Let the Consultation Begin

Consultation-FB“…Lenders have, as I’ve said in the past, no skin in the game and therefore the incentives are misaligned with good risk management.”

This quote, from CMHC CEO Evan Siddall, encapsulates policy-makers’ narrative on Canadian mortgage underwriting. This is what the public is reading about Canada’s housing market—and it worries them, but it shouldn’t.

(Siddall later told me that he misspoke, and that lenders do have skin in the game, but “not enough.”)

Siddall asserts that lenders are prone to moral hazard. “You would not design an insurance system with the insured having something more at risk.”

He adds, “Canada’s mortgage insurance system is one of very few, if any, insurance systems without a deductible.” He says our housing market is “not a well-designed system,” asserting that “a lender should not offload so much of its risk.”

“This is about aligning interests to face an unknown future with a more ‎robust system. It’s more about regime design, not current conditions.”

And so, he and the Department of Finance have what they think is a solution. After two years of CMHC preparing us for this inevitability, regulators have released a proposal whereby lenders eat more losses on government-guaranteed mortgages.

Here’s what we know about it so far, based on high-level industry conversations and yesterday’s announcement from the Department of Finance (DoF):

  • How risk sharing will likely work: Lenders would file a claim with the insurer when a borrower defaults, the insurer would pay 100% of the lender’s claim (if eligible) and then bill that lender for its share of the loss in the following quarter.
    • This would leave securitization investors insulated from risk, a wise move that avoids utter destruction of the NHA MBS market.
  • How much loss would lenders share: The amount would equal roughly 5% to 10% of the outstanding loan principal. That’s $15,000 to $30,000 on a $300,000 mortgage.
    • We’ll bet on the lower end of that 5-10% range for two reasons: a) Anywhere near 10% would be hugely disruptive for lenders, and b) regulators like to sometimes throw out big numbers so the market is thankful when they impose a smaller number.
  • How would it affect competition: The DoF writes, “Lender risk sharing could change competitive dynamics in the mortgage market.” Could? Whomever drafts this stuff has comedic talent. Reducing insurance coverage will hammer competition even further, potentially costing Canadians hundreds of millions in extra interest each year.
    • Here’s another statement from Friday’s release that might have been drafted by Captain Obvious: “Small lenders with fewer or less cost-competitive funding sources may…be less able than large lenders to absorb or pass on increased costs.”
      (I’m sure some policymakers would suggest we’re making implicit assumptions about the future here; that need not be true. But I don’t see how an RBC and a small monoline lender could possibly weather these changes equally.)
    • Insurers and funders buying mortgages will now have lender counterparty risk (i.e., risk that the lender won’t be able to pay its share of claims). Potential outcomes:
      • Insurers may increase premiums disproportionately for smaller, less capitalized lenders.
      • Funders may buy mortgages from smaller lenders at much less favourable prices, limiting their ability to compete.
    • How might consumers fare: Here’s what we expect:
      • Mortgage rates will shoot up as lenders try to offset this new cost, and as bank challengers become less able to undercut the banks.
      • Lending will partially dry up, or incur material surcharges, in rural, remote, high-unemployment or economically undiversified areas.
      • Insurance premiums may drop (one potential bright spot in all of this).
    • How much could rates jump: In short, meaningfully.
      • The DoF writes, “Preliminary analysis suggests the average increase in lender costs over a five-year period could be 20 to 30 basis points.1 (That’s over five years.)
      • Preliminary estimates from four lenders we spoke with are that the DoF’s estimates are laughably low, that the rate increase required to offset these changes is at least 15-20 basis each year.
      • The DoF suggests rates could rise more for “loans with lower credit scores in a region with historically higher loan losses.”
    • When would this take effect: We’ll get more clarity on this by Tuesday, but the final regs could be out before next summer, and it might take another 1-3 quarters to implement.


Is This All Justified?

Canadians are taking on too much debt. No question about it. And extreme housing prices in Toronto and Vancouver are flashing a red alert.

But this proposal isn’t about that. According to the feds, it’s about future underwriting quality and aligning lender incentives.

The government and CMHC charge that lenders don’t have enough reason to avoid risky lending. Yet, to the best of our knowledge, the Department of Finance has never publicly released any data to support this. 

In fact, CMHC’s own numbers peg insured NHA MBS arrears at a paltry 0.28% for banks (five times lower than in the U.S.), and a microscopically low 0.11% for mortgage finance companies (MFCs). 

The Charges Against Lenders

Officials claim that lenders aren’t sufficiently motivated to underwrite prudently, yet the government possesses the ultimate hammer already: It can deny insurance claims if lenders don’t underwrite to the exact specifications the DoF itself has created.

Officials say that lenders can’t be trusted to avoid moral hazard, but the government can easily compel regulated insurers to audit lenders and police underwriting effectiveness. Heck, if they’re not audited enough, audit them more.

Officials assert that arrears data are a “rear-view” indicator, but we’ve had decades of low arrears. How many years of rear-view indication do we need before we can start believing it?

Officials charge that the housing finance system hasn’t been tested yet, but what kind of test was the worst financial crisis since the Great Depression?

Officials warn that debt-to-income is at an all-time high, but lenders must already decline heavily indebted borrowers that don’t meet federal guidelines.

Officials downplay equity as a risk mitigator, but who loses money on a 75% LTV bulk insured mortgage?

Officials argue that MFCs get a free ride on taxpayers’ backs, but Ottawa is riding on lenders’ backs at the same time, through lender-paid insurance premiums, securitization guarantee fees, socioeconomic homeowner benefits and a more robust economy that generates higher tax revenue.

Officials charge that indebted borrowers are a risk to the mortgage system, but credit quality has soared since 2007 with 81% fewer sub-660 credit score borrowers, reports Genworth.

Officials suggest MFCs are “unregulated” and prone to fraud, but you don’t get arrears rates averaging 1 in 300 by turning a blind eye to fraud. (Of course, “unregulated” is a gross mischaracterization since, by virtue of their securitization activities, MFCs are subject to bank and insurer underwriting rules in B-20 and B-21.)

Officials argue that these moves encourage the further development of a private mortgage funding market, but where is this mythical market they speak of, what is Ottawa doing to cultivate it and how will it address the huge spread differences between bank-sponsored covered bonds and uninsured RMBS from lenders without investment grade credit ratings?

Officials say there’s excess risk to the economy, but withdrawing insurance support risks future liquidity crises, surging interest costs, less discretionary spending, employment losses in the economy’s #1 sector, a further entrenched bank oligopoly, falling equity in people’s #1 asset, wealth-loss effects and so much more.

Officials claim government-backed insurers have too much risk, but why not increase insurance premiums like every other insurance company in the world when risk is unacceptable? (Hint: It’s because insurance premiums are already actuarially too expensive for the true risk. That’s a fact by the way—if you believe CMHC’s own regulator-approved stress tests.)

Mandate Creep

The government has overstepped its mandate by stripping Canada’s world-class mortgage finance system of liquidity. Its incessant attacks on competition and mortgage choice can only result in higher costs for consumers, and the purported benefits don’t counterbalance these costs.

Consider taxpayers’ risk:

  • Ottawa guarantees roughly $774 billion of insured mortgages.
  • Arrears have averaged less than 1 in 300 (five times less than south of the border).
  • Average equity on CMHC’s insured mortgages is 46.8% (contrary to public perception, insured mortgages are not all high-ratio) and just 1 in 5 CMHC-insured borrowers currently have less than 20% equity.

Consider taxpayers’ reward:

  • CMHC has returned $20 billion in profit to taxpayers since 2006.
  • Insured lenders have saved consumers over $3 billion of interest in that time frame.

This is a question of cost-benefit, and Finance has simply not made its case. 

Suppose for a moment that Canada’s housing market gets annihilated. Imagine a U.S.-style housing catastrophe where an astronomical 6% of all prime insured mortgages go in arrears, with a 33% loss on each—again, insured mortgages have built-in equity buffers so 33% may not be realistic. That amounts to a $15-billion hit on insurers. (In reality we must assign a probability to a housing crash, so implied future losses are potentially less than this.)

But wait. CMHC alone has $16+ billion in capital plus more in unearned premiums. Moreover, Moody’s research pegs insurer losses in a U.S.-variety crash at less than half our estimate, or $6 billion.

Will a tail event burn through insurers’ capital someday? You bet your sweet bippy it will, just like the most expensive hurricane of all time (Katrina) ate a chunk of Allstate and State Farm’s capital. But you don’t complain about tail events if you’re in the insurance business. You price for them.

So let’s review. The current system has yielded over $23 billion in benefits to Canadian families and, housing armageddon notwithstanding, nothing is coming out of taxpayers’ pockets. 

Are Regulators Pulling the Wool Over Canadians…?

Objective data provides no economic rationale to dismantle what is arguably the most stable housing finance system in the world. Loss sharing is “a solution in search of a problem,” explains First National’s Stephen Smith, and he’s dead on.

Even banks—who could gain on rivals if this rule passes—challenge Ottawa’s rationale. “We don’t understand what a deductible is intended to achieve as a policy outcome,” Canadian Bankers Association policy expert Darren Hannah said. “If it’s supposed to be something to improve the quality of underwriting, well the quality of underwriting is already very strong.”

And, by the way, the government is not proposing “risk sharing” here. It’s proposing “loss sharing.” There’s a difference, because arguing that lenders incur no risk is an uninformed position that ignores their exposure to claims denial, loss of “approved-lender” status, loss of funders, loss of securitization conduits, loss of investors, losses for default management costs, loss of irrecoverable lender-paid conventional insurance premiums and loss of vital renewal and servicing revenue.

Penalizing lenders and consumers will not reduce defaults materially because lenders themselves are not a significant reason why borrowers default. Defaults are a function of unemployment, economic shocks, housing price shocks, overindebtedness, personal disposable income, interest rates, borrower confidence, loan-to-value ratio, loan amount, loan purpose, mortgage age, mortgage term and rate type—most of which can be underwritten for.

If a small group of mostly unelected policy-makers want to nonetheless force Canadians to pay thousands more for a mortgage, at least foster securitization alternatives that alleviate the disproportionate burden on small and mid-size lenders, and preserve consumer savings through competition. 

As it stands, the DoF is picking favourites, issuing press releases embracing competition while simultaneously destroying it, and costing consumers far more than they’ll ever save.


Sidebar: Yours truly doesn’t purport to be Merlin the Mortgage Policy Wizard and have all the answers. So if you see things differently, give us your take here. Just one humble request, and that is to keep posts civil and supported by fact. We won’t waste readers’ time by publishing comments that are rude or baseless.

Sidebar 2: Special thanks to the class acts on the Department of Finance and CMHC media relations teams. We’ve widely and publicly questioned their organizations’ policy choices but the professional folks over there always cooperate when we need answers.

1 A very rough estimate of the amount rates have fallen due to competition from brokers and insured lenders, and $1.8 trillion in mortgage volume over the past decade. A Bank of Canada study in 2011 found that “the average impact of a mortgage broker is to reduce rates by 17.5 basis points.” This, interestingly, approximates the broker’s advertised savings today (i.e., if you compare the lowest advertised 5-year bank rate, minus 10 bps discretion, and the average rate advertised by 100 of Canada’s most prominent mortgage brokers, as tracked by RateSpy.com).

  1. It’s easy to for lenders to lend cheap and easy credit since CMHC/taxpayers are taking all the risk. Go find funds in the open and free market…You the lenders , thanks to CMHC are reasons why we have housing bubbles in Canada. It’s all thanks to cheap and easy credit that we have debt to income ratios of 170%. The fact is money would not be so cheap if taxpayers were not taking the risk so it distorts the true value of risk.

    1. “It’s easy to for lenders to lend cheap and easy credit since CMHC/taxpayers are taking all the risk.”

      If you think getting a mortgage in 2016 is “easy,” you need to brush up on today’s underwriting guidelines, Tony.

      Regarding taxpayers taking all the risk, you must have skipped over most of this story.

      “Go find funds in the open and free market…”

      It is duly noted that you prefer bank domination of consumers’ mortgage choices and substantially higher borrowing costs for Canadian families.

      You the lenders, thanks to CMHC are reasons why we have housing bubbles in Canada. It’s all thanks to cheap and easy credit that we have debt to income ratios of 170%.

      By your logic, factors like organic population growth, income and employment growth, supply limitations, immigration/foreign buying and declining market interest rates have nothing to do with valuations. That’s quite a claim Tony. By the way, falling market interest rates (which are totally independent of CMHC and “taxpayers”) are a key housing demand catalyst. How would you propose we address that “problem?”

        1. According to the CDIC website they say “We are funded by premiums paid by our member institutions and do not receive public funds to operate.”

          This is the least publicly supported insurance company in Canada. I’m not sure if they have ever even had a major claim.

    2. Tony, lenders and CMHC aren’t the driving force behind the housing market growth? Its called low interest rates as well as supply and demand. Economics 101. Cost of funds are low, and your suggesting that the lenders increase interest rates and keep the yield, not passing it onto consumers, isn’t what we as Canadian home owners would wrap our arms around. The entire mortgage markets’ pricing is based on actual cost of funds. When banks take in deposits and pay little to zero interest rates on those deposits, are you suggesting they should lend out at a much higher cost and keep the gains and not pass them onto the consumer? That could have actually happened, if there wasn’t strong competition in the market, called mortgage monolines.

      Furthermore, Rob very well articulated the actual risks in the mortgage market. In Canada, versus the US, because we are so heavily regulated, we actually underwrote (and very very well, our mortgage borrowers, to ensure they qualify and can pay.

      Here is an important question we need to consider, where is the $20billion of CMHC profit going to come from when the mortgage market falls off a cliff? Is this government going to balance its budget and cut programs to offset it. No, it’s coming out of yours and my tax payer dollars. Lets not buy into the scam or inaccurate head lines of government backed mortgages. We should be calling our MPs , shouting from the roof tops, before equity is eroded across the country, banks earn more yield, borrowers pay more, GDP falls off a cliff, rental market pricing soars, and job losses in 6- 7 provinces begin to soar.

  2. Rob, thanks as always for great reporting and analysis. Mortgage Brokers, this is the second phase of the battle: risk sharing. We had no notice of the first attack but we have been given a full disclosure on this one. If mortgage brokers, brokerage owners, monoline execs and super broker bosses don’t want to take a stand on this one we have no one but ourselves to blame.

    Here’s what’s wrong with risk sharing:

    No need for it: Stephen Smith said it best: a solution in search of a problem. Siddall’s theory is there is some thing inherently wrong with a system that works beautifully. Clearly unless he has a hidden agenda, he should be able to produce a ton of sound reasons to make this change based on past history, current danger or financial forecasts. Oh but wait, what do we hear: crickets. His main reason as stated is: “no other counties do it” okay and that is important because……..? Our policies need to look exactly the same as other countries because………….? Okay so much for that one. is there a danger to the tax payer based on sovereign guarantees? if there is, show us the projections, the stress tests, let’s see all of it. Because as Rob says, the numbers would indicate no such evidence exists.

    Consumers pay higher interest rates: Why not put that front and center: Mr. Siddall appears to think that is a good idea, so let him make that part of his message. Let’s find out how much the politicians at who’s pleasure he serves think that is a welcome message to the Canadian people. Higher rates may stop a housing bubble but there are also 20 other methods to use to accomplish that goal without increasing mortgage rates. When you increase mortgage rates every single Canadian who just wants to renew their mortgage pays more. Those millions of people who have hardly seen any increase in their wages for the last 5 years will lose the one thing that helped them get by: lower mortgage payments.

    Harms only one part of the industry: Monoline lenders and therefore mortgage brokers. Why make a change that only jeopardizes one beautifully performing part of the mortgage industry. Better arrears rates then the banks, likely more exacting underwriting because insurer good will is so critical it the monolines existence and the huge benefit of providing choice to consumers which to Rob’s point would appear to save the consumer 17 basis points of interest, year in, year out.

    Let’s be clear on this: risk sharing is a policy that harms consumers and if Mr. Siddall believes there is a clear and present danger to tax payers that requires these rule changes to occur let him first open his books, show us his projections and stress tests and let’s have everyone dig in and verify the facts.

    Mortgage Brokers, wake up, do not be lulled by the effective response our monoline partners have made to the first round of rule changes, do not mistake today’s rates and programs for what may come later next year when the lack of bulk insurance on refinances raises rates and curtails capacity. We must take a political stand now before it is too late.

    1. Finance doesn’t think there’s no problem, nor does the Bank of Canada. The message has been fairly consistent (if not always completely explicit to the layman) through two governments, two BoC governors and three Finance Ministers. If you want to fight this thing, I think you need to recognize that Ottawa wants lower home prices and less debt on household balance sheets, and they intend to make it so by reducing access to mortgage credit. Saying that this is a “solution in search of a problem,” (or “We don’t understand what a deductible is intended to achieve as a policy outcome,” Darren Hannah at the CBA) won’t get you far. Suggest solutions that help improve the lot of your industry (compared to where you’d otherwise end up, not where you were three months ago) while also accomplishing the government’s obvious policy objectives.

      1. Finance’s policy objectives make no sense. Why should home prices be lower in Sudbury or Trois-Rivieres or St. John or Kamloops or Medicine Hat or Prince George or Halifax or Red Deer? There is no justification for it whatsoever. These rule Nazis think they know everything and listen to no one but themselves. They are doing irreparable harm to the market and to the net worth of every homeowner outside the 416 and 604.

        1. Because Canadians’ balance sheet problems aren’t confined to our largest cities. If people living in those areas can’t qualify on a 25 year mortgage at 4.6%, or they want 30 years because cash flow is too tight at 25, they’ve got big city affordability problems.

      2. There is a problem: property valuation bubbles in two cities. There are a host of fair, equitable and effective methods to deal with this issue that do not raise rates for folks who want to just renew their existing mortgages at better rates.

        Qualify 5 – yr fixed conventional mortgage at 4.64%.

        Reduce conventional amortization for purchases over $500K to 25 years.

        Eliminate mortgage insurance on purchases over 750K.

        That’s just 3 there are at least an other dozen additional tweaks so please do not suggest mortgage brokers have no interest in dealing with overgrown debt and property value bubbles. Just don’t dismantle a program that works so well for Canadians who want lower rates when there are so many other solutions.

  3. Merlin, (yes, you are Merlin!) . excellent article and objectivity Rob, as always. One important additional point is the recent changes, along with the proposed risk sharing are going to hit first time home buyers the hardest. Given these loans have the highest default rate and lowest equity coverage, they will have the highest deductible costs. If the key policy element of government backed insurance is to support first time home buyers in helping them obtain homeownership, the loss sharing proposed will hit this segment the hardest, forcing them to stay in a non existent rental market. Watch rental rates rise!

    All of these unintended consequences & potentially huge negative impact ….and .. .are as a result of an uneducated , inexperienced government making changes to control lending , real estate market & home ownership

  4. Arrears rates are frequently cited on this blog as a reason to maintain status quo. Yet the government has chosen to ignore the arrears rate argument.


    What’s your thoughts on their thinking process? What’s their motivation?

  5. Those measures, while necessary, could have some unintended consequences and backfire, Aubrey Basdeo, head of Canadian fixed income at BlackRock Inc., said in a phone interview from Toronto. “If I were a policy maker, I don’t think I could sleep at night because you never know what shock you’re going to have to deal with and you have very few arrows in the quiver.”

    Well said Aubrey


  6. Your argument seems to boil down to two opposing points:

    1) underwriting standards are strong and historical arrears are low, so lenders don’t need a deductible
    2) imposing a deductible will be a huge strain on lenders and consumers and largely raise mortgage costs on an annual basis

    How do you reconcile this? If the mortgage industry doesn’t fear losses and has confidence in the historical figures, why raise rates on account of a deductible they don’t expect to pay out?

    On a sidebar, would you advocate for a complete elimination of taxpayer supported CMHC insurance given that in your opinion underwriting standards are so strong and arrears data supports such low expected future defaults?

    1. Hi Steve, I wouldn’t quite oversimplify the arguments to that degree, but to answer your question, mortgage lenders fund themselves in the open market. While underwriting metrics (and not just 90-day arrears, but early defaults, denied claims, credit scores, debt ratios, etc.) are rock solid, there’s always the theoretical risk of a tail event that sends unemployment soaring. It’s like P&C insurance. Every year there’s a tiny chance of a category 5 hurricane and insurers (e.g. State Farm) price for that, which is why they’ve been around almost 100 years. That’s where credit ratings really matter by the way. No lender, not even our world-class major banks, will ever have the same credit strength as the government of Canada. So the market upcharges to provide capital to lenders, especially smaller lenders. Without the sovereign guaranty, market spreads would be prohibitively high for virtually everyone but the Big 6, and crush competition. Of course, there are also other factors that make deductibles costly, not the least of which are capital requirements.

  7. This is very well written, Rob. You spent a lot of time on it. Thank you. Comments are also very good.
    I have nothing of substance to add.
    This is starting to feel like the run-up to George W’s invasion of Iraq. The only sensible person in the cabinet was Colin Powell, who warned “If you break, it you own it.” I am getting an increasingly dire sense that the Liberals are going to own something quite nasty.

  8. Rob, well written as always.

    What the Government is not telling the public is that they are not willing to hold themselves accountable on the key element that will assist Canadians in all respects – that is jump starting our economic engine. An improved economy not only will drive a higher likelihood of lifting rates from rock bottom over time, will improve job creation, and also increase household income over time to only name a few. If addressed through reforms or investments that will introduce additional housing supply to the GVA and GTA, it will yield even further benefits and will address rising house prices in those respective areas. Rather, the Government decided to deflect the unknowing Canadian’s attention towards their tightening of mortgage regulations simply for optics and instead of addressing the underlying problem

    On the topic of household indebtedness, I often find an unwarranted level of focus on mortgage lending contributing to the overall household indebtedness and where opportunistic for the Government to bubble up this statistic in order to support their position on mortgage lending/housing prices. What is often left out is regulatory reform surrounding unsecured creditors. When was the last time lending guidelines were tightened for credit card issuers?

  9. I believe CMHC is the #1 reason house prices are so high in this country. As a broker myself, it’s hard not to be a little biased with all the new changes on the horizon. But high home prices are not a good thing for Canadians. Our government wants to take a step back to more traditional lending practices, which seems fair to me. Yes, it may hurt mono-lines and brokers in the short term. When the market crashes all Canadians are ultimately at risk, and I don’t see this as a positive thing. Lenders should share some of the responsibility for losses, and higher interest rates aren’t necessarily a bad thing. Higher costs = lower housing prices which is what most people want. Fortunately our government is nimble and taking initiatives in the right direction.

    What’s ultimately wrong with balance sheet, free-market lending practices? I believe our government should allow banks to give conventional mortgages to anyone they choose to. 25-35% down, self-employed with low reported income, 5-10 properties owned, no problem. In my opinion, the government is way too involved in mortgage lending. Our government ultimately likes to make money (ie people paying higher taxes) to keep things chugging along. This is likely getting in the way of the free market and prudent lending practices.

    Of course lenders won’t be happy with risk sharing.. Its like having car insurance with $0 deductible going up to $1000 deductible upon renewal. But don’t you think the person who crashes the car should be somewhat responsible for the accident?

    It would be nice if brokers could be on the same playing field as the banks. This is not the case and it sucks that the Big 6 dominate as much as they do. I’m confident, however, that brokers will have at least one bank to fund conventional mortgages through moving forward. Broker volume is just too high for all banks to close the door on us.

    Canadians (and brokers) will be fine. We are a resilient bunch.

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