Wednesday, January 12, 2011

Time for the government to get out of the mortgage game?

Neil Mohindra of the Financial Post came out today with a great article titled Canada's Mortgage Hazard.

As you know, Bank of Canada Governor Mark Carney has been sounding warnings about Canadian debt levels. The concern? Escalation of household debt is a risk to Canadian financial stability when interest rates begin to rise.

This was followed by the International Monetary Fund weighing in and identifying Canada's stretched household balance sheets as a near-term risk to our nation's financial system.

Not only were average Canadians scolded for taking on too much debt in this era of emergency interest rates, but banks were cautioned to curtail lending.

The response by some bank CEO's was to call on Finance Minister Jim Flaherty to tighten lending standards for residential mortgages, such as a reduction in amortization periods.

The banks claimed they were unable to individually take action because of the competition between them for that debt business.

In a year-end interview Flaherty countered:
  • "I find it just strange that I get some of the financial institutions telling me to mind my own business on regulatory matters - and then we have some worries about the level of consumer debt, and the banks are saying the government needs to move in and tighten standards."
The Financial Post article summarizes the problem which the blogosphere has been harping on now for several years.

Banks won't curtail lending because they are protected by the Canadian Mortgage and Housing Corporation (CMHC). The government-backed mortgage insurance is mandatory for all mortgages with a loan-to-value ratio in excess of 80%. Because of that, the conventional incentive for banks to set their own underwriting standards and monitor risk exposure has simply been washed away.

Rather than screening mortgage applications for risk, bank staff simply tick the boxes required by government. At most, banks have an indirect interest in assessing credit risk since households with too much mortgage debt may be more at risk of defaulting on other loans such as credit cards.

This is why the bloggers laugh at the assertions about Canada's 'sound banking system'.

The Financial Post article cuts right to the heart of the matter with a succinct observation:
  • “If the Canadian government sees rising household debt levels as a real concern and bank underwriting standards as the solution, the logical course is to exit the business of mortgage insurance and stop guaranteeing residential mortgages with public money. Such a move would protect taxpayers from a business they do not need to be in.”

    “As long as the government insists on backstopping the risk of high-ratio mortgages with taxpayers’ money, banks simply won’t have any skin in the game and will react half heartedly at most to calls for them to tighten lending standards to address concerns over rising household debt. Instead, the banks will simply sell as many high-ratio mortgages as they can, knowing that taxpayers will ultimately pay the price if rising household debt creates problems in the future”

This is exactly what the problem was in the United States with Freddie Mac and Fannie Mae.

As long as the government insists on backstopping the risk of high-ratio mortgages with taxpayers' money, banks won't take action. The banks will continue to sell as many high-ratio mortgages as they can, knowing that taxpayers will ultimately pay the price if rising household debt creates problems in the future.

The Financial Post suggests the time may have come for the government to begin exiting the business of insuring mortgages and providing government guarantees.

But will the voting public, now addicted to the crack cocaine of low interest debt, allow them to?

Sounds to me like we're back to square one with everyone pointing fingers and nobody taking any action.



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  1. You missed one other point in the article... there is actually DISINCENTIVE for the banks to sell conventional mortgages!

    Think about it... you can either:

    A) Sell a conventional mortgage, which makes the bank less money, and require more time to get through the paperwork since the internal bank employees need to figure out the risk/insurance/etc.


    B) Sell a high-ratio mortgage, spend zero time assessing the buyer's credit, get more money from the buyer, and flip all of the risk over to CMHC.

  2. Important point. Thanks for the comment.

  3. HI I enjoy your blog and think that you do a good job in writing it.

    Another reason the banks are worried about Canadian debt is the line-of-credits being taken out on inflated houses prices. This debt is not secured by the government like the mortgages are but just against the house. If the housing market corrects and/or interest rates rise the "safe" Canadian banks could be facing losses from people no longer able to afford the line-of-credits defaulting and the banks wind up with a house worth less than the debt they are owed.

    I fell that we have not avoided what has happened to the Americans just delayed it by a few years. Maybe the government can keep the real estate market inflated for a while longer but once the mania wares off there is going to be plenty of pain to go around.

  4. nice work whisperer

    the housing bubble is a slow motion train wreck that is politically impossible to stop.

    The warnings are given but little is actually done as high-risk loans are fueling prices and if that cat-nip is taken away, the party is really over.

    I really do feel that no political party has the willpower to stop the debt bubble as the hit to our economy would be huge.

    Condo prices are going to take a hit

    this is going to get ugly