Full Recourse Loans Won't Save Canada's Housing Market
The Canadian housing finance system is very different from the one that prevailed in the United States in the years before the U.S. housing bubble burst—but that might not be enough to avoid a major housing and mortgage crash in Canada.
When I write about that' country's housing bubble, the most frequent rebuttal is that comparisons with the U.S. bubble and bust are inappropriate because nearly all mortgages in Canada are "full recourse" loans—meaning that borrowers are on the hook for the full mortgage amount even in the case of a foreclosure.
Mark Perry described the alleged implications of this difference in a 2010 article for The American:
If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower's other assets and even take legal action to garnish the borrower's future wages. In the United States, we have a mix of recourse and non-recourse laws that vary by state, but even in recourse states, the use of deficiency judgments to attach assets and garnish wages is infrequent. The full recourse feature of Canadian mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer foreclosures than in the United States.
This is a very common point of view. Canada Mortgage and Housing Corp.—its version of Fannie Mae—makes the point in this recent article contrasting the U.S. and Canadian markets. Alex Pollock of the American Enterprise Institute also pointed to full recourse as a source of strength for the Canadian market in a 2011 op-ed for The Wall Street Journal.
Wall Street analysts agree.
"Legal recourse laws reduce the risk of households walking away from their mortgage and implicitly improve lending quality, unlike [in] the U.S., where reports of abandoned vacant homes were and remain rampant. By our estimation, around 90% of mortgages are full recourse in Canada, creating a more lender-friendly environment," analysts from Bank of America Merrill Lynch wrote in a 2011 note.
But recourse laws may not be anything close to the default deterrents that many think they are.
First, it's not true that the U.S. is uniformally nonrecourse. Two states with among the highest foreclosure rates, Florida and Nevada, are full recourse. In fact, the Federal Reserve classifies most states as full recourse. Ireland has full recourse mortgages and some of the harshest bankruptcy laws in the developed world. But as of December 2012, 11.9 percent of Irish mortgages were delinquent by 90 days or more.
(Read More: Canada's Housing Bubble)
The academic work on recourse laws has produced mixed results. An early study of defaults between states that allow deficiency judgments (court orders for additional payments when foreclosure falls short of paying off loans) and those that don't found no significant differences in default rates. But in another paper, the same authors found that when foreclosure occurs, lender losses are lower in full recourse states.
In 2010, two economists produced a working paper for the Richmond Fed showing that recourse laws made a significant difference when a homeowner is underwater on the mortgage. That is, they appear to provide lenders some protection against people with negative equity "just walking away" from their mortgages. But the study found no major difference when a mortgage has become unaffordable because of changes in the borrower's economic circumstances.
(Read More: A Warning About Canada's Banks)
Why would recourse loans not be as effective as many people think they are? One possibility is that getting a deficiency judgment encourages banks to make riskier loans in a booming housing market. Since the lender does not bear the risk of falling housing prices, they may be more willing to lend into a housing bubble.
In fact, there have been calls for outright prohibition of full recourse loans in Ireland on the grounds that they encourage irresponsible lending.
Full recourse mortgage lending has exacerbated the property implosion and the financial crisis facing homeowners throughout the country, according to the Irish Brokers Association.
The association has called for a ban on this form of mortgage lending, calling it unreasonable and anti-consumer.
With a full recourse mortgage the mortgage holder is fully liable for the total debt due on the loan agreement, even if the actual value of the property decreases.
This means the mortgage holder bears full responsibility, and the banks do not have to pay any price for their imprudent lending practices, the Irish Brokers Association said.
Full recourse loans may also exacerbate the economic downturn that accompanies a slump in housing prices. Rational borrowers will reduce consumption to save when falling housing prices put them at risk of deficiency judgments. As consumption spending falls, the economy contracts—which puts more homeowners at risk of default. This can prompt a recessionary downward spiral.
So even though Canadian mortgages are different than many here, that difference may not prevent a housing bust, a wave of defaults or a consequent recession. It's possible the recourse laws could make a recession even worse.
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