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An Examination of the Canadian Mortgage Broker IndustryBy Andrew T. WilliamsThesis Submitted in partial fulfillment of the requirements for the Degree of Bachelor ofArts with Honours in EconomicsAcadia UniversityApril, 2010 By Andrew T. Williams, 2010

This thesis by Andrew T Williams is accepted in its present form by the Department ofEconomics as satisfying the thesis requirements for the degree of Bachelor of Arts withHonoursApproved by the Thesis SupervisorBrian VanblarcomApproved by the Thesis SupervisorScot SkjeiApproved by the Head of the DepartmentHassouna MoussaApproved by the Honours CommitteeMatthew Durantii

I, Andrew Williams, grant permission to the University Librarian at Acadia University toreproduce, loan or distribute copies of my thesis in microform, paper or electronicformats on a non-profit basis. I however, retain the copyright in my thesis.Signature of AuthorDateiii

AcknowledgementsI’d like to thank Professor Skjei and Professor Vanblarcom for their patience andguidance through the entire process. I would like to thank my parents for their love andsupport throughout. Finally, I’d like to thank the many people I interviewed and emailedfor their help and interest.iv

Table of ContentsAcknowledgements.ivTable of Contents.vList of Tables.viiList of Figures.viiiAbstract.ix1 Introduction.12 The Mortgage Brokerage Industry in Canada.42.1 What is a Mortgage Broker? .42.2 A Young Canadian Industry.62.3 Recent Trends in the Canadian Mortgage Market.72.4 Housing Bubble Fears.113 Critical Issues in the Mortgage Broker Industry.143.1 Problems with Experience and Consumer Confidence.143.2 Mortgage Fraud.153.3 Efforts to reform.183.4 The Major Banks in Canada: An Overview.203.5 Advertising.233.6 Bank Brokerages.253.7 Status Quo Bias .264 MarketCharacteristics.294.1 Introduction.294.2 Monopolistic Competition.294.3 Asymmetric information.324.4 Price Discrimination.324.5 The Three Types of Price Discrimination.364.5.1 1st Degree .364.5.2 2nd Degree.374.5.3 3rd Degree.385 Price Discrimination in the Mortgage Market.425.1 Introduction.425.2 Assumptions.435.3 An Estimate of Consumer Surplus in Canada.435.4 Graphical Representation.45v

6 Conclusion .486.1 Summary.486.2 Conclusion.507 Bibliography.528 Appendix A.57vi

List of Tables Table 2.1 Residential Mortgage Credit by Institution .9Table 3.1 Sentiment by Bank.21Table 5.1 Calculated Findings.46vii

List of Figures Figure 2.1 Average Mortgage Rates.8Figure 2.2 Existing Home Prices.10Figure 3.1 Trends in Public Support For the Banks.22Figure 3.2 Advertising Recall.25Figure 4.1 Residential Mortgage Credit % By Institution.31Figure 4.2 Price Discrimination.35Figure 4.3 Second Degree Price Discrimination.37Figure 4.4 Third Degree Price Discrimination.38Figure 5.1 Increase in Consumer Surplus.45viii

AbstractThis thesis seeks to answer the question “why are mortgage brokers relativelyunder used in Canada and what could be gained from increasing their usage?” Throughexamination of the current market, mortgage brokers were found to be impeded by acombination of the following factors: broker inexperience, a history of fraud, the majorbank’s dominance of advertising and consumer opinion, and the established status quobias amongst Canadians. A third degree price discrimination model was subsequentlyused to estimate the consumer cost of these impediments. The consumer surplus costwas calculated to be 41.2 million in 2009. Individually, consumers can benefit from theuse of mortgage brokers but the mortgage industry as a whole benefits from thedecrease in dead weight loss, calculated to be 15.89 million. It is the existence of thesesavings that will likely encourage growth in this industry in the future.ix

Chapter 1 – IntroductionOn July 13th 2009, a Globe and Mail reporter named Rob Carrick interviewedRobert McLister, the author of the Canadian Mortgage Trends blog and registeredMortgage Planner. In the course of the interview, Carrick mentioned that only 10% ofpeople renewing their mortgage shop around for a better interest rate.1 McListercomments that if a borrower was to consult a mortgage broker instead of going to abank directly, they would likely be able to lower their interest rate more than 30 basispoints from the given bank rate.2 Interestingly, McLister mentions that only about athird of Canadians use mortgage brokers which means a large number of the Canadianhomebuyers are missing out on significant savings.The research question that this thesis will focus on is as follows: why aremortgage brokers under used in Canada and what could be gained from increasing theirusage?In 2009, total mortgage credit in the Canadian market was a record 930billion3 and surveys suggest that only 30-40% of this was obtained through mortgagebrokers. 4,5 The mortgage market in Canada predominantly features the monopolisticallycompetitive “Big Five” banks.6 These banks originate more than half of all mortgage1Rob Mclister, interview by Rob Carrick. Getting the Best Mortgage Rate (July 13, 2009).Mclister3Bank of Canada. Residential Mortgage Credit. CANSIM, 03 08, 20104CMHC. "2009 Mortgage Consumer Survey Results." CMHC, 2009: 35Will Dunning, "The Canadian Residential Mortgage Market During Challenging Times."CAAMP, April 2009: 7 - 10.6Note 1 - See Appendix A for a List of the Big 5 banks21

credit in Canada and are the first choice of a majority of Canadian customers.7 Inaddition to these banks, there are over a hundred smaller credit institutions and CaissesPopulaires present in the Canadian banking industry. These institutions are the secondlargest provider of independent residential mortgage credit in Canada with about 13%of the total market in 2009.8 In comparison, the mortgage broker industry, as recentlyas 15 years ago was largely marginalized to the role of lender of last resort in Canada.Art Trojan, the head of Norlite Financial Services, one of Canada's largest brokerages,said that in the past:"The stereotypical image of the mortgage broker was that of a guy who's sittingin a back room, saying, 'Hey buddy, do you need some money? We're going tocharge half a point extra and, if you miss a payment, we're going to break yourlegs.'"9While this makes for a lively caricature, the industry’s transition into a more reputableprofession is both complex and incomplete.This thesis will explore the limitations currently facing the Canadian mortgageindustry, despite efforts to reform. The main reasons for such limitations include: brokerinexperience and fraud, Big 5 marketing dominance, and consumer status quo bias.7Will Dunning. "Risks are Contained Within the Canadian Mortgage Market." CAAMP,October 2008: 38Bank of Canada. “Residential Mortgage Credit.” CANSIM, 03 08, 20109Paul Kaihla. “Canada Mortgage Broker: If you're looking for a cut-rate mortgage, don'tgo to the bank -- call a broker.” an business.htm (accessed 02 2010).2

The structure of this thesis is as follows: in Chapter 2, an industry backgroundwill be presented and the role of mortgage brokers will be explained. In addition, anaccount of the current trends in the Canadian housing market will place the followingdiscussion in greater context. In Chapter 3, the critical issues relevant to the brokerindustry will be detailed. The goal is to provide an understanding of the limits andproblems that impede the broker industry from achieving greater market power.Chapter 4 will define the fundamental characteristics that distinguish themortgage industry. Third degree price discrimination will be introduced as the primaryeconomic rationale for the existence of limited market competition. Chapter 5 will takethe theoretical framework put forward in Chapter 4 and apply it to the CanadianMortgage Market. A numerical example will be constructed to examine the question “Ifthe limitations inherent in the mortgage broker industry were removed, what would bethe increase in consumer surplus.”In summary, this thesis will initially present a review of the deficiencies presentin the mortgage broker industry. Following that, the market structure will be consideredas a whole and an estimation of consumer surplus currently forgone will be provided.Taken together, this analysis will explain why brokers are under used in Canada and theconsumer costs associated with this underuse.3

Chapter 2 – The Mortgage BrokerageIndustry in Canada2.1 - What is a Mortgage Broker?A mortgage broker is an agent that represents the interests of the consumerwhen securing a loan from a bank or credit institution. Their role is to find the lenderwith the mortgage terms and interests rates that best suit the borrower’s needs.Typically, they work independently and do not originate any loans themselves. Instead,they constantly compare rates between the lending institutions into order to establishwhich ones on a given day are offering the best deal. They also have access to privatelenders and broker only institutions that customers would not be able to contactthemselves. In addition to comparing rates, brokers study the lending profiles of variousinstitutions. They learn the types of projects that each institution favours, whether it ismortgages for hotels or low income city townhouses. Matching a bank’s lending strategyto the risk and credit profile of the borrower allows the broker to find the lowest ratesavailable.Mortgage brokers also maintain strong ties with the lending institutionsthemselves which allows for greater negotiating power. Rate discounts can benegotiated on the basis of number of borrowers the broker brings to the bank, thequality of borrowers, and amount being borrowed. Naturally, the more customers thatthe broker matches to a certain bank, the increased likelihood that they will offer aquantity discount to the broker. Brokerages such Quebec’s Multi Prêts Hypotheques4

bring in over 100 million worth of credit to the banks yearly and this allows for a verystrong bargaining position.10 Some smaller credit institutions, such as First NationalFinancial, rely entirely on brokers to find potential borrowers. By working solely withbrokers, they are able to completely eliminate the need for a physical location fromwhich to interact with and meet customers.Another fundamental part of these interactions is the broker’s negotiatingexperience. As they represent the borrower’s interests and receive compensation on atransaction basis only, they are motivated to negotiate the best deal possible.Compensation comes mostly in one of two forms: a finder’s fee from the lendinginstitution for bringing in a borrower, or a commission based on a percent of the totalmortgage acquired. The finder’s fee is the most common form of compensation makingbroker usage a cost free process for most consumers. In the event of a commissionbased broker, the Canadian Mortgage blog puts the average commission at 65 basispoints.11 Brokers are entitled to charge a commission themselves but few forcompetitive reasons.10Paul Kaihla. “Canada Mortgage Broker: If you're looking for a cut-rate mortgage, don'tgo to the bank -- call a broker.” an business.htm (accessed 02 2010).11Ibid5

2.2 - A Young Canadian IndustryMortgage brokerages have been present in Canada for at least the last 50 yearsbut it was only towards the end of the century that the industry began to becomeinstitutionalized.12 One of the earliest associations was the Ontario Mortgage BrokersAssociation (OMBA) which was founded in the 1960s and ceased operations in 1996.13In 1975, the Alberta Mortgage Broker Association (AMBA) was created to maintain “ahigh level of integrity and professionalism” within the Alberta broker community.14 Inalignment with AMBA’s goals, the Mortgage Brokers Association of British Columbia(MBABC) and the Mortgage Brokers Association of Ontario (IMBA) were created in 1990and 2000 respectively. Nationally, the industry was formally unified in 1994 with thecreation of the Canadian Institute of Mortgage Brokers & Lenders (CIMBL) which servedas “the industry voice with government, media and regulators.”15The rise of broker associations had a noticeable effect on how the Canadianbanks use interest rates to entice customers. Economist Virginie Traclet, in her 2005 paper"The Structure of the Canadian Housing Market and Finance system," found that the increasein the mortgage broker and virtual banking industry in the 1990s pushed majorCanadian banks to begin discounting their posted rates on a customer to customer12Lawrence B. Smith, "Financial Intermediary Lending Behaviour in the PostwarCanadian Mortgage Market." The Quarterly Journal of Economics, Aug., 1967: 493.13Mal Eccles, interview by Andrew Williams. IMBA History (February 02, 2010).14Alberta Mortgage Brokers Association, “About AMBA.” 2010.http://www.amba.ca/Default.aspx?tabid 71 (accessed February 2010).15CAAMP. “About CAAMP.” 2010. http://www.caamp.org/info.php?pid 330 (accessedNovember 2009).6

basis.16 Discounts could range from 25 to 125 basis points depending on one’s credithistory, personal relationship with the bank, or personal wealth. However, the effectivemortgage rate (the posted rate minus the discounted rate) remained unchanged in thelate 90s because of the banks began to increase their posted rates to offset theirdiscounting. Traclet notes that as of 2005: “the maximum discounted rate offered bybanks is now broadly in line with the rate offered without negotiation by virtual banksand mortgage brokers.” 17 This statement corroborates the previously presentedtheoretical basis for a mortgage broker's ability to reduce consumer mortgage costsrelative to banks. If consumers can receive low rates from brokers without the burdenof extensive negotiations, they stand to save substantial amount of both money andtime. It is therefore significant that most consumers in the 90s and 2000s did not usebrokers despite the gains they might make.2.3- Recent Trends in the Canadian Mortgage MarketCanada's housing market is currently one of the most robust in the world withover 219,569 million worth of new mortgage credit being extended in 2008.18 Despitethe recent recession, Canadians have embraced homeownership as a long-term meansof investment. In an attempt to stimulate national investment, the Bank of Canada hascontinually decreased target interest rates from late 2007 onwards. One can see from16Virginie Traclet. "Structure of the Canadian housing market and finance system." Bankof Canada, 2005: 417Ibid, 518CMHC. "CHS - Mortgage Lending 2008." CMHC, 2008: 57

Figure 2.1 that since 2007, the average mortgage rates for five year fixed termmortgages has fallen slightly over a full percent.19Figure 2.1 – Average Mortgage Rates1412Interest Rate1086Average 2001200220032004200520062007200820090YearSource: CMHC. "Average Residential Mortgage Lending Rate: 5 Year." CMHC, 2010: 1-2.This decrease in rates has stimulated an increase in mortgage investment by consumers.As seen in Table 2.1, total outstanding residential mortgage credit increased 20% from2007 to 2009. The National Housing Act (NPA) Mortgage Back Securities section of thetable shows a 12% increase over the measured time period. These NPA mortgages arelargely originated from one of the big five banks and then securitized by the Canadiangovernment through the CMHC. There is not a decrease in residential mortgage19James MacGee. “Federal Reserve Bank of Cleveland: Why Didn't Canada's HousingMarket Go Bust?” February 12, ry/2009/0909.cfm (accessed Feburary 2010).8

originated by the banks, rather, there is a decrease in mortgage credit held andsecuritized by the banks.Table 2.1 – Residential Mortgage Credit by InstitutionInstitution2007Chartered BanksTrust and Mortgage Loan CompaniesLife Insurance CompaniesPension FundsNational Housing Act Mortgage-BackedSecuritiesCredit Unions and Caisses PopulairesSpecial Purpose Corporations (Securitization)OtherIn Millions ons l772137100% 930,023Source: Canada, Bank of. Residential Mortgage Credit. CANSIM, 03 08, 2010This increase in mortgage credit however, has largely been contained in a few of thecountry’s major cities: Vancouver and Toronto being the most robust. Influence of thesemarkets pushed average housing prices to the highest they have ever been in the fourthquarter of 2009.2020Tony Wong. “YourHom.ca: Mortgage Debt Soars in Canada.” November 17, le/726557--mortgage-debt-soars-incanada (accessed January 2010)9

Figure 2.2 – Existing Home PricesSource: Canada, Government of. "Canada's Economic Action Plan." Action Plan. 12 02, 2009.www.actionplan.gc.ca (accessed February 2010).Figure 2.2 shows housing prices from the first quarter of 1989 to the first quarter of2009. The last 10 years have been characterized with massive growth in housing pricesin both Canada and the US. The Canadian Real Estate Association reports that whilehousing prices rose 11% in 2009; this figure is heavily skewed by the nation’s mostheated markets.21 This data is consistent with the International Monetary Fund’sfindings that the western provinces are overvalued by about 8%22 when compared to21Alyson Fair. “CREA News: MLS home sales grow stronger in the third quarter.”October 15th, 2009. -growstronger-in-the-third-quarter/ (accessed January 2010).22Evridiki Tsounta. "Is the Canadian Housing Market Overvalued? A Post-CrisisAssessment." International Monetary Fund, 2009.10

the rest of Canada. Controlling for regional variation, the IMF found that “Canadianhome prices presently reflect long-term fundamentals and are close to equilibrium.”23 Itis only in specific cities that the combination of low interest rates and limited housinghas pushed housing prices to their recent heights.2.4 - Housing Bubble FearsDuring the fall of 2009, various media outlets reported fears of a potentialhousing bubble. Traditionally, housing markets follow the overall economic conditionsof the country and one would typically expect a price decrease in the housing marketduring a recession. Despite these pressures, Canadians purchased houses while theinterest rates were low, thereby keeping the housing market strong.Another concern was that if interest rates were to rise quickly, Canada would seea wave of mortgage defaults similar to the 2007-2008 American experience. However,the major Canadian banks and various government organizations were quick to dismissclaims of a housing bubble. The Bank of Canada declared that the interest rate wouldnot rise sharply but instead stay at its current overnight rate of 0.25 until the secondquarter of 2010 before rising slowly as the economy enters full recovery.24 EconomistMichael Gregory of BMO Nesbitt Burns believes that the housing market is on the23Rob McLister, Melanie Mclister. “Canada Mortgage Trends: The Good News AboutCheap Money.” November 2, n mortgage 24TradingEconomics.com. “TradingEconomics : Bank of Canada Holds Rate Low.”January 19, 2010. Rate.aspx?Symbol CAD (accessed February 2010).11

rebound, not in an inflationary bubble. In a recent Globeinvestor interview, he gives hisreasons for this belief:“Discretionary and big-ticket purchases of all types were postponed in the postLehman panic, creating an abnormal amount of pent-up demand Once thepanic subsided, pent-up demand started to unwind, pulled by record lowmortgage rates, cheaper home prices (around 9 per cent on average), and anemerging sense among consumers that the worst of the recession was over.” 25Cities like Vancouver are expensive because of its year round warm temperatures andinternational reputation. It is likely that lower interest rates added to Vancouver’s highprices but they should not be seen as the determining factor.The Canadian Mortgage and Housing Corporation (CMHC) were criticized forrelaxing their standards in their housing insurance appraisals but this was later found tobe largely unfounded.26,27 It's true that CMHC insured more debt than ever before in2008 but both the IMF and the Bank of Canada report that it was not done in a recklessand dangerous way.28 The people taking advantage of the low rates were those that hadsteady jobs and good credit ratings, not the marginal customers that characterized the25Virginia Galt. “GlobeInvester: Three Views on a Housing Bubble.” November 16, .20091116.escenic 1365253/GIStory/(accessed November 2009).26James MacGee. “Federal Reserve Bank of Cleveland: Why Didn't Canada's HousingMarket Go Bust?” Febuary 12, ry/2009/0909.cfm (accessedFeburary 2010).27Rob McLister, “The Good News About Cheap Money.” November 2, n mortgage 28Ibid12

2008 subprime crisis in America. A 2006 CAAMP consumer survey also accessed the fearof default expressed by Canadians and found that only 9% of mortgage holdersconsidered themselves in danger if interest rates increased.29Mortgage brokers during the last 5 years have increased their market presenceby 11% thanks partially to the strength of the housing market. 30 High housing prices inthe most expensive areas of the country have made seeking the lowest mortgage rateextremely important. The difference of even a few basis points can have a massiveeffect on the total cost of one’s mortgage. The recent increase in the use of brokers willbe fully expanded upon in subsequent chapters. In addition, a theoretical demonstrationof the increase consumer surplus achieved by getting a lower mortgage rate will beprovided.2930Will Dunning. "Consumer Mortgage Choices in a Changing Market." CIMBL, 2006: 7CMHC. "2009 Mortgage Consumer Survey Results." CMHC, 2009: 313

Chapter 3 – Critical Issues with theMortgage Broker Industry3.1 - Problems with Experience and Consumer ConfidenceThe inherent individualism of the broker industry, combined with the lacknational standards of education until 2004, has resulted in an inconsistently trained andexperienced workforce. Despite the ability to reduce consumer searches costs andmortgage rates, the inconsistent quality of the individual brokers presents a substantialobstacle to the industry. Various broker associations have increased the industry’sstandards but unfortunately, many young and poorly trained brokers are hindering theindustry’s ability to compete with the banks. While no one has actually measured thedamage done to the industry by inexperienced brokers, there are signs of the negativeeffects they produce.Consumer satisfaction surveys are a possible way of measuring the public'sopinion of both brokers and banks. CAAMP recently commissioned Maritz Research, tofind consumers’ opinions about a range of broker and bank issues. The 2009 reportnoted that despite interest rate discounts, consumer “satisfaction is slightly higheramong those originating with a Bank or Credit Union” rather than with a broker. 31 Inagreement with the Maritz research, the 2009 CMHC Consumer Survey also found that,31Kyle Davies, Rob Daniel. "Fall 2009 Canadian Mortgage Industry Snapshot: KeyFindings." CAAMP, 2009: 1114

on average, consumer’s rate satisfaction to be higher with banks rather than withbrokers.32Despite the advantages of being able to obtain lower rates, brokers are stilllimited in their appeal to Canadians. One possible explanation for this can be found inthe Maritz report's additional findings. The survey found that consumers place a veryhigh value on confidence in the lending institution, rating it just below the highestconcern: “interest rate obtained.”33 Customers confidence in brokers is likely to beundermined by the fact that many brokerages are relatively new and do not have thesame history of reliability that the banks have. While there are a number of wellestablished and experienced brokerages that have been in the industry for many years,the recent success of the industry has encouraged many to become brokers. These newbrokers are of varying quality because their training is limited and their practice time isshort. Broker experience can be therefore characterized in two main ways: limited (newbrokers) and established (experienced brokers).3.2 - Mortgage FraudThe first efforts to improve training and general professionalism in the industrycame with the creation of CIMBL and the various provincial associations. Theseinstitutions sought to redefine consumer’s traditional perception of brokers being a32CMHC. "2009 Mortgage Consumer Survey Results." CMHC, 2009: 1-4.Kyle Davies, Rob Daniel. "Fall 2009 Canadian Mortgage Industry Snapshot: KeyFindings." CAAMP, 2009: 1-16.3315

“lenders of last resort.”34 Compounding this negative perception is the widespreadassociation of mortgage fraud and brokers. Mortgage fraud is defined by the CriminalIntelligence Service of Canada as the“Deliberate use of misstatements, misrepresentations or omissions to fund,purchase or secure a loan. Simply put, mortgage fraud is any scheme designed to

broker usage a cost free process for most consumers. In the event of a commission based broker, the Canadian Mortgage blog puts the average commission at 65 basis points.11 Brokers are entitled to charge a commission themselves but few for competitive reasons. 10 Paul Kaihla. "Canada Mortgage Broker: If you're looking for a cut-rate mortgage .