Last week, The National Post reported on the Canadian Mortgage and Housing Corporation (CMHC) and their growing insurance load coverage. According to the story, the CMHC is edging closer to a $600-billion government-imposed limit on mortgage default insurance, backing nearly $541-billion in mortgages. If the demand grows for mortgage default insurance, the CMHC will need to request a limit extension – something that could create increased risk for taxpayers should the Canadian housing market collapse.
What is Mortgage Default Insurance?
Implemented in 1954, mortgage default insurance is issued on high-equity loans (i.e. when the consumer provides less than a 20% downpayment). The purpose of mortgage default insurance is to indemnify the lender in the event the borrower defaults. With that being said, it’s the borrower who is responsible for paying the insurance rate.
Looking at the Numbers
The last time the CMHC asked to bump their insurance cap was in 2008. Back then, the CMHC was backstopping $450-billion in loans. On the surface, it would appear that the nation’s banking system has processed nearly $100-billion dollars in high risk mortgages over the past 48 months, but that’s not exactly true.
In order to cut costs and improve their balance sheets, Canadian lenders have gotten into the habit of providing insurance on low risk, high downpayment mortgages. This optional coverage allows the banks to secure bulk or portfolio insurance loans, thereby reducing capital requirements.
Of the $541-billion in loan insurance backing, more than three-quarters is considered low-ratio. While the risk of default is low with these high downpayment clients, the risk still exists. Lenders that purchase bulk insurance do so because it means the government is behind them if a borrower defaults and the lender can’t afford to cover the bill. Bulk insurance also enables banks to mange their capital more efficiently and makes it easier for smaller lenders to compete with larger operations.
Assessing the Risks
Bulk or portfolio insurance is nothing new, so why the sudden interest? According to the Crown corporation’s spokesperson, Charles Sauriol, the CMHC “has received an unexpected level of requests for large amounts of CMHC portfolio insurance.” Just how large? Well, Scotiabank reportedly posted more than $17-billion in mortgaged-back security issuances last quarter.
Still, the beauty of portfolio insurance is that the risks are minimal. There’s a relatively strong relationship between default risk and loan-to-value (LTV). As such, rarely do high-ratio borrowers stop making mortgage payments. However, should the unthinkable happen and mass defaults occur, the Canadian housing market would have some major problems.
Remember, the government guarantees CMHC’s liabilities; if ever mass defaults were to occur on a scale similar to the U.S. housing collapse, the tab would be covered by the premiums paid by the borrowers (through mortgage default insurance rates) and the lender (through portfolio insurance payments).
If for some reason these premiums couldn’t cover the tab, Ottawa (i.e. Canadian taxpayers) would be on the hook for 100% of the shortfall. The likelihood of that happening? According to sources, is much higher than you’d think. Apparently big banks have negotiated the premiums down so low that should they ever be required to cover mass default, there may not be enough in the coffers to foot the bill.
As of today, the CMHC has no plans to ask for a limit extension above and beyond the current $600-billion ceiling. As such, lenders should anticipate cutbacks on portfolio mortgage insurance. According to Canadian Mortgage Trends, these cutbacks could result in a number of repercussions:
- Smaller lenders would be required to pay more for conventional mortgage funding, which could kill off rate competition from non-bank lenders.
- An increase in bank capital costs, which would either impact earnings or increase mortgage rates.
- Discourage non-bank lenders from entering the market, reducing choice for borrowers.
- Force lenders to find alternative, uninsured funding sources for conventional mortgages (an alternative that would likely have positive outcomes as it would cut the government’s exposure in the event of mass defaults).
- It could generate interest in the covered bonds market (stay tuned to Mortgage Talk for an article on the benefits of this mortgage product).
- Smaller lenders may become more choosy when it comes to selecting which conventional borrowers to lend to.
- Mortgage brokers will be forced to lean more heavily on banks for conventional financing, which could cause the banks to increase mortgage rates.
- Private insurers could see a rise in activity as lenders shut out by CMHC turn to them for support. This could allow private insurers to charge more for portfolio insurance packages.
While the Canadian government is taking a risk by backing the CMHC, there is also the opportunity for great rewards. In the last decade alone, the government has earned more than $14-billion in profit as part of the agreement. But that was then, and this is now. Stay tuned to Mortgage Talk Canada for more information on this story as it unfolds.