Canadian mortgage debt

I feel bad about writing too many abstruse theory posts. How many angels can dance on the head of a monetary pin?

Here's something more practical. Think of it as a companion to Livio's post about Canadian house prices. Why would we worry if Canadian house prices are overvalued? One important reason (though not the only one) is that if house prices are overvalued that is one reason (again, not the only one) to expect they might fall. And if house prices fall, people with large mortgages might have negative equity, and this might lead to defaults, and problems in financial markets.

For American readers especially: let's remind ourselves that Canadian mortgages are mostly recourse mortgages, so you can't just hand in the keys to the bank and walk away from your mortgage to escape negative equity. But nevertheless, if you can't make your monthly mortgage payments (because say you lose your job), the ability to sell your house for more than the mortgage (or for the bank to sell it for more than the mortgage) still matters.

Most headlines about household debt just talk about average debt. As I have argued in the past, average debt is a next to useless measure. This is more than just saying that averages don't tell the whole story ("my hands are burning but my feet are freezing so on average I'm just right"). When it comes to debt, the average tells us even less than it normally does.

For every dollar borrowed there's a dollar lent. Credits=debits. Average net debt (debits minus credits) must be zero by definition (OK, for a closed economy). The representative agent, who personifies the average, does not borrow from himself.

Debt must be disaggregated across the population. Some people borrow from other people. Some have positive debt; others have negative debt. What we need to do is look at the whole distribution of debt across the population. Or, more precisely, we need to concentrate on one tail of that distribution. Concentrate on the people most at risk of default. Those will presumably be the people with the highest debt to asset ratios, or the highest debt service to income ratios. Or, better still, those who have both a high debt asset ratio and a high debt service ratio. Because if things go wrong, they won't be able to make the monthly payments, and won't be able to pay off their mortgage by selling the house.

And I'm very glad to see that Will Dunning, chief economist of the Canadian Association of Accredited Mortgage Professionals, has done just that (pdf).

This to my mind is the most important paragraph in his survey (page 32):

"Thirdly, most of the home owners with mortgages have substantial amounts of
housing equity. Most of those who might face unaffordable increases in mortgage
costs could solve their problems by selling their properties. Among those for whom
the estimated tolerable interest rates are below 5%, an estimated 11% have less than 10% equity. This very small group – representing about 25,000 households – would have the least ease of selling out of a problem. 6% (about 10,000 households) have 10-14.9% equity and 13% (about 25,000) have 15-19.9% equity. A substantial
majority (69%) has 20% or more equity."

In other words, he asks 'how many households are most at risk because they have both a high debt service ratio and a high debt asset ratio?'. And he answers: '25,000 households'. He could be wrong of course. But at least he's asking the right sort of question.

I have no special expertise whatsoever in evaluating Will Dunning's Report. I worry about the response rate to the survey data he relies on, and whether there might be any response bias. But apart from that it looks good to me.

Someone reading this must know more than me. What do you think?

Comments

[Jacques René Giguère]

The Caisses Populaires Desjardins group has published last november a study about Quebec household at risk.The methodology might be more reliable. Anyway , it gives graeter numbers.

in french
http://www.desjardins.com/fr/a_propos/etudes_economiques/actualites/point_vue_economique/pv1102.pdf

and english

http://www.desjardins.com/en/a_propos/etudes_economiques/actualites/point_vue_economique/pv1102a.pdf

[Nick Rowe]

Jacques: Yes, that's a good study. It too insists on disaggregating, and looking at the tail of the distribution with the highest risk. But what i especially liked about Will Dunning's study is that he looked at the joint tail -- those with highest debt service and highest debt asset ratios.

High debt/income is not a problem, if you have low debt/assets. High debt/assets is not a problem, if you have low debt/income. It's when you have both high it's risky.

I don't know if any others have done the same thing, in looking at the joint tail?

[Determinant]

What, a macroeconomist sorry for posting abstruse theory?!? What will be next, a repudiation of aggregation as a method of economic analysis? Is that the Four Horsemen I just saw trotting up the driveway?

I'm not surprised the at-risk group appears to be of manageable size. Canadian banks and other lending institutions didn't lose their heads loaning money to anyone with a pulse, they always applied the Total Debt and Net Income rules for mortgage affordability. Which is not to say there won't be pain, but the pain will likely be in line with the experience of recent recessions and not the Great Depression Again experience of the United States.

[jesse]

Hi Nick, one thing to consider is while the distribution matters as to who will default, it also helps to remember that prices are set by marginal buyers and sellers. Imagine a situation where a market is filled with 97% low-debt-ratio homeowners and 3% high-debt-ratio homeowners. Due to some trigger, whatever it is, the profligate homeowners are forced to liquidate, either by choice or by necessity, but the market is depressed and relatively illiquid. Who sets the market price? There can be large fluctuations in price with a small amount of stock changing hands, so while the distribution may matter in terms of breadth of distress, a large breadth of distress is not necessary to precipitate substantial price drops at the margins.

[Nick Rowe]

Determinant: Best laugh I've had today! Let's hope you are right about the banks.

jesse: good point. (When you say "price" I assume you mean "house prices"?) Yes, that is a worry. A small rise in interest rates causes those high-risk owners to sell, but that same rise in interest rates means that potential buyers can't afford to buy at the prevailing price. Also, a small group of high risk owners are forced to sell, which pushes price down, which forces others to sell, etc.

But my reading of the Report says that only a minority of new mortgages are low downpayment. Though, whether those are the marginal buyers remains an open question.

[Frances Woolley]

Nick, as you rightly point out, mortgage debt in itself is not a problem - one can't always walk away. So why are people so worried?

Think about the life of someone born in 1940 or earlier - someone who is retired now. A few people went to university, most didn't, but in any event most got a job pretty much straight away, and by the end of their 20s were married with a steady job, a mortgage, and kids. Sure, it was tough for a few years paying the mortgage and raising a family on a not-huge salary - and the story was slightly different for those who came of age during the great depression.

The point is, by age 50 to 55, a person born in 1930 or 1940 could generally count on having the kids out of the nest, and having the mortgage more or less paid off.

That gives 10 to 15 solid years to saving before retirement. Oh, and people used to have employer pensions.

Since that time
- more and more people are going to university
- student loans are getting bigger
- people are entering the labour force later
- they're entering the housing market later
- they're having kids later
- and houses are getting *much* more expensive.

Put that all together and do the math - it's entirely possible for someone to be 65 and still not have their mortgage paid off.

***But it's not the mortgage that matters.***

It's the fact that, until the mortgage is paid off, you're highly unlikely to be able to put aside any substantial amount for your retirement.

[Mike Moffatt]

There's one factor that, IMO, trumps all of those:

Average new house size in Canada, 1945: 800 sq ft.
Average new house size in Canada, 1975: 1075 sq ft.
Average new house size in Canada, 2003: 1800 sq ft.

Which is even more remarkable when you consider how the size of the average family is falling.

We bought the smallest new house we could find (1350 sq. ft.) and it's still significantly larger than the 1950s style ranch house I grew up in.

[Mike Moffatt]

Good discussion of the house size issue here.

[Mike Moffatt]

Also, I think the student loan issue is often exaggerated. Here's why:

In Canada, there are roughly 250,000 graduates a year (Source). For the roughly 60% of students that graduate in debt, debt levels are around $22 000 (source).

In Canada, there are over 1.5 million new cars purchased per year, the vast majority of which are financed (source). I can't find Canadian figures, but in the U.S. the average car loan is $24,864, roughly the same amount as student debt: (Source).

While we'd all like to have less debt (who wouldn't), a university education is a remarkably good deal and doesn't depreciate like a car does. Yet a rough back-of-the-envelope analysis shows that car debt dwarfs student debt.

[Patrick]

Frances: "one can always walk away"

Is that what you meant to say? CMHC loans are recourse... (well, the bank is backstopped by CMHC and then CMHC sues the borrower to be made whole).

[Ian Lee]

Nick:

1. re recourse in Canada - while this is technically legally correct - I did not know any Mortgage Manager anywhere in Canada (when I was a Mortgage Manager in late 70s and early 80s) who, having foreclosed on the house and discovering a shortfall, then launched a legal action against the debtor for the residual (nor do I believe any Mtg Mgr would do so today). Although some may believe the humorous stereotype of bankers as hard hearted, callous people waiting for the opportunity to harm a powerless, vulnerable Canadian, in fact, banks and bankers in Canada have always been very sensitive of their public reputation. Moreover, the 250,000 Canadians across Canada in chartered banks are ordinary middle class members of their communities (as are the 250,000 employed in all facets of insurance, credit unions, caisses etc).

2. at the depths of the 1980-81 recession (and after) when mortgage interest rates shot up from 10.5% to approximately 20%, the reported mortgage delinquency ratio increased from .5% to 1% of mortgages across Canada (measured by percentage of mortgage dollars outstanding - not units of mortgage debtors). Note that credit card and consumer loan delinquencies increased very dramatically at this time - but mortgage delinquencies barely moved.(and the few that could no longer afford the mortgage payment were quietly, gently advised by the Mortgage manager, that perhaps, it was in their best interest, in order to keep their good credit rating, to sell the house, liquidate their debts from the house sale and return to the housing market at a later date when rates declined).

3. CIBC Deputy Economist Ben Tal did a very nice analysis of Caandian mortgage indebtedness - The Mortgage Market — The Long And Short Of It - last year and concluded (similar to CAAMP and to me) that the actual number of mortgages at risk from increases in interest rates, was small. Indeed, about half of all homeowners have no mortgage while another 25% possess substantial home equity. Those at risk are overwhelmingly young people, starting out, who bought a home in the last 5 years, with the minimum downpayment.

4. approximately 70% of the $1.5 trillion debt owed by Cdns is mortgage debt, offset by a long term asset i..e the home. The more interesting side of the consumer balance sheet is the assets side reportd by the BoC at $7.5 trillion minus $1.5 Trillion debt = net worth of approx $6 Trillion.

The $6 T net worth is comprised of approx $2 trillion in home equity, $2 trillion in pension assets and $2 trillion in business investments outside of pension plans.

5. The final point is an intangible. Canadians have an almost religous attachment to their home and will do anything to keep it, including stopping payments to other creditors. That "intensity of ownership" can only be measured indirectly through e.g. delinquency ratios of 1% when mortgage interest rates reached 20%.

The key difference between the US and the Cdn mortgage houisng system is that Cdn mortgage borrower must have "skin in the game" (legislated under the Bank Act) with 5% down payment which prior to late 90s was 10% (although CMHC tried to offer zero down payment mortgages on 40 year amortization in 2006 but Canada was saved by then Governor David Dodge who provided a private tutorial to the CMHC President and brought the attempt to emulate Fannie and Freddie to a quick end).

[Frances Woolley]

Patrick, no.

Nick, would you mind editing my comment, please?

[Nick Rowe]

lovely comments here. I have no useful responses.

Except: Ian: "Although some may believe the humorous stereotype of bankers as hard hearted, callous people waiting for the opportunity to harm a powerless, vulnerable Canadian, in fact, banks and bankers in Canada have always been very sensitive of their public reputation."

Shhhh! Don't spread that around. We need to keep up the image of bankers who will chase you to the farthest corners of the earth to recover what you owe!

[jesse]

"you're highly unlikely to be able to put aside any substantial amount for your retirement"

Oh but they are! They are investing in real estate, which they will liquidate upon retirement and downsize to smaller accommodations, living off the balance. That works until it doesn't.

Nick: "A small rise in interest rates causes those high-risk owners to sell"

I would argue even that isn't required. There can be other triggers even with low interest rates. An interesting question is whether perpetually low interest rates can keep prices elevated in perpetuity. I would argue that if rents are anaemic and if the rental pool has been depleted due to higher quality tenants becoming owners (ownership rate increasing to 70%), earnings growth will be low and from a DCF perspective that means the low cost of capital is offset by low earnings growth -- the NPV under such a situation should be lower. In other words, if long rates portend an extended period of low inflation and sub-par wage growth, investors may be improperly extrapolating favourable rental terms when determining the business case to purchase at current property valuations.

[Nick Rowe]

Frances: I was wondering about that. I have changed "can" to "can't".

jesse: Yep. The relevant discount rate should presumably be the interest rate *minus the expected growth rate in rents*.

[Determinant]

Anyway, all mortgages above 80% Loan-to-Value are insured against default by CMHC. CMHC though its bank clients has recourse to your assets; the insurance is to ensure and insure that the borrower will not pose a systematic threat. All that risk gets pooled into CMHC which is open and transparent about its risk because its debts are Government of Canada obligations.

Before anyone gets carried away with Fannie and Freddie comparisons, CMHC always been part of the Government of Canada's debt porfolio since CMHC's inception. CMHC has always been public about what it does and the Government has always been public about its statutory relationship with CMHC. It's all there in the Main Estimates and has been since the 1940's.

Additionally mortgage-backed securities in Canada are also insured by CHMC before they go on the market, both against default and against prepayment risk. With a MBS your prepayment, virtuous though it is costs the end lender money through lost interest. Banks just shrug and find another customer whether they own the loan or not, bond holders get stuck. Thus to get the MBS market off the ground in Canada CMHC insures against prepayment risk.

[Ian Lee]

Determinant - not quite - I have an Op-Ed under review with National Post-Financial Post at this moment, dealing with CMHC and its alleged transparency - where BTW, CMHC will NOT provide an aged list of delinquency - by down payment e.g. 5% vs 7% vs 10%, aged by borrower's age, work experience, credit rating, location.
In the many years I have examined crown corps within the GoC universe, I have not found a crown more secretive than CMHC.

2: To my knowledge, i.e. with the public data available concerning CMHC, I am not aware of CMHC pursuing any Canadian for a residual deficit subsequent to foreclosure. (nor should they - the solution to minimize default and foreclosure risk - which is the nuclear option to banks and should be avoided at almost all costs (although in 2006 CMHC did not understand this), is the absolute insistence on "skin in the game" or down payment requirement by buyers to ensure not only psychological buy-in but to ensure a sense that "hey - this is MY house". When the bank/CMHC funds 100% of the purchase, "it is the bank's house and I am merely making rent payments to the bank".

3. Re CMHC, Fannie and Freddie - as someone who approved millions of dollars of residential and commercial mortgages over many years, CMHC then and now does not possess a deep understanding of mortgage and credit risk.

What "saved" CMHC from large losses, is a myriad of CMHC rules surrounding default and foreclosure that impose significant costs on Caanda's chartered banks - such that the banks are typically not reimbursed for 6-12 months after mortgage default. Thus, banks self-impose diligent, prudent, cautious credit underwriting standards on borrowers in order to mitigate the possibility of foreclosure - and this is validated by the delinquency and default metrics in Canada.

Today, CMHC has 70% market share - where is the Canadian Competition Tribunal???? - and CMHC has a 100% guarantee from the Govt of Canada for the almost $500 BILLION mortgage insurance (liabilities) issued by CMHC (about 1/3 of Cdn GDP), while the private mortgage insurance firms have a 90% guarantee from the GoC for mortgage insurance. Where is the level playing field?

Moreover, the private mortgage insurance firms are fully regulated by OSFI while CMHC is the only major insurance firm in Canada EXEMPT from OSFI regulation. IF OSFI regulation is so good - and many believe it is including me - then why is CMHC exempt from regulation? What are they hiding?

And why is CMHC managing the MBS market and not the superb professionals at the Bank of Canada?

And why is CMHC in social housing - which is a provincial responsibility?

And why are the signficant numbers of housing statisticians and economists located in CMHC not located in Statistics Canada?

And why is CMHC in the energy efficiency business - instead of those programs being managed by NRCan?

And why is CMHC managing "green programs" instead of Environment Canada?

The remarkable mission creep in CMHC makes the Libyan adventure look like really petty stuff.

[Ben Rabidoux]

Take a second look at the CAAMP methodology. Two points worth considering:

1) It was done via an online survey. Presumably, the respondents were asked to estimate their equity position by estimating the current value of their home minus their mortgage. Yet studies show that home owners over estimate the value of their residence by 5-10%, meaning a significantly larger portion of low risk households is likely.

2) It excludes HELOCs.

Why not look at mortgage debt as a percentage of GDP? Certainly the marked variance from the long-term trend right around the time that CMHC loosened mortgage insurance requirements should give us a hint at what is really driving house prices. And if it is credit expansion amid a falling interest rate environment, that is not a sustainable trend.

http://www.theeconomicanalyst.com/content/so-much-%E2%80%98conservative%E2%80%99-canadian-consumer-another-look-canada%E2%80%99s-credit-bubble

[Ben: sorry. For some reason your comment got caught in our spam filter. NR]

[jesse]

"What "saved" CMHC from large losses"

... is an absence of a prolonged stagnant or bear housing market. Why would CMHC rarely need to pursue those in foreclosure? Here are 2 ideas: 1) because they can recoup the full amount on a sale, and 2) because there is no point trying to squeeze blood from a stone. But they have every right to go after other assets.

The $500BB is hyperbolic: this is not insuring against fire or flood where it's the structure, not the land, that's under insurance. CMHC is insuring a mortgage backed by both the land and the structure and there is an inherent floor to prices due to residual value, even at the trough of a severe housing recession. By my estimates while CMHC may have $500BB insurance in force, it will only need to make $20-30BB of shortfall after the properties are liquidated and it clears its assets and cash balances. The problem is they will need a substantial temporary loan about 2-3X higher than this to handle potential time lag between payouts to lenders and liquidation of the underlying asset. This is the same situation as AIG, where AIG couldn't come up with the cash to pay out claims but there was a large time lag they needed to bridge to recoup the money. And the claims were correlated, so I agree I doubt CMHC has any first-hand knowledge of what a correlated real estate bust can do to mortgage insurer balance sheets. There are some clues as to what MI should be: try to get insurance for non-amortizing HELOCs that CMHC no longer covers as of mid-April. What are the premiums?

There are lots of reasons to get angry at CMHC but I doubt taxpayer exposure is extreme, insofar as a few tens of billions of dollars isn't extreme. Based on their publicly available financial statements, I'm just not seeing a giant clusterf*ck, though it will look like it when they go begging for bridge loans from the government. Maybe they can use the old line that the government has reaped profits from CMHC's businesses over the years so it's time to give a little back. I can't say that's a completely bunk argument.

[Determinant]

Ian, competition in mortgage default insurance is perfunctory at best, it always has been. For decades CHMC was the source. Even with "competition" the other insurers have a 90% backing from the Government of Canada, which is sham competition.

The real explanation is of course that nobody can beat the sovereign guarantee of the Government of Canada backed with the ability to print money. Everything else flows from that.

CMHC is exempt from OSFI for the same reason that Government of Canada Bonds are exempt from provincial securities regulation: they are government entities and therefore immune to default risk. No, Greece doesn't count, they don't have their own currency. We do.

[Patrick]

Ian: You ask some good questions. But rather than asking them as an empty rhetorically device, you might consider researching some answers. Why IS CMHC doing all those things? What's the history and what was the rational at the time? And ending with that absurd sinister hyperbole makes the whole diatribe trite and comical:

"The remarkable mission creep in CMHC makes the Libyan adventure look like really petty stuff."

Honestly, that's silliness. Might as well work a Hitler reference in there too.

Geez.

[Stephen]

I work in real estate as a property assessor. Market value of homes is the market. Real estate agents can mess up the value when they own homes and are having a bad month. They get the ppl they represent to sell there's for a cheaper price (homes can easily take 4-8 months to sell at arms length).

What happened during the boom was just a mix of sellers asking for too much and buyers agreeing. People who owned older homes wanted to get newer bigger ones and renters wanted their homes. The banks were too happy. Appraisers cut corners (banks made many do that. Appraising is a very hurt profession here in Alberta now). Housing market values come from sales of similar homes. the only option when housing gets too hot, like it was, would be for banks keeping the book value based on a hybrid of sales and cost to build (called sales and cost approaches in the profession).

Labor costs are up and people are moving more into cities of all sizes. Homes need more components (like a wall that is pre-built or floors) to be built in lower costing labor areas. Agglomeration is not cutting costs enough. You need cheaper labor in such cases. And of course technology to do it and fair priced transportation.

[Declan]

"Debt must be disaggregated across the population."

We've covered this before, but I've never seen anything to convince me that the total amount of debt isn't a pretty good proxy for the number of at-risk debtors. Good luck convincing me that Canadian debt levels are just as high as American ones before they're meltdown, but we're OK because we've done a better job spreading the weight over the donkeys than they did.

Similarly, since the current home-ownership rate in Canada exceeds the highest point reached in the U.S. before their downturn, we'd again relying on a distribution effect to say that the 'extra' 10% of the population now in homes in Canada vs. normal levels is that much more prudent than their American counterparts because our debt levels are distributed differently across the population? Maybe, but it seems like a stretch.

Relying on the value of the asset for comfort is unwise in my opinion, like saying there's no risk from a housing meltdown because housing prices are so high.

It's true that recourse mortgages will have lower default rates than no-recourse ones when people are in negative equity situations, but that depends on people having other assets to take recourse against. If you're bankrupt, you're bankrupt, and I think a lot of people are a lot closer to bankruptcy now than in previous housing downturns.

Also, keep in mind that even if the default rate doesn't increase much, banks will still lose a lot more money trying to foreclose and sell into a down market than they will in a strong market. Just the strain of the ever growing stock of foreclosures will cause increased losses as properties sit and collectors are overworked.

For all that, I'm not too worried about the impact of a housing downturn on Canadian financial markets. It helps that we've pre-emptively applied a 100% government guarantee to most of the riskiest stuff (and 90% to a bunch more), so there's a lot less uncertainty there. It also helps that the less competitive financial industry here has prevented the rise of too many large WaMu/Countrywide/etc. type operations that are giant balloons looking for a needle. By the same token it helps that OSFI has restricted financial industry leverage reasonably effectively over the last couple of decades.

Yes, a housing downturn will hit the banks earnings and their capital levels and this will affect their risk appetite (willingness to lend) across the board, and it will lead to increased regulatory scrutiny, and the bank stock prices will likely fall a chunk, but I don't see a big financial meltdown/contagion risk like we saw in the U.S., or we see a risk of currently in Europe on the sovereign debt issue.

[RSJ]

I think there is an additional risk that is not being addressed here -- apart from the risk of default.

Suppose that no one defaults. Every homeowner is current. Nevertheless, a bubble is not about default, but about households bidding up the price of houses because they believe that they can re-sell them later (where later could be "retirement") for an even higher price.

Now what happens when the mood changes, and households believe that prices will decline -- again, no one needs to default for prices to decline. The situation works in reverse -- household are willing to pay less for houses today because they will need to absorb the capital loss.

If the price of the asset is expected to go up, that *increases* demand for the asset up until the present price is equal to the discounted expected future price. If the price is expected to decline, this *decreases* demand for the asset.

When there is a large speculative demand for the asset -- i.e. when expected price appreciation accounts for a large portion of the current purchase price -- then the demand for housing is at risk of large swings. The downward swing, or reduction in demand, can hurt the economy even if no one defaults.

[Ian Lee]

Patrick - if you examine the House of Commons debates when CMHC was established in 1948 and the subsequent debates concerning renewal of CMHC legislative mandate (including the 1999 debate and the committee hearings thereto) you will discover that CMHC was established in 1948 by the King Liberal Government to provide inexpensive, low rate mortgages with low down payments to returning veterans of the second world war.

In 1954, the National Housing Act was amended to remove CMHC as a direct lender and instead was mandated to provide default mortgage insurance to banks and other mortgage lenders for "high ratio mortgages", advanced to consumers with less than the required down payment.

Neither MPs in debate nor did the CMHC Act state that CMHC should develop multiple "diversifications" (if you are hung up on the word mission creep"). To be much more formal, I would characterize CMHC as inadequately supervised and operating beyond the scope of its authority in adopting unnecessary and inappropriate diversifications.

And we are not asking the question that should be asked: why is CMHC providing mortgage insurance today in 2011 with mature Canadian financial markets and some of the strongest financial firms in the world (according to World Economic Forum)? In 1948, one could argue (tenuously) there was a "market failure". But today, there are insurance firms that want to enter the market - but cannot because of the GoC sovereign guarantee (Determinant - I agree with your comment) that acts as a barrier to entry.

In 2010, the CMHC finance VP testified to House of Commons Finance Cmte that mortgage insurance is a very important (essential?) service being provided of vital importance. Sitting beside him, in contradiction, I testified that the provision of food to people is important and yet we have not nationalized Loblaws or Metro or Safeway.

Determinant - I do not accept the argument that because CMHC is owned by GoC, that CMHC is exempt from GoC regulation. I distinguish sharply between "government as regulator" and "government as deliverer" of certain services. Indeed, many government agencies are subject to the regulations of other government agencies.

While the role of government as regulator or referee of the hockey game is absolutely vital e.g. OSFI, it is by no means clear why government owns some of the hockey teams e.g. CMHC, EDC, BDC, CCC, Farm Credit. I do not see the policy benefit of owning commercial firms selling private goods goods or services to private consumers - while the policy benefit of owning pure public goods e.g. Bank of Canada or CBC, is much more clear.

[Patrick]

Ian : Thanks for the response.

[Determinant]

And we are not asking the question that should be asked: why is CMHC providing mortgage insurance today in 2011 with mature Canadian financial markets and some of the strongest financial firms in the world (according to World Economic Forum)? In 1948, one could argue (tenuously) there was a "market failure". But today, there are insurance firms that want to enter the market - but cannot because of the GoC sovereign guarantee (Determinant - I agree with your comment) that acts as a barrier to entry.

This is not true. There is a fundamental difference between an entity with a sovereign guarantee and a private insurer with limited finds. Banks and other lends know this and have acted accordingly. The market is rational in this regard. As to why the sovereign guarantee is important, see below.

Secondly, CMHC has always been in the business of improving the quality of housing. In the aftermath of the Depression and then the Second World War Canadian housing stock was in a sorry state. The infamous "toilet question" on the census was a genuine attempt to find out how many homes had inadequate plumbing, among other deficiencies. CHMC implemented a policy of not lending against any home not compliant with its National Building Code which went a long way to improving the quality of housing in Canada and promoting building codes generally.

Third, the example of what went wrong in the United States should provide all the justification needed for implementing mortgage insurance with government guarantees. When banks loan money against the value of homes they start up the fractional-reserve banking process. Given the large amount of banking activity devoted to the provision of mortgages in Canada it should be clear that a large proportion of the Canadian money supply is tied to mortgages. Just as in the United States, a spike in defaults in Canada would contract the money supply.

A sudden contraction in the money supply due to defaults is the one thing a modern monetary economy cannot tolerate. Every economic transaction is conducted through the medium of money. Without enough money we get the Financial Crisis of 2008 and a 1930's Depression. We get a glut of supply without enough purchasers due to a money shortage.

In such a situation interest rates don't matter. If the total supply of dollars falls due to the fractional reserve process turning on itself we need more dollars, period. Mortgage insurance with a sovereign guarantee means that the government, the source of dollars, is quickly presented with the problem and has to do exactly the right thing, issue more bonds and print more dollars. The problem is quickly elevated to the people who actually need to deal with it and have the authority to do so: the Minister of Finance and the Governor of the Bank of Canada.

Private sector arrangements can't do this. They can't print money which is exactly what needs to happen in a large-scale crisis.

[Patrick]

"And we are not asking the question that should be asked: why is CMHC providing mortgage insurance today in 2011 with mature Canadian financial markets and some of the strongest financial firms in the world"

Given the current insatiable appetite for very low risk financial assets, it seems to me that it makes perfect sense for the government to use mortgage insurance to backstop mortgages which can be use to 'manufacture' low-risk bonds. Nobody else but the government can do that. That they piggy-back it on housing policy is fine with me as it seems to work pretty well. My personal experience is that my wife and I would have been forced to pay more for much lower quality housing had we not been able to get a CMHC backed mortgage. I wouldn't want to remove a system that improves people's financial position and provides access to better housing without some convincing evidence that the system is doing more harm than good.

Also, CMHC just withstood the worst financial crisis since GD 1.0. That doesn't mean CMHC can't be improved, but it just doesn't look to me like there's a whole lot to get upset about. And trying to spin the evolution of CMHC into a sort of sinister anti-democratic plot strikes me as a rhetorical device designed to achieve an ideological end. It really doesn't add anything to the discussion.

[Determinant]

To be even more clear, insurers of all sorts frequently reinsure themselves for the risk they take. When a really large case walks in off the street the agent handling it licks his lips and goes to work; the underwriters in the back office make the appropriate arrangements to "lay off" the excess risk in the reinsurance market.

And it gets better, reinsurers reinsure themselves too, a process known as retrocession. So you end up with a daisy chain of risk. Warren Buffett made a large part of his fortune building up an impregnable balance sheet and being the man at the end of the daisy chain, he charges a hefty premium for his services.

In Canada given the size of the mortgage market, most of which is held directly on bank balance sheets and the fact that those same balance sheets directly govern the usable money supply, we cut out the retrocessionaires decades ago and made the government responsible for excess mortgage default risk. The point is that a really bad case of defaults will not detonate our banks nor contract the money supply and send the rest of the economy into a tailspin.

RSJ:

You're right and that's exactly what happened to the Canadian residential property market in the early 1990's. That recession, our last caused house prices to flatten. The market was weak for a number of years. It happens, which is why I said pain happens but like then it should be manageable.

[Whitfit]

Patrick says: "My personal experience is that my wife and I would have been forced to pay more for much lower quality housing had we not been able to get a CMHC backed mortgage."

I'm curious about this - do you mean that you would have had to buy private mortgage insurance at a higher rate, increasing costs and decreasing the housing you could buy? Or you would have to rent? At the P/E earnings described, renting doesn't seem like such a bad deal, but what is it that would have made this different in your context?

I am just trying to understand what the need is for mortgage insurance at all, and I think this goes to Mike Moffat's point above about average house size (that people expect [ownership of] high housing quality with little in the way of financial assets/cushion on the equity side, and are willing to vote for politicians who will use public resources to give them that quality through an explicit guarantee to a public mortgage insurer).

Why isn't the "insurance" portion of a mortgage part of the mortgage price? Isn't the rate of interest affected at all by default risk? There were other issues mentioned above - housing quality issues etc... that were helped by CMHC. Is that still needed? The best way to actually deliver those results?

I wonder if in Canada we don't have something akin to a "transitional gains trap" in the housing market, where mortgages are virtually risk free for financial institutions (insured if under 20%, enough equity if not a high ratio mortgage and recourse regardless) such that they largely compete on price (and confusing mortgage systems - part fixed part floating, savings mechanisms tied to the mortgage, cash back - that are designed to have consumers make bad decisions through behavioral downfalls). The transitional gains are to the incumbent owners of houses, and in the end we have just bid up house prices so that average people need to get government backed insurance and take on huge debts to buy houses, but are backstopped by the government so that they banks don't have to price the risk in to those consumers.

Part of my perspective, as it seems of many here, is a personal interest in this market. My wife and I rent, while saving so that we can make a 20% down payment on a house in a few years and not pay mortgage insurance. Now, maybe the appreciation of houses will be higher than the cost of insurance (I think that is what drives many people's decisions - a desire to get into the housing market as soon as possible at all costs) and we will end up being behind. Maybe the price of houses will fall and we will be better off (when will all those baby boomers start downsizing?!?). But, in the end, I am not sure why the government should be subsidizing this market given the depth of the Canadian financial system.

[jesse]

One thing to look for is that banks that issue low ratio loans may not be qualifying borrowers under the same terms as is required under CMHC mortgage insurance. If prices falter, low ratio loans become high ratio loans and there is a potential affordability gap when those with reduced equity attempt to qualify for MI. CMHC can only do so much and there's a huge matzo ball floating out there: what happens to low ratio loans if prices drop? It's a worthy question and one I think the Bank of Canada has been asking for some time now; being the "lender of last resort" for otherwise "healthy" loans is a burden that CMHC may be unprepared for in the coming years.

[jesse]

Determinant, the problem I have with MI is that housing recessions and concomitant defaults are correlated, unlike other types of insurance. It is very difficult to formulate a business case in this situation (see AIG). We have clues what insurance companies do for these events: they simply do not insure or won't pay out due to lack of funds, realizing the dreaded counterparty risk. I remember a few years ago where severe hurricane and flood damage in the US caused insurance companies to balk at payouts because they would go insolvent. Many if not most insurance policies explicitly exclude events that are highly correlated, or charge separate insurance for them.

MI is akin to a severe earthquake or hurricane that wreaks heavy widespread damage. Since these events are decades apart, the only thing the insurer can do is reserve significant capital to handle a rush of payouts over a relatively short period of time. Needless to say such insurers' balance sheets look rather bloated compared to insurers of uncorrelated events. CMHC's reserves look woefully inadequate for what in other countries has proven to be a correlated claim schedule.

[jesse]

Patrick: "I wouldn't want to remove a system that improves people's financial position"

How does taking on more debt "improve people's financial position"? Offering government-backed rates does not change the investment's risk profile. Socializing the housing market at valuations that are above what investors would consider reasonable on a cash flow basis -- as is the case now -- simply translates to higher debt loads for the government, which are paid through rents it collects from citizens and corporations, and crimps their ability so spend on more productive measures.

The other problem I have with government guarantees on mortgages is that they risk putting the cart before the horse, and I think that is definitely true now. House prices are high because land values are high, so we need government guarantees to allow people to afford buying them even at accommodative interest rates. This seems to be begging the question. In my view THE problem is high land prices relative to the utility (rents) they provide. Therefore I strongly advocate supporting policies that reward investors and homeowners who reap returns on rents, not speculation. If they want to speculate, fine, just don't do it on the government's dime.

[Patrick]

Whitfit: Buying with a CMHC backed mortgage meant we paid less in mortgage payments than we would have paid in rent for the same house. That might be particular to the time and place (Edmonton, early 2000's). The house (a very modest one) has appreciated substantially subsequently, which won't continue and may not be the case for someone buying today. In any case for the same money we would have had worse housing and wouldn't have been accumulating an asset (or been covering our short position in housing, to borrow from Nick). So compared to that alternative, we were much better off with CMHC than without.

More generally, to the extent that people are willing to issue mortgage because they are able to stick them in low-risk bonds backed by the full faith and credit and then sell them, I have to imagine that this increases the supply of mortgages and thus keeps prices (interest rates, fees) down.

[Determinant]

Determinant, the problem I have with MI is that housing recessions and concomitant defaults are correlated, unlike other types of insurance. It is very difficult to formulate a business case in this situation (see AIG).

Which is why I said the beauty of the Canadian system is that the sovereign guarantee means that the government will automatically expand the money supply to deal with that demand.

If the money supply would contract anyway there would be no price inflation, it's just good assets for bad.

It's all Functional Finance. Money isn't fixed. If worse comes to worse the government will just print some more.

Drat, I knew this thread would come back to theory sooner or later. Nick, you just posted this as a warm up to your next post, right? Laying the groundwork for a post about Modern Monetary Theory, right? Let the peanut gallery chew on a soft toy for a while while you whittle away at an MMT bat to hit us over the head with?

[Patrick]

jesse:

It's not just debt. At the very least, you're covering your short position in housing (again, borrowing from Nick). Even assuming the house doesn't appreciate in real terms (not unreasonable in the long term), you still have to live somewhere. So the choice is paying rent or paying a mortgage. I suppose you could look at it as an NPV problem: If the NPV of the flow of rent payments is less than the inflation adjusted future value of the house minus mortgage payments (adjusted for inflation) blah blah then you'd want to rent.

Nick has a bunch of posts on this a while ago.

[jesse]

"the government will automatically expand the money supply to deal with that demand"

Well why not expand that to every and all things? Mis-allocating capital is a net impediment to economic growth; printing money will be unlikely to deviate beyond that required to fulfill medium-term inflation targeting.

"you're covering your short position in housing"

A "short" position can imply an obligation, not an option, to buy at a future date. I was reminded by someone today that while a true short exists for developers who must sell upon project completion to cover their obligations, a renter does not ever have to buy, but may convince himself that he does. In other words, for every non-owner, buying is really an option. Not so for the owner when it comes to selling; often selling is not an option.

The point I was making was around thinking that access to low government rates provide some net economic benefit. Perhaps they do for homeowners but the business case for ownership doesn't change. If the government thinks it is providing an overarching social good by providing cheap financing, fine, but it will end up absorbing the spread in the long run. If the economy is the better for it, higher taxes will offset this burden but the burden is there. This is what the Americans have found out the hard way; losses are acute during housing busts. Will increased home ownership in Canada produce net economic benefits? I will reserve judgment for a while longer.

[ian lee]

Determinant -
"This is not true. There is a fundamental difference between an entity with a sovereign guarantee and a private insurer with limited finds. Banks and other lends know this and have acted accordingly"

I spoke recently to a Treasurer in a certain bank, who told me that the banks are deliberately booking MI with CMHC due to the 100% gtee re Basel, because they do not have to set aside reserves for CMHC MI, which they do for private insurers with only a partial gtee.

But I still do not understand your argument that CMHC must provide mortgage insurance. Australia privatized their CMHC in 1997 - this did not damage their economy.
The key to risk mitigation in mortgage lending is actually not mortgage insurance as such – it is the credit underwriting standards established relating to down payment requirement, income and debt ratios, credit history – in short the 5Cs of credit.

"Secondly, CMHC has always been in the business of improving the quality of housing. In the aftermath of the Depression and then the Second World War Canadian housing stock was in a sorry state"

Relative to most countries around the world, the housing stock in Canada was in good condition - it all depends on your referent point. I grew up on a farm - in conditions that you and likely CMHC would have characterized as a sorry state - but not so relative to the standards, incomes and expectations of the time. And your judgment of the housing stock does not provide a compelling argument for federal intervention in an area of provincial responsibility.

"Third, the example of what went wrong in the United States should provide all the justification needed for implementing mortgage insurance with government guarantees".

Actually, a good number of analysts came to the opposite conclusion, as I did in my paper to the Financial Armageddon event at Carleton in fall 2009. Please see NY Times business reporter Gretchen Morgenson's just published book, Reckless Endangerment, where she provided convincing evidence that Congress watered down the underwriting standards e.g. no down payment, 40 year amortization, which led to the crisis. Moreover, as noted above, Australia privatized their CMHC without a collapse.

Patrick: "And trying to spin the evolution of CMHC into a sort of sinister anti-democratic plot strikes me as a rhetorical device designed to achieve an ideological end. It really doesn't add anything to the discussion."

It is disingenuous to suggest that different interpretations contrary to a particular philosophical position or argument are "ideological". As Arendt noted (The Human Condition), there is no Archimedean point in the social sciences from which we can declare A to be “ideological” while B is understood as pure and non-ideological. This is a rhetorical device, unfortunately used in some social science units, to dismiss and thereby avoid analysis and evidence provided.

[Determinant]

Ian, I did not say privatizing CHMC would cause harm to our economy. I did say that privatizing CHMC would expose Canadian banks to retrocession risk, such that their private mortgage insurers would not cover their liabilities. Australia got lucky this time but this isn't guaranteed.

I understand exactly what your bank treasurer is doing and it's entirely rational.

CMHC does not face retrocession risk; the sovereign guarantee means it can't default since the government can print money. Or cause higher inflation, or just plain confine mortgage defaults to line-items bank balance and not affect the rest of the economy.

The housing stock in Canada was OK in that it was intact, the government wanted building codes for plumbing and insulation. The used CMHC to get them with good results.

Strangely I'm fine with that effort. But then again I just did have a job interview with the Public Service of Canada so maybe I'm biased.

[Patrick]

Determinant: Good luck!

Ian: I don't see how I'm pretending to know less than I really do by suggesting that you're spinning a yarn, not making an evidence based argument. It raises the question: why?

As I said, I think you ask some good questions, but it stops there.

[ian lee]

Thanks Determinant. I (think) understand the logic of your arguments. The most compelling argument you provided is the retrocession risk. However, if I understand this argument, it is present with all banks and all insurance companies - which is why it is absolutely essential that ALL financial services firms be rigorously regulated e.g. OSFI and not the US alphabet soup of agencies that encourages regulatory arbitrage.

Moreover, privatization of CMHC does not emasculate or neuter government monetary or fiscal authority and their tools to intervene if e.g. a housing bubble is forming by e.g. increasing down payment requirement and/or shortening maximum amortization (which I advocated since 2006 when CMHC tried to go in opposite direction).

My criticism of CMHC is not that they are backed by the GoC per se. It is that most employees on Montreal Road (CMHC HQ) have no experience in writing mortgages and simply do not possess a deep understanding of the mortgage business – hence their attempt to go zero DP and 40. (why I admire Carney is that not only does he possess a PhD in economics, but he worked for 14 years in investment banking before becoming a public servant in Finance and then BoC).

BTW, good luck on your application. As someone who has taught in many developing countries including China, Russia and Iran with remarkably corrupt bureaucracies, Canada has one of the most honest, competent public services in the world. Specifically, the public servants in Finance, PCO and Bank of Canada are simply outstanding in terms of education, intelligence and understanding. This is one reason that we want them “steering”, not “rowing”, to use Bill Clinton’s phrase from Gaebler and Osborne’s book.

Patrick – you misunderstood my point. ALL analyses and arguments are “ideological” or are grounded in a certain philosophical foundation or as we say today, “ a point of view”. As Arendt noted, the only people with no “interest” in a position or in the world are buried in the cemeteries. Thus, to dismiss an analysis as “ideological” is simply an attempt to avoid addressing the merits of the analysis or the evidence (cf Poli Sci and Sociology), by ruling the analysis "out of order".

[Patrick]

I don't agree. In any case I'm dismissing the hyperbole. To the extent that there is analysis, I'm fine with it.

[Whitfit]

Ian: "The key to risk mitigation in mortgage lending is actually not mortgage insurance as such – it is the credit underwriting standards established relating to down payment requirement, income and debt ratios, credit history – in short the 5Cs of credit."

This is exactly the point. I still don't see what makes the housing mortgage market special, except for the politics of bribing the middle class with their own money - a bribe that only pays off if you take advantage of the program. Why can't the risks be dealt with by a price (interest rate) that takes into account the risk profile of the borrower (assuming that the financial institutions can properly take on those risks - but that is really the job of financial regulation, not housing subsidies by the state).

Patrick: I guess I'm not trying to pick on your description of your situation - it made sense for you, but what I am struggling with is that it seems to me there are many situations in which we would like the government to subsidize our consumption - we get a nice house (or nicer than what we could otherwise afford), or some other type of consumption good. What makes housing special, especially the growing sized and equipped middle class family home? Leaving aside minimum standards, which I don't think is the issue for most CMHC insured buyers.

I also can't help but wonder if the appreciation we see is a result, in part, of all of these pro-housing ownership policies. We just push up prices (at least in space constrained regions such as urban areas), and nobody ends up being further ahead, with people being forced to be reliant on the subsidy of CMHC guarantees. The only winner is existing homeowners who can sell a current home and not have to buy a new one in an urban area.

[Patrick]

Whitfit: Those are all good points. Subsidizing people to buy houses no doubt suppresses supply of rentals, which feed a self-fulfilling prophesy of buying being cheaper than renting. Renting has risks too - the landlord can kick you out, or raise the rent. Does CMHC backstop loans for building of rental units? I don't know.

AFAIK CMHC doesn't suffer big losses and the vast majority of people pay back their loans. So it makes me wonder if CMHC is really just correcting for a market failure - perhaps irrational risk aversion on the part of lenders? Or maybe they're just taking advantage of the law of large numbers to pool risk. Seen in this light, they might be making the market more efficient.

The equipment in houses doesn't worry me. I think it's mostly technological progress. Size is an issue, and urban planning is a huge issue - we need to stop building suburbia. It has no future. But that's a different topic for a different day.

[Determinant]

My thanks to all who expressed their best wishes. The interview did go very well, and they are hiring a sizable pool, so I am hopeful. I can't saw which program specifically, for specific reasons, but it is Core Public Service, that is a proper Department.

"This is exactly the point. I still don't see what makes the housing mortgage market special, except for the politics of bribing the middle class with their own money."

What makes the housing market special is its size. I'm an engineer by training and engineers always admit that risk exists. The size of the risk is what makes the housing market so dangerous. We have five chartered banks in this country who provide the majority of mortgages. They hold the bulk of that mortgage risk on their balance sheets, they don't sell it. The economically useful money supply is also directly tied to bank's balance sheets. Therefore, a "macroeconomic headwind" has the capability to decimate bank balance sheets and therefore the money supply.

If the money supply is reduced like that, we get a Great Depression/Financial Crisis economy. So we have to face the choice of a) providing every Canadian who wants to own a home the capability to do so with 5% down and b) restricting the amount of bank capital devoted to mortgage lending. Before CMHC downpayments were on average 50%, so most financial institutions limited their exposure to mortgages (trust companies and life insurers at that time actually).

I hope I have made clear the point that in order to maximize the amount of capital devoted to mortgage lending the government decided to step in and insure mortgages. This also has the happy effect of insulating mortgage defaults from the rest of a banks balance sheet, protecting the broad money supply the Canadian economy uses. This is a critical feature to prevent the Canadian economy generating its own Depression and it needs the sovereign ability to issue money to work.

Now you can come back and say that we should use private institutions, and I would say that you can, but you will restrict mortgage lending. The Government made a policy choice in the 1950's to encourage home ownership and a property-owning democracy. You can argue against that choice but that's a political stance. The policy is in effect though.

On supersize risks, even Warren Buffett, insurer extraordinaire has talked in his annual reports that there are risks too big for even he to take and he makes that his business. He said that in that case governmennt may have no choice but to step in, such as after an earthquake followed by a hurricane followed by another earthquake. The private sector has its limits.

[jesse]

On a related note the government is introducing a bill to increase oversight of CMHC: http://www.parl.gc.ca/HousePublications/Publication.aspx?Language=E&Mode=1&DocId=5088345

- It limits government underwriting to 90% in case CMHC defaults. In effect the government is instilling some counterparty risk onto those who use CMHC as a "free hedge".
- The government can delay payments by up to 2 years, so say the inconceivable happens and CMHC is rendered insolvent by a high number of default claims; claimants can tap Her Majesty's backstop funds but may only receive 90% of their money back after clearance and may have to wait 2 years.
- The Ministry of Finance can cut off certain lenders from taking CMHC mortgage insurance policies, from what I can ascertain, on not much more than a whim.
- The Ministry of Finance has access to CMHC's books and will make them public.
- The Ministry of Finance can cause CMHC to increase capital reserve ratios if it deems it is taking on too much unhedged risk.

Am I wrong in thinking this is a big deal?

[jesse]

@Ian Lee: "Australia privatized their CMHC in 1997 - this did not damage their economy. "

With all due respect, Australia's prices are overvalued with respect to its incomes and rents. If house prices exhibit prolonged weakness as has been the case in other jurisdictions, we do not yet know if their private mortgage insurance scheme will remain solvent.

[Whitfit]

Determinant: I hope I have made clear the point that in order to maximize the amount of capital devoted to mortgage lending the government decided to step in and insure mortgages. This also has the happy effect of insulating mortgage defaults from the rest of a banks balance sheet, protecting the broad money supply the Canadian economy uses. This is a critical feature to prevent the Canadian economy generating its own Depression and it needs the sovereign ability to issue money to work.

This is part of what I wonder about - why is this such a good thing? Does it drive up the price of houses in space constrained regions? More capital chasing the same amount of property? Do we just end up with higher house prices?

With respect to the money supply, if the effect of running the housing market works this way, isn't this a huge government program? Why are banks even in this market? I thought there was a real market in financing houses. This makes me wonder if there is just a competition for servicing as many mortgages as possible, with little attention paid to risk and related factors. That is why all of my young professional friends are offered mortgages of sizes that seem preposterous to me. And thus, why they bid up the price of houses to the max that they can afford, with no concern about fragility or risk.

I just don't get what the market failure is. I understand that a government guarantee spreads the risk around and thus minimizes the insurance price, and it can do so because when there is a systemic change it has the ability to print money to cover its losses. But I am uncomfortable that we have decided to finance the use of this capacity of the government to eliminate risk for the financial institutions in this market (why not nationalize it instead?), or why risk can't be priced into actual mortgage prices, based on people's credit ratings, down payment amounts, and income.

Do we not actually have more risk from a depression/macroeconomy perspective by having everybody so leveraged up with housing debt, or at least everyone who is in their first few years of housing ownership (which, thanks to the pro-ownership policies is actually pretty substantial in population)? Sure, maybe the banks will be ok because the government will just print money to pay of their assets if need be, but that doesn't mean that this is a great way to run an economy.

Determinant: The Government made a policy choice in the 1950's to encourage home ownership and a property-owning democracy. You can argue against that choice but that's a political stance. The policy is in effect though.

And how. But, that doesn't mean we shouldn't examine this policy to consider whether it actually makes sense in the contemporary context. I mean, now that we are a "property owning democracy" where everyone cares only about their own house and property tax rates, who cares about parks and public spaces and public goods?

I think this is what I am partly concerned about. We have subsidized the private consumption of owner occupied housing as a policy direction. Wouldn't it be better to have lower home-ownership rates, smaller home units, more public space and services in our urban areas, higher down payment requirements, and banks that are looking for returns by investing in businesses and industry rather than fighting to provide mortgages backed by the government, using sneaky tactics like confusing people by offering "combined savings and mortgage products" (why are those financial products better offered tied together?) and spending absurd sums of their income marketing to middle class households?

And I know I keep saying subsidy, where everyone thinks this mortgage insurance is a free lunch because house prices keep going up and CMHC has not had to pay off huge sums. But, if there is a significant housing decline, things could get ugly. And maybe part of the cost is a misallocation of resources.

[Sina Motamedi]

I think Determinant has won this comment debate hands-down.

[K]

Whitfit:  Couldn't agree more.  The system is inefficient, broken and dangerous in all the ways you say, and several more that I have discussed many times before in this forum (but which I'll be happy to discuss again if the conversation is really veering OT anyways).  Needless to say, trying to figure out the fair value of anything in an economy that is so ridden with subsidies and pro-corporatist regulatory distortions, and potentially subject to unknown new ones in response to every turn of the market, is basically pointless.

[jesse]

Great comments Whitfit. While increased home ownership may be a noble policy decision based on a perceived "public good", whatever that entails, there are tangible downsides including reduced labour mobility.

[Determinant]

- It limits government underwriting to 90% in case CMHC defaults. In effect the government is instilling some counterparty risk onto those who use CMHC as a "free hedge".
- The government can delay payments by up to 2 years, so say the inconceivable happens and CMHC is rendered insolvent by a high number of default claims; claimants can tap Her Majesty's backstop funds but may only receive 90% of their money back after clearance and may have to wait 2 years.

These two points are shams. Prompt payment of claims is a fundamental point of insurance, otherwise it's not insurance. The point about the 90% limit on claims is also nonsense. First, when the Northland Bank and Canadian Commerical Bank went bust in 1985 the (Conservative) Governement of the Day stepped in to cover all deposits, not just up to the $60,000 limit that CDIC specified. Deposit insurance in the UK with a 90% limit also failed in the debacle over Northern Rock. These sorts of limits have been refuted in market tests.

- The Ministry of Finance can cut off certain lenders from taking CMHC mortgage insurance policies, from what I can ascertain, on not much more than a whim.
- The Ministry of Finance has access to CMHC's books and will make them public.
- The Ministry of Finance can cause CMHC to increase capital reserve ratios if it deems it is taking on too much unhedged risk.

They government always had these powers. They are just making them more public. Bit of a yawner if you ask me.

I do take issue with the "free hedge" assertion. We may be talking across one another. The bankers on this thread are asserting a bank manager point of view; I on the other hand have insurance training and come at it from that point of view. In banking interest is determined by the time value of money and the default risk, though loan management means the former dominates the later. If you are an excess risk often you just don't get a loan, period. Or get it insured, or have a higher downpayment. Interest doesn't govern default risk as much as many think it does. There are other tools for that.

In insurance we want to take risk. The premium and payout obligations are determined, the actual risk incurred is what forms the insurance counterpart to interest. Banking is more interested in the time value of money, insurance is more interested in default risk (or death, or disability) and doesn't care so much about the time value of interest. So taking on default risk is what insurance is all about, the corollary is that an insurer should adequately compensated. CMHC has been a net revenue payer to the Crown for decades, so I believe it is charging an adequate premium for its services. Since we are taking risk there is a residual risk that can't be handwaved away, that risk lies with the government.

Those in the thread who wondered why mortgages aren't nationalized need to break it down thus: the capital is provided by the bank, the interest is determined by the time value of money. The default risk is ceded to CMHC for a premium. At no time in CMHC's history has it had to resort to the Crown for excess coverage, though it is macro-prudential that it can. Therefore the system is working. In the beginning in the 1930's the government did provide direct NHA mortgages, capital and all. It is more efficient and enlarges the pool to its greatest extent if the banking sector provides the capital and the government covers the default risk.

The thing with insurance as compared to banking is that you can't slice and dice risk too much, else you are not pooling the risk and not actually insuring anything. If you underwrite too strictly you'll choke the market and not get anywhere, underwrite too softly and you'll go under. The later hasn't happened to CMHC in six decades so I'm not seeing the problem.

On a final note, CMHC HAS been successful in its mission of making ownership an alternative to renting. For a payment P you can rent or own, and most families with children and stable incomes choose to own. For example my parents and grandfather were United Church ministers. The United Church requires that ministers be provided with a manse (family-sized house) manse or a housing allowance. Given the United Church's size and the fact that it serves all of Canada, it forms an excellent point to compare the value of renting vs. owning. In fact the trend given the availability of mortgages is for owning (housing allowance) to dominate over renting (manses).

[jesse]

Determinant: "This also has the happy effect of insulating mortgage defaults from the rest of a banks balance sheet, protecting the broad money supply the Canadian economy uses. This is a critical feature to prevent the Canadian economy generating its own Depression and it needs the sovereign ability to issue money to work."

I understand the need for governments to step in and underwrite natural and other disasters and this was convincingly advocated by Keynes and others. But debt accumulation is a different beast entirely in that the "disaster" is a consequence of lending and monetary policy. I understand the need for the government to want to influence marginal debt accumulation using CMHC as a vehicle -- and the past 5 years have shown how powerful an effect this can be -- but I think it a flawed line of reasoning that the potential deflationary fallout from recent asset and debt bubbles justifies the existence of an emergency government backstop for just such events in the first place. Why were debts allowed to inflate to the point where they are considered a significant deflationary risk in the first place?

My concern with a blanket statement that government guarantees on deflationary events are necessary to avoid deflation is that it misses the broader issue, that certain "disasters" are completely avoidable. On this front the absolute government guarantee on mortgage debt appears to have limits, at least after reading the recently read Bill C-3. Your and other's comments here are timely.

[Whitfit]

Determinant: That is a very interesting point re: the distribution of roles between the banks and CMHC on capital provision and default risk.

I don't think I truly appreciated that banks bear virtually no default risk in their investment in Canadian residential real estate. The fact that there have been not major crises in six decades, with such low insurance costs is also interesting. That either means that the system works, or that the kinds of events that would lead to problems have not occurred.

You are certainly correct that the policy goal of having people buy real estate has worked. I am still less than convinced it is all for the good, though.

Sina Motamedi: I didn't know that the point of coming here was to win - though I will say that I have learned a lot from Determinant and the other posters in this thread, so I will claim to have won ;) I do believe that is the point - to learn and better understand, not to "win" a thread.

[Determinant]

A bit of both. The developed world managed to avoid a general 1930's meltdown until 2008. Even then Canada repeated our own Depression history by NOT having a banking crisis. Plus claims history has shown that once people reach 20% equity they have very little default risk. The bulk of the risk is concentrated in the 5-20% equity range. This is the segment that banks insure. They don't insure other loans because the default cost is negligible.

[Patrick]

" The government can delay payments by up to 2 years"

If history is any lesson at all, Her Majesty would pony-up pronto in the event of a macro level catastrophe that lead to large scale coordinated/correlated defaults.

I have a hard time believing such a catastrophe is in the card. I've never been accused of optimism, so maybe I'm just naive ... After all it wasn't that long ago that it seemed inconceivable that the US would be starring down the barrel of a lost decade. Seems to me that because it isn't possible to walk away in Canada without the risk of being sued into bankruptcy I really have a hard time imagining what sort of catastrophe would lead to mass coordinated default. It would have to be so bad that people simply don't care about the risk of being sued. And if it came to that, I think CMHC might be the least of our problems.

[Determinant]

Jesse:

The question here is why to bad things happen to good people? We don't have perfect foresight of our actions. In a system with significant default costs we have to plan for the worst. The flip side is the Total Debt and Net Debt rules that Canadian banks always applied which helped greatly. But so long as we insist on making somebody pay for defaults, we have to find a victim when bad things happen. Insurance is a game of pass the victim.

[Sanchez]

Not all states have non-recourse loan statutes. Look at Nevada with both the residential and commercial mortgages....one of the worst states affected by the housing bust and Nevada is a RECOURSE state. It still didn't prevent prices from declining.

[jesse]

@Determinant: "But so long as we insist on making somebody pay for defaults, we have to find a victim when bad things happen."

I understand the reasoning for, and mostly agree with, the government underwriting correlated events. From what I can tell, while Canada may have not had "subprime" or whatever, there is still the problem of increasing loan exposure via assets that are obviously (in my view) overvalued.

It is incorrect to cite a de facto government guarantee as free license to accept asset bubbles, though I do not think you are explicitly stating this. As I mentioned further up, I see CMHC and the government as begging the question through their policies in the past 5 or so years. Affordability is poor because land prices are high, therefore policy should be designed to improve affordability at current market prices, in part by underwriting mortgage insurance and providing preferred interest rates. It "begs the question", why are land prices high, exactly?

[Whitfit]

Jesse: "Affordability is poor because land prices are high, therefore policy should be designed to improve affordability at current market prices, in part by underwriting mortgage insurance and providing preferred interest rates. It "begs the question", why are land prices high, exactly?"

But, might the high price of land and affordability policies not be connected? I wonder if all we have done is inflated the cost of housing to the maximum that a family's cashflow can sustain, and maximizing the capital that banks will push into the housing market, because the default risk has been pushed on to the federal government, and thus the mortgage issuers have low to no risk on their balance sheet for those assets. Any move to increase affordability might just push up prices, and have no effect on affordability.

See:

Gordon Tullock, "The Transitional Gains Trap"

Bell Journal of Economics, 1975, vol. 6, issue 2, pages 671-678

Abstract: Many government programs which appear to be designed to help some particular industry or group do not seem to be succeeding. The explanation offered here is that the program, when inaugurated, generated transitional gains for the individuals or companies in the industry, but that these have been fully capitalized, with the result that the people in the industry now are doing no better than normal. On the other hand, the termination of the particular scheme would, in general, lead to large losses for the entrenched interests.

[Patrick]

OT nitpik: "Begging the question" is a logical fallacy. "Raises the question" is a new line of inquiry.

http://en.wikipedia.org/wiki/Begging_the_question

[jesse]

@Whitfit: "But, might the high price of land and affordability policies not be connected?"

That's my point. Justifying the need for a government guarantee so as to improve affordability adversely affected by a government guarantee is a logical fallacy, begging the question.

(Patrick yes that's why I put "beg the question" in quotes because it both annoys and amuses me when politicians use the dual-purpose phrase. So I raise the question, why are land prices high compared to the utility said land provides, really?)