Canada's Housing Bubble

CD Howe released an interesting commentary on the current role of CMHC in the mortgage market.  It is well worth the read as it not only highlights the potential (and unnecessary) risks to taxpayers, which we’ll discuss, but also debunks the notion that high home ownership rates are beneficial to the broader economy.

On the dominance of CMHC in the mortgage insurance market:

“Dominating the market in Canada means that as of 2010, CMHC insures mortgages worth approximately $500 billion, almost the entire Canadian mortgage insurance market.”

As I’ve noted before, CMHC is the enabler to our current housing addiction.  Absent their involvement, interest rates for the riskiest (and increasingly the most common) home buyer would be higher than for others….as is fair and as has been the case throughout the entire history of banking.  Banks who would put their own capital on the line would naturally ask the borrower who has only 5% to put down and a less-than-stellar FICO score to pay a higher interest rate to compensate for the additional risk.

However when the government (taxpayers by extension) guarantee the loan value, the bank is ensured a profit from the interest payments or securitization fee.   The normal operation of the credit market is thrown out the window and turned on its head.  Thus, the riskiest borrower becomes the safest and is given an artificially low interest rate.

On potential taxpayer risks:

“CMHC’s mortgage insurance book now backstops mortgage lending equivalent to more than 30 percent of (Canada’s) gross domestic product.”

“This Commentary leans toward the view that state involvement in housing markets, while perhaps inevitable in the political sense, creates large risks that need to be suitably managed – and have often not been in the past and present.”

“This Commentary’s message is simple: the Canadian and US experience illustrates some of the large financial sector problems and taxpayer risks associated with government agencies’ participation in the mortgage lending market.”

Let’s put things in perspective.  The +30% of GDP exposure represents a significant risk.  Obviously the entire mortgage portfolio would never turn non-performing simultaneously.  However, with the bulk of insured mortgages being for the maximum amortization length and with anecdotal evidence suggesting that the average down payment of new home buyers is not significantly more than the 5% minimum, it exposes an increasing percentage of the portfolio to negative equity risk.  Negative equity is the number one predictor of mortgage default….even in recourse jurisdictions like most of Canada.

From a more philosophical or moral perspective, it raises the question of why the government guarantees profits for certain businesses but not others.  Banks should be subject to profit risk just as most other profit-seeking businesses are.

On distortions to the economy caused by government involvement:

“Many western countries have public policies that support home ownership on the grounds that homeowners contribute to a stable society through positive ties to community, family and work.

But governments’ activities in housing markets have contributed to distortions in the economy and greater risks in the financial sector, with potentially large costs to the public.

Specifically, governments have stimulated more mortgage lending than markets would otherwise demand and have deliberately extended that lending – particularly in the United States –to households who clearly could not sustain it.”

Whether or not Canadian households can ‘sustain’ current debt levels will become clear when either the credit bubble busts under its own weight leading to a jump in unemployment, or when a rise in interest rates exposes fixed rate mortgage holders to higher renewal costs.

“And the message from the Canadian and US experience is that while federal guarantees against mortgage default may facilitate lending, that guarantee socializes risks that are larger than they would have been absent a government role.”

The distortions are indeed significant.  Housing now represents 20% of our total GDP, a level not seen since the housing bust of the early 90s.

On CMHC transparency:

“The Canadian public neither has, nor can have under current reporting arrangements, a complete understanding of the risks to which they are exposed by way of CMHC’s mortgage lending or insurance activities. Other mortgage lenders and insurers must by law comply with OSFI oversight and regulation with respect to capital adequacy, for example;  CMHC does not.”

The commentary makes some excellent suggestions on how CMHC might improve its current operation to better shield taxpayers from unnecessary risk.  The report is well worth reading in its entirety.

Cheers

Ben