The U.S. mortgage game: How should it change?

Some Canadians are feeling a bit smug about their nation's relative economic calm – there's no housing bubble bursting or financial giants failing, and the Canadian dollar is strong.

But the financial mess in the United States has caught the attention of our neighbors to the north. "Canadians are terrified that the US mortgage malaise will cross the border," notes Fred Langan, host of CBC's Newsworld Business News, a cable show in Toronto.

Their fear is probably unjustified. Canada's home-mortgage system differs widely from the US system. Its banks are well-regulated and far less troubled by risky mortgage-backed securities.

Those securities were the primary reason for the dramatic negotiations in Washington last week between the Bush Administration and Congress over a gigantic $700 billion bailout proposal. That money would buy up broken mortgage-backed securities and hopefully thaw frozen US credit markets. Without available credit, the US economy could plunge to greater depths.

Such a major recession would be a real concern for Canadians. The US is Canada's biggest customer. For one thing, Ontario factories make a lot of cars sold south of the border.

Because the US financial crisis is often blamed on the current mortgage-financing system, there is already talk, beyond the rescue package, of reforming the system to prevent a future crisis.

One major issue is who absorbs the risk on what is usually the biggest investment for a family – a house.

From 1975 to 2005, US house prices never fell, notes Karl Case, an economist at Wellesley College in Massachusetts. Over that 30-year period, a house initially priced at $100,000 rose, on average, to $650,000. In New England, that house would be priced at $1 million, and in California $1.6 million. Homeowners and investors began to believe that there were "no snake eyes on the dice," says Professor Case.

Then the gamble went awry. House prices dropped decidedly, and so the nation faces financial trauma.

Today financial institutions hold some $12 trillion in outstanding mortgages on single-family homes in the US. Because mortgages usually are 20 to 30 years long at fixed interest rates, banks and other financial institutions take the risk of inflation and changes in interest rates.

In Canada, most mortgages are short term, running about five years, with renewal often involving a change in interest rates and the size of payments. (That was the system in the US prior to the Great Depression in the 1930s.) In effect, the Canadian homeowner assumes more financial risk.

"Neither the US or Canada has an optimal solution," says Robert Shiller, an economist at Yale University, New Haven, Conn.

He proposes structuring mortgages differently so adjustments in payments would be made automatically and continuously over the life of the mortgage according to an index taking account of housing costs and other financial measurements. The goal would be to enable homeowners to afford to make payments.

Professor Shiller also suggests development of an insurance system to protect against the loss of home equity. The result, he says: fewer foreclosures, which are costly to homeowners, lenders, and the nation.

At the moment, the Center for Responsible Lending (CRL), an advocacy group, calculates that the nation will suffer 2.3 million foreclosures in the next two years.

Alex Wormser, an entrepreneur in Marblehead, Mass., proposes another mortgage formula he calls "Ramp," where mortgage payments would rise each year according to the national inflation rate. This system, he says, would permit a reduction of 45 percent in the initial payments on a long-term, fixed-rate mortgage. That would make homes more affordable for more people and reduce risk for lenders.

At his suggestion, a former chief economist of the Department of Housing and Urban Development did a four-year study of this practice in such nations as Chile, Turkey, Mexico, and Iceland, reaching favorable conclusions.

Mr. Wormser claims such a system would obviate the need for a $700 billion rescue package.

To deal with the immediate situation, CRL and the Consumers Union have pushed for bankruptcy law changes to allow bankruptcy judges involved in foreclosures to alter mortgages to help people keep their homes. The mortgage industry opposes such "cram down" processes.

Of course, one source of the mortgage problem has been weak ethics on the part of some mortgage brokers and those applying for mortgages. The 1984 Secondary Mortgage Enhancement Act, intended to increase competition for mortgages from such government-sponsored institutions as Fannie Mae and Freddie Mac, exempted private mortgage brokers from registration and disclosure.

"That is the beginning of the problem," says Jane D'Arista, an analyst with the nonprofit Financial Markets Center, Howardsville, Va. The financial industry ended up issuing mortgage investments that are opaque and in some cases shady. "We don't know the volume or value" of these securities, she says, advocating enough disclosure to establish a market for them like that of a stock exchange.