The typical Canadian mortgage matures in 5 years or less. Why can't Canadians get (say) 30 year mortgages? I used to think that the answer was "inflation", or "inflation uncertainty". Now I don't. Now I think the answer is "Section 10 of the Canada Interest Act". Which we should abolish.
Why can Americans get 30 year mortgages? I used to think the answer was "some sort of implicit subsidy by Fanny and Freddy". Now I'm not so sure.
This post is mostly about Canada. But it has implications for Americans. On reading US comments and responses to my previous post, I get the impression that there's a general assumption that the US 30 year mortgage only exists because of government support. I'm not sure that's right. Or rather, it may depend on what sort of 30 year mortgage we are talking about.
We really need to distinguish "closed" from "open" mortgages.
A 5-year "closed" mortgage means the interest rate is fixed for 5 years. That's the typical Canadian mortgage. If you want to pay it off earlier, you have to compensate the lender by paying the difference between the old and new interest rates over the remaining term of the mortgage. That means you never have any incentive to renew a mortgage if interest rates fall.
A 30 year "open" mortgage means you can pay it off any time you like. So if interest rates fall, you have an incentive to renegotiate the mortgage and take advantage of the new interest rates. That means the interest rate you pay cannot rise, but can and probably will fall. That's the typical American mortgage.
The 1880 Section 10 of the Canada Interest Act puts a maximum penalty of 3-months' interest on repaying any loan over 5 years after 5 years have passed. That's a small penalty, and it would take only a small fall in interest rates to make it worthwhile for a borrower to exercise his option to renegotiate created by Section 10. In effect, closed mortgages of longer than 5 years are effectively banned in Canada. All mortgages longer than 5 years are effectively open mortgages, whatever the contract says.
There is a market in open mortgages in Canada, but nearly all are for very short terms, like 6 months or 1 year.
In Canada: open mortgages for longer than 1 year fail the test of the market; and the market for closed mortgages for longer than 5 years is effectively banned.
What are the implications for Americans? The typical American 30 year open mortgage would probably fail the test of the market. But a 30 year closed mortgage might very well pass the test of the market.
Why do I think a 30 year fixed rate closed mortgage might meet the test of the market, if it weren't banned in Canada by Section 10? Because it meets the desires of both borrowers and lenders, or at least some borrowers and lenders.
Let's start with the borrowers. We are born with a long position in human capital, and a short position in housing. We will need somewhere to live for the rest of our lives. Buying a house is a way to cover your short position in housing, and protect yourself against the risk that future rents may rise. If our only asset is human capital, the stream of our future wage income, but we can't sell our human capital in the futures market, the next best thing may be to finance the house with a 30 year mortgage with a fixed interest rate. (The ideal mortgage would be one where the monthly payments were positively correlated with our wage income, but that vehicle might not exist). A variable rate mortgage might be better, if the level of interest rates were positively correlated with the level of our wages (as opposed to the rate of change of our wages, i.e. wage inflation), but they might not be. And the market shows that more Canadians chose a 5 year fixed than a variable rate mortgage. And the open mortgage is a weird hybrid, that is fixed when interest rates rise, but variable when interest rates fall. Except for people planning to sell their house in the next year, who want to minimise the hassle of dealing with a closed mortgage, I can't think why it would meet the needs of borrowers. And it fails the test of the market, at terms longer than 1 year.
Now the lenders. People about to retire at 65 need a safe investment for the next 30 years or so. Or the pension plans that offer them a life annuity need a safe investment. Except for the fact that mortgages are typically not indexed for inflation, a 30 year fixed rate closed mortgage looks close to ideal. And if the Bank of Canada sticks to its 2% inflation target, this concern matters less than it did in the past. If all fluctuations in nominal interest rates are due to fluctuations in real interest rates, and not to fluctuations in expected inflation, as they should be under credible inflation targeting, then variable rate mortgages will not provide a good inflation hedge, and will create risk of real interest rates fluctuating.
If a good seems to meet the needs of potential buyers, and sellers, but doesn't exist in the market, the presumption should be that the fact that Section 10 of the Canada Interest Act bans the good is the reason why it does not exist.
But what if I want to move house in the next 30 years? No problem, and it isn't a problem in Canada already, if you want to move house in Canada before your 5 year mortgage is up. Mortgages can be transportable (you take them with you to the new house), or assumable (the new buyer, OAC, takes over your mortgage). Really, mortgages are just like fridges and stoves in that regard. You don't get a 10 year stove because you think you will move in 10 years. And if you want to sell and rent? Can't you just use the proceeds to buy a bond, and leave the bond as collateral for your mortgage? And if you suddenly win the lottery, and want to pay off your mortgage? You can always pay the interest rate differential, plus any transactions costs.
Canada Deposit Insurance Corporation insures GICs of 5 years or less, but not longer than 5 years. That might also be part of the explanation why Canadian mortgages are 5 years or less. Banks borrow at terms up to 5 years, so want to lend at terms up to 5 years. Maybe.
Eric Lascelles of TD has written an excellent primer (pdf) on the Canadian mortgage market (with some comparisons to the US).
I thank all the commenters on my previous post for excellent comments that helped me write this post. Blogging is a team-effort. Comments are integral to blogging. That's how we can cut across disciplines and areas of expertise. And we need to. That's worthy of a post sometime.
Worthwhile Canadian Initiative 
We cant have 30year morgages here because we are Canadainas, and as such we have to pay more than our neighbours for everything, it is the premium we pay for having good governance I guess…
In the US prior to the depression the typical mortgage was a 5 year balloon payment.
Under this norm the home ownership rate was about 40%.
After the 30 year mortgage became the norm the home ownership rate rose to about 60% and had small cyclical moves around this level until recent years when it rose significantly from this level — largely because of “liar” loans and other declines in lending standards.
If you think home ownership is a good thing the shift from 4 year balloon mortgages to 30 year
amortized mortgages was a good thing.
I have seen estimates that the average age of a US mortgage is around four years.
So while I found your post to be very good and highly educational, I still come out with the conclusion that there is not a great deal of difference between the US 30 year mortgage and the Canadian 25 year reset mortgage except that the Canadian borrower takes on more interest rate risk.
“Except for the fact that mortgages are typically not indexed for inflation, a 30 year fixed rate closed mortgage looks close to ideal. And if the Bank of Canada sticks to its 2% inflation target, this concern matters less than it did in the past.”
Locking into a 30-year commitment based on a policy that is less than 30 years old seems … dangerous. And over reasonable periods of time, floating rate mortgages are effectively indexed to inflation (plus a spread). And wages are (for the population as a whole) indexed to inflation (wage growth basically is inflation).
The problem with your idea of arguing that the market should go closed is that the consequences of getting it wrong are significant for both sides; the consequences of getting a floating – and hence open – mortgage is that the consequences and costs are less significant.
Alternatively, if the costs ex ante of a closed mortgage are not reasonably estimable or there is no market, the upfront cost may be too high. Could this be why there is no market for it?
I’m not an expert, but I really don’t think the market for 30-year interest rate derivatives/swaps/options in Canadian dollars is deep.
Yield curve anyone?
When people shop for mortgages, they have two instincts. One is to pay as little money as possible, the other is to get the security of payment predictability. The first is a purely logical consideration, the second has a significant emotional component. The US achieves the second goal by sacrificing the first.
The entire thrust of microeconomic research into mortgage strategy in Canada has been to show that shorter terms are better, even when we try to stack the deck as much as we can against that strategy. The corollary is that the choice of a 5-year fixed term is motivated primarily by fear. As this fear is greater than the actual risk, a borrower pays a net premium for their peace of mind that is over and above the actual value of the risk being transferred.
Second, when we look at the mortgage market and its history, the entire thrust in Canada has been to ensure that as large a pool of capital as possible is available for mortgage lending. This has been an explicit goal of the CHMC since its founding.
It has been noted before that mortgages are like annuities. In fact, before 1954 chartered banks were banned from loaning mortgages. Life Insurance companies were in fact the largest players in the mortgage market. They used mortgages to invest their annuity and life insurance premium income. Insurance and annuities were their deposit base. However banks and trust companies had larger pools of capital available, so the role of insurers faded.
Banks were allowed into the market in 1954 when CHMC began its current insurance operations. However their participation dwindled in the 1960’s as rates climbed. They had a legal limit of 6% interest on all loans under the Bank Act. Trust Companies didn’t have this same limit and became the main mortgage lenders. The 6% cap was lifted in 1967 and banks entered the mortgage market with a vengeance. Banks had and still have the deepest pockets, which was why the government made the changes it did.
Second, there is also the problem of intermediation. Banks of course borrow short and lend long. But in the US they do that to the extreme, borrowing short CD’s and lending long 30-year mortgages. With rising interest rates in the 1960’s many mortgage lenders faced a shortage of deposits with which to make loans. The secondary market was designed to fill this gap. Banks could originate a mortgage, get a payment and get around the deposit problem. If a lender makes a mortgage it doesn’t want to keep, it can always sell it.
In Canada we never had a secondary market like that. Banks here were concerned in the 1960’s about getting caught with an inverted portfolio: low long-term mortgages with high-rate deposits. Borrowers, looking backward also didn’t want to keep what they thought of as high-rate mortgages and refinanced often (see Nick previously). The answer was to invent the rollover mortgage which met borrowers and lenders needs halfway. Canadian banks still engage in duration transformation, but they do it be transforming mismatched 0-5 year deposit yields with corresponding mortgage rates. They don’t engage in transformation of 1-year GIC’s into 30-year mortgages. They view this as too risky. Look what happened to the US Savings & Loan industry.
If the mortgage is only for 5 years, are housing prices significantly lower? Are down payments 20%+? I can’t imagine the fall in housing prices if America allowed only 5 year loans. No one could afford houses here under those terms at the current price level.
@Spencer:
The ultimate testament to the fact that there is not so much practical difference between the two forms of mortgage is that home ownership rates in the US and Canada are identical. In fact due to the US mortgage crisis we now have a 1% advantage. The additional interest rate risk has not in fact proved to be a detriment in Canada
@azmyth:
In Canada the “term” of a mortgage is not the same thing as the amortization. Canadian mortgages are amortized as instalment loans over a 25-year period, just like US mortgages are amortized over 30 years. However the interest rate is “fixed” for a term, which is 1-5 years. When the “term” expires you can pay off the mortgage in full without penalty or renew for the remaining balance with your lender. The mortgage “rolls over”. You can think of a bit of a balloon loan, but since we only have 6 national chartered banks, a few trust companies and the credit unions, banks are very willing to roll over their own mortgages. They prefer the income and want to keep their customers. Canadians can and do change mortgage lenders frequently and easily so the market is competitive.
Furthermore, the Canada Mortgage and Housing Corporation insures all mortgages against default. This is why banks are willing to roll over mortgages so easily.
The minimum for “standard” mortgages is a 20% downpayment. Buyers can pay as little as 5% down if they pay an additional premium to the CMHC for default insurance.
In short, in Canada mortgages are for 25-year amortizations, 20% down for regular loans, 5% down for insured loans.
In Denmark, the 30-year FRM is open — full prepayment is allowed at par. Alternatively, Denmark has offered Adjustable Rate Mortgages for the last 15 years or so. Rates on these “adjustable” mortgages are fixed for set periods, with rate resets coming at 1, 3, 5 or 10 years. With these mortgages, you can only prepay at a rate reset (unless you buy them back at market prices, which is equivalent to paying a full prepayment penalty). So a 5-year ARM seems similar in this respect to a 5-year Canadian closed FRM. Yet 30-FRM open mortgages continue to exist in Denmark, and have at times in the past decade constituted more than 50% of mortgages sold. Does this pass the test of the market? What’s more, Denmark mortgages are required to be “match-funded.” This means that rather than trust the banks and the financial system to allocate risk through the market, the government requires that specific bonds be issued that have liability profiles equivalent to the asset terms (including prepayment where applicable). And so there is a market for sellers (owners) of these bonds as well.
The average duration of 30 year fixed mortgages is 7 years. Competition drives pricing to be approximately equivalent to a 7 year adjustable. Over the business cycle, adjustables will be less expensive than 30 years, then match and exceed them. The popularity of adjustable and fixed mortgages vary over the cycle, but fixed remains popular, largely because it removes uncertainty, of payments but not of wages. A recession will lower rates and refinancing to a fixed will lock in rates at the low for the cycle even though adjustables will be slightly cheaper then. Disinflation favors adjustables, inflation favors fixed, and short term favors adjustables, and long term favors fixed. There is little difference between 7 year adjustables and 30 year fixed otherwise and neither has won out, but the fixed remains more popular and has increased market efficiency as a result. Plenty of people should like to lock in 30 now, but few would have liked to lock in 30 when inflation peaked, so their popularity would vary. This may be driven by past memories of inflation or future expectations. Adjustables are assumable but that is largely irrelevant since differences in the amount of the existing loan and future loan would necessitate an expensive second offsetting any benefit from assuming it. Portability is also irrelevant for the same reason, due to differences in housing market prices and whether you are moving up or down scale. A closed 30 would fluctuate in value more due to its duration than an open one though.
Nick, you have been confusing me with these last two posts.
My immediate reaction from reading these posts is that all these different products can be priced, and so any of them can become “the” main product. What will determine this will be custom, maybe tax policy, or some other sunspot.
One is not inherently better than the other.
But you seem to argue that the market can only price one type of product, and not the other, or both. Why?
Is it really so much more expensive and difficult to price a fixed rate mortgage over a variable rate mortgage? One would assume that if anyone had the resources to do this, it would be the financial sector, and not households. And therefore there would be some economic value to having the creditors do this instead of households, providing households with some certainty at a small profit.
And it’s pretty clear, if you look at what is happening in other countries, that mortgage terms are all over the map, some predominantly fixed, and others predominantly variable, with a lot of heterogeneity. It doesn’t seem to be the case that the financial sector can only handle one type of mortgage product.
@determinant: You write that CMHC insures all mortgages – to be exact, it (or its competitor…) insures all mortgages that do not have a 20% downpayment.
@RSJ: it’s not quite so easy to structure and price a fixed 30-year mortgage, especially with no prepayment restrictions. Not many banks or other borrowers can borrow that long. Yes, some of the necessary can be done using derivatives, interest rate swaps, etc, but that means finding counterparties that you would take the risk of for 30 years. (I know of a Russian mortgage securitization that went bad due to Lehmann Bros’ failure and the swaps needed).
In many countries, yield curves don’t go out to 30 years, and the other capital markets tools are not there to price these things. Even in Canada, the differential between 1-year and 20-year govt bond yields is about 3% today (and you would expect the yield to grow larger for less credit-worthy borrowers – if it was possible for them to borrow).
So it’s not clear that ‘anyone has the resources to do this’ except government – even in the U.S. the full 30-year fixed is entirely dependent on government support.
You say that ‘mortgage terms are all over the map’, some predominantly fixed, some predominantly variable. I would be grateful for a resource on this – to my knowledge, there are only two markets in which long-term fixed rate is a dominant product, US and Denmark. I know of no others where it is a product commonly available in domestic currency without direct government support. (I may not be up-to-date, though, particularly as regards some EU markets).
“The entire thrust of microeconomic research into mortgage strategy in Canada has been to show that shorter terms are better, even when we try to stack the deck as much as we can against that strategy.”
Determinant: can you provide some references for this microeconomic research? I’m interested in getting deeper into this topic. Thanks.
GA,
Believe it or not, there is a ton of documentation. The Eurozone has a Mortgage Product Experts Group that busy themselves issuing reports.
But here I found a nice summary of the market via Google
Nation: Home Ownership Rate Predominant Type Of New Mortgage Amortization Period
Canada 66 Variable 40%Initial Fixed 60% 25
Finland 58 Variable 97% 15-20
Germany 42 Mostly Initial Fixed Or Fixed 28
Italy 80 Fixed 28% 10-15
Norway 77 Variable 90% 15-20
UK 70 Initial Fixed 28% Variable 72% 25
USA 69 Fixed 74% 30
The default provisions differ. The downpayment and mortgage insurance requirements differ. In some countries, the loan is attached to the person while in others to the property. Refinancing penalties differ. Heloc options are different. Tax treatment is different. Use of securitization is different. Existence of subprime lending options are different.
And add to that that you can get foreign (euro) loans.
To the naive observer, it at least seems that the varying products are the result of custom — and this includes how each nation handles defaults and the nature of government support — rather than any market optimization process per se. Or rather, a combination of random custom initial conditions and then market optimization within that context.
And this isn’t even considering mortgages in Asia. I think in Japan, the majority of mortgages are long term fixed rate. You can get variable if you want. South Korea requires 80% downpayments. In Singapore, you can get a long term fixed, but no one can afford to buy their own house.
“I think in Japan, the majority of mortgages are long term fixed rate. ”
If that’s true then Nick would surely argue that’s why Japan never had any serious real estate bubbles… Oh wait, forget it.
@RSJ: I see no evidence whatsoever that contradicts what I wrote – not many markets where fixed are predominant. I’ve seen lots of these studies and when I’ve looked at the comparisons in detail, very few are full-term fixed.
From your link, “initial fixed” (e.g. as in Canada, fixed for some period, floating or re-fixable thereafter, also known as hybrid ARM in the U.S.) and floating dominate. Only Italy gives a concrete figure for fixed with no qualifier of 28% – and notice the limited term. Germany’s is vague as they’ve combined initial fixed and fixed, which are quite different.
I’d be grateful for a source for your Japan comment: this source says the opposite, that floating in a broad sense represents 70%. (The graph in the text shows about 5% ‘fixed whole period’ but I can’t comment on the discrepancy).
Click to access PER038_032707_Letter_US.pdf
In previous rounds of looking at quite detailed global reports/comparisons, I repeat, I’ve only seen USA and Denmark as having very considerable portions of market in fixed rate. (Terminology is a big issue and you have to look at details – such as what ‘fixed rate’ means in Canada is really an initial fixed rate term). Again, I might well be out of date, but every time I’ve seen detailed info, the conclusion has been that most of the world has floating or hybrid floating/fixed as the standard product.
@RSJ: Clarified the Italy issue. Your source above appears to be, ahem, modest in its accuracy or at least in terminology. BIS says: ‘More than three quarters of credit for house purchases is at variable rates or rates renegotiable in less than one year. Only a small fraction of new lending is at rates fixed for 10 years or more.’ http://www.bis.org/publ/wgpapers/cgfs26gobbi.pdf
I heard that during the Japanese housing bubble that Japanese banks were actually writing multi-generational 100 year mortgages.
I do not know how accurate this is, but I heard it multiple times.
In London many people do not own the land they build on. rather they have a 100 year lease.
It must really make for confusing mortgages.
RSJ: All products (actual and hypothetical) can be priced. There is the “supply price” (the lowest price at which a potential seller would be willing to sell them). And there is the “demand price” (the highest price at which a potential buyer would buy them).
But for some products (sardine-flavoured ice cream, maybe) the supply price exceeds the demand price. These products fail the test of the market. They could exist, but they don’t.
So, of all the potential products out there, some exist in the market, some fail the test of the market, and some are banned. In Canada, 1 to 5 year closed mortgages, and 1 year open mortgages, pass the test of the market. Greater than 1 year open mortgages fail the test of the market (they are sardine-flavoured ice cream). And greater than 5 year closed mortgages are banned.
I now have a second source confirming that 25 year mortgages did once exist in Canada. Lisa tells me that her parents had a 25 year mortgage in the late 1960’s. (It would have been an open mortgage, of course, de facto, given Section 10. I do not know how common these mortgages were. I couldn’t find any references by Googling.
Section 10 is over 100 years old. I don’t know of any change in the law around the early 1970’s. My guess is that maybe section 10 plus the increase in inflation uncertainty, and hence interest rate uncertainty, is what killed off the Canadian 25 year mortgage? But it’s still surprising that they haven’t returned recently, now that inflation has stayed lower. But interest rates do fluctuate more nowadays than they did in the 1950’s and 1960’s.
eliminating the prepayment penalty does not BAN 5+ year mortgages. 30 year American mortgages are NOT closed and can be prepayed at anytime WITHOUT penalty.
To understand the difficulty facing a bank who lends this product you have to understand that the bank has sold a 30 year option on rates. Buying the requisite hedge to offset this risk is difficult to price, and expensive. A bank lending a 30 year mortgage faces a lot of risk whether rates go up or down and many banks have gone under with the wrong hedges (in the 80s).
markets for 30 year capital and options on interest rates are very inefficient and illiquid. They would probably not exist without government support (FHA, HUD, Fannie, Freddie)going back to 1930s. In many other markets (i.e. commodities like oil, natural gas, corporate bonds) which are as widespread as mortgages, it is not typical to see markets for 30 year capital. There is just too much uncertainty.
dwb: that’s what I was saying.
Banning (limiting) prepayment penalties after 5 years bans 5+ years closed mortgages. Open mortgages are not banned. US 30 year mortgages are open.
And yes, those difficulties of supplying 30 year open mortgages are one of the reasons I suspect they wouldn’t exist without government support.
But 30 year closed mortgages might maybe exist without government support, if they weren’t banned.
Determinant @5.16:
Yes, banks who borrow with 5 year GICs wouldn’t want to lend on 30 year fixed rate mortgages. But what about pension plans? According to Eric Lascelles, pension plans already own a significant minority of mortgages. Wouldn’t pension plans prefer 30 year fixed rate closed mortgages to 5 year fixed rate closed mortgages? I would think they would. Their liabilities are much closer to 30 year fixed rate mortgages, so they would get a much better maturity match than at present.
Much to my surprise Royal bank is advertising a 25-year fixed. I haven’t tried calling to get info or to confirm that this is really truly fixed throughout the term.
http://www.rbcroyalbank.com/products/mortgages/view_rates.html
But here’s the interesting bit (from my perspective anyway): rates at five year fix are 4.5% (‘special’ price but it’s always special), and 8.25% at 25-year. But the jump in rates happens at 7-year fix at 6.85%. Note the difference in monthly payment (25-year, monthly) between 4.5%@ $553/mo and 8.25%@ $779/mo is almost 40% per month!
Given the Bank Act restriction on penalties, it should not be difficult to figure out the cost of the option of prepaying (that is, between a 7-year truly closed and 7-year closed for only five years. I forget how to do the detailed analysis, but to give a sense, the difference between current BoC yield on the five-year (2.598%) and this Royal Bank rate is 1.89%, and between the seven-year BoC (3.059%) and the Royal rate is 3.79%. This is not the proper analysis, but rough difference of 1.9% gives an idea of the magnitude of the premium one is paying just to have the two-year quasi-open option. (For anyone who remembers how to do this analysis or has the time to look it up, the BoC 25-year yield is 4.149% and the difference to the Royal rate is 4.1%).
Hope I’ve not misunderstood anything here.
Nick: “The typical American 30 year open mortgage would probably fail the test of the market.”
Hello, argument or explanation???? You said at the beginning of the post that “there’s a general assumption that the US 30 year mortgage only exists because of government support. I’m not sure that’s right.” So if that’s not right, doesn’t that imply that the mortgages don’t fail the test of the market?
@Nick
You’d think they would, but then again why do pension funds invest in stocks instead of bonds? I believe that they are chasing returns in order to increase the discount rate and therefore lower their required contributions.
It is the old story of safety and security vs. price.
Secondly, Mortgage-backed securities have a prepayment risk that government securities don’t. Every time a borrower prepays his mortgage, the lender loses principal and interest. CMHC explicitly insures against this loss to bond holders. However this program has only been active for the last decade or so.
Furthermore for many years many large public pensions like the CPP, Ontario Teacher’s Pension Plan and the federal Public Service Superannuation Plan were required to be exclusively invested in government bonds. Mortgages just didn’t make the cut.
@GA
The NHA creates recourse to CMHC on all NHA mortgages up to 80%. On high-ratio mortgages up to 95% the borrower has to pay an extra premium. However you are right in that the majority of default risk is in high-ratio mortgages.
Adam P:
I made two arguments for why a 30 year open mortgage would probably fail the test of the market (assuming 30 year closed mortgages were allowed):
1. Empirical A: In Canada closed and open mortgages are in direct competition for terms of up to 5 years. Nearly all mortgages from 2 to 4 years are closed, so open mortgages fail the test of the market from 2-5 years. Extrapolate from that to 30 years.
Empirical B: At greater than 5 years, closed mortgages are banned, but opens are allowed, in Canada. 30 year open mortgages don’t exist, so they fail the test of the market in competition against 5 year closed.
In other words, in Canada, 30 year open mortgages don’t exist, and so they fail the test of the market even when their closest competitor (30 year closed) is banned.
That empirical argument looks pretty strong to me.
2. My theoretical arguments that both borrower and lender would prefer a 30 year closed to a 30 year open.
“My theoretical arguments that both borrower and lender would prefer a 30 year closed to a 30 year open.”
this is my point, you haven’t made any good theoretical argument here. Isn’t it just as plausible to suppose that in Canada 30 year open mortgages don’t exist because they’re not offered? And the reason they’re not offered is because the canadian mortgage market is far, far less competitive then the US market?
Adam: continued. My argument that a 30 year closed might pass the test of the market is weaker.
Empirical: the 5 year fixed closed is the most popular Canadian mortgage. That looks very much like a “censored?” distribution, where the right hand tail has been cut off, by Section 10. Extrapolate out to 30 years, and maybe there’s still some tail out there?
Theoretical: as above. A 30 year closed looks like the sort of product that some borrowers and some lenders would want, because it allows them to hedge their liabilities better than anything else.
Adam @ 11.15 (we were posting at the same time):
My 2 paragraphs beginning “Let’s start with the borrowers” and “Now for the lenders”. That’s my theoretical argument. I thought it was a good one.
Ok, Nick: “Let’s start with the borrowers. We are born with a long position in human capital, and a short position in housing. We will need somewhere to live for the rest of our lives. Buying a house is a way to cover your short position in housing, and protect yourself against the risk that future rents may rise. If our only asset is human capital, the stream of our future wage income, but we can’t sell our human capital in the futures market, the next best thing may be to finance the house with a 30 year mortgage with a fixed interest rate.”
The only part of this paragraph that is relevant to the discussion of closed vs open mortgages is the last sentance (the rest bears on the rent vs buy decision).
And there is no argument here, “the next best thing may be…” is not an argument, it’s an assertion
Futhermore, it’s an incorrect assertion. It’s surely the case that real wage growth is lowest in recessions which is when interest rates fall. The ability to refinance in order to mitigate falls in real disposable income is valuable to the individual agent and valuable to the macro economy as it helps the monetary policy transmission mechansim.
Now, as for the empirics surely you’d agree that really what matters in determining whether borrowers would prefer the prepayment option or not is the price of the option. It should be obvious that the Canadian mortgage market, with so much less competition amongg lenders, may well be simply pricing that option at a prohibitively high premium. How is that less plausible?
Continuing: “(The ideal mortgage would be one where the monthly payments were positively correlated with our wage income, but that vehicle might not exist). ”
Actually, with respect to aggregate wages such a mortgage does exist. It is called a rental contract (sometimes called a lease) and you can leave at little cost if you have an idiosyncratic negative wage shock.
Then you say: “A variable rate mortgage might be better, if the level of interest rates were positively correlated with the level of our wages (as opposed to the rate of change of our wages, i.e. wage inflation), but they might not be. And the market shows that more Canadians chose a 5 year fixed than a variable rate mortgage.”
Again, the part about what “the market shows” needs to account for pricing (in particular monopolisitc pricing).
finally: “And the open mortgage is a weird hybrid, that is fixed when interest rates rise, but variable when interest rates fall. Except for people planning to sell their house in the next year, who want to minimise the hassle of dealing with a closed mortgage, I can’t think why it would meet the needs of borrowers.”
Once again, ” I can’t think why…” is not an argument, it is an assertion.
Nick, no doubt that 30 year fixed closed mortgages satisfy both sides of any interest rate uncertainty for the entire duration of the loan. But let me give an argument in favour of the five year fixed. The shorter duration encourages lenders to provide better service to borrowers, because 5 years hence, borrowers could be shopping around to other banks. It also incentivizes borrowers to maintain good credit with their bank because in five years, the bank may choose not to refinance. Overall, this prevents people from gaming the system, because they know that the system will eventually catch up to them, within 5 years.
@determinant: Could you provide a reference that states that all mortgages are insured by CMHC? My understanding is that mortgages in NHA MBS are insured, but this is by no means all mortgages.
rogue: your argument makes logical sense. But I don’t believe it. Once you’ve got the mortgage, the only thing left is to make the monthly payments. The bank doesn’t need to do anything thereafter. I can’t think of any way (ooops! Adam will be after me for that argument;-) ) in which the performance of the bank could be unsatisfactory thereafter.
Adam: “I’ve looked for the Loch Ness monster, but can’t find it” is an argument that Nessie does not exist. Not a 100% proof, of course. The strength of the argument depends on how hard you have looked, and whether Nessie would be visible if she existed. Bayes Theorem probably applies here. If the likelihood of seeing Nessie if she existed is high, then if you look and don’t see her, your posterior is low.
Nick, on what basis do you claim to have looked for the reason that pre-payment options make sense?
You did not say “I’ve looked for the Loch Ness monster, but can’t find it”, you said “I needn’t bother looking for the Lcoh Ness monster because I can’t really imagine it actually existing”.
After all, you claimed that the prepayment option is socially inefficient because it increases the consumption variance of both borrowers and lenders. You didn’t back the claim up with any reasoning, I keep giving you an argument that pre-payment options in fact reduce the consumption variance of the borrower. Your response was “you may have a point but wouldn’t a two way bet be better?”. You gave no argument as to why the 2 way bet would be better. You gave no argument for why I’m wrong. You’re not giving any argument about anything, just assertions.
It is impossible to say whether it would pass or fail the market without knowing the environment and pricing. A closed 30 year fixed means the lender is taking on a lot of credit risk and a lot of inflation risk. Their liabilities are real not nominal after all, a retiree wants a constant real income, not a constant nominal income. A few years ago they would probably have been eager to do so, now days I expect much less so. A borrower would be taking on a lot of risk as well from moving, default, death, and destruction that assumability and portability can’t fully adjust for. The price different between 5 year open and closed is probably small and closed may be chosen for convenience rather than cost, but a 30 year would be much more costly than either 5 year and even a 30 year open. At times, when rates are low, it would be popular among borrowers but less so lenders, while when rates are high, it would be popular among lenders but less so borrowers. Its popularity would probably wax and wane with exuberance.
Some loans do have prepayment penalties but these are a few months interest for a few years of a mortgage, and most loans have prepaid penalties in the form of points.
@greg, the idea you are thinking of is called the “option-adjusted spread”: the parallel spread over a reference curve that will yield the market price, when the all-in curve is used to discount all cashflows, ignoring their contingency. But you need to to start with a zero curve for reference, not a par curve.
@Nick, it seems to me that others have raised a material objection to your “natural supply and demand” argument that I have not seen you address. The trouble is that the market demands a price (“higher yield”) to accept interest rate risk, but mortgage borrowers have a degree of natural protection against interest rate risk that make this price unappealing. That is because much of the variability in nominal rates is due to inflation rather than real rates, but wages rise with inflation.
@Phil – yes, the option-adjusted spread. And I know it’s more complicated than starting with the par curve, but it is an interesting starting point.
And thank you for putting the argument on inflation so simply. I agree completely (and have been trying to say this) – it’s overly simplified, but in general terms (over long haul), inflation and wage increases are basically the same thing. (Actually wages tend to rise more quickly than inflation).
So Nick: if wages rise roughly at inflation (or slightly above) over long haul, don’t we all have natural hedges?
Assume that (ex post) real interest rates were constant, so that changes in nominal interest rates always reflected, one for one, changes in actual inflation. Assume that real wages were constant, so that nominal wages also reflected inflation. Then a variable rate mortgage would give perfect indexation for inflation, and would dominate a fixed rate closed mortgage.
Under those assumptions, a variable rate mortgage would also dominate an open mortgage. Because an open mortgage is indexed to inflation if inflation falls, so nominal rates fall. But is not indexed to inflation if inflation rises, so nominal rates rise.
Now make the exact opposite assumption. Assume the Bank of Canada does its job perfectly, so that actual and expected inflation stays constant, and all changes in nominal rates reflect changes in real rates, and bear no relation to real wages. Under that assumption, the fixed closed mortgage, lent by a pensioner, borrowed by a wage-earner, dominates the variable rate and the open mortgage.
The real world is some sort of average of those above two extremes.
In other words, out of the three types of mortgage, there are circumstances in which the variable rate is best, and circumstances in which the closed rate is best, but none where the open mortgage is best.
While I have the utmost respect for the Bank of Canada, assuming anyone, anywhere does their jobs perfectly for a 25-year mortgage’s lifespan – and doesn’t change the monetary regime in that period – is not something I’m comfortable with stating is a ‘dominant strategy.’
To extend this argument slightly, what’s the downside of one to the other? It seems to me the downside is pretty clear with the fixed close – what if there’s a global financial collapse (even if the BoC is well run, or some external shock? – and not so much with the variable. With the variable, as long as you’re careful to avoid payment shocks during periods of increased inflation, the ‘average borrower’ doesn’t have much to worry about.
Mark to market matters. That’s what’s been bothering me about a thread that’s been going through the comments for the last few days. When I wrote my initial comment on the “US mortgages are weird…” post, saying that 30y fixed is bad because people could suffer a big loss when they move, what I really meant was that the value of things matters. Changing life circumstances like a a big move/divorce/loss of job can cause unseen paper losses to turn very real. And even if the losses aren’t suddenly realized, they are still there resulting in long term accrued pain over the lifetime of the mortgage.
But even if the borrower for some reason (that I don’t understand) is indifferent to the value of his/her mortgage, the bank certainly isn’t. A 30 yr fixed mortgage currently has a duration of about 20 years. That means that every 1% change in the 30 yr rate causes a 20% swing in the value of the mortgage. So it’s just too volatile to be consistent with lending someone a significant fraction of the value of their house. 80% mortgage is too much, never mind 95%. What if the housing market drops and the borrower has to move? The new house may not support the old mortgage and if the borrower has lost a job she/he wont be able to service it. There is just way too much leverage required to buy a house to be consistent with 30 yr fixed and the banks would never do it. And if you really think banks should do this, why shouldn’t they just give you a 40% bigger mortgage with a 2% higher rate right upfront when you first got the mortgage? The mark-to-market of your mortgage would exceed the value of your house which is unacceptable whether it’s a new mortgage or an old one.
And even if they wanted to do 30 yr fixed mortgages, most banks would not be able to hedge themselves either by issuing 30yr fixed notes or through interest swaps. They also have too much leverage to be good credits for that kind of risk. In the OTC derivatives market it’s known as contingent credit risk. It is a major consideration for the BIS, played a significant role in the dynamics of the crisis, and it cuts most institutions out the market for swaps over 10 years.
So maybe in a world less leveraged, things would be different. And maybe Nick’s intuition that 30 yr fixed is somehow right, is correct, and it’s just distortions in our economy that have put us in a very suboptimal equilibrium where it’s not possible. Which leads me to my next point…
If it wasn’t for meddlesome governments we would be able to cover our house funding risk the same way we cover our housing risk: by just getting the same mortgage as everyone else. Once we own all the assets of the world in exactly the same proportions as everyone else, we will be devoid of risk that our relative claim to the earth will be diminished by exogenous factors, and the world will be in a state of glorious utility optimum.
And a form of that meddling, of course, is by way of telling banks what kinds of mortgages they are allowed to underwrite. Nick, for example, can’t get the 30 yr fixed mortgage that he might like to have, because the banks can’t enforce the terms against him. But what about meddlesome deposit insurance? Banks (especially in Canada as far as I remember) fund a large portion of their balance sheet for little (M2) or no (M1) cost. This represents a permanent endowment of hundreds of billions of dollars. Some of that benefit certainly goes directly to bank managers and shareholders, but lending competition drives a large chunk of it towards reduced lending rates. So the price of credit is vastly reduced compared to a free market system in which banks would likely have to depend to a much greater extent on wholesale borrowing. People therefore are able to borrow vastly more than otherwise thereby driving up property (principally land) values, thereby increasing the capacity for borrowing, thereby increasing M1/M2… big paper asset values, big debts, big money supply, big bank profits. If you live in the US it’s even worse. The mortgage tax deduction inflates housing/mortages vastly higher again, and insures people never pay them off. It’s like paying a permanent land value tax in the form of seignorage. And this high state of leverage, as discussed above, has a significant impact on the kinds of mortgage choices we are able to make. It probably makes them very unnatural which I think is part of the reason why it’s so hard to reason about them.
I’m still trying to figure out what the right mortgage is in terms of hedging wage risk. (Nick, you pointed out that I was confusing risk in the level of wages with risk in the rate of change of wages. That was exactly my mistake; thanks. But now it looks like you are making the same mistake in your last post which looks similarly motivated to mine. What gives?). Part of the answer, I think, is in looking at mark-to-market of the mortgage (same as looking at the mortgage as a wage hedging problem). When people look at the floating rate mortgage they look at the risk that they might pay e.g. 2% more next year, which they see as a loss. In fact it’s not a risk as you can always terminate the mortgage at zero cost and not pay next years interest. But lets imagine that you are stuck paying it for a year. And then lets imagine that you are in a fixed mortgage instead. A 2% surprise is nothing compared to the 20% surprise in mark-to-market you might experience with the latter. So I think the risk of the floater is overstated, and the low risk of going fixed a mere illusion (the “accrual illusion”?). You’d really have to make a strong case for fixed being a good hedge for your income stream.
But either way, the issue might be a lot smaller and the choices less critical if our world was freer and our governments less meddlesome.
Quoted from Adam P at 11:54 am:
It’s surely the case that real wage growth is lowest in recessions which is when interest rates fall. The ability to refinance in order to mitigate falls in real disposable income is valuable to the individual agent and valuable to the macro economy as it helps the monetary policy transmission mechansim.
I’m far from an expert in economics, but Adam P’s argument makes sense to me. I was very confused when you wrote that a 30-year open mortgage — a mortgage whereby in effect the interest rate can only decrease — would fail to meet the needs of borrowers. Why would a borrower NOT want the option to pay less interest whenever possible? Am I missing something? I think I might be …
Winston: “Why would a borrower NOT want the option to pay less interest whenever possible? Am I missing something? I think I might be …”
A borrower certainly WOULD want that option, if it were free. But it won’t be free, since the lender loses if he exercises it, so the lender will make him pay for the option. Open mortgages always have a higher interest rate than closed mortgages (without that option). It’s my contention that the borrower would never want that option if he had to pay for it (except in a few special circumstances, like where he expects to sell the house soon, and doesn’t want the hassle of transferring the mortgage). Adam says I haven’t proved my contention, and I might be wrong.
K: interesting comment. Thinking about mark-to-market values is a good heuristic. The mark-to-market value of a variable rate mortgage is always equal to the book value, right? (Unless there’s default risk). But the two can deviate wildly for a 30 year fixed closed. (And they can deviate, but only in one direction, for a 30 year fixed open??)
I don’t think banks would want to hold fixed rate 30 year closed, for just this reason. But I think pensioners, or pension plans, would. So they could issue 30 year annuities (or life annuities, which must look similar in aggregate). Better even than a 30 year bond, which pays a lump sum principal at the end.
(There was some discussion by Eric Lascelles about converting mortgages into bullet bonds, but I didn’t understand it, because I don’t know what a bullet bond is.)
“(Nick, you pointed out that I was confusing risk in the level of wages with risk in the rate of change of wages. That was exactly my mistake; thanks. But now it looks like you are making the same mistake in your last post which looks similarly motivated to mine. What gives?).”
Maybe I’m making the same mistake too! My head is not totally clear on this. The case I was assuming is where all changes in the price level (and level of nominal wages) were anticipated just as they happened, and reflected in short-term nominal interest rates.
So the price (and wage) level goes 100, 100, 110, 110, and the 1 year ahead nominal interest rate goes 5%, 5%, 15%, 5%.
OK, I think I’ve got it now!
There’s a difference between “variable rate” and “adjustable rate” mortgages. Eric Lascelles talks about it. I forget which one’s which, but in one of them you would pay that extra 10% interest immediately, so your annual payments would go 100, 100, 150, 100. And in the other one the extra 10% interest is added to the principle, so your payments go 100, 100, 110, 110, which is exactly what we want, for full indexation.
My numerical example above assumes an interest-only mortgage (infinite amortisation) for simplicity of doing the math.
Here’s another simple example to illustrate the difference between closed, open, and variable rate mortgages. And which is better.
Assume a 2 year mortgage. The variable interest rate will be 5% in the first year, and either 4% or 6% in the second year, with a 50% probability of each.
If the lender is risk neutral, the interest rate on a closed mortgage will be 5%, the same as the average expected rate on a variable. And the interest rate in the first year of an open mortgage will be 5.33%, and either 5.33% or 4% in the second year.
All three mortgages have the same expected cost to the borrower and lender. The lender, being risk-neutral, is indifferent between all three.
If inflation is zero, a risk-averse borrower will prefer the closed mortgage, and a risk-lover will prefer the variable (or just go to the casino instead). If inflation in the second year is unknown, but fully reflected in interest rates, a risk-averse borrower will prefer the variable. The only case where a borrower would prefer the open to the other two is if interest rates reflect inflation, and the borrower is risk-averse for interest rates above 5.33% and risk-loving for interest rates below 5.33%. Which is a weird assumption. Which is why I say open mortgages are weird. And in any case, he could just buy the closed, and spend the 0.33% interest saved on lottery tickets or the casino.
That’s my argument, Adam. Not quite a “proof”, by JET standards. But it is an argument.
Nick @ 7:42
Looks right. So the ideal mortgage has payments of short rate minus inflation minus amortization. Inflation is added to the principal. Fully indexed, no mark to market risk, and payment shocks are in the form of changes to real rates only – exactly what the Bank is trying to achieve when it changes real rates.
And as far as lenders go, I don’t se why pensioners would want to hold fixed rather than floating. They don’t need market risk either and they do need inflation protection. The above mortgage seems an ideal investment.
The only remaining problem is the rate index. Libor/prime are strongly linked to bank credit. In a crisis libor can/did stay elevated frustrating attempts at easing. Why should your payments be linked to someone elses credit? They should be based on the Bank target rate plus spread.
Ok, Nick that’s fine. Now here’s the thing, as far as I can tell you seem to be assuming deterministic consumption for the borrower (maybe not constant if the economy is growing, but not random, or at lest uncorrelated with interest rates).
Suppose we tweak your example by adding a Phillips curve. So, as before inflation is unknown but fully reflected in interest rates. This time though, lower interest rate, lower inflation rate state goes with lower real income growth (real income doesn’t have to fall, it just needs to grow less than expected).
In this case the fixed mortgage generates a variable consumption path because the monthly payments stay the same in the face of lower real income (again, relative to its ex-ante expected value) while the open mortgage provides a hedge against lower real income growth by lowering the monthly payments in the lower income state and thus allowing consumption to be maintained.
Might a risk-averse borrower happily pay 33 basis points more in interest to have such consumption insurance? Perhaps he’d even pay more than that for such insurance.
Wait though, there’s more. Since the open mortgage insures against falling consumption but allows the borrower to spend his extra income in the high inflation/high income growth state then it actually increases the expected consumption level vs the closed mortgage (or the variable rate mortgage). Thus, some of the 33 basis points is goes back to the borrower in the form of higher expected consumption implying that 1)the price paid for the lower variance of consumption is less than 33bp, and 2) the open mortgage dominates the variable rate mortgage.
Thus, I claim that with my small tweak to the model specification you conclude that the open mortgage dominates both the variable rate mortgage and the closed mortgage.
Now Nick, does assuming a Phillips curve make the model more or less realistic than a model with variable inflation but no variation in consumption?
K: “And as far as lenders go, I don’t se why pensioners would want to hold fixed rather than floating. They don’t need market risk either and they do need inflation protection. The above mortgage seems an ideal investment.”
If all changes in interest rates reflect inflation, then pensioners too would want floating. But suppose inflation is always zero, so all changes are changes in real interest rates. To make it simpler, assume the pensioner is very risk-averse, and will live for 30 years. He needs to consume $100 each period, or will die. But any consumption over $100 gives him no extra utility. It is as if he has a short position in a stream of payments of $100 per year for the next 30 years. And he wants to cover that short position. If interest rates change, the Present value of $100 will change too. (The mark-to-market value of his 30 year annuity will vary.) But he doesn’t care about that. Or rather, he wants the mark to market value of his annuity to vary in exact proportion with the PV of his required consumption stream. And a 30 year fixed rate mortgage is a 30 year annuity.
You lost me on the rate index. Sorry.
If wages didn’t track inflation closely, but could be expected to do so over 5 years, you might prefer a 5 year adjustable. An absence of inflation risk would imply an absence of recession risk, so the only reason to prefer a 30 year open over closed would be that you might not need the money, or need more or less of it in the future, (say have to move to an area too expensive to own and have to rent), but an adjustable would still seem more attractive then. Isn’t everyone risk seeking if they believe rates are below what they believe to be a natural rate and risk adverse if they believe them above that?
Adam: Wow! this is getting very hard!
Let me see if I can get the intuition.
A fixed closed nominal mortgage won’t be ideal, because it’s not indexed.
A mortgage that is fully indexed to inflation is good, but is not ideal, because it’s not indexed to real income as well.
The ideal mortgage, for someone who spends (say) half his income on the mortgage payments, in expected terms, would be a mortgage that is double-indexed to nominal income. (If nominal income falls 1%, the mortgage principle would fall 2%). That way, his disposable real income (after mortgage payments) would be constant.
Make the right assumptions about how nominal interest rates are correlated with nominal and real income (Phillips Curves), and I can easily see how a variable (or adjustable) rate mortgage would come closer to that ideal than a fixed rate closed mortgage. Make exactly the right assumptions, and I can even see that a variable rate mortgage could be ideal.
But I still can’t see any assumptions under which the open mortgage would dominate both fixed closed and variable. That’s because the variable rate mortgage will (under the right assumptions) make mortgage payments follow nominal income in both directions, up and down. But an open mortgage has payments that can go down, but not up. So if there were a very big inflationary boom, with nominal interest rates and real and nominal income rising a lot, the open mortgage wouldn’t make payments go up to follow. So the borrower’s consumption would rise in very good states. And full insurance being optimal, he wouldn’t want to pay an amount equal to the expected value for that to happen.