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Skin in the Game

The government’s guarantee of mortgage default insurance “subjects Canadian taxpayers to large, ill-defined risks.”

Source: C.D. Howe Institute Policy commentator, Finn Poschmann

“As long as the government insists on backstopping the risk of high ratio mortgages with taxpayers’ money, banks simply won’t have any skin in the game.”

Source: Fraser Institute Director, Neil Mohindra


Measuring RiskA contingent of vocal critics, like those above, have charged Canada Mortgage and Housing Corporation (CMHC) and the government with taking undue risks on the taxpayer’s dime.

They paint an alarming picture of Canadians being forced to bail out insurers when homeowners default en masse.

Many of their arguments center on the inherent risk of the underlying borrowers. (In partial defense of these critics, affordability and debt ratios have indeed become stretched among limited segments of the population.)

Yet, those we talk to with an inside view of mortgage underwriting question how overblown and one-sided the risk debate has become. By one-sided, it means that legitimate counter-arguments are not making it to the mainstream press in proportion to the negative charges being made.

There is ample evidence to suggest Canadian mortgage risk is well in check. Here are just a dozen such reasons why:

  1. The #1 reason is that Canadians pay their mortgages…through thick and thin—through up markets and down markets. Canada’s default rate (fresh off the presses from the Canadian Bankers Association (CBA) is 0.42%. That means just 42 out of every 10,000 prime mortgagors are behind on their mortgage payments by 90+ days. The all-time high in modern times is 1.02% in 1983. Canada’s arrears rate has remained at, or near, the lowest arrears rate in the world. That’s been true throughout multiple business cycles, including 2008-2009, one of the worst global recessions and housing cycles in memory.
  2. By and large, Canadians with mortgage insurance have considerable equity. 71% of insured mortgages are low-ratio, says TD. That means there is generally significant leeway if a borrower defaults and insurers have to liquidate the property. 87% have at least 10% or more equity, according to CMHC in 2010.
  3. Canadian mortgages are full recourse. That means, if you default, you can’t thumb your nose at the lender and turn in your keys. In most provinces, insurers or lenders will get a judgment to collect any deficiency once they liquidate your property. As a result, strategic defaults (as made popular in the U.S.) are not in the borrower’s favour here.
  4. Canadian lending standards are stringent and carefully monitored by governmental agencies including the Finance Department, Office of the Superintendent of Financial Institutions Canada (OSFI), provincial regulators, and the Bank of Canada.
  5. Debt has risen sharply, but so have assets. Canadians’ asset values “more than swamp the size of their debts,” says BMO economist, Sal Guatieri. As per the Montreal Gazette: “Average household net worth has risen to an impressive six times the size of disposable income.”
  6. Canadian insured mortgages entail a much smaller risk of payment shock than in many countries, thanks to artificially high government-imposed qualification rates, as well as the predominance of 5-year fixed terms. (That said, the risk of payment shock has gone up thanks to the government restricting homeowners’ ability to reset their amortization back to 35 years at maturity. Amortization resets are a last resort strategy for homeowners when rates rise and improved cash flow is required.)
  7. Default insurers are multi-billion dollar enterprises that insure to make a profit. They do assume risk, but that is precisely their business. They get paid well for what they do. In fact, default insurers get paid well enough to build reserves that are 150%-200% of government guidelines, and in CMHC’s case, return billions in profits to taxpayers (thus reducing each and every person’s tax burden). If insurers mismanage risk, they bleed losses and the axe comes down on management. Apart from certain competitive pressures (which make them marginally less conservative), insurers are motivated in every conceivable way to write good business.
  8. Canadian mortgage underwriters are incentivized to avoid undue risk. Underwriter compensation, for example, is frequently linked to low arrears levels. One lender we spoke with last week gears 30% of its underwriters’ bonuses to arrears. (Keeping one’s job is another good motivator for an underwriter.) In short, you can bet every penny that underwriters, as a whole, are strongly encouraged (read, “required”) to approve quality deals.
  9. Insurers perform regular, significant and thorough quality assurance (QA) auditing of every approved lender, from the smallest monoline, to the biggest banks in the land. These audits ensure underwriting standards are being met and due diligence is being properly performed (including employment verification, income validation, asset checks, etc.)
  10. Canada’s rules on proving income are conservative compared to many countries. Unlike our American cousins who loved to rubber-stamp their NINJA (No-Income-No-Job-or-Assets) mortgages, Canadian fulfillment personnel actually look at a person’s documentation and call their employer to verify job status (imagine that!). Even standards for insured stated-income mortgages, which comprise only a small ratio of Canadian loan volumes, are relatively cautious. Insurer sources state that defaults on stated-income mortgages are well-contained, making these products amply profitable.
  11. Insurers are regularly required to stress-test their portfolios, using inputs like extreme unemployment or rapid and unexpected interest rates hikes. These tests include government-mandated hypothetical scenarios designed to “break” the insurer. The results are then reported back to the federal government.
  12. Banks do have skin in the game. In fact, one might say they have pounds of flesh in the game.

Let’s talk a bit about point #12. Critics charge that lenders have no risk in writing bad loans because the government (with taxpayer backing) covers all their costs when borrowers default. That is unequivocally untrue.

There is a major misconception on this point, even among widely-quoted analysts. Neil Mohindra, recent author of a broadly disseminated and critical report from the Fraser Institute, told us: “I am not aware of any costs that mortgage insurance does not cover.”

That is, by no means, an affront to Neil. He was very gracious and helpful in responding to our questions. It’s merely a commentary that certain realities about our industry are beyond the purview of outside analysts.

CMHCAnother case in point was the hubbub that occurred when the media learned that CMHC’s total authorized insurance jumped to $600 billion in 2010. Little did some realize that billions of this cap was earmarked for portfolio insurance (i.e. ultra-low-risk insurance on low-LTV mortgages).

The point is, too many commentators make influential judgments on Canada’s default insurance system without considering its checks and balances.

Lenders are, by no means, Scot-free when they sell an insured mortgage. Here is a sampling of very real costs that mortgage insurance does not cover:

1. When a borrower defaults, lenders are stuck with:

  • Originator compensation costs (often exceeding 40-100 basis points)
  • Hedging costs (often $500 to $1,000 or more depending on the rate hold)
  • Underwriting labour and expenses
  • Labour and expenses for recovery and collections
  • Channel support, marketing, and other client acquisition costs
  • Administrative and servicing labour and expense (TD Bank notes that: “Even with an insured mortgage, the lending institution manages the mortgage, directly handling payment collection, foreclosure, and sale of the home, where applicable.”)

2. Lenders must fork out higher portfolio insurance premiums when default rates are abnormal

3. Higher defaults raise capital costs, which shrinks or eliminates profit margins (Xceed Mortgage showed everyone just how thin insured lending margins have become). Non-bank lenders with above-average defaults, for example, may find it impossible to secure the cost-effective financing required to sell off mortgages to investors.

4. Once ratings agencies (S&P, Moody’s, Fitch, etc.) catch wind of default problems, you can bet they’ll downgrade that lender, which has costly repercussions.

5. High defaults are blasted by equity analysts. That tends to have a decidedly negative impact on a lender’s share price.

6. Most mortgages are held on lender’s balance sheets. Only 29% of mortgages are securitized, according to TD. (See Mortgage Market Primer) Now more than ever, lenders are closely scrutinized. They want only performing loans on their books.

7. Cross selling is a huge profit driver for most lenders. Customers who default cost lenders multiple lost opportunities for revenue in other areas.

8. Similarly, when a lender takes back a person’s home, that lender can kiss goodbye any and all referrals from that customer.

9. Defaults tie up a lender’s capital. The lost-interest revenue can be considerable when calculated over an entire portfolio of arrears. Non-performing mortgages also cannot be financed. Therefore, lenders must keep them on the balance sheet, which entails carrying costs.

10. Customers who default on their mortgage often default on other debt with that lender. This raises lender risk further because lenders are not insured for non-mortgage products (like credit cards, lines of credit, car loans, etc.).

The reality is, Canadian mortgage lenders have a long-term perspective, largely because they bank on retaining quality clients. (For lenders, the second mortgage term is far more profitable than the first term.)

George-Hugh-INGING Direct’s Head of Mortgage Origination, George Hugh, says, “As a bank, I’m not interested in your money for the short term.”

“I don’t look at insurance as offsetting risk. It mitigates risk…but doesn’t offset it. We have valuable relationships with the insurers and we are partners. We don’t view them as a venue to offset risk.”

Defaults are especially feared today because lending profit margins are so tight. Hugh cites a 60-basis point gross spread on some mortgages, which is razor-thin by historical standards. Hugh estimates that lenders must swallow up to 15 basis points in costs that insurers don’t reimburse upon default.

Another key point is that most defaults happen in the first year after closing. “After 6-9 months of payments, underwriting is irrelevant,” one insurer executive told us. Things like unemployment, illness and marital splits then become the primary risk factors.

This 6-9 month default window is a key point because lenders’ costs cannot be recouped that fast. Costs are instead recovered over five years in many cases. As a result, most people who default give the lender little chance to recover its non-insurable costs.

Canadian-Mortgage-Default-InsurersBased on data we were provided by one insurer, bad underwriting is simply not a material risk factor. 70% of that insurer’s defaults occurred when a borrower lost his or her job. Second in terms of impact, were losses from home price declines associated with economic shocks. A distant third, were large rate increases.

Many will look at all of these factors and think, “If Canada’s system isn’t broken, why are people rushing to fix it?” The fact is, additional regulations should be welcomed if they abate risky segments of the market. On the other hand, tinkering with the $2.78 trillion residential real estate market, which represents 1/5 of Canada’s entire economy, has its own serious risks.

Moreover, we can never forget the utility that government housing sponsorship affords us on a national level. Yes, real estate values have been magnified by government support of housing. (Some people love that home prices have been strong and some people hate it.) The benefits, however, include materially lower mortgage rates, added stability in the real estate and mortgage funding markets, added tax revenue, housing research, and vital programs for low-income, rental, senior citizen, new immigrant, rural, and self-employed borrowers…to name just a few.

In fact, in 2008 “over 40% of CMHC’s total business was in areas, or for housing options, that are less well served or not served at all by the private sector mortgage insurers,” says TD. Funding these programs is incredibly expensive and made possible, in part, by CMHC’s considerable mortgage insurance revenues.

Despite the strength of our housing system, that doesn’t mean we shouldn’t strive to make it better.

Ideas-to-improve-mortgage-insuranceHousing critics have proposed various ideas to improve Canadian mortgage finance, and some deserve a further look. Here are a few:

  • Adopting legislation to further support covered bonds
    • Covered bonds are backed by insured or non-insured mortgage assets and by the full faith and credit of the financial institution sponsoring them, as opposed to securities that rely fully on the government’s guarantee.
  • Encouraging insurers to use risk transfer mechanisms to manage exposures, where appropriate
  • Augment reserve requirements
    • Mohindra writes that mortgage insurance is prone to “catastrophic levels of losses.” Internationally speaking, he is right. In Canada, risk levels are far lower. Several years ago when CMHC had a deficit, “$200 million was injected” by the federal government, says Mohindra. (Since then CMHC has significantly bolstered its reserves and underwriting systems.) Contrast that $200 million with CMHC’s $7.3 billion in profits to taxpayers last decade + billions more in additional tax revenue. TD estimates that mortgage defaults “would have to increase by three- to four-fold to compromise the profitability” of CMHC’s default insurance program. (see: Mortgage Market Primer)
  • Subjecting CMHC to OSFI oversight and regulation
    • Presently, CMHC is not under OSFI’s watchful jurisdiction, as are private insurers. A single centralized regulator for all insurers seems intuitively sensible. It eliminates any regulatory advantages and helps ensure all insurers have equal, full, and transparent disclosure requirements.
  • Reducing CMHC’s government guarantee from 100% to 90%, like its private competitors.
    • Mohindra says that a “10% deductible might be enough” to encourage more prudence when lenders underwrite CMHC-insured mortgages.
    • This would certainly level the playing field between insurers, because lenders would no longer have to set aside extra capital for privately-insured mortgages. (See: Mortgage Insurance in Canada: Make it more competitive)
    • An across-the-board 90% guarantee would also mitigate the perceived risk from investors who buy non-CMHC-insured mortgages (this risk premium raises the cost to lenders who use private insurers). We saw how powerful this difference can be during the credit crisis, when private insurer market share plummeted.
  • Higher standards for riskier loans.
    • This is where the government could have got it right, had it consulted the industry further and not succumbed to the bank lobby and one-sided media accounts. By higher standards, we mean tougher qualification criteria for insured mortgages where LTVs and/or debt ratios are high. It does not mean thoughtless blanket regulation that affects impeccably-qualified borrowers and risky borrowers simultaneously.

Despite all the debate and disquieting headlines, Canada’s mortgage insurance system has earned respect worldwide, and for good reason. Scotiabank says: “The structure and micro economic foundations of the Canadian financial system are much different than in the U.S. and the U.K. (as just two examples) and work to limit the downside risks to the household sector.”

Canadian housing emerged from the credit crisis with hardly a scratch. While we do have a measure of housing risk in this country, every mortgage system has risk. What’s more important is that our country has a lending system that incentivizes underwriting and borrower prudence. At the same time, the regime we employ must allow maximum flexibility for deserving low-risk borrowers.

Rob McLister, CMT