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What American Bankers Can Learn from Canada

The battered U.S. banking system is showing signs of a turnaround. That's welcome news around the globe, and certainly here in Canada, where we rely heavily on our southern neighbor and largest trading partner.

A number of institutions, including JPMorgan (JPM), Bank of New York Mellon (BK), Goldman Sachs (GS), and U.S. Bancorp (USB), have opted to return their TARP funds to the U.S. Treasury, while in recent weeks banks have raised tens of billions of dollars in fresh equity to shore up capital levels. Private equity firms are starting to take over distressed institutions, a sign that the smart money is betting on a return to profitability. And loans are flowing to small businesses and homeowners as well as to large corporations.

While we hate to rain on anyone's recovery, our northern perspective makes us see things differently. That's because in Canada, strong capital levels and increased loan activity offer only a partial picture of a bank's health. Equally important are lending standards and risk management. By those metrics, we still view the U.S. banking sector with some concern, especially in residential lending, which was at the center of the financial crisis.

Four Lessons from Canada As U.S. lenders stabilize and reopen their credit pipelines, this is a good time to reflect on the Canadian experience, where more prudent lending and borrowing played a big part in preventing the housing bubble that proved the near-undoing of the American banking sector. Indeed, Bank of Canada Governor Mark Carney described the essence of Canada's financial strength in an Aug. 12 presentation to the Canadian Financial Forum in Beijing: Canada's sound policy framework and its balanced economy have been key to the resilience of its financial system.

Our view is that without improving the management of credit risk, all the fresh capital in the world will not prevent another cycle of misery. Here are four lessons to help U.S. financial institutions regain their vigor and avoid the next storm.

Lesson One: Homeownership Is Not a Constitutional Right

To understand how the Canadian and American systems diverged when the storm hit, start with the concept of homeownership.

For many Americans, owning a home, a long-held symbol of financial independence and personal success, has in recent years become almost a constitutional right. That entitlement was aggressively encouraged by mortgage lenders offering "innovations" such as no-documentation loans with flexible payment options, often requiring minimal down payments and even 0% introductory interest.

U.S. public policy furthered the goal of single-family homeownership, with government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE) buying up vast pools of mortgages that could be sliced and sold to investors. The subprime boom was in some ways a byproduct of American patriotism, though it proved to be the nightmare version of the American Dream.

In fact, Canadian and U.S. homeownership rates are remarkably similar to one another. The key difference is that more stringent credit requirements and due diligence by lenders in vetting mortgage borrowers have helped keep Canadian foreclosure rates significantly below those in the U.S.

Lesson Two: Lenders Have Rights, Too

By law, Canadian banks may not lend on residential property where the loan-to-value ratio is more than 80% of the appraised value at the time of the loan, unless the loan is insured by the Canada Mortgage & Housing Corp. or another government-guaranteed insurer. That is in marked contrast to 90% and even 100% home loans marketed in the U.S. during the recent bubble.

Canada's banks do not entertain "no-doc" loans. Expected by their regulator to maintain prudent lending standards, our banks demand full documentation and verification of a borrower's identity, income, assets, and credit history. These steps are taken to ensure that banks are lending wisely and have assessed and priced their risk sensibly.

In the U.S., a lender generally has the right only to foreclose on a property, but not pursue a borrower's assets. A Canadian lender can go to court and secure a judgment against a borrower to cover interest and loan costs as well as principal, and will garnish wages or seize the borrower's personal assets to recoup the loan. As long as the lender does not realize the full amount of the mortgage debt, the borrower remains personally liable for the outstanding amount. These lenders' rights provide some discipline to the Canadian housing market: Borrowers think twice about overmortgaging themselves, knowing their future earnings could be clawed back if they default.

Lesson Three: The Benefits of On-Balance-Sheet Accounting

During the boom years, U.S. lenders regularly off-loaded the risks related to their mortgages by securitizing them into complex instruments for investors, including large blocks of collateralized securities backed by subprime loans. Few commercial banks grasped the true risk of these securities. When the securities turned toxic, banks had to absorb them.

In Canada, the majority of mortgage loans originated by banks remain on their balance sheets. Indeed, during the recent global liquidity crisis, the sale of these high quality insured loans provided an important source of liquidity for Canadian banks. Canadian bank capital regulations require banks to deduct gains on sales from securitizations and to cap servicing rights when calculating available capital. Canada's banks also have stricter capital requirements than U.S. banks—including historically higher levels for all-important common stock and cash reserves, the so-called Tier 1 equity benchmarks. Those cushions played a key part in sustaining Canada's financial system during the crisis, without the government having to step in to rescue banks.

Important for investors, four of the country's five largest banks were profitable at the end of 2008 and all were profitable in the first quarter of 2009.

Lesson Four: Learn to Be Boring

A final lesson for American banks in returning to full strength: If banking becomes exciting, something is probably wrong. Step back and take a breath. It's O.K. for banking to be boring.

Capital exists as a shock absorber to cushion losses. If lenders get caught up in another round of lending euphoria without sufficient due diligence on their credit exposure, they will once again suffer severe capital losses when the next bubble bursts.

Maybe it all boils down to personality. In a recent report, the International Monetary Fund posited how Canada's banks managed to make it through the financial crisis. "Canadian residential mortgage markets: boring but effective?" That is an interesting challenge for U.S. mortgage lenders: Try to be a little more boring. It just might be the best recipe for regaining fiscal health.
Toronto-based Elliott co-chairs the financial institutions practice at Fasken Martineau, one of Canada's largest law firms.

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