Fixed-rate mortgages need rates fixed for longer

Stubbornly high housing prices are one of the main reasons for the steep drop in young Canadians’ “sense of hopefulness,” according to Statistics Canada. Given the state of the market, their hope seems unlikely to be buoyed any time soon.

Last year, interest rates were the highest they have been in 22 years and inflationary pressures, especially shelter costs, remain strong. Together, inflation and interest rates are eroding Canadians’ purchasing power. Already, one in three mortgage-holders has been forced to stretch their amortization period beyond the standard 25 years, which means paying off the mortgage years later at higher cost. And longer amortizations contribute to higher housing prices, according to the Office of the Superintendent of Financial Institutions, Canada’s banking regulator.

To address the crisis, the Department of Finance should investigate whether Canada’s banks along with Canada Mortgage and Housing Corporation (CMHC), the agency that guarantees Canadian mortgages, are sufficiently buffered to offer longer-term fixed rates than the conventional five-year term held by most homeowners. With interest and monthly payments renegotiated every five years, what Canadian banks call a “fixed-rate mortgage” is really a variable rate loan with five-year resets. This provides much less risk protection than a long-term loan in which the interest rate and payment remain fixed for the life of the loan, which is the norm in the U.S.

The evolution of the 30-year mortgage in the U.S. began as one of the major interventions following the Great Depression, in which mortgage terms as short as one-year and fully repayable had created an avalanche of foreclosures. New Deal laws allowed funding for residential construction companies that also acted as lenders. Mortgages became collateral and were sold to investors as securities. By 1938, policy led to the creation of Fannie Mae (the Federal National Mortgage Association). As a government-sponsored agency it performs three functions. It buys up mortgages from the banks, freeing their capital and allowing them to pursue more mortgage sales; it bundles mortgages and sells them to investors; and it guarantees mortgages against default. Over the years, fixed mortgage terms stretched to 10 and 15 years.

In 1968, the Johnson administration reorganized Fannie Mae as a shareholder-owned, government-backed company. This led to the dominance of the 30-year mortgage. Today, more than 90 per cent of U.S. homeowners choose 30-year mortgages. Fixed rates over such a long term protect homeowners against future rate hikes, while also allowing refinancing if interest rates drop. When interest rate risk is assumed by more sophisticated mortgage buyers and investors who can hedge against market fluctuations, 30-year mortgages can stabilize a country’s financial markets.

Countries like Denmark — where about half of mortgages are for 30 years — rely instead on “prudent lending” instead of the Fannie Mae capital market-centric funding model. Fixed-rate mortgages also exist in Germany, though generally for terms ranging between 10 and 15 years.

Several reasons are commonly cited for why Canadian banks don’t extend loan periods beyond five years. First, banks’ retail deposits remain their core mortgage funding source. But only deposits with maturities of up to five years qualify for deposit insurance. To persuade depositors to accept longer deposit terms, banks would need to offer higher interest rates. These added costs would inevitably be passed on to borrowers. To balance a creditor’s assets and liabilities, argue the banks, a five-year term is needed. And Canadian banks don’t have the privatized government-sponsored enterprises (GSES) like Fannie Mae and Freddie Mac (the Federal Home Loan Mortgage Corporation) to securitize the country’s mortgages.

CMHC does have two programs that perform a similar backstop function for Canada’s mortgage market. First, mortgage-backed securities (MBS) issued under the government-backed National Housing Act insure a wide pool of mortgages against default. And since 2001 the Canada Housing Act Trust has acted as a go-between, buying back MBSS from lenders and transforming them into the more attractive government-backed Canada Mortgage Bonds, which trade into a larger and more liquid market with better margins for investors. Appropriately expanded, these programs could secure a longer-term fixed rate mortgage market in Canada.

Longer-term fixed-rate mortgages would help prevent the housing market being lost to a generation of Canadians.