The Great Mortgage Amortization Debate

The Amortization Debate

You’ll recall that bank CEOs of all people are now putting pressure on Flaherty and Harper to curb debt levels by, among other things, raising down payment requirements and/or shortening maximum mortgage amortization lengths.

With mortgages representing nearly 70% of total household credit, limiting the expansion of that form of debt becomes the obvious target.  And rightly so.

You may recall that mortgage debt in Canada topped $1 trillion earlier this year.  Lest you somehow think this growth is benign/sustainable, I suggest you compare the 5 year rate of growth in inflation, wages, consumer credit, and mortgage credit.

The trend is not sustainable.  Period.  But is it benign?  Is it a big deal that we now have the highest ever level of debt relative to disposable income and house price valuations that scream ‘bubble’?

Hyperbole?  Check for yourself…

CMHC Mortgage Amortization History

Before looking more at the implications of a mortgage rule change like the one being proposed, it may be helpful to provide a brief overview of the mortgage changes that have occured over the past few years:

  • In 1999, the National Housing Act and the Canada Mortgage and Housing Corporation Act were modified allowing for the introduction of a 5% down payment….a far cry from the minimum 25% of a few years earlier.
  • In 2003 CMHC decided to remove the price ceilings limitations. That is, it would insure any mortgage regardless of the cost of the home.
  • In 2005 and 2006, CMHC began insuring 30, then 35 year amortization mortgages.
  • In 2007, CMHC allowed people to purchase a home with no down payment and ammortize it over 40 years. This was changed back to a 5% down payment requirement and a maximum amortization length of 35 years in 2008 once the idiocy of this policy was blatantly obvious.

Here’s the point:  CMHC has been in existence for almost 65 years.  For the first 60 of those years, they never insured mortgages with amortizations greater than 25 years.  Only in the past 5 years has this experiment been started.  The 35 year ams that are now on the chopping block have been around only since 2006.  So let’s understand that any move to shorten amortization lengths is NOT some new, revolutionary move, but rather a move back towards norms that are both long-standing and fiscally prudent.


Effect of CMHC Rule Changes on House Prices

In an amazing report, the City of Calgary’s Corporate Economics division studied the effects of the amortization rule change on house prices in the city (hat tip to Jen for bringing the article to my attention).  Since CMHC rules affect all markets equally, strong parallels can certainly be assumed in the aggregate Canadian housing market.  Their conclusions?

“Our analysis of CMHC rule changes on Calgary prices indicates that for every year that insured mortgage terms were extended beyond 25 years Calgary house prices rose by between $6,000 and $10,000. Between 40% and 70% of residential price changes in Calgary between 2004 and 2009 can be attributed to CMHC amortization rule changes.”


Expanding on this data, Mike Fotiou over at the Calgary Real Estate Review assembled the following graph.

Lengthening mortgage amortization lengths clearly has an effect on real estate prices.  The total impact across the Canadian market is debatable, but let’s not get caught up in semantics.  The effect is pretty clear.

Mixed Reactions to Proposed Rule Changes

The implications of such a rule change on credit demand would be dramatic.  It would immediately shrink the pool of potential buyers, cooling house sales and prices.  Don’t think that those whose livelihood depend on the continued reckless expansion in consumer credit don’t understand the repercussions.  You can expect a fierce lobby from realtors and mortgage professionals on this one.

Canadian Mortgage Trends (an excellent site overall) had a post today in which they discuss the proposed mortgage amortization changes.  Their position is predictable:

“Blanket regulation, like across-the-board amortization reductions, handicap hundreds of thousands of well-qualified homeowners and lessors. These people may have very legitimate needs for the cash-flow flexibility that extended amortizations provide. Forcing strong borrowers to make less-optimal budgeting decisions serves few interests, and is not what government was intended for.”

I’m curious how these well-qualified borrowers overcame that ‘handicap’ and the ‘legitimate need for flexibility’ for the 60 plus years prior to the rule changes in 2005.  And as for the last sentence, exactly what should the role of government be when it comes to insuring the profits of private, profit-seeking financial institutions using taxpayer money?  I’d argue that its role should be as limited as possible.

Another telling quote comes from the comment section of this same post where the author makes this statement:

“Responsible borrowers who don’t pose a risk to others earn the right to manage their affairs as they see fit. Amortization flexibility allows strong mortgagors to reduce risk and/or allocate funds to better uses. Mortgage innovation of this type is made possible only by a free market and should be encouraged to the maximum extent possible.”

First let me suggest that the author take the time to understand what a ‘free market’ really is.  If banks chose to offer these mortgages and bond holders willingly offered up the funds and no government guarantee is involved, give ‘er.  THAT would be an example of the free market.  I love it that when the government steps in to insure extended amortization mortgages, it’s the blessed hand of the free market, but when the government seeks to rectify this obvious error in judgement, it’s the evil hand of the state.

The more important oversight on the part of the author is in their inability to understand or appreciate the role that this excess credit creates in the broader economy.  We’ve established that these rule changes have had an impact on house prices.  They’ve also had an impact on home ownership levels, which are now at their highest point ever at nearly 70%.

As debt becomes more affordable, credit demand booms.  Credit enters the system at a great rate as more new mortgages are originated at higher and higher sums.  Credit booms of this nature always do one thing:  They pull demand forward.  They create the illusion of prosperity.  The process goes like this:

  • Mortgage loans are originated then the proceeds deposited back into the banking system by the seller.  This provides new deposits upon which the banks can lend.
  • Rising house prices create additional credit demand via the wealth effect and cause a feedback loop.  HELOC demand explodes. More money enters the system.
  • People spend money on things they otherwise would not, simply because they feel richer.  This consumer spending sustains parts of the economy that would not otherwise prosper.  Unemployment trends lower.  The feedback mechanism strengthens.

But the debt must eventually be repaid, and therein lies the great catch.  When a society embraces a secular trend towards debt tolerance and consumerism, it’s also likely that it will experience a mean reversal in the form of an equal but opposite secular trend.  The expansion in debt cannot outpace income growth indefinitely, but two things can prolong its life:  Declining interest rates and/or loosening standards.  But even these have their limits.

The extent of the pain associated with the fallout of a busted credit bubble is directly proportional to how large a society lets that bubble become.  We have not travelled as far down that road as our American friends, but we’re far enough now that the return to a mean will be far from painless.  With mortgage debt being the catalyst for the current credit bubble, it becomes absolutely imperative that the brakes be put on as soon as possible.

The alternate ending is not a pretty one!


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17 Responses to The Great Mortgage Amortization Debate

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  2. Kenny says:

    Hear hear! Excellent post, even though I don’t expect it will change Rob’s opinion.

    One small correction. The ‘5 year’ numbers all appear to be 4 year numbers. 2005 is the start year, so only 4 years pass between then and 2009.

  3. Peter says:

    Right on! This should be required reading for anyone contemplating buying RE.


  4. jesse says:

    Those canadianmortagetrends commenters blathering on about “free markets” and less regulation would crap their pants if the government removed their de facto underwriting of CMHC MBSs. Maybe they should google the term “haircut”. Thanks for the chuckle.

  5. jesse says:

    “I’m curious how these well-qualified borrowers overcame that ‘handicap’ and the ‘legitimate need for flexibility’ for the 60 plus years prior to the rule changes in 2005”

    In all fairness, they saved and borrowed at higher interest rates. An actuary looking at groups of individuals with non-salaried income streams from the past generation would assume the risk can be spread, which is exactly what happened about 6-7 years ago.

    The problem is cash flows from those who have such income streams can be highly correlated. Think Realtors and mortgage brokers.

  6. Sam says:

    Can we see less bias? What is the cost of borrowing over these time periods? Unemployment levels? GDP growth? Those dollars for monthly payments, down payments are coming from somewhere? How much mtg debt does the avg Joe owe?
    You show graphs of high ownership. What percent in that group has outstaning mortgages? What is the ltv in those assets.

    This market is not all zero thirty five. What percent is thirty five year Amos as a part of chic book?

    Including the above questions and answers would be a better and fair analysis.

  7. Well, we are not in that bad situation. There will always be these ups and downs in a capitalistic society. That does not warrant a punishment for 22% of the homeowners, existing or wouldbe. there should be viable solution withouting destroying the exaisting system. BOC pointed out to those in this weeks speech.

  8. Kenny says:

    For some more information. This last year (from the fall caamp report) 30% of new mortgages were for 35 years. 42% were for over 25 years. As mentioned, these are a 4 year old product, not some long established existing system.

    To the people that complain, and say ‘free-market’, longer than 35 year mortgages can (do?) exist, just the government will not guarantee them. So if the government stops backing the 35 year mortgage maybe your ‘free-market’ will step up and continue to offer them. They’re only offered to people who are good credit risks, so who needs taxpayers guaranteeing it, right?

    Also from the fall caamp report, 6% of mortgage holders would be challenged by a 1% increase in rates. The report doesn’t consider this a problem though because “By the time their mortgages come due for renewal, they will have seen some income growth and the amount of mortgage principal will have been reduced, and the future impact of interest rate increases will be less than it might be today.” Of course if they have a 35y mortgage and can’t afford a rate increase they’re unlikely to have paid more than the minimum payment, so they will have paid about 5% of their mortgage in that first 5 years. They better have had some good income growth.

    Another very telling fact is where some of the debt is coming from. 18% of mortgage holders took equity out of their house last year. The average amount… $46,000. So there are even more people at risk of a rate increase because they’re not paying their mortgage down at all.

    Finally, I’d care a lot less about people overspending if it truly was a free-market. Instead CMHC is using my money to back people taking out 35year $0-down (cash-back) mortgages. CMHC had outstanding $138 billion in 2007, $290 billion mid-2009, and now ~$480 billion. I do not want to pay more taxes because someone else wasn’t responsible enough to realize that housing can go down, and rates can go up.

    I hope they set the amortization back to 25y, let the free-market handle higher amortizations, raise the down-payment to at least 10% (w/o using a cash-back option) and declare the whole experiment a failure. Oh, and privatize the CMHC.

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  10. AG Sage says:

    Actually, Vancouver has gone as far as the U.S., sad to say.
    chart of u.s. canada and vancouver house prices

    And the econ report from Calgary was an excellent catch. Kudos to the person who found that gem.

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