,800 in upfront fees and taxes for purchase, but only about $1,100 on refinancing. - Table 1 summary (costs pertain to a $240,000 mortgage at a five percent interest rate for Canadian prepayment penalty calculation): - Canada (Purchase): Settlement Costs $1,700; Recordation Taxes $100; Prepayment Penalty n/a; Total Cost $1,800. - Canada (Refinancing): Settlement Costs $1,000; Recordation Taxes $100; Prepayment Penalty $500 + $2,500; Total Cost $4,100. - United States (Purchase and Refinancing): Origination Fees $1,000 to $3,000; Settlement Costs $1,000; Recordation Taxes $1,000; Prepayment Penalty n/a; Upfront Points varies; Total Cost $3,000 to $5,000 plus points. - U.S. example of paying points: on a $240,000 30-year fixed mortgage on February 14 AimLoan.com offered: (i) 5.25 percent with zero points; (ii) 5.00 percent with 0.5 percentage points; (iii) 4.75 percent with one percentage point. - Rate lock-ins: U.S. lenders may charge for rate lock-ins, whereas they are generally free of charge in Canada; Canadian lock-ins typically give benefit of any rate declines between commitment and settlement. - Net conclusion: effective prepayment penalties in the United States and Canada seem comparable; extra costs of refinancing in the U.S., plus upfront points, equate, or maybe even exceed, the three-month interest penalty paid by Canadian borrowers. ### C. Mortgage Insurance - Mortgage insurance (MI) plays a big role in setting mortgage lending standards in Canada. - Prior to 1967 Bank Act amendments federally-regulated depository institutions were not permitted to hold uninsured conventional mortgages; until 2007 such mortgages were subject to a 75 percent LTV ceiling (it is now 80 percent). NHA MBS are also bound by same criteria. - Most Canadian MI is underwritten by CMHC; several private-sector firms compete. The federal government covers 90 percent of private insurer losses. - Differences between Canada and U.S. MI regimes: - In Canada MI covers the full amount of the loan; entire premium is paid upfront by the borrower. - In the United States MI covers only losses that exceed the LTV ceiling (e.g., 20 percent for an 80 percent ceiling); part of the premium is paid upfront by the lender and part paid monthly by the borrower; borrower can cancel insurance when LTV drops through the ceiling. - Comparative NPV example: for an 80.01 to 85 percent LTV mortgage at a five percent per annum discount rate, the NPV of the U.S. 32 basis point annual premium is less than the Canadian 175 basis point upfront premium up to seven years. For more leveraged mortgages, the breakeven point occurs at five years. - Table 2: Comparison of Canadian and U.S. Mortgage Insurance Premia on Prime Loans (Source: CMHC, Fannie Mae and Freddie Mac) - LTV 80.01 – 85%: Canadian - paid upfront 175 bps; United States - paid annually 32 bps. - LTV 85.01 – 90%: Canadian 200 bps; United States 52 bps. - LTV 90.01 – 95%: Canadian 275 bps; United States 67 bps. - Note: U.S. premia do not include recently introduced upfront loan-level price adjustments and adverse market delivery charges for borrowers with FICO credit scores below 720. ### IV. PRIME BORROWER MORTGAGE FUNDING ACCESS - Payment affordability criteria are similar to those in the United States for prime borrowers. - To qualify for mortgage insurance, gross debt service should usually not exceed 32 percent of gross household income, and total debt service cost should usually not exceed 40 percent (versus 31 and 43 percent to qualify for U.S. FHA insurance). - Approval criteria for adjustable-rate loans in Canada are usually based on the three-year fixed-term rate, which is usually the highest fixed rate inside of the five-year term; U.S. practice is to use the current floating rate (though some Canadian lenders have started using current floating-rate loan rates). - To qualify as a prime borrower for CMHC MI purposes, the borrower or guarantor must have a minimum credit score of 620 (it was 600 prior to October 15, 2008). If insuring a loan with an LTV between 60 and 80 percent, the credit score must be at least 580. No minimum credit score required for loans with LTVs below 60 percent. - Three firms offer credit scoring services in Canada: Equifax, Trans Union and Experian, based on FICO formulas. - Canadian borrowers have faced larger down payment requirements historically but are now roughly in line with U.S. counterparts. - Federally-regulated deposit-taking institutions have been able to underwrite insured mortgages with LTVs as high as 95 percent since 1992. - No limits to individual loans that CMHC and other mortgage insurers will insure; by contrast Fannie Mae and Freddie Mac MI is only available on loans up to the conforming limit ($417,000), which in 2009 was raised to $625,500 for loans in “high-cost” areas. - Market structure differences: - Lower securitization rate in Canada than the U.S. - Far fewer loans are initiated by brokers in Canada (about 30 percent versus 70 percent in the United States). - Canadian brokers act as middlemen; most non-prime loans are brokered. - Banks service their own mortgage portfolios; non-bank lenders usually retain sub-servicers. - Key features keeping delinquency rates in check: - Lenders have recourse to all the borrower’s other assets and income if the loan goes to foreclosure (unlike typical U.S. practice). - Virtually all mortgage payments are made via auto debit from a borrower's bank account. - Canadian borrowers can opt for weekly, biweekly, semimonthly, or monthly payment schedules; almost all U.S. mortgages require payments at the beginning of the month. ### V. SUMMARY AND POLICY SUGGESTIONS - Prime Canadian homeowners are well served by their mortgage finance system, with accessibility and costs roughly in line with those in the United States. - Although Canadian mortgages impose what seem to be hefty penalties on prepayments, when all costs of originating and refinancing are considered, the effective penalty is comparable, if not smaller, than those paid by U.S. homeowners. - Interest rates on fixed-rate mortgages are comparable after accounting for Canadian deep discounts of posted rates and U.S. buying of points upfront. - Homeownership rates: virtually identical in Canada and the United States at about 68 percent of all households. - Policy recommendation: policymakers could consider eliminating barriers to development of a more vibrant market for fixed-rate mortgage loans longer than five years embedded in the Interest Act and CDIC deposit insurance; until that happens, rates on fixed-term residential mortgages beyond the five year term will remain uneconomical for most borrowers. - Longer fixed-rate terms would help households better manage financial risks. - Notable policy development: in 2008 the Canadian government expanded the CMB program to include a ten-year maturity that may contribute to availability of longer-term mortgages in Canada. - Counterpoint: policymakers may prefer to keep mortgage terms short to reinforce counter-cyclical impact of short-term interest rate swings. - Historical note: from 1984 to 1997, CMHC offered mortgage rate insurance to help households manage interest rate risk, which undermines argument that the effective term cap is designed as a macroeconomic stabilizer. *Source: _wp09130 - 4.00 percent in mid-March 2009, versus 7.00 percent on the open counterpart. The rate* ### Box 1. Canadian Covered Bond Issuance ### Box 1. Canadian Covered Bond Issuance ### Definition and structure of covered bonds - Covered bonds are backed by identifiable and legally “ring-fenced” pools of loans. - In the event of issuer insolvency bondholders have an unsecured claim on the issuer plus a priority claim over other unsecured creditors on the pool. - The assets remain on the issuing bank’s balance sheet; the issuing bank retains the ultimate credit risk and is encouraged to maintain loan quality. - Covered bonds contrast with traditional securitization vehicles (e.g., mortgage-backed securities (MBSs)), where the issuing bank has little if any “skin in the game”. - Covered bonds do not provide the capital relief associated with securitization. ### Regulatory framework and issuance limits in Canada - The Office of the Superintendent of Financial Institutions (OSFI) has set rules for covered bond issuance by Canadian deposit-taking institutions. - OSFI includes an issuance cap of four percent of the institution’s total assets, which implies $95 billion of potential issuance (versus total outstanding mortgages of about $800 billion). - The cap was put in place to limit the size of the claims that this preferred class of claimant would have on the institution’s balance sheet. - Similar limits have been placed on U.K. and U.S. covered bond issuance. - Canadian covered bonds are “structured” covered bonds, with terms and conditions defined in a bilateral contract between the issuer and bondholder, unlike many European covered bonds whose terms are defined in country-specific legislation (E.g., German Pfandbriefe and Spanish Cedulas). ### Motivations for banks to issue covered bonds - Covered bonds help banks diversify their market-based funding sources beyond the MBS market, which can occasionally be constrained. - Covered bonds represent cheaper funding than unsecured senior debt because they carry credit ratings that are higher than those on the issuing bank, being effectively collateralized by the cover pool. - For Canadian banks, covered bonds offer advantages over Canada Mortgage Bonds (CMBs), including greater flexibility around assets and simpler asset-liability matching processes. ### Canadian issuers and program details - Royal Bank of Canada (RBC): - First to set up a covered bond program. - Issued €2.0 billion five-year bonds in October 2007 and €1.5 billion ten-year bonds in June 2008. - Maximum program size is €15 billion, about two percent of RBC’s total assets. - Cover pools comprised only conventional uninsured residential mortgages. - Bank of Montreal (BMO): - Established a €7 billion program. - Issued €1.0 billion five-year bonds. - Cover pools comprised a mixture of insured and uninsured mortgages. - Canadian Imperial Bank of Commerce (CIBC): - Set up an €8 billion program. - Issued €2.324 billion two-year bonds. - Cover pools comprised only insured mortgages. - Bank of Nova Scotia: - Set up a €15 billion program but had yet to issue any bonds. ### Market functioning and challenges (2008 context) - European covered bond markets remained functional through most of 2008, while most private-label MBS markets (i.e., not issued by the U.S. government-sponsored enterprises) were shut down. - Since late-2008 banks’ ability to issue covered bonds was severely impaired by: - The impact of government guarantees. - Rating changes. - De-leveraging of the financial sector. - Government-guaranteed bonds undermined demand for covered bonds because government-guaranteed bonds are eligible for a zero risk weight under Basel II and the European Capital Requirements Directive, versus a 10 percent risk weight for covered bonds. *Source: Box 1. Canadian Covered Bond Issuance* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09130.pdf_