“…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.)
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).