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The Retreat of Housing’s Greatest Ally

OttawaIf you have an interest in Canadian residential real estate, you’ll want to understand what happened on Friday.

In a series of interviews, Finance Minister Jim Flaherty stunned us all by alluding to far-reaching changes to the foundation of Canada’s housing market.

For 58 years, the government has offered mortgage default insurance to qualified Canadians. The idea has been to make homeownership more accessible, which in turn bolsters the broader economy.

Now, the government’s direct support of that insurance is in question and there are potential implications for home prices, mortgage availability and mortgage rates.

Jim-Flaherty-DOFThe comment that lit up headlines Friday was this one from Flaherty:

Over time, I don’t think it’s essential that a government financial institution provide mortgage insurance in Canada. I think what’s key is that mortgage insurance is available at a reasonable cost in Canada. I think there is a role to regulate but whether we, the Canadian people, have to be the owners and shareholders of a financial institution to do this is a question. I don’t think it’s essential in the long run.” (Source: Financial Post)

It’s hard to know exactly what outcomes Flaherty has in mind. What is clear, however, is the Canadian government’s about-face on policies that have created one of the strongest housing markets in the world.

Those policies, in part, have fuelled home values and boosted exposure to default insurance. But they’ve also saved housing from imploding during the worst financial crisis in generations.

Going Private

mortgages-marketWith his comments Friday, Flaherty has put the government’s support of housing finance in doubt. That is despite describing housing risk as “moderate” and saying that it is “not a system that requires change right now.”

This presumably means that private enterprise will eventually assume much more of the housing and insurance risk borne by the government. One can envision a sale of Canada Mortgage and Housing Corporation (CMHC), a reduction in the federal guarantee of mortgage insurance, limits on conventional mortgage insurance, or some combination or equivalent.

In many ways, this is seemingly healthy. For example, one may wonder why a lender has to insure a mortgage against default when the borrower has 20% equity. Other things being equal, that borrower is significantly less likely to stiff their lender than someone with, say, only 5% down.

It therefore seems reasonable that a lender should assume the modest risk of a conventional mortgage, without relying on a government guarantee.

But the reality is that Ottawa’s enormous and diversified balance sheet is deemed far more capable of absorbing this risk than an individual lender’s. And thus far, Ottawa has decreed it a greater good to:

  • Promote home ownership (which our economy is largely built upon)
  • Subsidize mortgage risk-taking
  • Insulate financial institutions (which Canadian depositors and financial markets rely on) from the remote possibility of widespread defaults, and
  • Keep rates and insurance premiums low.

It also cannot be forgotten that CMHC is a profit-generating enterprise. It and its shareholders (we the taxpayers) earn a handsome return from insuring risk, to the tune of $14 billion over the last 10 years. That’s money we’d otherwise have to cough up through higher taxes or fewer government services.

Of course, some of that profit will be consumed if/when mortgage defaults materially exceed forecasts. Such losses, however, should be expected. Abnormally high claims impact all insurance companies and insurers plan for this eventuality. The concern should not be whether CMHC occasionally has losses, but rather how big those losses are.

Incidentally, the new oversight of CMHC by the Office of the Superintendent of Financial Institutions (OSFI) is a welcome change because it gives regulators a much deeper understanding of this exposure. Our only hope is that OSFI will not slash homeowners’ borrowing options in knee-jerk fashion if it deems risk to be inordinate. Hopefully it will instead consider remedies targeted at the actual risk. Those may include increasing insurance premiums or implementing new means-based lending guidelines (instead of blanket changes).

The Actual Risk

Measuring RiskWe must have read a dozen news stories about this topic over the weekend. Most of them included CMHC opponents railing against the downsides of mortgage insurance.

Despite that, not one single critic could quantify how big the risk actually is.

The go-to phrase of CMHC opponents is “taxpayer risk.” They paint a dire picture of Canada’s mortgage insurance system going broke, and leaving taxpayers on the hook for a bailout.

Without quantifying that exposure, however, the words “taxpayer risk” are primarily emotionally-charged rhetoric. No one is in a position to conclude that risk is excessive, or for that matter reasonable, without seeing and understanding all the data.

Unfortunately, public numbers on CMHC’s portfolio risk are few and far between.

(As a side comment, CMHC reporting leaves a lot to be desired. Yes, it’s getting better, but we still don’t have up-to-date statistics on things like debt ratios of high-ratio borrowers, average down payments of first-time buyers, average non-housing net worth of high-ratio borrowers, etc.)

What we do know (based on 2011 CMHC and CAAMP research) is that:

  • CMHC’s stress tests, which the Department of Finance should be auditing very carefully, imply a 1 in 200 probability of insolvency
  • Average home price is $369,677, but CMHC’s average insurance exposure is just $138,716 (as of its last quarterly report)
  • 3 in 4 insured borrowers have more than 20% equity
  • Average loan-to-value (LTV) of a CMHC borrower is 63%
  • 90% of CMHC-insured properties are valued at less than $400,000
  • Only 1% or fewer insured borrowers would have a Total Debt Service (TDS) ratio more than 45% (i.e., in the danger zone) if average mortgage rates rose to 5.00%. (Source: CAAMP research, May 2011)
  • 76% of CMHC borrowers have fixed rates
  • 73% of high-ratio CMHC borrowers have strong credit (i.e., scores >= 700)

In sum, the risk group—which includes those with weak repayment history, high debt ratios, and low equity—is small and clearly contained.

What’s more, as of Q3 2011, CMHC had $17.4 billion in capital set safely aside to cover claims. In a doomsday scenario, CMHC sources have assured us that it could handle obscene prime default rates on the order of 3.00% or more. That’s three times the all-time high of 1.02% in 1983, which occurred after a year when fixed mortgage rates averaged 17.89%. (Arrears today are a mere 0.38% per the latest CBA data.)

In Canada, the average high-ratio borrower pays down at least 2.00-2.50% of principal per year. People don’t like losing assets they invested tens of thousands of dollars in. Nor do they enjoy sleeping on the street. Nor can they avoid paying their lender by defaulting and handing in their keys.

This, and strong qualifications overall, make Canadians very prone to paying their mortgages—even when their home is worth less than what they owe.

The Repercussions of Privatization

financial-marketsThe financial markets take great comfort in our government’s sponsorship of housing. Politicians trying to exculpate themselves from “risk” should carefully consider the repercussions of knee-jerk policy changes.

A move to limit or privatize mortgage insurance could be disastrous if implemented too quickly. Investment in Canadian real estate, and in the industries that support it, would see a substantial retrenchment. Funding costs might also surge as investors scurry to re-price mortgage risk in an uncertain market.

For that reason, some of the short-sighted headlines we’ve seen this weekend (like “Get government out of the housing market”) cannot be taken at face value.

Those who advocate wholesale privatization of our housing system should be careful what they wish for. Removing the government’s guarantee would markedly diminish:

  • Securitization (which the market requires to fund up to 1/3 of all mortgages, and which some lenders depend on exclusively)
  • Insurance coverage and lending in rural or smaller markets
  • Insurance for multi-unit residential properties (a vital source of rental housing)
  • Jobs and economic growth (given that more than one in five GDP dollars – $330 billion – and 1.2 million construction jobs are tied to to housing activity)
  • Support for smaller lenders (Australia is case in point. Its minimal backing of housing finance has allowed the four dominant banks to control 87% of the mortgage market and, to a large degree, dictate rates.)

On that last point, some might question the need for greater mortgage competition in Canada, given all of our credit growth. We’d agree that it’s certainly less of an issue in the current environment (unless of course you ask a mortgagor—for whom paying $1,000-$2,000 more interest over 5 years has an impact).

But fast forward 3-4 years.

Consumers may come to rue the day that their government retreated from the insurance market, effectively signing the death warrants of many smaller lenders. Homeowners would undoubtedly face less mortgage discounting, fewer mortgage options, and higher mortgage-related fees.

For many years thereafter, major financial institutions with large balance sheets would likely be the only ones able to raise competitively-priced mortgage funds in a non-government backed system. Big banks would effectively get a free pass to run over smaller competitors.

It’s also foreseeable that a fully-private insurance market would limit certain borrowing options that people rely on today. Examples include self-employed programs, new-to-Canada programs and the like. Barring that, we’d potentially see insurance premiums increase by thousands of dollars in some cases.

This underlines a key point in this quickly-evolving debate. Structural changes of this magnitude have untold implications and represent a long-term paradigm shift. Officials need to think several moves ahead if they’re contemplating changes of this enormity.

That’s why it’s odd to hear Flaherty saying things like this about CMHC reforms:

“We’re doing these reforms now; we’ll see how it works.”

Well, hopefully it “works” okay.

At times, Flaherty makes housing policy sound almost like a trial and error endeavour. Unfortunately, it’s not. The government has one chance to get this right if its goal for home prices is truly a soft landing.

What’s Next

JumperIn the short term, Flaherty’s comments will, at a minimum, agitate the market. (The market hates uncertainty.)

In speaking with a bank executive from a major dealer last week, he told CMT, “MBS buyers want me to talk them off the ledge of the Canadian housing market,” meaning that many institutional investors believe a substantial housing retracement is looming. Talk of the government curtailing support for mortgage insurance will only elevate these concerns.

Fortunately, major changes do not seem imminent. The Finance Department is closely reviewing CMHC’s mortgage-backed securities business, but Flaherty says: “…Give us another year or so: I think we’ll have even a better handle on CMHC from a securitization point of view.”

The Boogeyman in “Risk”

risk-of-mortgage-insuranceAs ideal as it may sound, it’s impossible to have a riskless financial system. CMHC-critics campaign against “taxpayer risk” but removing the government from Canada’s insurance system doesn’t eliminate taxpayer risk.

If government sponsorship of housing was pulled and housing investment plummeted as a result, it would simply beget a different type of risk. That’s the type that results from the economic drain of a derailed real estate market and tumbling housing wealth. That is a risk that should get taxpayers and property owners really worried.

Despite all the comments above, we believe the government is right to call for more risk assumption by the private sector. Privatizing CMHC’s commercial functions may very well have merit. Reducing its 100% government guarantee absolutely has merit, it’s just a matter of how much.

But removing this guarantee altogether or constraining access to low-ratio insurance will have damaging consequences.

If the government did end up making system-wide changes to default insurance, one could only hope that it would painstakingly model every potential ripple effect. The net worth of 9.5 million homeowner households would be riding on it.

Rob McLister, CMT