What U.S. Banks Can Learn from Canada

On the night hockey superstar Wayne Gretzky lit the cauldron to open the Winter Games, something was conspicuously absent in the host city: winter. With rain and temperatures near 50F, Vancouver was the focus of a weather-obsessed nation.

Right now, Canada's business community is fretting about a different sort of climate event. The country's housing market is so hot, and has become so untethered from its foreclosure-ridden U.S. counterpart, that alarms are beginning to sound about a Canadian real estate bubble. In Toronto, the average home in January sold for about $392,000 (U.S.), a 19% jump from a year earlier. In prime areas of Vancouver, you can find Lilliputian one-bedroom condos listed for $575,000 or more. Price increases are forecast for every province.

For a country whose economic fortunes usually move in lockstep with America's, this is an odd—and disconcerting—phenomenon. The most surprising part is who's trying to cool off home prices: Canada's top bankers. They earn huge profits from mortgages. Yet the leaders of the major banks recently urged the government to tighten mortgage rules to chill down the market, even though that would cut into profits in the short term. And the government quickly responded, announcing changes on Feb. 16 that enforce stricter requirements for borrowers, among other (tougher) rules.

This effort may be the surest sign yet of the gulf between the Canadian and American financial systems. More than $1 billion in goods cross the border daily, but when it comes to banking, the two countries are leagues apart, and the credit crisis proved it. Canada did not have to bail out its banks (though Ottawa did adopt measures to lubricate the credit markets). When American and European banks were teetering in 2008, only one of Canada's six major banks reported a loss. Last year, none did.

The stability hasn't gone unnoticed. Canada's bankers have won admiration from President Barack Obama, former Federal Reserve Chairman Paul Volcker, and Nobel prize-winning economist Paul Krugman, among others. What explains the success? Krugman points to stricter regulation—certainly a factor but not the whole story. Yes, regulators kept Canadian banks from taking on too much debt, which helped them through the crisis, but there were cultural and business reasons at play, too.

As in the U.S., it comes back to real estate. Canadian banks did not fail because they mostly avoided the big mistakes with mortgages. They didn't lend to people who couldn't prove a sufficient income. They did give no-money-down mortgages, but not many—and the practice was effectively banned. They made scant use of teaser rates.

They didn't they do these things largely because they didn't have to. Domestic banks own 80% of the mortgage business, and most of that is in the hands of the Big Six. Refinancing is expensive and a hassle. Canadian tax law also plays a role. Mortgage interest isn't tax-deductible, creating a disincentive to borrow. And heaven help the defaulter; banks can go after assets other than the home to make themselves whole.

All of these elements make home loans a low-risk business, so Canadian banks tend to keep their mortgages rather than bundle and sell them. That forces careful lending, which leads to profits, which leads to healthy banks, which leads to more lending—a virtuous circle. Royal Bank of Canada (RY), the largest institution, holds $117 billion in residential mortgages, more than 40% of its loan portfolio. "That's the core of the balance sheet of Canadian banks," says Rob Wessel of investment firm Hamilton Capital Partners. RBC's provision for losses on domestic mortgages last year? Less than $18 million.

It's a great business, and the formula is dead simple. "Just stop doing the stupid things, and these are money machines like God has never created before," Ed Clark, CEO of Toronto-Dominion Bank (TD), said last year. By acting together, Canada's banks and government may prevent a full-blown bubble. But don't expect bragging. Like a snowless winter, that would be un-Canadian.

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