THE EVOLUTION OF THE MORTGAGE MARKET IN CANADIAN CONTEXT

1. Legal Developments
2. Financial Developments
3. The Recent Past
4. The 1980s

INTRODUCTION

Significant changes have taken place in the mortgage market in Canada over the past three decades. Dramatic shifts in the availability of funds, in the sources of funds, in interest rates, and in the nature of mortgages have occurred. Short term mortgages, variable rate mortgages, high ratio mortgages, new repayment schemes, new lending institutions, and insured mortgages, were all innovations in the not too distant past, but are now commonplace.

While these changes are significant, they represent but one further step in an evolutionary process by which the mortgage instrument and financial institutions have adapted to changing market conditions. As the requirements of both borrowers and lenders have become increasingly complex and diverse, mortgage lending practice has evolved from that of a simple repayment plan to a multitude of complex payment arrangements offered by a wide range of public and private institutions.

From Feudal Times to the Twentieth Century: Legal Developments

The origins of Canadian mortgage lending practice and law may be traced to feudal times in England. During this period, private ownership of fee simple interests in land became common as the relative power of the Royalty and the Lords diminished in the face of the growth and development of the merchant and gentry classes. In order to facilitate the acquisition of interests in land, with capital values greatly in excess of the purchaser's annual income, loans secured by the right of ownership of the interest became common. Under the initial system of mortgage lending, the vendor supplied credit to the purchaser, a system similar to today's vendor mortgage or "mortgage takeback". A major difference is that in feudal times the vendor retained not only the legal title to the property, but also retained the right to occupy and use the property (i.e., physical possession). The purchaser received possession of the legal title and of the property only after the full amount of the purchase price and interest had been paid. The system offered the vendor a very considerable measure of security when agreeing to sell a property to a purchaser who could not afford an "all cash" purchase in a period where debt financing was not commonly practiced or accepted.

By today's standards, the feudal lender appears to be much better off than the borrower, who was generally not even entitled to the income stemming from the property as a means of retiring the debt. Further, should the purchaser (or mortgagor) have fallen in arrears in the payment of the mortgage loan, even so much as one day, the right to ultimately take the property could have been forfeited, as well as all payments made to that date and the borrower remained liable for the unpaid balance on the loan.

Gradually, as property ownership and mortgaging became more widespread, the separation between possession of the legal title and possession of the physical property became more distinct. First, the Courts of Equity recognized that the purchaser of a property who had granted a mortgage had the right to the profits from the land once it had been purchased. Once this was decided, there was no advantage to the vendor to retain possession of the property. The vendor's income was seen to come from the interest payments rather than directly from the property. Vendors did retain the possession of the legal title, thereby holding the right to regain possession of the property if the mortgagor defaulted upon one or more terms of the mortgage agreement.

From this, the doctrine of the equity of redemption developed, wherein the borrower had the right, for a limited period of time, to repay the loan and retain possession, even if default had occurred. This final step acknowledged that the borrower was the owner of the property, and the lender merely held the right to obtain possession of the property if the borrower was unable to repay the borrowed funds.

From 1900 to the 1970's: Financial Development

In this century, both mortgage instruments and mortgage lending practice have undergone significant change. This recent evolution has focused on repayment plans and risk protection rather than the evolution of legal rights that had previously occurred. During the first three decades of this century, mortgage financing was characterized by long-term loans where interest was paid periodically (generally monthly) throughout the life of the loan. Partial payments of principal seldom occurred; rather, the entire principal amount was repaid (or refinanced) upon maturity.

This arrangement was satisfactory from the lender's point of view as the mortgagor's income was regarded as security for the interest payments and the property served as security for the principal. From the borrower's viewpoint, the "interest only" repayment plan minimized current expenditure and allowed for the establishment of a savings account to build toward principal repayment at maturity. Periods of stable interest rates, low inflation, and stable property values (such as occurred during the first thirty years of this century) resulted in interest only loans being generally regarded as satisfactory investment (and borrowing) vehicles.

The economic collapse during the depression greatly altered both lenders' and borrowers' perceptions of the quality of these mortgage loans. During the depression, many lenders found themselves with the full amount of principal outstanding on a large number of loans made to individuals who had no income and whose property was worth considerably less then the borrower's indebtedness. Conversely, many borrowers found themselves forced to live off their savings rather than retire a mortgage loan when due. Market participants were made abruptly aware of the "principal risk" associated with interest only loans.

The market response to this situation was a shift, after the depression, to repayment plans where periodic payment of both interest and principal occurred during the term of the financial arrangement: no longer was principal repayment deferred until the maturity date. The most common form of these repayment plans was the long-term, fully amortized mortgage, where each payment is constant in amount and is comprised of interest due plus a partial repayment of principal. At maturity, rather than the full amount of principal being due, the full amount of principal had already been fully repaid. This form of repayment was the rule in mortgage lending, particularly in the residential sector, for almost thirty-five years.

Another major innovation during the period 1935 to 1970 was the use of mortgage default insurance. In Canada, this developed from the federal government's attempts to stimulate the demand for, and supply of, housing during the post-World War II period. As direct federal intervention in housing is precluded by the Constitution (formerly the British North America Act), the federal government used indirect measures, primarily through the mortgage market, to implement its housing policies. To increase the supply of mortgage money, the federal government attempted to motivate financial institutions to increase the extent of their participation in mortgage lending, particularly by reducing the risk of loss in the event of default. The most successful method (and one which is still in use) took the form of government insurance against default on mortgage loans granted under the terms of the National Housing Act (mortgage insurance is discussed in detail in a subsequent chapter). Borrowers paid insurance fees into a fund established and managed by the government to compensate lenders when default occurred. While the original mortgage insurance program applied only to residential loans, the use of mortgage insurance has since spread to the non- residential markets. This insurance, the steady expansion in the economy, the relatively slow inflation rate and the slow growth in interest rates resulted in the terms of mortgage loans remaining relatively unchanged between the early 1950's and the late 1960's. The insurance program played a major role in attracting new lenders to the mortgage market, particularly the chartered banks.

By the end of the 1960's, fundamental changes had occurred in the Canadian economy which affected not only the nature of the mortgage but also brought about widespread changes in the characteristics of the entire economy. The most visible indicator of these changes was the rapid inflation which occurred. The rapid inflation corresponded to a period of rising consumer demand. The increase in demand intensified competition between investment and consumption demands for the money supply. Interest rates, consequently, rose significantly in order to ration funds, and long-term lenders found themselves forced with an unforeseen form of risk, the risk that funds loaned would be committed at a rate significantly lower than that paid to the source of funds. Individual borrowers (but not corporate borrowers) were protected, to some extent, from holding long-term debt at rates above the current rate, by virtue of prepayment rights granted by the Canada Interest Act. Mortgage lenders, on the other hand, had no comparable protection from being locked-in to long-term loans at rates below the current rate. From the lenders' viewpoint, the opportunity cost of a heavy commitment to long-term fixed rate assets was first (and dramatically) illustrated by the 31 % (9% to 11.8 %) increase in conventional mortgage interest rates in the three-year period commencing in January of 1972. Given the 75 % (12.5 % to 21.46%) increase that occurred between Sept. 1979 and Sept. 1981, the 1972 increase does not seem significant, but, in its time, this first "jump" was of great concern to holders of fixed rate, long- term debt instruments.

In these circumstances, it was necessary to modify the mortgage agreement to give both borrowers and lenders increased protection against the risk of unexpected interest rate fluctuations. The partially amortized mortgage, which offers such protection, emerged as the most common form of mortgage loan. This form of repayment plan involves periodic payments based on a long period of time, however, the loan matures on a short-term basis. At maturity, the full amount of the outstanding balance must be repaid or refinanced at the rate (and other conditions) prevailing when the term expires. This partially amortized mortgage permits both lenders and borrowers to share the risk of possible fluctuations in the long-term lending rate. Rates on these shorter term documents (one, two, three, or five years) were generally less than rates on the longer term mortgages (reflecting expectations that rates would increase in the future). This rate differential was the natural offshoot of the mortgagor accepting a portion of the risk relating to swings in interest rates. On the other hand, borrowers with an expressed preference for rate security over a longer term have found that it is necessary to pay a compensating premium in the form of higher contract rates.

Although such a sharing of risk makes good economic sense, the risk of homeowners having to refinance at higher rates - the consequence of partially amortized mortgages and rising rates of interest - has prompted, in the 1980's, the introduction of interest rate insurance

The 1970's: The Recent Past

From 1970 to the present, extensive experimentation and change have characterized the mortgage market in Canada. Prior to 1970, the major changes in the mortgage document and the mortgage market were designed to stimulate the general demand for mortgage credit and promote further institutional participation in mortgage lending. While the changes appeared to be meeting the changing needs of society, in terms of impressive increases in new net capital formation in real estate, particularly new residential construction, governments felt that select groups in society were not receiving the benefits of these changes.

The 1969 Report of the Task Force on Housing and Urban Development (Hellyer Report), a report to the federal government, suggested some shift in direction in government housing and mortgage lending policies. The recommendations were consistent with the notion that housing ("decent and affordable") was a fundamental right for all Canadians. As a consequence of the Hellyer Task Force Report (and other similar studies made public at about the same time), a shift in policy and emphasis has occurred in the mortgage market in Canada. The new direction has been towards greater emphasis in social housing, housing for select groups in society (e.g., old age, low income, handicapped) and "affordability".

In the period of "affordable housing" policies, a great deal of political and governmental attention had been given to stimulating and/or subsidizing the demand for owner-occupied housing. The method that such government housing programs have generally followed has been to alter the house purchase requirements for selected groups. One such alteration which, historically, has been widely used, is the subsidized reduction of the "front end" or downpayment costs of home ownership, generally through such measures as higher loan to value ratios (up to 95%) or initial acquisition grants. As entry costs were, through subsidy programs, progressively reduced relative to house prices, the ability of purchasers' income to service the debt-to make the required monthly payments-became the effective constraint for additional potential purchasers to which government officials wished to extend the opportunity of home ownership.

An examination of the standard, constant payment mortgage, in the context of an awareness and an expectation of inflation, reveals two major characteristics which may be seen as placing impediments to the goal of continued expansion of the percentage of Canadian households that are owner-occupiers (or, alternatively, that are making mortgage payments). First, if a borrower's income increases over time, the actual gross-debt-service ratio will decline over time (assuming that the income increases exceed increases in real property taxes). Consequently, the borrower's long run housing consumption will be constrained to a level that is based on the available income at the time the loan is initiated. If gross-debt-service ratios could, somehow, be adjusted to reflect these expected changes (increases) in borrowers' income, households would be able to obtain a larger mortgage, thereby facilitating house purchase sooner than would otherwise occur (and, parenthetically, the purchase of a more expensive house).

In response to such conclusions, a number of mortgage repayment schemes were developed (primarily under government auspices) which make provision for increasing, rather than constant, monthly payments.

The 1980's: Refinancing Concerns and Mortgage Supply Stability

The short-term partially amortized mortgage permits periodic readjustment of mortgage rates. This allows lenders to balance (or match) the rates offered on their liabilities (deposits, etc.) and their assets (mortgages, etc.). Clearly, in periods of falling or stable rates, such adjustment would not attract much attention. In a period of rising rates, however, the situation where a borrower's payments could double upon refinancing would attract much attention, particularly if it occurred at the end of a period of concern about "affordability".

Such a situation occurred between 1978 and 1982, when interest rates increased from a low of 10.31% in August of 1978 to a high of 21.46% in September of 1981. Consider a hypothetical person who took out an $80,000 mortgage in September, 1976. The mortgage had a rate of 11.76%, per annum, compounded semiannually, with monthly payments, a twenty-five year amortization period and a five year term. The loan would have monthly payments of $812.12. At the end of the contractual term, the outstanding balance was $76,241.30. On the date of refinancing, the interest rate was 21.46% per annum, compounded semi-annually. With a 25 year amortization, the new payments on the outstanding debt were $1,314.26. Such dramatic increases in payments (particularly when they occurred in the 1982 recession) attracted significant attention to the borrower's risks regarding the partially amortized mortgage. The extent of the impact of the recession and rapidly increasing interest rates on home ownership in Canada is indicated by claims on the default insurance funds established under the National Housing Act. From its inception until 1979, this fund grew steadily, with revenues consistently exceeding expenditures. From 1979 to 1983, however, claims greatly exceeded revenue. For example, in 1983, revenue to the fund was $89,390,000 and expenses were $349,683,000. Clearly, many established owners were defaulting on their mortgages, unable to make payments on homes purchased in the optimistic late 1970's in the restrained 1980's.

As an attempt to reduce such risks, the federal government introduced, in 1984, an interest rate "insurance" program, whereby borrowers could, by paying an initial insurance fee, buy insurance against having to make payments based on an interest rate that is more than a specified number of percentage points greater than the rate specified in the original mortgage.

Thus one major development in Canadian mortgage lending practice thus far in this decade is the use of interest rate protection to assist housing affordability. This particular affordability concern is not with acquisition housing (as it was in the 1970's); rather, it is with maintaining the affordability for those who already own.

The federal government has also taken steps to stabilize the flow of mortgage funds by attempting to attract more investors to the mortgage market. In 1986, Canada Mortgage and Housing Corporation (CMHC) launched a new program. The CMHC created a new financial instrument called NHA Mortgage-Backed Securities (MBS) which are designed to help provide a steady flow of mortgage funds into housing in Canada. Modeled after the successful U.S. "Ginnie Mae" security, the MBS is a new investment vehicle which can be bought and sold on financial markets.

The MBS represents an undivided interest in a pool of (insured residential first) mortgages. In turn, these financial instruments are secured by the value of the underlying real estate. Only NHA insured mortgages are allowed to be pooled to create an MBS, and these mortgages are all guaranteed by CMHC. Thus, the MBS is a very secure instrument, guaranteeing the investor a specified income flow even if the mortgagor should default. An MBS is created by an issuer (approved by CMHC) who brings together a pool of NHA insured mortgages. Investors purchase an interest in this pool and become entitled to the regular monthly payments made by the borrowers in the pool. If borrowers prepay some (or all) of their mortgages, the payments plus penalties, if any, go to the holders of the MBS.

The MBS offers a number of benefits to the investment and housing industries. Investors are guaranteed timely monthly cash flow. This is particularly attractive to retired persons, who prefer the monthly pay of the MBS to the semi-annual pay of the typical bond. Furthermore, the MBS offers a double guarantee, the NHA insurance on the underlying mortgage, and the government guarantee of timely payment on the MBS Certificate.

Issuers are offered a new source of off balance sheet financing (since reserve requirements on new business may be avoided) and are protected from fluctuations in interest rates. Issuers of the original MBS, and dealers on the secondary market, will generate fee income from servicing and selling the securities. Home buyers will have more mortgage financing available to them, which will, in turn, help the housing and construction industries which are plagued with cyclical ups and downs when the supply of mortgage funds changes with interest rates.

Compliments of Real Estate Division of UBC