Canada’s Mortgage Monster?

Chris Sorensen And Jason Kirby of Maclean's report, The CMHC: Canada’s mortgage monster:

David LePoidevin isn’t the first person to suggest Canada’s roaring housing market is headed for a U.S.-style crash. But he is a rare breed of money manager for daring to point a finger at the Canada Mortgage and Housing Corporation, the country’s biggest mortgage insurer. In a fall 2009 note to his clients, LePoidevin questioned what was underpinning the country’s skyrocketing home prices, aside from rock-bottom interest rates. “The stock market was sure not providing huge capital gains to the masses,” he wrote. “Did the banks all of a sudden open up the lending spigots? In fact banks have actually reduced the number of their mortgages held from the peak of third quarter of 2008. The smoking gun is the CMHC and its securitization policies.”

As mainstream economic commentary in Canada goes, it was damning stuff. And it provided ammunition to critics who argue the Crown corporation’s policies have inflated a housing bubble. The CMHC is arguably the most influential player in Canada’s $1-trillion housing market. Its main function is to provide mortgage insurance for prospective homeowners who put less than 20 per cent down on their houses, protecting the banks in the event of defaults. The CMHC also helps to spread risk by finding investors to buy CMHC-insured mortgages that have been pooled together into so-called mortgage-backed securities. All of this is guaranteed by the government.

Almost immediately, LePoidevin’s bosses at National Bank leapt to the CMHC’s defence. In a letter to an Ottawa newspaper that had referred to the commentary, co-chief executive Ricardo Pascoe said the Vancouver portfolio manager’s views were “personal” and “do not reflect the views of National Bank Financial Group.” When reached by Maclean’s, LePoidevin declined to talk about the public rebuke or the CMHC in general. A National Bank spokesperson justified its actions, saying the company “felt that the commentary was treading on social and political issues.”

The apparent unwillingness of the country’s sixth-largest bank to challenge the CMHC is curious given the role similar U.S. institutions Fannie Mae and Freddie Mac—quasi-government agencies that securitized mortgages—played in the U.S. housing crash. But it’s far from unusual. Several other critics, including economists, realtors, lawyers and analysts contacted by Maclean’s, say they have also been the target of attack. One bank economist who once publicly raised fears about a housing bubble says he didn’t dare openly criticize the CMHC because of the agency’s reputation for snuffing out dissent—an allegation the CMHC denies. The economist spoke on the condition his name not be used.

Even worse, the public knows next to nothing about what lurks inside the CMHC’s books, aside from the smattering of details it releases in its annual report. And, unlike every other major insurance provider in the country, the CMHC doesn’t answer to Canada’s top financial services regulator. It falls under an amalgam of government acts and departments, including Finance and Human Resources, while also working with the Bank of Canada. Yet on specific decisions that dramatically loosened mortgage lending rules last decade, CMHC officials have testified they did so on their own with the approval and oversight of the CMHC’s board of directors—a board that includes a political consultant, real estate developers, a small-town lawyer and even the owner of a plumbing company—though not one single economist or recognizable financial services professional.

It all raises troubling questions about the agency, its oversight and, ultimately, the health of the country’s frothy housing market, a key driver of the Canadian economy. And, as LePoidevin found out the hard way, asking hard questions seldom yields satisfactory answers.

Since taxpayers, through the CMHC, and not the banks are ultimately on the hook in the event of a housing crash, a growing chorus of critics has been calling for more transparency and oversight, if not outright reform. Stephen Jarislowsky, a billionaire Montreal investor, says home prices are likely overvalued by as much as 20 per cent in some Canadian markets thanks to CMHC policies that encouraged banks to lend far too much money to people to whom they shouldn’t have. The core problem, he argues, is that promoting home ownership makes for good politics in Canada, if not always sound economic policy.

“The CMHC is influenced by the political process, just like [Fannie Mae and Freddie Mac] were in the United States,” says Jarislowsky. He notes the average debt-to-income ratio of Canadian households recently surpassed that of the U.S. for the first time in 12 years. “The political folks are guaranteeing mortgages that the banks might never have made if they had to keep them on their own books,” he says.

At the end of 2009, the CMHC insured roughly $473 billion worth of mortgages (it expected that figure to rise to $519 billion last year, though updated figures haven’t been released), which is nearly the entire mortgage insurance market in the country. The CMHC also assists the financial sector by buying pooled mortgages and reselling them to investors as bonds, giving banks and other institutions an immediate source of cash that they can re-lend. As of 2009, the CMHC had securitized $300 billion worth of mortgages. So critical is this function that Ottawa relied on the agency to prop up the country’s big banks during the financial crisis, giving the CMHC permission to buy $66 billion worth of mortgages.

It’s a familiar-sounding story to American ears. “The Canadian government mortgage apparatus echoes uncannily our experiences down here with Fannie and Freddie” says Jim Grant, author of the widely read Grant’s Interest Rate Observer newsletter. “CMHC has distorted the housing market by making homes, especially ones that are on the pricier end of the spectrum, more affordable and encouraged a lot of people to get in over their heads.”

Grant and other critics argue the CMHC’s balance sheet looks strikingly similar to both Fannie and Freddie if you compare the mortgages the agency insures against its equity. Using the CMHC’s 2010 forecasts, it insures $519.1 billion in mortgages against $9.9 billion in equity, which works out to around 1.9 per cent (although the CMHC says it has another $6.7 billion in “unearned” premiums that could be used toward future claims). By comparison, in 2007, at the peak of the bubble, Fannie Mae backed up US$2.7 trillion of mortgage-backed securities with US$40 billion of capital, or 1.5 per cent equity against its overall exposure. But the CMHC says its capital levels are double what the Office of the Superintendent of Financial Institutions requires of mortgage insurers (though the CMHC is not regulated by the OFSI). But such assurances in the absence of transparent disclosure offer limited comfort. As C.D. Howe researcher Finn Poschmann wrote in a recent report: “Parliament and the voters to whom it answers have no formal documentation of the way these exposures are calculated or managed.”

What bothers Grant is that the CMHC’s government-backed guarantees encourage banks to feel they have less to lose if loans go bad. “The risk has been shifted, rather than reduced, from the stockholders and depositors of the big Canadian banks to the Canadian taxpayer,” he says. And if house prices fall and borrowers get into trouble, the ripples would run far and wide. “A sharp break in Canadian house prices would inflict terrific damage to consumer confidence, would hurt the Canadian labour market, and ultimately produce a lot of the unpleasant results that have been America’s burden to bear since 2007.”

The CMHC argues such concerns are overblown. It points out that the Canadian mortgage system is fundamentally different than in the U.S. That’s because mortgage interest is not tax-deductible, a relatively small number of mortgages are securitized, and lenders can generally go after homeowners who don’t make their payments. The CMHC also points to Canada’s low rate of mortgage arrears, currently less than one per cent. Finally, the industry never got swept up in the subprime lending trend, the CMHC says. “We don’t have those products in Canada,” says Pierre Serré, the CMHC’s vice-president of insurance product and business development. “And if we did, CMHC certainly did not insure them.” Lending weight to the CMHC’s claims, a 2009 IMF report called Canada’s residential mortgage markets “boring but effective.”

Canadian lenders didn’t go overboard with the sorts of gimmicky mortgage products—loans with low initial “teaser” rates or so-called NINJA loans (no income, no job or assets)—that got Americans into so much trouble. But it’s not like they shied away from taking risks. For two years beginning in 2006, the CMHC offered insurance on mortgages with amortization periods of up to 40 years, nearly double the traditional 25-year period, and loans with zero down payments. The products were later reined in by Ottawa after the U.S. housing market tanked.

The CMHC dove into such high-risk products largely without supervision. While the government had previously relaxed conditions for guaranteeing mortgage insurance as part of a plan to introduce more private sector competition, it was the CMHC’s management and board that ultimately made the decision to go to 40-year amortization periods. In the same way, in 2007, the CMHC introduced a program for self-employed Canadians who have difficulty documenting their earnings to nonetheless obtain mortgage insurance by “stating” their income. While the program was restricted to borrowers with good credit ratings, one mortgage broker told Maclean’s self-employed Canadians were able to get much larger mortgages than those in the same field who had documented incomes. Then, a year ago, the CMHC backtracked and significantly tightened its rules on stated-income mortgages.

“We’re allowed to operate and make decisions with regards to mortgage insurance products and policies within the [government's] guarantee, and when we do so we advise the government of any changes,” says Peter De Barros, a spokesperson for the CMHC. Still, the move to riskier mortgage products drew the ire of then-Bank of Canada governor David Dodge, who sent a letter to CMHC chief executive Karen Kinsley in 2006 warning about the dangers of throwing fuel on a hot housing market. “A home purchaser is able to borrow at very low interest rates because you and I as taxpayers essentially guarantee that mortgage,” Dodge said during an interview earlier this year on Business News Network. “So it’s not at all unreasonable for us as taxpayers to say, ‘Look, Mr. Borrower, you’ve got to have an equity stake in this as well, so if things go really bad it’s not all on the Canadian taxpayer—part of it is on you.” (Dodge declined to be interviewed for this story.)

Critics say that, given what happened in the U.S., it’s irresponsible to not have someone watching over the CMHC. “They are the only major financial institution in Canada not regulated by OSFI,” says Ian Lee, an assistant professor at Carleton University’s Sprott School of Business and a former bank manager. “Housing is so huge and the consequences are just so large. It’s not like they’re deciding what to do about the price of ballpoint pens.”

So how much risk have taxpayers been exposed to? The CMHC doesn’t reveal specific data about the credit exposure that it has taken on, other than to say it is manageable and in line with internal guidelines. As for the question of whether the CMHC’s policies could contribute to a housing crash, the agency says there’s no reason for Canadians to lose sleep. It says more than half of CMHC-insured mortgages have a loan-to-value ratio of less than 80 per cent based on the value of the original loan, and that the average equity in a CMHC-insured property is 45 per cent. “The mortgages are getting paid down—as a matter of fact, we see that about half of our folks made extra payments, more than just the minimum required principal payments,” says Serré, adding that rising home prices have also helped improve the debt picture.

But such aggregate figures don’t necessarily provide an accurate snapshot of how homeowners are faring, according to Poschmann at C.D. Howe. Important questions remain unanswered—like what is the geographic breakdown of its mortgages? Of those people with lower equity in their homes, what is the size of their mortgages? What classes of loans are they? What are their terms? “You can’t come up with an independent assessment of exposures based on the information they publish,” says Poschmann. “You can manage risks better with oversight and daylight, but right now we have pretty opaque books.”

While the CMHC says it has a sophisticated automated system to check creditworthiness of borrowers and property values, its biggest private sector competitor (which also has its mortgage insurance guaranteed by taxpayers, albeit only up to 90 per cent) nevertheless suggested during a 2007 hearing of the Senate banking committee that more than a third of all mortgages insured by the CMHC could be considered risky. Winsor Macdonell, the vice-president and general counsel of Genworth Financial, told the committee he assumed the CMHC’s portfolio looks similar to Genworth’s given that both provide mortgage insurance for the entire Canadian market. “When I talked about our portfolio, 36 per cent are people with low or poor credit,” he said. “Those are the people who are at risk.” Genworth declined to talk to Maclean’s for this story.

Serré declined to comment directly on Macdonell’s remarks. “I’m not exactly sure what low or poor credit is,” he says. “But I want to make clear that our mandate is not to get people into home ownership, our mandate is to provide the housing of choice. The last thing we want, as a government insurer, is to get people in a position where they can’t manage their debt.” For the sake of Canada and its fragile economic recovery, let’s hope he’s right.

Wow! Where do I begin? It was only a week ago when I delved into the topic of the Canada bubble and now another bombshell article from Maclean's questioning the practices of the Canada Housing Mortgage Corporation (CMHC). (Track daily news on the Canadian housing bubble on canadabubble.com and greaterfool.ca).

First, I used to work at the National Bank of Canada. I never met Ricardo Pascoe but I heard he's not exactly the type of guy you want to piss off. I can only imagine the phone call Mr. LePoidevin got after he wrote that stinging memo, probably telling him to "zip it". The CMHC is extremely important to Canadian banks.

In October 2009, Murray Dobbin wrote a commentary, Why Canada's Housing Bubble Will Burst. It was way too political for my taste, blaming "Harper Conservatives," (Liberals are as much to blame) but Mr. Dobbin did make a good point on banks passing off risk:

The banks themselves have taken on virtually no new risk. According to CMHC numbers in the two years from the beginning of 2007 to January 2009, Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. Fully 90.5 per cent of all growth in total Canadian mortgage credit outstanding since 2007 has been accounted for by Mortgage Backed Securities. Of course, the banks have no interest in saying no if you have qualified for a securitized CMHC loan -- because they bear no risk if you default.

If that sounds like sub-prime mortgages, it should. Sub-prime is any loan below prime. If a bank refuses you a loan, and CMHC gives you one, the loan is sub-prime. As Lepoidevin says in his warning letter, "Every single U.S. lender specializing in sub-prime has gone bankrupt. The largest sub-prime lender in the world is now the Canadian government."

But is it right to compare the CMHC to US agencies and subprime lenders? No, but let's go back to that Maclean's article above. The CMHC says "more than half of CMHC-insured mortgages have a loan-to-value ratio of less than 80 per cent based on the value of the original loan, and that the average equity in a CMHC-insured property is 45 per cent." In other words, a sizable portion of CMHC-insured mortgages have a loan-to-value ratio greater than 80 per cent based on the value of the original loan. Moreover, the CMHC does not publish the weighted loan-to-value ratio of their mortgage book pre and post 2007. As for the "average equity in a CMHC-insured property being 45 per cent," that too doesn't tell us much. You have to take the median and separate out CMHC-insured properties pre and post 2007.

Keep in mind, there are a lot of young two-income couples who bought homes in the last five years that they were able to purchase because they took out huge mortgages (insured by the CMHC). If one of them loses their job, they're going to be in big trouble. I'm not worried about two doctors who have a guaranteed high income taking out a huge mortgage (even though I think it's stupid). I'm more worried about some salesperson making a lot of money, taking out a huge mortgage thinking they're going to be able to make the payments in the future because they'll continue making a lot of money. If they lose their job, they're cooked. There is no way they're going to find another job that pays them as much. Just look at what happened in the US.

The Maclean's article made some mistakes too, citing some Carleton professor who said the CMHC is the "only major financial institution in Canada not regulated by OSFI." This is false. The two largest Crown corporations in Canada, the Canada Pension Plan Investment Board (CPPIB) and the Public Sector Pension Plan Investment Board (PSPIB), manage hundreds of billions in assets among each other and are not regulated by OSFI even though OSFI regulates private pension plans. Why is this the case? It's all about governance. These public pension investment boards want to operate at "arms-length" from the government. While I agree with this "arms-length" approach, best governance standards around the world have the same entity in charge of oversight for private pension plans also in charge of oversight at public pension plans. OSFI isn't perfect but they have qualified people who can ask some tough questions to these financial institutions and assess the risks they're taking. Whether or not OSFI wants this responsibility is another matter.

Other large financial Canadian Crown corporations like the Business Development Bank of Canada (BDC) and Export Development Canada (EDC) are also not regulated by OSFI, however, they fall under the Financial Administration Act and are subject to a lot more public scrutiny than most Crown corporations. The truth is there is no perfect governance anywhere, and all Crown corporations have secrets they don't want to share publicly. The problem is that someone somewhere has to aggregate and assess all the risks these Crown corporations take. Is it going to be OSFI or another entity? Who knows? All I know is that if I was advising the Prime Minister of Canada, I'd tell him to create a new financial supervisory agency and ask David Dodge to head it (I'm biased, I like David Dodge a lot because he understands what's at stake).

After my last post on the Canada bubble, I received emails from a few money managers asking me the best way to short Canada. Let me be clear on something, this bubble isn't going to burst anytime soon. When it does, it's going to be painful and last for years, but I continue to believe Canadian equities will make new highs. Don't bother shorting Canadian banks either, and if you do, be aware that some banks are a lot more prudent than others in their lending standards. I wouldn't short Canadian bonds either. The best way to "short Canada" is through the Canadian dollar, but it will continue to track oil prices higher. It might decouple if housing tumbles, but it's a tough call to make right now. All this to say that this bubble will last longer than skeptics think. And don't just blame banks. Large Canadian credit unions are aggressively lending to pretty much anyone looking for a mortgage. This is another disaster waiting to happen (can't short credit unions either).

Finally, I want to publicly apologize for some silly comments I made about suburbia USA when I wrote about my recent experience with the CCSVI procedure. Those comments were rude, arrogant and stupid. There are a lot of hard working, decent folks living in these towns and I shouldn't have written anything negative about their way of life. I'm sorry if I offended anyone. Below, some serious humor on the CMHC.