Dismantling the old saw that it can’t happen in Canada.
This comes up constantly in discussions on the current house price bubbles in some cities in the US and Canada, and whether a US-style crisis could happen in Canada: The housing bust in the US during the Financial Crisis was marked by banks receiving “jingle mail” from homeowners who saw the value of their homes plunge and their equity turn negative. These folks didn’t feel like paying the mortgage anymore and just turned in the keys to the bank though they had jobs and could have made their mortgage payments.
These “strategic defaults,” it is said, won’t happen in Canada. Therefore, there will not be a US-style housing crisis and financial crisis in Canada. In won’t happen in Canada, they say, because mortgages are “recourse,” and in the US they’re “non-recourse.” We hear this constantly. But it’s wrong.
I’m not a lawyer, and this is not legal advice. For legal advice, pay a lawyer. I’m just trying to shed some light on a tough issue – while dismantling the old saw that a US-style housing bust and financial crisis cannot happen in Canada.
In the US of A:
States vary in how much recourse mortgage lenders have, and it’s not that clear-cut whether they’re “recourse” or “non-recourse.” A working paper by the Richmond Fed in 2010 on defaults in recourse and non-recourse states classified 11 states as “non-recourse.” That’s good enough for our purposes.
In these 11 states, banks’ recourse in collecting on residential “purchase” mortgages after default is limited to the value of the collateral (the home). If the debt is larger than the value of the home, usually determined by proceeds from the foreclosure sale, the lender is generally barred from trying to collect the remainder of the debt from the borrower.
The 11 “non-recourse states” in 2010:
- North Carolina
- North Dakota
And a 12th state, Nevada, has since made the list.
Some of the states on this list are non-recourse only for “purchase mortgages”; lenders may have recourse in collecting on other mortgages, such as a refi.
The 38 “recourse” states in the US:
In the remaining 38 states and the District of Columbia, lenders may obtain a “deficiency judgment” and try to recoup the mortgage debt beyond the value of the collateral. Thus, the vast majority of states are considered recourse states. Of the big four states, only California is non-recourse. New York, Texas, and Florida are recourse states.
Some states require judicial foreclosures (in court), others require non-judicial foreclosures, and in some, both are an option. And there are numerous other laws that impact results.
For example, in Florida, a recourse state, lenders have to use judicial foreclosure. Armed with a deficiency judgment, banks can try to collect the amounts of the defaulted debt not covered by the greater of the fair market value of the property or the foreclose sale price. However, the Richmond Fed points out that Florida has “an extremely generous homestead exemption such that if the property is an investment property rather than a primary residence, the borrower can partially shield his or her assets from collection on the deficiency.”
Then there is also the option of putting a property, particular if it is an investment property, into an LLC, which will limit any recourse to the assets held by the LLC.
In other words, results may vary.
The non-recourse provinces in Canada:
Even in Canada, there are two non-recourse provinces:
In the rest of Canada, mortgages are generally recourse loans. But even in Alberta and Saskatchewan, a mortgage is only non-recourse if it is not insured by the government’s mortgage insurer CMHC. If the mortgage is insured, the CMHC may pursue the borrower for the deficiency.
Recourse v. non-recourse states in the US housing bust
In its working paper, the Richmond Fed tried to determine if there were differences in default rates in recourse states v. non-recourse states – “the first study looking at difference in how borrowers default,” it said. Here are some of the findings:
- Deficiency judgments are “rare in practice,” in both recourse and non-recourse states. “This may be because it is often costly and time-consuming for a lender to pursue and collect on a deficiency judgment.”
- Deficiency judgments may be rare for another reason: “The mere threat of a deficiency judgment may deter default, implying few deficiency judgments in practice.”
- There was “no difference” in the probability of default across recourse and non-recourse states for properties appraised at or below the median price at origination.
- For properties appraised at $500,000 to $750,000 at origination (2005 dollars), borrowers in non-recourse states were more than twice as likely to default.
So yes, for homes priced at origination substantially above the median price, “strategic defaults” were more likely in non-recourse states than in recourse states.
But here’s the thing: In the US, only 11 states are non-recourse. Yet the housing bust and foreclosure crisis was spread across much of the country and crushed lenders in recourse states just as hard, including in Florida and Nevada. It caused the government and the Fed to bail out the banks and the federal mortgage insurers (Fannie Mae and Freddie Mac).
In that respect, the US and Canada are on the same level: In a smaller part of the country, mortgages are non-recourse; in the vast majority of the country, mortgages are recourse. Government entities insure certain types of mortgages in both countries. Mortgage-backed securities exist in both countries, as do subprime borrowers. Loans for down payments are a thriving industry in Canada that even the provincial government of British Columbia has now entered.
Recourse was no protection in the US against defaults and a financial crisis. This shows that when housing implodes hard enough after an enormous bubble, and if the bust is associated with a broader economic downturn, as housing busts inevitably are, in the end, what happened in the US can happen in Canada.
The question now being asked, years too late: How will this end? Read… If Mortgage Rates Tick Up Even a Little, What’ll Happen to Canada’s House Price Bubble?