10% Down Payments & Other Policy Debates

Down-PaymentHousing accounts for an immense 1/5th of Canada’s GDP. That makes mortgage debt and housing policy enormously important topics from an economic standpoint.

With the stakes so high, it’s painful to watch critics exhort blanket changes to mortgage rules, based primarily on their opinions in lieu of credible data.

Case in point is this editorial on down payment size.  The author, Ted Rechtshaffen, advocates a move to 10% minimum down payments because 5% downpayments are riskier. Interestingly, Rechtshaffen sprinkles the word “risk” 10 times throughout his article, without ever attempting to quantify that risk.

His story leads off by proclaiming that CMHC poses a “big risk” to taxpayers. Rechtshaffen asserts, “CMHC would be put in a significantly lower risk position than it is in today (with 10% down payments).”

  • This, of course, begs several questions, including:
    • How “significant” is the risk? The latest figures demonstrate that only 2% of mortgagors have less than 5% equity (Source). Only 9% have less than 10% equity. If home prices fell and those numbers doubled, that alone would not cause widespread defaults. The large majority of insured mortgages have strong covenants, with 680+ Beacons and sub-40% TDS ratios. Regardless of what home prices do, Canadians are not keen on ruining their lives by defaulting on mortgages and having a judgement against them. Borrowers cannot escape insurers like Americans can with their strategic defaults. As they’ve done in many past corrections, Canadians with negative equity will stay in their homes until they build enough equity to move.
    • What is the economic cost of eliminating 95% financing?  5% down payments have been around, off and on, since the 1960s—most recently reintroduced almost twenty years ago. What exactly would eliminating them do to home sales, home prices, employment, consumer spending, and the endless other economic variables linked to housing?  Proposing stricter down payments without addressing these issues is like taking an experimental drug without researching the side effects. Rechtshaffen says eliminating 5% down payments would cause “short-term pain.” You can say that again. But that’s not exactly the thorough analysis such a far-reaching policy recommendation should rely on.
    • Is the risk offset? Insurers love to be profitable, but they care more about avoiding losses. Anyone can find isolated cases where insurers over-exposed themselves, but exceptions don’t make the rule in this case, especially with insurers being under the Finance Department’s microscope. The reality is, Canadian insurers calculate default probability with precision (Canada has the lowest default rate of any major country), and are paid exceedingly well for any risk they assume. If borrowers want to put down less than 10%, they pay 37% higher insurance premiums to do it. If regulators or insurers believed this surcharge was insufficient, they could increase premiums and/or reserve requirements at any time.

Rechtshaffen writes that banks prefer insured 5%-down mortgages versus 25%-down conventional mortgages.

  • Which raises the questions:
    • How accurate is that? Don’t lenders lose money in both cases? The fact is, while default rates are low in each case, they are notably higher with 95% financing than with 75% financing. Moreover, lenders incur meaningful mortgage default losses in either case. Insurance may reduce risk on individual mortgages, but that reduction doesn’t eliminate a lender’s exposure, and by no means does it encourage questionable lending across a lender’s entire portfolio.

Rechtshaffen says buyers with 5% down “can least afford…to take on home ownership…those with only 5% down payment might default on their mortgages.”

  • Which begs the question:
    • Is down payment size all that matters? Of course…it’s not. Would you rather lend to a Doctor/Dentist/Lawyer/Accountant/Engineer just out of school with 5% down, an 800 Beacon score and 35% TDS, or an unskilled worker with 10% down, a 620 Beacon and 43% TDS? Other things being equal, the former is lower risk despite his/her lower equity. There is so much more to underwriting than down payment size. Critics continually ignore this vital point and lump all borrowers into one bubbling cauldron of “risk.”

Rechtshaffen adds: “A significant number of home buyers, who are on the borderline of being able to afford a house, might be saved from a financial disaster” if 5% down payments are eliminated.

  • To which one should ask:
    • How “significant”? According to CIBC, just 4.1% of homeowners have high debt ratios (TDS over 40%) and less than 20% equity. (Click for chart) These, it says, are Canada’s higher-risk borrowers. Yet, given that only a portion of these individuals would default on their mortgages, the ratio of borrowers with high default risk cannot be considered extreme.

*************

It’s easy to pen an essay on “risky mortgages” and play to the hype being propagated in so many news stories these days. It’s not so easy to do honest research and attempt to shape public policy in a way that penalizes bad behaviour and rewards deserving borrowers.

For that reason, the housing finance debate would be more productive if critics, especially ones that have a national media source as their soapbox, would come to bat with research and data.

Many, like Rechtshaffen, are good people with good intentions and we wholeheartedly agree that risky borrowers should be forced to put down more than 5% (in some cases, significantly more). But not everyone should.

The economic and social benefit of permitting well-qualified purchasers to buy with smaller down payments is measured in billions. Roughly half of home buyers, according to CAAMP data, are first-timers—many who haven’t had an opportunity to amass large down payments. These folks account for a vast slice of the $307 billion in real-estate-related spending.

Media outlets should start recognizing their duty to readers and pressuring their columnists to back up influential claims with hard data. Before commentators throw around alarming words like “risk,” editors should make them quantify the risk.

When it comes to mortgage policy, borrowers with high-default probability must be isolated from strong and deserving borrowers. The latter should be left with as many government-supported financing options as possible. Doing so promotes jobs and economic growth with no risk to taxpayers.


Rob McLister, CMT

  1. I think there is room to argue that 5% down mortgages reduce default risk.
    Lets assume I have 45,000 and I want to buy a $400,000 house. If I put 5% down $20,000, use $5000 for legal fees, moving costs, furniture purchases etc and keep $20,000 for an emergency fund that leaves me with an emergency fund equal to 10 months mortgage payments if I loose my job, get sick, … By contrast, if I put $40,000 down then I have no emergency fund.

  2. Most journalists who write about mortgage rules have little if any industry experience. They don’t know underwriting and they sure as hell have no idea what kind of applications are being approved or declined. I’ve never taken guys like Rechtshaffen seriously with respect to mortgage commentary. It takes more than a mutual fund and marketing background to understand this business.

  3. One point that is missing here: 5% down mortgages make it ridiculously easy for anyone to borrow the downpayment (every major bank offers a “Cash Back” mortgage option, and some even up to 7% back).
    If you make the down payment 10%, the buyer would have at least needed to save *something* before buying.
    Buyers who’ve never been able to save a dime in their lives are a risk – they have to make significant lifestyle changes to get in the routine of paying that mortgage.
    When you have such a low down-payment requirement to get in, and you now have about 70% of all Canadian households owning property, you’ve definitely included riskier borrowers into the market.
    If you change the down payment to 10% or even 20%, you make buying a house a long-term decision, and not some instant gratification that is available to virtually everyone.

  4. Mr. Rechtshaffen is the atypical, uninformed, opinionated, headline grabber. He and Garth Turner should go on tour…call it the Uninformed Tour of 2011.

  5. Excellent response, now if only we can get the policy makers to listen to us. Thanks for your consistent insights!!!

  6. Are you really serious?
    Have you taken into account what *if* ever the home prices reduce. A 5% drop would wipe the equity, and any further would start to put your mortgage into Reverse.. then would you be willing to put money towards paying your mortgage, where you own more than house value is? Just ask some 10%-12% home owners in US, how they feel.
    Once you do some research into it, lets revisit the question ‘does 5% down reduces default risk’

  7. Hi Stats,
    Cash-back down payment (CBDP) products do seem at odds with the tighter lending rule movement. While they represent a very tiny slice of overall volume, it’s somewhat surprising that they haven’t been targeted yet by the Finance Department.
    One could argue that lenders assume the risk of the cash back (since it’s not insured), but at the same time, CDBP mortgages have a higher probability of negative equity and entail higher interest and payments–which impact debt ratios.
    It’s worth noting, however, that lender underwriting is notably tougher on CBDP mortgages. Therefore, I’d be hesitant to agree that it’s ridiculously easy for anyone to get them. :)
    Cheers…

  8. ComputerExpert’s hypothesis seems to have some merit.
    Patiently – have you considered that there are extremely different laws between Canada and the States when it comes to strategic defaults?
    Try walking away from an insured mortgage and see how that goes for you.

  9. Great write up and commentary Rob. Having worked in the housing industry for many years I know that when it comes to assessing mortgage risk CMHC pretty much sets the gold standard. Mr. Rechtshaffen should also know that CMHC is not taxpayer supported, its mortgage insurance business is supported by insurance premiums in the same manner as any other insurance company and it is in fact one of Canada’s most profitable crown corporations. One would expect individuals such as Mr. Rechtshaffen to know the limits of his expertise less his qualifications be seen as those of an individual whose education exceeds his abilities.

  10. Using CMHC ‘s cost of insurance as a guideline, it would appear that CMHC sees 5% downs as “riskier”. But also CMHC does have huge (historical ) data to define whether the risk, and premiums associated with that risk, are adequate, and they have adjusted, from time to time their premiums to reflect associated risks.
    As anecdotal “evidence”, to add to the discussion, I had just under a million dollars of second and third mortgages held under management in the early ( and that was the “risky” 90’s,) when prices in real estate dropped dramatically. It was interesting that all my third mortgages, with little to no equity initially, were all maintained with perfect payments, while those seconds with 15% or more ( initial) equity were the first to cry “I cant handle payments” when their (net) equities approached zero. It seemed that those with smaller equities actually wanted to protect their homes, where those with larger (initial) down payments were less desirous in maintaining payments on a house with no (net) equity. In fact many wanted to “give up their home” so they could go and buy back in at lower values. So their inability to afford was investment based as opposed to ability to afford based. Yes, not scientific and NO, doesn’t mean thirds (with no equity) are better than seconds (with equity) but it does suggest that risk is more than just downpayments, and yes more than GDS ratios.

  11. Same with the skip a payment schemes. How can the banks get away with what essentially extends a 30 year mortgage to 35 years when the government has removed that option on insured mortgages.

  12. The laws aren’t as different as you might think. The number of US states that have lender recourse outnumber those that are non-recourse, and include Flordia, Nevada, and Michigan. (See the web url for more info).
    In regards to cash flow, CompuerExpert’s idea might have some merit, but I’d argue that if it wasn’t for the 5% down rates the place he wanted to buy would be less expensive.

  13. I tend to agree with your overall point that if you’re going to make an argument for or against, you need the data. As usual, I don’t agree with most of the rest :)
    Borrowers cannot escape insurers like Americans can with their strategic defaults
    This is a tired argument and not true. Some of the hardest hit states in the US have recourse mortgages, just like most provinces in Canada.
    Canadians with negative equity will stay in their homes until they build enough equity to move.
    Disregarding of course all the people that are forced to move by death, divorce, or employment changes.
    5% down payments have been around, off and on, since the 1960s
    This is very interesting. I was not aware there was a period of 5% down back then. Does anyone have more information about this? Do they mean 5% down and CMHC insured? There’s a big difference between a bank deciding to allow 5% down of their own accord and a government backstop of 5% down.
    If regulators or insurers believed this surcharge was insufficient, they could increase premiums and/or reserve requirements at any time.
    If this was a free market I would agree with you, but it’s not. When the overwhelming majority of the insurance market is government backed, you can’t make an argument about the free market setting appropriate insurance premiums to compensate for the risk. The fact that there is no significant private competition is a very strong indicator that the rates are artificially low.
    Moreover, lenders incur meaningful mortgage default losses in either case.
    You know that the losses from a default on an insured mortgage and an uninsured one are not in the same ballbark. Your statement that the vastly reduced risk does not encourage questionable lending does not follow from this argument at all.
    As for the number of risky borrowers, I think you have to look at the big picture. 70% ownership rate, higher price to income than ever and higher than the US reached. The big picture does not match the story of everyone being responsible.
    The economic and social benefit of permitting well-qualified purchasers to buy with smaller down payments is measured in billions.
    I take issue with this. Of course if you look at the recent decade of house price explosion, the effects have been positive. The wealth effect of appreciating housing has stimulated the economy greatly.
    But of course this cannot go on forever. Consider the steady state (arguably we have reached it now). Is it really beneficial to the economy that the average house price/income sits at 5 instead of 2.5? Of course not. All it does is expose everyone to much higher interest rate risk.
    15 years ago, a $20k down payment got you a $100k house. Now, a $26.8k (20k inflation adjusted) down payment will allow you to borrow half a million. Not exactly a surprise to see what prices have done.
    Loosening regulations is done with good intentions, but the desired effect of more affordable houses are always just short term. In the long term you end up with affordability the same and extremely elevated risk.

  14. Hi Robert
    Great piece. I do think there is a fundamental question that you have left unanswered: Why does housing represent 1/5 of Canada’s GDP, which is well above its historic norm and at the level consistent with other nationwide corrections in the past?
    How/why did it get to these levels? Is it sustainable at these levels? To answer yes is to embrace the ‘this time it’s different’ mantra that has left so many economists eating their words. Why is it different this time?
    If the answer is no, there are significant economic implications that should be explored.
    I’m curious to hear your answer.
    Cheers,
    Ben

  15. This is technically not true. Canada Mortgage Bonds which are made up of CMHC mortgage backed securities are backed by the Government of Canada.
    Furthermore, in the event that CMHC’s capital is depleted by a rise in delinquencies, it is the Government of Canada who is implicitly on the hook.

  16. @ Patiently….waiting
    No all people are looking for short term flip. My family purchased our home to LIVE IN for 10+ years. Over longer terms, appreciation takes care of itself.
    I didnt buy the home I live in to generate revenue. I didnt buy the home to get a large HELOC so I could buy my token BMW 3 series.
    5%, 10%, 0%, the rules are the rules, and you will always find people to dispute the rules.

  17. Someone needs to walk over to this ____’s office and smack the ____ out of him. Why journalists continually write about topics they have little or no knowledge on is beyond me. He is an uneducated ____.

  18. LS,
    Thanks for stoking the debate. As usual (with respect) I must disagree with your disagreements.
    Re: Lender recourse – Canadian and US recourse laws do not compare well because of the state-by-state differences. Numerous states, including problem states like Arizona and California (CA on purchase loans), do have anti-deficiency statutes that prohibit lenders from seeking judgments.
    Re: Negative equity – Obvious exceptions are implied. Canadians have been through various “crashes” over the years and default rates during those periods were quite manageable. Barring death or insolvency, people with negative equity have a strong economic incentive to find a way to stay in their homes.
    Re: A “free” insurance market – It is wholly inaccurate to dismiss Genworth, and to a much lesser extent CG, as viable private competitors. Both CMHC and lenders would disagree with that assertion. Moreover, government involvement is all the more reason that regulations will be tightened when necessary. All the major lending restrictions enacted since 2008 were government imposed, and regulators are now as vigilant as ever.
    Re: Default costs – I’d invite you to read this article again: Mortgage Default Costs. Feel free to post your own calculations of lender default losses on a conventional mortgage with 20%+ equity, versus a high-ratio mortgage with 5% equity. The fact is, lenders have more than sufficient economic motivation to avoid defaults in either case, be it an insured or uninsured mortgage.
    Re: Economic impacts – I’m glad we agree on something, namely that well-qualified borrowers have an important stimulative economic impact. If the government pulls the rug out from under qualified first-time buyers, the result won’t be pretty. In a market due for a correction, a soft landing should be the goal. A 10% down rule could lead to the opposite, which is partly why the government hasn’t enacted one.
    Nobody expects home prices to rise forever. At the same time, the government cannot change policy every time someone thinks there’s going to be a correction. Critics’ opinions of home values differ from the market’s, which is skewed by a few metro markets. There is no argument that prices have escalated considerably, but prices are driven by demand–which has risen–and affordability–which has stayed roughly the same over the years. (On that note, have a peek at this chart from RBC.)
    P.S. You lost me with your down payment point. 15 year’s ago the average home price was $151,755 and 5% down was available to first-timers then as well. Hence, $20,000 down could buy you a $400,000 house technically speaking.

  19. Ben. I’m very curious about your data. Would you be able to post your data showing:
    a/ The “historical norms” for housing spending, as a ratio of GDP?
    b/ The historical “levels” that are “consistent with other nationwide corrections in the past.”
    Thanks
    Mike

  20. Kenny,
    Good point, although I’m sure the person in this example (see web url) might do things differently in retrospect.
    Obviously in a declining housing market, bankruptcy is something that anyone with negative equity will take a hard look at. I’m also sure the vast majority of borrowers with the ability to service their debt will continue to do so when weighing the alternatives.
    I don’t see Canada experiencing the same catalysts for drop in value that the US did. Especially over such a short time period (1-2 years). If nothing else, I think any price declines here will be a lot longer and more orderly than some people are forecasting.

  21. Numerous states, including major ones like Texas, Arizona and California (CA on purchase loans), do have anti-deficiency statutes that prohibit lenders from seeking judgments.
    Of course that is true. I’m just saying it’s not a black and white issue and just the fact that lenders have recourse in Canada does not mean it will eliminate defaults (although it does reduce the rate somewhat).
    Barring death or insolvency, people with negative equity have a strong economic incentive to find a way to stay in their homes.
    Certainly the desire to stay is there… Whether that is enough.. Not sure but I won’t argue this, like you say, precedent is on your side.
    It is wholly inaccurate to dismiss Genworth, and to a much lesser extent CG, as viable private competitors.
    Not sure how you can call them private when they are backed 90% by the government.
    All the major lending restrictions enacted since 2008 were government imposed, and regulators are now as vigilant as ever.
    But you have to consider how drastically those rules were loosened in the previous decade.
    The fact is, lenders have more than sufficient economic motivation to avoid defaults in either case, be it an insured or uninsured mortgage.
    I don’t think we can make a determination about what is “sufficient”. Certainly the risk and loss is less on an insured mortgage. Unless there is a banker here I don’t think we can say whether that difference affects their risk tolerance on loan quality in any way. Happy to see some data though.
    A 10% down rule could lead to the opposite, which is partly why the government hasn’t enacted one.
    I agree it is too late to backpedal now. At this level of bubblyness, enforcing 10% would be a disaster.
    15 year’s ago the average home price was $151,755 and 5% down was available to first-timers then as well.
    I was under the impression CMHC didn’t allow 5% until 1999 as stated here: http://www.cmhc-schl.gc.ca/en/corp/about/hi/index.cfm
    Although it mentions a pilot, the extent of which I don’t know but assume was limited as is the nature of pilots.

  22. Hi LS, Wish I had more time to debate with you further. A lot of it boils down to semantics and I’ll have to leave it at that for now.
    Two quick things…
    I believe Texas does have recourse so I take that back. I saw TX in a non-recourse list but called one of our lender contacts down there to be sure, and he says they do.
    He notes, however, that “laws are one thing, but lender enforcement is another.” Depending on the circumstances, American lenders in hard hit recourse states often do not pursue a deficiency judgment, and strategic defaulters seem to realize that.
    Re: Private insurers. Genworth and CG are private because their capital and operations are funded by private sources, not the government. The government may ultimately guarantee their claims, but that is a minuscule probability and GE and CG would have to burn through billions in capital first. The guarantee does not reduce their desire to manage risk properly because insurers that make billions in profit usually like to remain solvent. :)

  23. Just my 2 cents as an uninterested party(directly anyways), I would prefer to see 10% dp’s, but that ship has sailed. Problem with 5% down is that a buyer holds nearly no equity, minimum 5% equity should be imposed. Anyone buying should be made to pay CMHC fees up front with no cash backs. If the market does “correct” itself 10 to 20% as some are calling for, there will be a lot of temptation for those with high debt levels and 1% equity struggling to make a mortgage payment to bail. Either that or make cmhc mortgages be underwritten properly. If someone is carrying high consumer debt levels, perhaps they need to be looked at a bit closer rather than using a cookie cutter approach to underwriting.

  24. Quote:
    “make cmhc mortgages be underwritten properly. If someone is carrying high consumer debt levels, perhaps they need to be looked at a bit closer rather than using a cookie cutter approach to underwriting.”
    Broc:
    You imply that CMHC doesn’t underwrite properly. #1, that is baseless. #2, could you entertain us with evidence to support your statement? #3, you are commenting about a topic that seems over your head. If you truly understood the lending process you would know that insurers already apply much stricter criteria to consumers with high debt levels.
    I don’t mean to be difficult, but it just irks me when people take a stand without facts.

  25. Hi Ben,
    Thanks for dropping by. Appreciate the comment.
    This story’s GDP reference was to show what’s riding on housing policy decisions. The question you pose is a very interesting one, but not one this particular story meant to answer.
    That said, I took a cursory look today at the figures we have on housing spending vs. GDP. The data I have goes back only 20 years but I’d hesitate to compare today to pre-1990 anyhow. Low interest rates and accommodative lending are a relatively recent phenomenon and have been significant factors in deviations from long-term averages. So many things have changed since the 70s and 80s. The Bank of Canada only started inflation targeting in 1991, for example.
    Anyway, here is a chart of housing expenditure to GDP. I don’t know the exact average but it’s around 19% over the past 20 years. The latest data we have puts us a little over one percentage point above that.
    As for judging sustainability, I’d need to be able to predict interest rates and employment, neither of which I can do. What I do know is that strong employment is good for housing, as are low rates.
    On the other hand, for every 1% that rates rise, affordability drops by roughly 9%, and affordability is what’s keeping the party going. In turn, when rates head up I’d certainly be concerned about prices in a few major markets.
    Cheers…
    Rob

  26. Scratch that question. $770 billion refers to owner occupied mortgage. The balance must be investment properties bringing the total up to $1000b.

  27. Because banks can do whatever they want to do in the free market. The government should have no say on conventional financing rules.

  28. Also remember when you say housing is 1/5 of GDP remember can’t only be attributed to housing going up but could also be reflected in the other 4/5 of the economy slowing down (ie. manufacturing) such that housing makes a greater contribution. For this reason reason I would argue this isn’t the bester indicater of the housing market along with the popular price to income ratio, which also includes the income of renters.

  29. Hi Dave, Housing as a ratio of GDP is definitely not the only or best indicator. The 1/5 ratio was only noted to illustrate housing’s contribution to the overall economy.
    Cheers…
    Rob

  30. By “taxpayer supported” I presume John means CMHC is not taxpayer funded. That is a fact. CMHC pays its own way and has returned billions in profits to taxpayers in the last decade. CMHC earnings have padded the federal treasury and kept taxes lower for everyone.

  31. Problem with 5% downpayment? People put their downpayment on a credit card. Just like I did (bonus miles on cash advance). Unfortunately, not everyone buys a house that is exactly the same price as their yearly after tax income or pays off that credit card within a week, just like I did.

  32. Really? If that’s your true opinion, then you have absolutely no business in this business. I’m all for the sharing of opinions, but please don’t make comments just to be a tool.
    Furthermore, if you took any time to consider the implications of your proposal, you’d never have posted this in the first place.

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