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1. If CMHC must announce insurance premiums in advance, and cannot change them quickly without notice, and doesn't know where the demand and supply curves will be, it might be hard for CMHC to hit an exact quantity target by raising insurance premiums. It won't know how much to raise premiums. Maybe that's why CMHC chose quotas over raising premiums.

Couldn't it get around this just by auctioning off the quota at the beginning of the year?

Alex: "Couldn't it get around this just by auctioning off the quota at the beginning of the year?"

Yes. And if it did that the revenue from selling the quotas would go to the CMHC/government, which means a quota would be exactly like a tax (except for the uncertainty of forecasting demand and supply bit).

Good point.

Nick,

Great catch, and great post. My only thought is also your number 3: If they are trying to contain systemic risk, why the *#%^ don't they raise insurance premiums???

"I would need to draw a lot more diagrams to explain why this paragraph is true."

I guess it's not that complex. At the free competitive equilibrium (unlimited quota), the banks make no profit. In the limit where the quota goes to zero, the banks obviously also make no profit. Somewhere in between the profit is maximized (the supply that would be provided by a single monopolist). Assuming there is at least *some* competition in the mortgage sector, the supply is above the profit maximizing level, so restricting supply a bit will definitely increase profits. CMHC is just doing its bit for the "health" of the banking sector.

"I keep wondering if I left my brain on a farm..."

Nope, seems all there.

The quota vs. insurance question is really motivated, IMO, by the political question of whether CMHC should exist as a Crown corporation or not. There is a significant body of opinion that mortgage insurance should be provided by the private sector, not the government; this exists both inside and outside the Department of Finance. A quota is much more direct as an incentive for a private mortgage insurance market to develop. This is what the current Government wants, it seems to me.

However, IMO given that Genworth is underwritten by the Feds at a ratio of 85% demonstrates that unsupported competition in Mortgage default insurance is impossible. It isn't that CMHC exists that creates the market failure, it's the fact there there is a large uncertainty inherent in the market that an economic depression might destroy private sector insurers. It's a glaring example of the fact that the ultimate insurer is the government.

The question is not whether the government should insure mortgage default, it's how much, and if in fact the private sector can provide it more efficiently. The evidence is that they can't.

Nick,

Lets say that there is an asset in the economy that is prone to irrational exuberance and therefore excessive use of leverage (perhaps there is a fundamental need for that asset and therefore a fear of being left without it). And that that asset is therefore prone to bubbling even when the level of interest rates otherwise maintain the rest of the economy at equilibrium.

Given that that asset is occasionally going to crash and lead to debt exacerbated depressions, it makes sense for government to provide mandatory insurance of all borrowing against that asset at a premium rate sufficient to fund the occasional systemic bailing out of said debt in sufficient volume to circumvent said depressions. Such premium rate would likely have to be relatively high, i.e. high enough to discourage borrowing by more than the existence of insurance encourages it.

Alternatively, we need changes to the monetary framework that permits unlimited stimulus in the face of debt-deflation, i.e. unlimited negative rates. Or pro-cyclic land value taxes high enough to eliminate the private value of land. Barring either of those, I'm in favour of high-premium mandatory government insurance.

K: Thanks! Ah, you make me start feeling it's great to be back at it!

Good paragraph explaining my paragraph. I should have thought of that. But it's not 100% complete. It doesn't explain where elasticity of demand and supply fit into the picture. It doesn't explain that (e.g.) if demand is perfectly elastic even a large quota (small drop in Q) would be bad for banks. Plus, the point generalises even if profits (quasi-rents/producers' surplus) are not zero in free market equilibrium. (But it's still good, even if not 100% complete.)

Determinant: I hadn't thought of that angle. But let's suppose you are right, and that the government wants to encourage private mortgage insurers to enter the market. Wouldn't an increase in CMHC premiums have exactly the same effect as a quota in providing an incentive for private insurers to enter the market? The diagram says you get the same Pb for CMHC-insured mortgages either way?

Determinant: "There is a significant body of opinion that mortgage insurance should be provided by the private sector, not the government"

Would mortgage insurance even exist without government intervention?

I always thought that the "insurance" element of the loan should be part of the interest rate, which should be made up of: cost of funds + administrative costs + profit + something to cover default.

If the bank wants to bundle its loans, insure defaults or whatnot to minimize the effect on it of default risk, shouldn't that be done by the bank as part of its back office function and rolled into the price (interest rate) of the loan?

The way it works now, you either qualify for the loan or you don't, and the price of the loan (interest + mortgage insurance) seems to have nothing to do with your creditworthiness, as long as you meet the thresholds [although that might not be true for some categories of higher credit risk]. This seems to be a strange way of running the business of property loans.

I am not convinced that the government intervention in the market does anything to increase home ownership as opposed to just increase prices, which are now capitalized into the system, but given that the gov't is in the market, it can't easily extract itself without causing significant ripples.

Whitfit,

"I am not convinced that the government intervention in the market does anything to increase home ownership as opposed to just increase prices"

I'm not sure if you are familiar with, or even referring to, the Canadian system. If government is an optional, additional supplier of insurance then it could only add to demand, and thus inflate the price of real estate (see e.g. Fanny/Freddy). In Canada, however, government insurance is mandatory for all high LTV mortgages, and therefore, depending on the insurance rate, could either increase or reduce the equilibrium price compared to a free market.

I happen to suspect that the premium rate is much too low which means you are right. But you are not necessarily right.

Honestly, it's all a bit sickening. Here we have the BoC on the record worrying about both a weak economy and an inflated housing sector. One policy rate, two markets! And yet, on the other hand, we have the jokers at CMHC in charge of the perfect, complementary, policy instrument - the mortgage spread - and wielding it in completely incompetent fashion.

Can we just put the Bank in charge of both rates? Now??

Christ!

Nick - thanks for this post, great explanation of the issues.

The "jokers" at CMHC are simply obeying the dictates of the Minister of Finance, their lord and master. If you want to change the premium regime for mortgage insurance, you'll have to talk to the Minister of Finance to get the National Housing Act changed.

Besides, the Mortgage Insurance Rate is not a perfect complementary policy, it targets only high LTV mortgages. Better to just lay a general tax on all mortgages as a percentage of the interest rate. Then you target the whole market equally.

Whitfit:

In the absence of default insurance, the "default" provision in mortgage interest rates is rather high, 2-3%. Defaults or provision for default has to be charged directly to a mortgage lender's capital. Default insurance pools the risk of default against the premiums paid entire industry instead of capital, so the interest premium is much lower (2-3 percentage points off the nominal rate). That's partly why default insurance was instituted.

Nick: An absolute cap directly forces lenders to look elsewhere for insurance. A government guarantee is the best there is, lenders still might pay the rate increase to get a GoC credit backing instead of resorting to the private market (which barely exists as is). Pure politics.

BTW, I may suggest CMHC reform to target the real estate market directly at the next NDP Policy Convention. Thanks K!

Determinant: " If you want to change the premium regime for mortgage insurance, you'll have to talk to the Minister of Finance to get the National Housing Act changed."

Are you saying the CMHC insurance premiums are written into the National housing Act, so you need Parliament to vote to change the law in order for CMHC to change the insurance premiums? (Genuine question.)

Determinant,

" Better to just lay a general tax on all mortgages as a percentage of the interest rate. Then you target the whole market equally."

The best policy option, by far, is the land value tax, which would put an end to real estate bubbles once and for all.

Aside from that, any insurance premium should reflect the expected loss (plus risk premium of course when the instrument has systemic risk). Low LTV mortgages have low expected loss and so should pay lower premiums than high LTV mortgages. I don't think there would be any risk at all to conventional mortgages if CMHC wasn't jacking up the market by subsidizing the issuance of high LTV mortgages.

Given that banks are already subsidised via taxpayer funded deposit insurance, mortgagors are subsidised twice over in Canada, aren’t they? In the UK we have a slightly different form of lunacy: deposit insurance plus the recently implemented “Help to Buy” scheme.

Obviously, IANAL and deciphering laws is not something mere mortals should attempt, nonetheless... A quick peruse of the Act suggests that CMHC sets premiums and the Finance Minister tells them what loans to take, and presumably how many.

Maybe CMHC didn't want to raise rates (for whatever reason), and the Finance Minister fell back to plan B?

Or, as Nick alludes to, maybe the Finance Minister didn't like the optics. Raising premiums that go into government coffers looks like raising taxes and sticking it to first time home buyers, whereas quotas on loans looks like putting the evil banks on a short leash. The banks will gladly play meek and mild because they get a few billion for their troubles, and most people don't realize that the quotas are (probably) a huge gift to the banks.

Given that banks are already subsidised via taxpayer funded deposit insurance, mortgagors are subsidised twice over in Canada, aren’t they? In the UK we have a slightly different form of lunacy: deposit insurance plus the recently implemented “Help to Buy” scheme.

Deposit insurance in Canada isn't meant to protect the Big 5 banks; it's insufficient to cover problems at one of those institutions. It's meant explicitly to promote competition by allowing smaller startup banks to attract deposits on reasonable terms. Deposit insurance is a tax on the big banks to subsidize their competition, since deposit insurance isn't risk-rated for institution size.

Nick,

Your supply / demand curve is a bit misleading. Even with a quota on an individual bank, that does not preclude more banks from springing into existence to fill demand gaps.

"With a quota, that shaded area goes to whoever is given the quotas, because each unit quota is worth the difference between Pb (the price you can sell the good at) minus Ps (what sellers would be just willing to accept to produce one more unit)."

This statement is a bit misleading because it assumes that the supply demand curve looks the same whether there is one bank writing mortgages or 1,000 banks writing mortgages. Why wouldn't the demand curve for mortgages from an individual bank fall to intersect points Ps and Qq? A mortgage buyer would certainly shop around for the best deal and so why do you think there would even be a shaded area for an individual bank to capitalize on?

Are you saying the CMHC insurance premiums are written into the National housing Act, so you need Parliament to vote to change the law in order for CMHC to change the insurance premiums? (Genuine question.)

I'm saying if you want to use default insurance to target the housing market like K suggested, you need to change the NHA provisions because using CMHC premiums in that way isn't contemplated in the Act and therefore is either difficult or impossible.

CMHC and the NHA aren't set up right now to be a junior Bank of Canada.

Premiums right now are set to cover CMHC's costs and earn a profit, nothing else.

Nick,

Looking harder at the supply / demand curve, it appears that the supply curve is drawn the wrong way for mortgages. Mortgages are not inherently supply limited. What would the supply curve look like for a software company that can make 100 copies or 1 million copies of the same software package for nearly the same cost? Close to horizontal after the first couple of hundred probably?

You would expect the same thing for a mortgage lender. You may even expect that as economies of scale take over a larger bank can operate on smaller margins and still stay in business resulting in a downward sloping supply curve.

With a downward sloping supply and demand curve do the two curves intersect at a point where the total value of mortgages exceeds the total market value of the housing stock?

Determinant,

"Premiums right now are set to cover CMHC's costs and earn a profit, nothing else."

Right. And if premiums are set so low they fuel a giant bubble and subsequent bust, they will not be sufficient to cover the subsequent costs. Making sure that premiums are high enough to prevent that scenario seems to be exactly their mandate. Unfortunately they've been to busy fiddling with lending rules, the principle goal of which appears to be to minimize any possible impact on bank profits.

Isnt the whole thing in itself a kind of bail-out? I have never heard of the Canadian system before, but in generel the idea of mortgage guarantees are counterintuitive to me. If I really want people to buy homes, I give them a tax credit for doing so, or maybe even a cash grant. Why on earth would I make the subsidy conditional on them getting financing? Thats kind of weird. And even if we insist on insurance, why not insure the homes itself rather than the mortgages? To me it all seems like a roundabout way of giving out risk free cash.
But maybe there is some incentive or information-selection based reason why mortgages make more sense than going straight to the consumer, however I cant see it.

Alex1,

"And even if we insist on insurance, why not insure the homes itself rather than the mortgages?"

I presume you are asking why a lender cannot purchase insurance on the value of the home that he / she has written a mortgage on? It creates a conflict of interest between the mortgage lender and borrower. Bank makes loan to purchase house and property, bank buys insurance on house, property owner levels house in anticipation of selling land to commercial developer coming to the area, bank cashes in insurance policy on house.

Ralph: in both cases there are insurance premiums. Canadian banks pay for deposit insurance, and Canadians who have CMHC-insured mortgages have to pay a premium to CMHC (typically 1% or 2% of the total mortgage amount IIRC, so it's not trivial). It is not obvious (to me) those insurance premiums are too low, so it is not obvious that deposit insurance and mortgage insurance amount to a subsidy to banks. If past experience were a guide to future risks (it won't be, with low probability big events, because history isn't long enough) we would say those premiums are big enough to cover the expected costs. In other words, it's a judgment call. I don't know if it is a subsidy.

Frank: that's a good point, which I was alluding to in my point 2. I would put it like this: if it is indeed true that you can easily open up a new bank and collect a new $350 per month quota by doing so, then my red quota supply curve will shift to the right as new banks open up, until we get back to the original equilibrium Pfm Qfm. In which case the quotas don't work (except to increase the number and reduce the size of banks).

It seems like the quota rather than raised price is because the CMHC is looking to adjust how banks finance their mortgages, not directly the number of mortgages issued by an individual bank. The premiums are related to mortgage issuance, not mortgage securitization, so raising that price would have the effect of reducing the amount of mortgages issued, but may or may not alter the amount that is securitized.

Neil: good point. I was sort of wondering about that difference. But why would they want banks to keep more CMHC mortgages on their own books, rather than securitising them? And if they did want banks to do this, again, why not a price rather than a quota on securitisation? (And if banks do want to securitise mortgages, a binding constraint on the quantity they can securitise would also reduce the total number of mortgages, not just the proportion that are securitised.)

I'm not entirely certain of the why. If the quota is a result of a finance minister request, it may have to do with some other political goal (Increase supply of bank preferred shares and reduce supply of mortgage backed securities? General fear of mortgage backed securites because of how that blew up in the states?) rather than anything to do with CMHC's risk profile.

It'll probably reduce supply of mortgages slightly, but likely much less than straight up raising the price of insurance, since the mortgage market itself is somewhat removed from the mortgage financing market that the policy is targeting.

As for "why not put a price on securitization," this may have to do with the enabling legislation or the politics. The current government seems to greatly prefer to over-regulate rather than put a price on things, so it's certainly in character.

Nick,

A couple of observations. First, it appears that the $350 million per issuer quota is only a temporary allocation until a new allocation methodology is announced in September (see http://www.cmhc-schl.gc.ca/en/hoficlincl/mobase/upload/AllocationMethodologyforNewGuaranteesofMarketNHAMBS.pdf)

Second, the announcement also addresses Nick's "new" bank idea, because the monthly quota applies to all members of a related group (for example, TD Bank and TD securities are both issuers, it seems that the monthly quota will apply to both of them).

The question seems to be, while is CMHC using a monthly quota ($350 million per issuer) or other allocation methodology to achieve a yearly quota ($85 billion in aggregate). And the answer seems to be that CMHC is unable (perhaps not surprisingly) to accurately predict the demand for securitization (since half-way through the year they've used up 2/3rds of their annual quota - apparently CMHC didn't anticipate the current demand for the guarantee of mortgage backed securities). It's interesting that the announcement of the change also stated that CMHC would be canvassing issuers for information about market demand for the balance of the year (suggesting that CMHC doesn't otherwise know). You might push the question back and ask why set an annual quota, as opposed to charging a higher fee for MBS guarantees, but if the CMHC is generally unable to predict demand for the guarantee, they're not likely to get the price right.

In terms of Finance's objectives, by all accounts it is intended to increase the cost of bank financing (since, in practice, the monthly quota will only be binding for the big banks - CMHC publishes a monthly breakdown of NHA backed securities (http://www.cmhc-schl.gc.ca/en/hoficlincl/mobase/upload/R303c_eng.pdf), the ones coded 975 appear to be the ones the current change is focused on) and therefore mortgage rates. The Globe reported that this change may increase mortgage rates by 20 to 65 basis points. As a way of increasing mortgage rates without either (i) increasing the bank rate or (ii) doing anything politically sensitive (i.e., anything that will get blamed on the government), this is a pretty good way of going about it.

A 20-65 basis point hit seems high, since the underlying mortgages are all insured (meaning that the CMHC's guarantee of the MBS only ensures that creditors get paid on a timely basis - one way or the other, they're going to get paid). Then again, I gather that the "complication" of collecting on the underlying mortgage insurance does give rise to increased credit cost (i.e., the yield on CMHC backed securities are generally higher than government bonds with the same term, despite the fact that they're both backed by the credit of Elizabeth Windsor in right of Canada).

In terms of the distributional effects of the $350 million quota, given that it is only likely to bind for some issuers, it might have the effect of giving an edge to smaller players at the expense of the banks (I'm not sure that's intended or why that might be desired) - so they might increase market share with lower rates. Presumably, though, the expectation is that it will bind the market as a whole, so I take Nick's point that it will result in a windfall for lenders a the expense of borrowers. Politically, though, that's probably better than capturing that windfall through higher fees by CMHC (particularly if the limit only binds the banks - so long as smaller alternative lenders aren't bound by the quota, they might continue to offer low rates, and consumers (or at least price sensitive consumers) can seek them out and complain about the banks).

Bob: very good informative comment, as always.

Like Alex, my first thought was to auction off the quota.

BTW, Does anyone know if CMHC is still selling bulk portfolio insurance? The last time I had a look at the details, it seemed that a lot of insurance was being purchased for conventional mortgages. If banks need to purchase insurance on low LTV loans in order to sell them off, what does that say about their due diligence? Any legal scholars wish to broach the issue of 'fraudulent conveyance'?

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