Ask Questions First, Regulate Later

Mortgage-RulesThe potential for new mortgage restrictions is again making headlines.

This latest bout of concern is being fuelled, among other things, by:

It’s clear that debt-to-income ratios cannot be left unchecked forever. Eventually consumers will have to reign in credit or the government will do it for them.

The repercussions are undeniable. Unabated debt can put Canada’s economy in peril. If macro shocks occur, high debt ratios mean people have less ability to weather income reductions or home price declines.

Mark-CarneyThe nightmare scenario is runaway defaults. Defaults sparked by economic crises can create a “negative feedback loop” says BoC head, Mark Carney. That occurs when desperate home sellers drive down prices and beget more desperate home sellers.

The good news is that Canada’s regulators are keenly aware of these risks. The BoC, default insurers, and major lenders regularly collaborate on ways to control systemic risk. One important tool is “stress testing” which involves creating “what-if” scenarios using dire economic assumptions.

The BoC, for example, said yesterday that it uses an extreme scenario of 11% unemployment in some of its models. In that hypothetical case, it says defaults would top out at 1.4%. That is bad, but it is manageable. (Insurers stress test for defaults of 3% and up.) By comparison, the U.S. default rate is 8.70%.

If it gets to a point where additional mortgage restrictions are warranted, the government can take either a shotgun or rifle approach. Focusing the cure on problem borrowers, not the entire population, is the more sensible approach.

Blanket regulation, like across-the-board amortization reductions, handicap hundreds of thousands of well-qualified homeowners and lessors. These people may have very legitimate needs for the cash-flow flexibility that extended amortizations provide. Forcing strong borrowers to make less-optimal budgeting decisions serves few interests, and is not what government was intended for.

While we’re on the topic, it’s interesting that amortization changes have been getting so much media play lately. Amortizations alone are a terrible indicator of default risk. Default risk is multivariate, meaning other things come into play, like down payments, debt ratios, credit risk, etc.

An 800 Beacon borrower with 10% down and a 35-year amortization is significantly less risky than a 650 borrower with only 5% down and a 25-year amortization. Moreover, it’s statistically shown that people with high credit scores make more pre-payments. Pre-payments offset extended amortizations.

Targeted solutions work better because they weed out fringe borrowers with the highest probability of default. Solutions along these lines might include:

  • Requiring 2.5%-5% higher down payments for less credit-worthy or more leveraged borrowers
  • Raising minimum credit scores for 90-95% refinancing.
  • Implementing minimum liquid net worth requirements for LTVs over 90% (to cushion against negative equity scenarios)

Until such remedies are required, there are some immediate actions the government can take:

  • Monitor debt and home equity levels closely. You want to ensure people can ride out a 10%+ home price correction and withstand a 3% hike in mortgage rates. The borrower groups who are most at risk must be properly identified and tracked.
  • Encourage lender prudence. Frequent warnings encourage prudent lending. The last thing on earth a mortgage lender wants is a default problem, especially when it’s been warned about repeatedly.

What the government doesn’t need to do:

  • Be swayed by rhetoric. Bank executives who preach responsibility with 25-year amortizations, and then promote interest-only HELOCs (with infinite amortizations) and easy refinancing (with 125% collateral charges), should be taken with a chunk of salt, not a grain.
  • Make rules prematurely. Finance Minister Jim Flaherty stated yesterday, “There is no reason for extreme concern now.” He noted that Ottawa is regularly in discussions with banks about default rates. Defaults are not an issue at this time.Moreover, interest rate increases will have a chilling effect on highly-leveraged consumers. BOC Governor Mark Carney says rate increases and April’s mortgage rule changes are already “beginning to have an impact.” Another 1-2% hike in rates will, to a large degree, self-moderate debt levels, as well as any housing excesses.

    New mortgage rules, if significant, premature and coupled with higher unemployment, could turn a natural and cyclical housing decline into a small-landslide.

    As a side note: Canadian mortgage defaults are minute by all standards. They could easily rise in the face of falling home prices or significant unemployment. There is no question there. Yet, the fact remains that Canada’s full-recourse, government-backed, highly-regulated mortgage system is designed to keep them contained.

What lenders need to do (and are already doing):

  • Be vigilant. Borrowers who are maxing out their allowable debt ratios will become higher risks. Carney says debt ratios are “likely to deteriorate further” and interest rates could impose a “brutal reckoning” on consumers who over-leverage. The guy with 5% down, 44% TDS ratios, minimal savings, the minimum permissible credit score, and high credit utilization could be trouble in the making.

Rob McLister, CMT

  1. I don’t share your comfort in the Bank of Canada’s stress test.
    You say,
    “Blanket regulation like across-the-board amortization reductions handicap hundreds of thousands of well-qualified homeowners and lessors. These people may have very legitimate needs for the cash-flow flexibility that extended amortizations provide. Forcing strong borrowers to make less-optimal budgeting decisions serves few interests,”
    I say: the solution for high prices is lower prices, not longer amortizations. The lax lending standards here are prolonging the bubble and will only make the burst more painful. I understand the political necessity of the government’s actions in recent years, but it will end badly, judging from history.

  2. Hi Former…
    Appreciate the feedback. With the greatest respect, I don’t share the opinion on lax lending standards. Being intimately connected with the business, I see what the lenders approve and decline. I see suspect lending in perhaps 1 out of 100 cases or less. Barring unforeseen fraud, the system has numerous checks and balances to discourage risky lending.
    A tiny fraction of people shouldn’t get the financing they do. That’s been the case since the very beginning of mortgage markets, albeit today it’s more-so.
    However, to say Canada’s mortgage system is lax is quite honestly a generalization that’s not borne out by the data. It would be like me saying all borrowers are strong.
    The data will get worse eventually but the market here is night and day different than the one to our south. Again, we maintain that it’s illogical to impose restrictions on honest borrowers that can pay their debts for the “greater good” of driving down home prices.
    Cheers,
    Rob

  3. We could have taken a 15 year mortgage on our house but chose 35 years instead. We did that to invest the payment savings in our business. I wouldn’t want to lose that option.

  4. I think we have a different perspective of the word “lax.”
    Look across geographies/history and find other banking systems that have lent 95% loan-to-value and gotten away without creating a bubble. I can’t think of any.
    The good news is that — US housing crisis aside — residential mortgages have historically been the safest part of banks’ loan books. It’s the economic weakness that accompanies a housing correction that is something to be feared.
    So perhaps,in a housing correction, Canadians will indeed keep paying their underwater mortgages. But what of the economy overall, and the negative wealth effect, were that to occur?
    One last thing. Ask yourself this: If there was no CMHC, would banks still be lending 95% LTV at such low rates? The CMHC has reduced risk for the banks, and extended the bubble beyond what it would have been.
    It’s like I said in my last post. The cure for high prices is lower prices not longer amortizations.
    Cheers

  5. Be careful what you wish for. Take away government housing support and we lose jobs, home prices fall and we all pay much higher interest rates.

  6. Am I the only one who thinks credit card debt causes problems for more Canadians than 35 year amortisations do…

  7. Why is everyone pretending that 35-year amortizations are such a critical part of the mortgage market… they’ve only been around since 2006!!!
    Please stop pretending that Canadians have a “right” to these types of loans… did all of you complain when 0%/40-yr options went away?
    The housing market needs some serious downside pretection right now, and stopping the highest leverage / longest amortization borrowing is one way to accomplish that.

  8. Hi Stats,
    Absolutely agree with you that people have no God-given rights to anything financial. They earn it by working hard and being responsible.
    Responsible borrowers who don’t pose a risk to others earn the right to manage their affairs as they see fit. Amortization flexibility allows strong mortgagors to reduce risk and/or allocate funds to better uses. Mortgage innovation of this type is made possible only by a free market and should be encouraged to the maximum extent possible.
    Note, this is not to suggest that over-leveraged or high-risk individuals should be afforded these same liberties.
    Cheers,
    Rob

  9. German banks require a 20% down payment. Maybe we should all move there where everybody rents and home prices haven’t risen in 15 years.

  10. Said it before, and I’ll say it again.
    If these loans are so prudent, if the risk of default is so remote, if the people who are taking out these loans are so creditworthy, then let the private sector insure and fund these loans.
    Let those who *choose* to be shareholders in the banks enjoy the profits when things go well and suffer the loss in the event of a default.
    The way it’s set up right now, every Canadian is forced to guarantee the profits of banks and every Canadian is compelled to take a loss in the event of a default.
    That’s messed up.

  11. Hi Encore,
    Even on a theoretically riskless mortgage rates would go up without a government guarantee. Look no further than Canada Mortgage Bonds which trade at a premium to governments, despite having the same credit quality.
    Well-qualified Canadians don’t want to pay higher rates. Moreover, CMHC generates significant profits for Canadian taxpayers. The issue that really matters is credit quality. Those who are high risk should have their borrowing curtailed. Those with minuscule default risk are economically beneficial members of society and deserve latitude with their financial choices.
    Cheers,
    Rob

  12. What is wrong with high prices? I bet you’re hoping the stock market doesn’t go up either. Here’s an idea. If you don’t like high prices sell and rent!!

  13. We do not know what discussion BOC is having with the industry. All we know that they are having a free ride with public money. i.e. 1% overnight on 2% inflation. When they are saying enough to this sweet arrangement then there must be something more to that.
    Nice article Rob. Love reading it.

  14. Very well said. Totally agree with you on lax lending standards, although as you say the CMHC is what is allowing this lax lending (5% down, 35 years, with a downturn imminent or at least likely) to occur.

  15. Let’s see, who does high prices help? The only people it helps are those that are selling their home and getting out of the market completely, or those that are downgrading to a cheaper home. It doesn’t help buyers or anyone who wants to upgrade to a more expensive home. In summary, if you are a first time buyer, or you are someone who wants to upgrade to a more expensive home, high prices suck.

  16. Hi Deborah G,
    Your link posted is ‘interesting’. Here is a link for the case study of Calgary showing a 10% increase in population from 2004 to 2008.
    http://www.altapop.ca/cities/calga.pdf
    There is seemingly no mention of that detail in the graphs showing housing prices in Calgary.
    That study absolutely can not be applied to all of Canada as each city/town in Canada did not have an influx of population growth similar to Calgary. Sorry.

  17. Being in the real estate sales side of things I can say that people are taking on way too much debt. I deal with people all the time who should not be able to buy a house yet they show up prequalified and ready to go. People borrowing for the down payment, getting cash back on closings, I’ve even seen people using their credit card to pay for their lawyer fees. People who are hard pressed to come up with the thousand dollars needed as a deposit to accompany the offer. How this is considered prudent lending is beyond me.
    I look at my parents and the cost of housing when they bought the house I grew up in and it was around two times household income. Now to buy the same house it is just over four times. So what this means is that people are now using up much more of their disposable income just to have a roof over their heads. I fail to see how this is a good thing.
    Housing in Canada has been turned into a “stock market” with people gambling money they don’t have looking for gains. I know many people who are building houses just to turn around and resell them for a profit. The number of speculators in the market is baffling. To hide behind qualified lenders deserve options is disingenuous at best.
    There is a very real problem that has to be dealt with before we fly off the huge debt cliff that these low interest rates and 5% down 35 yr amortizations have created.

  18. Hi Deborah,
    Thanks for the link and kind feedback.
    In these parts we don’t fear an honest debate, especially with a site that calls us “excellent” (before ripping into us). lol
    By our response being “predictable,” I assume the site means we predictably stand up for borrowers, but I’m not sure. ;)
    I won’t retort anything we’ve already covered but I will say this:
    • The fact that long-amortizations weren’t around 5 years ago doesn’t diminish their utility today when used properly. Nor does it mean the government should revert the entire market back to times gone past when only a portion of borrowers are actually at risk. The Finance Department endorsed 35-year amortizations because they served a valid purpose (and no, that purpose was not to allow overleveraging as some irresponsible borrowers have done).
    Tightening up rules for high-risk borrowers may very well be justified if it gives Canadian markets peace of mind. There is absolutely no dispute that many Canadians are living beyond their means. That said, re-imposing unnecessary restrictions on strong low-risk borrowers is completely unjustified from a risk mitigation standpoint.
    • With all respect, the author’s characterization of mortgage insurance is a “bit” off base, and I’m being kind. This topic has been covered extensively in other CMT stories (accessible via the search function). Suffice it to say, government support of the mortgage market benefits Canadians in countless ways, including but not limited to, lower interest rates, lower insurance costs, and a more accessible national housing market. And, no, the word “accessible” isn’t meant to imply that affordability has improved in places like Vancouver or Toronto.
    • Somehow the point about “free markets” got twisted like a pretzel, but that’s fine. The actual point was that extended amortizations were borne out of competitive pressures by private insurers. This very same free market competition also eliminated insurance fees, reduced premiums, and added premium portability—all significant money-saving benefits for homeowners. Had the government fostered an anti-competitive mortgage insurance environment, consumers would be worse off today. A true free market is self-correcting and unaffected by political agendas. Canada will never have a truly free market because a degree of regulation is essential. But let’s hope it stays free enough (from misinformation especially) that deserving borrowers who present minimal risk aren’t penalized with more regulation.
    Cheers,
    Rob

  19. Sorry but that is a really bizarre way of looking at the problem. Yes rates would be higher without cmhc. That’s because the market would demand more to compensate for the risk. And we wouldn’t have this explosion in home values if every Tom dick and Harry was not able to borrow the max at rock bottom rates.
    Low rates on astronomical values is not doing us any favors. I’m all for choice in the market, but the only good solution to this disaster is to get rid of the cmhc
    Lets get the government to manage all our products! After all they could make it cheaper and save us money by withholding profits from the evil corporation. Don’t have to look far to see how well that works.

  20. Per the Bloomberg quotes linked to, from time to time on this site, a 10 yr Cdn “bond” yield is 0.8% higher then that of a 5 yr.
    A longer borrow demands the compensation of a higher interest rate – makes sense.
    By the same logic should a 35 yr amort loan pay a rate premium to a shorter term borrow?
    A borrower could pre-pays or otherwise reduces term to get a lower rate on renewal. Is that utopian?

  21. ls:
    You speak of strong home prices as a negative. I find this far more “bizarre” than anything else I’ve read here. Please share your wisdom into why housing strength is so ghastly a concept. The reality is that most people would much rather live in an economy with a robust real estate market. There are vital wealth effects and employment benefits that Canada would never have otherwise. Without CMHC and its support of the securitization market we would live in a much poorer nation with significantly higher interest rates.

  22. “Housing strength”.
    What a strange way of putting it.
    Yes, the people with houses have benefited from the run up in the last decade, no doubt.
    However, all that did was pull in demand from the future. Now a family looking to get into a house has no choice but to saddle themselves with a mortgage that is far higher than what families were paying 10 years ago. The average house price is over 5 times average income, which by any measure is unafforable.
    The only reason it works is because of CMHC distorting the market, and rock bottom rates. Yes it works for the short term, but overall it is obviously bad policy to encourage more indebtedness for the same assets.
    By your measure the .com bubble was also a good thing. After all, it could be described as “dot com strength” and it made a lot of people very wealthy. The difficulty is of course that that kind of appreciation is not even remotely sustainable.
    Without CMHC and its support of the securitization market we would live in a much poorer nation with significantly higher interest rates.
    We would live in a country without a housing bubble. You can’t seriously argue that our last decade of housing appreciation is sustainable.

  23. Tomas — good point, but also keep in mind that a mortgage term is typically 5 years, so you’re getting the rate reset 6 times over 35 years.

  24. You are forgetting that higher prices boost home equity. That helps every single homeowner in the country. People can use that equity to live off, retire with, spend or invest. My home is worth 30% more than it was 5 years ago. That is allowing me to use my equity to purchase an investment property and generate more income. Rising prices don’t hurt people that want to upgrade. Prices for starter homes and upgrade homes move up together and incomes rise along with home prices. That means affordability for upgraders usually unaffected by rising prices. Obviously this assumes you don’t plan to upgrade from a $300k house to a $1 mil house.
    The only people that have a harder time are the small percentage of first time buyers. My opinion is that first time buyers who can’t afford to buy should rent and save a down payment. There is nothing wrong with that. My wife and I did it for four years.

  25. The “free market” put most of those insurers out of business, yet CMHC remains with its 35-year/5% down offers (even with no competition).
    With CMHC being by far the largest provider in this market, I don’t see this as free market at al1! Who is driving them to offer this to every buyer that comes along?
    Yes – the Teacher’s Pension Plan has snapped up the former AIG (now Canada Guaranty), but I don’t think they’ve made much of a dent in CMHC’s dominant position?

  26. Hi Folks,
    A small request here. To keep on point let’s try to center the discussion on the topic of 35-year amortizations and mortgage regulations. There are other threads better suited for general comments on CMHC.
    Thanks!
    Elizabeth, CMT

  27. Hello Rob
    This is Ben from Financial Insights. As a sort of a ‘peace offering’ let me say that I think you provide excellent advice in general to your readers (hence the endorsement of your site on my blog entry). I do significantly disagree on the role that governments should play in the mortgage market and on the notion that the current market in any way represents a free market, hence my rebuttal.
    I also very strongly disagree with your comment above which indicates that government guarantees of mortgage debt benefit the broader economy over the longer term. But that’s a post for another day.
    As always, my concern is in the aggregate debt levels being propelled higher primarily via new mortgages. The economic impacts of increasing debt levels relative to income and inflation is clear and is a topic I discuss often over at my blog.
    In short, I’m sorry you felt that I ‘ripped into you’. It wasn’t meant as a personal attack but rather as a means of initiating the very debate we’re now seeing on your site.
    Cheers,
    Ben

  28. “evil corporation” LOL
    That tells us everything we need to know about your insight and objectivity LS.

  29. Hi Ben,
    Thanks for the note. One gets a thick skin debating these issues so no offence taken. :) I was being more facetious than anything.
    Both sides have been articulated so I won’t refry the beans, so to speak.
    I will say I’m in 100% agreement with you that debt levels should be reigned in. Our hope is that this happens in the not-to-distant future, and that it happens without removing options for strong borrowers.
    In any event, all the best with your site! You have a terrific writing style.
    Cheers for now,
    Rob

  30. Hi wjk,
    You can always count on full disclosure, but thanks for keeping us honest. ;)
    As Mortgagemaniac notes, the placement fees that lenders pay bank reps and brokers are not geared to the amortization a customer chooses.
    Cheers,
    Rob

  31. Absolutely agree Computerguy!1
    Credit cards and other department store high interest credit is what is hurting Canadians.
    We buy what we can’t afford in the first place, and then pay an exhorbinant amount of interest, driving up the cost drastically, when they couldn’t afford it in the first place.
    People will default on these creditors before the mortgage in most circumstances, so I think this is where our ‘credit issues’ truly lie within our country.

  32. Hi Rob
    Great place you have here, I enjoy reading it daily. I see many are comparing Canada to the USA in many many ways. Also this repeated statements about 35 yr 25 yr this down payment and that have no real value to the Canadain situation. Everyone in this country is examined so thourally to see if they can qualify for ANYTHING that it would be amazing if all these checks turned out to be worthless. The US situation was a scam artists dream come true. The deals made south of the boarder would be impossible in Canada … right? The amount of sneaky deals people signed to get them selves a lower rate mortgage or home with a reduced ARM for one year and then under the idea that they could remotgage to keep a lower rate before they were hit with the bigger rate hidden in their mortgage was, for 70% their downfall. Then jsut look at rates, many many US people said the same thing, 3% became 18%. Over and over through out the USA. I don’t care who you are, if you have a 350k mortgage after your 25% down and inerest rates go up 600% and you have to renew at this same time or have a variable rate that didn’t get ;ocked in, are You going to afford your mortgage at 6 times what you where paying the day before. I am thinking No.
    The real issue in all this isn’t the 5%, 6%, 7% mortgages its when they go to 15% and even if you have NO credit card debt and No car loan, its not going to help. Bottom line, everyone in Canada now has to have 75% downpayment for a house and has to be able to make payments at the 15% to 20% interest rate. No car loans allowed, no CC’s allowed.

  33. See the problem with NOT removing options for the GOOD borrowers and BAD borrows is it is almost impossible within Canada. The government has to draw the broad based line. By design, centrally planned rules will almost always be broadly stroked. This is due to the fact they have no idea about micro conditions amongst each unique borrower. All they are looking is to reduce Y on their charts. In this case Y, is the personal mortgage debt. Sure there are solutions that might be able to precisely sift through everyone and only hit bad borrowers. However, there’s too much bureaucracy behind solutions like that. In this particular case I would much rather have a broad rule to protect the economy in the long term. It’s not like they’re taking away human rights for added national security.

  34. Hi Gary,
    Appreciate the post but I’m afraid I must differ with you. On the contrary, it is quite common to set borrower-specific lending guidelines. The government, insurers, and lenders do it regularly.
    Here are some of the many examples:
    • Loan-to-value maximums based on credit scores
    • Debt ratio maximums based on credit scores
    • Amortization maximums based on loan-to-value
    • Insurance premiums based on amortization
    • Insurance premiums based on loan-to-value
    • Insurance premiums based on income type
    • Insurance premiums based on property type
    • Minimum credit scores for borrowed down payments
    • Qualifying rates based on mortgage term, etc…
    These types of criterion are applied to each of Canada’s 5,550,000 mortgage holders.
    Conditional lending guidelines are indeed the very foundation of any mortgage system. They protect the market and add fairness because more qualified borrowers are granted more flexibility, and less qualified borrowers are restricted in order to reduce risk to the system.
    Cheers,
    Rob

  35. Without CMHC I wouldn’t have a home that I own, I would be paying someone rent and the costs associated very similar? I believe they should bring back 40 yr amortizations for 1st time home buyers only. Thanks.

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