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NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
Dodging Innovation , September 28th, 2007

It seems that Mr Dodge is not a fan of mortgage innovation. In recent comments he warned that they help
overheat the Canadian real estate market. And who can blame him given the experience south of the border?
In the eyes of many, the meltdown of the US subprime market has painted the mortgage market in black and
white: Plain vanilla mortgages—good, all the rest—bad.
It’s true that the surge in exotic mortgages since 2004 created an artificial demand in the housing market
south of the border, and was primarily behind the current mess in the subprime space. A sharp deterioration in
underwriting standards in those years and extremely easy ways of passing on the risks were the main catalysts
there.
But what’s missing from the discussion is the fact that exotic mortgages in the US existed well before 2004—
and back then the market was functioning just fine. What triggered the current difficulties in the US mortgage
market was not the existence of exotic mortgages, but their overuse. For example, the share of interest only
mortgages in new mortgages jumped from 5% in 2003 to 20% in 2006. Ditto for the share of subprime
mortgages which reached 22% in 2006—more than double the level seen in 2003.
In Canada the exotic mortgage market that Mr. Dodge is so concerned about is still in its infancy. The
subprime market, at 5% of originations, is only half the size seen in the pre-2004 US mortgage market (when
the market was still functioning normally). Interest-only mortgages are only one percent of originations—
clearly not a factor. And passing along the risk is not as common in Canada, with less than 20% of mortgages
being securitized.
Another innovation that Dodge is concerned about is the recent use of mortgages with long-term
amortizations. Indeed, we estimate that between 40% and 50% of new mortgages taken over the past year
have an amortization term of more than 25 years. But it is far from clear that this trend has added to house
price inflation in any meaningful way. If, as we suspect, the vast majority of these home buyers would have
bought a similar house regardless of the availability of the increased amortization option, then this trend is not
inflationary since it does not represent additional demand.
Not only are mortgage innovations important to a normally functioning market, but their role in Canada
should, in fact, grow over time.
Those new products are largely about serving under-served populations through more effective market
segmentation and niche marketing. Self-employment is currently the fastest growing segment of the labour
market, rising by a dazzling 7.5% over the past year—six times faster than the pace of growth seen among
paid employees. Many of those self-employed don’t fit into traditional credit scoring matrixes and are heavy
users of new mortgages products. Ditto for new immigrants, as well as professionals with high income
volatility (due to increased reliance on commissions and bonuses). Limit mortgage innovation in Canada, and
you shut-out those fast growing segments of the population from the housing market.
Benjamin Tal
Senior Economist, CIBC


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