In our primers, we’ve now covered some of the important concepts that will be referenced frequently on this blog, namely deflation, the housing bubble, and the significance of mass psychology in financial events. This primer will add on to the primer on the Canadian housing bubble and give some insight into what has enabled this bubble to reach such significant proportions.
It is not possible to understand the Canadian housing bubble phenomenon without understanding the role of CMHC (Canada Mortgage and Housing Corporation) in mortgage lending. First, a bit of history.
CMHC was created in 1946 (the known as Central Mortgage and Housing Corp.). The mandate of CMHC was to administer the National Housing Act and the Home Improvement Loans Guarantee Act. Essentially it was created to provide soldiers returning home from war with access to affordable mortgages.
Today, CMHC describes their role as follows:
“Canada Mortgage and Housing Corporation (CMHC) is Canada’s national housing agency. We are committed to helping Canadians access a wide choice of quality, affordable homes, while making vibrant, healthy communities and cities a reality across the country. CMHC works to enhance Canada’s housing finance options, assist Canadians who cannot afford housing in the private market, improve building standards and housing construction, and provide policymakers with the information and analysis they need to sustain a vibrant housing market in Canada”
It’s the bold part of this statement I want to focus on. We will see shortly that the mandate to ‘(help) Canadians access…affordable homes’…by…’enhancing finance options’ is a self-defeating mandate. CMHC works by acting as the guarantor for any mortgage where the purchaser is unable to pay a specified amount as a down payment (20% for residential properties). Essentially CMHC guarantees the full value of the loan so as to protect the lending institution in the event that the buyer defaults on their mortgage and the bank is unable to recover the full value of the loan by selling the home. Consider an example:
Imagine a homeowner buys a $200,000 home with a 5% downpayment, leaving a mortgage of $190,000. Since the homeowner does not have the required 20% downpayment, they pay a CMHC insurance fee and CMHC guarantees that they will cover any losses so the bank can be assured of a profit. A year later the economy sours, the homeowner loses their job, and real estate falls by 10% (I know real estate only goes up, but just use your imagination). The homeowner is no longer able to make payments and defaults on the mortgage. The bank takes possession and sells the home to recover their capital. The problem is that the home is now worth only $180,000 but the bank has lent $190,000 leaving them with a 10K loss. Seeing as how we embrace capitalism some strange system where we guarantee private banks a profit at the expense of taxpayers, we can’t allow that! How else can the bank CEOs get their fat bonuses. So instead the bank waddles up to CMHC and ask for the difference. CMHC obliges and promptly hands over the 10K.
As I touched on in an earlier post, any time the government steps in to guarantee things, they actually defeat their own purpose. In this case, let me ask you whether or not CMHC has been successful in helping to keep the costs of home ownership affordable? Let me refresh your memory of how affordability currently measures here in Canada (and this is with record low interest rates):
So what is really going on here? A more appropriate wording of their mandate might be, “To provide artificially cheap mortgage rates for borrowers who may not otherwise qualify for such rates and to ensure that the banks have no reservations about lending to said individuals”. In this respect, they are a resounding success. In a mortgage market free of government manipulation, a lending institution would carefully consider what interest rate to charge a person. They would take into consideration their credit worthiness, payment history, and down payment since negative equity is one of the important determinants of default rates. Now imagine two people came in to a bank. One with a FICO score of 800 (excellent credit) and a down payment of 25%, the other with a FICO score of 650 (average or slightly below average credit) and a down payment of 5%. In a normal, functioning mortgage market, who should get the lower rate? If you were asked to lend money to one of them, which would you choose? If you did decide to lend money to the less credit-worthy person, you would ask for a higher interest rate to compensate for the increased risk. And so it should be. The effect of the CMHC guarantees ensures that both individuals get the low rates, one of which would be an artificial, manipulated low rate.
You may ask, “why hasn’t CMHC spurred a bubble before now?”
Excellent question. To answer that, let me walk you through some key events that have greatly changed the mortgage market landscape in Canada.
In 1954, the federal government expanded the National Housing Act to allow chartered banks to enter the NHA lending field. CMHC introduced Mortgage Loan Insurance, taking on mortgage risks with a 25% down payment.
In 1999, the National Housing Act and the Canada Mortgage and Housing Corporation Act were modified, allowing for the introduction of a 5% down payment – a change launched as a five-year pilot in 1990, extended and finalized in 1999 – removing a significant barrier for first-time home buyers. Yes….imagine the injustice of actually having to SAVE to purchase a home, as all the generations prior had done.
In 2003 CMHC decided to remove the price ceilings limitations. That is, it would insure any mortgage regardless of the cost of the home.
These two developments had the effect of increasing the outstanding mortgage balance in Canada by 125% between 2000 and 2009. Thanks once again to Jonathan Tonge for compiling the chart.
In 2007, CMHC allowed people to purchase a home with no down payment and ammortize it over 40 years. This was changed back to a 5% down payment requirement and a maximum amortization of 35 years in late 2008.
In an effort to prop up the real estate market in 2008 (when affordability nosedived and the economy soured), the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. The approval rate for these risky loans went from 33% in 2007 to 42% in 2008. By mid-2007, average equity as a share of home value was down to 6% — from 48% in 2003. This resulted in a shocking 9% increase in household debt between June 2008 and June 2009, the only such increase during a recession in Canadian history.
I have long maintained that the net effect of these policies has been to pull demand forward, particularly in the past few years, and to raise home ownership rates to artificially high levels. In Canada we are currently at the highest home ownership rate in our history, hovering around 70%. How many more people can buy? CMHC has been absolutely pivotal in getting many new individuals into the market, but have massively skewed prices in the process.
So just how much does CMHC insure and what is the risk to taxpayers? In March 2010, the Fraser Institute released a study highlighting the risks to taxpayers and suggesting a privatized mortgage market structure similar to the one Australia uses. This study confirmed that the taxpayer risk from a housing collapse is greater in Canada than elsewhere. It notes that a stunning 90% of all insured residential mortgages in Canada are covered by the CMHC. This amounts to an estimated $480-billion (now no doubt over half a trillion) for which Canadian taxpayers would be on the hook if the housing market tanked (although any loss would obviously only be a fraction of this amount).
Those who have payed CMHC fees may protest that it won’t be taxpayers on the hook, but that their fees will cover future losses. Perhaps. But consider that standard loan fees reach a maximum of only 3.3% of the total loan value. Not much of a cushion. As you can see in the following chart, the standard premium for a non-traditional down payment (such as this ridiculous offer….gotta love our ‘conservative’ banks) is 2.9%, plus a 0.4% surcharge if it is amortized over 35 years.
It’s not hard to see that CMHC is the crutch supporting a wounded housing market. It has had a role analogous, though not identical to the one played by Fannie Mae and Freddie Mac in the US. See how things turned out for them. Canadians are on the hook for a significant amount of debt and it is absolutely my belief that we will pay up in the next few years. Government interventions in free markets can have the effect of propping up demand over the short term. But free market principles, fundamentals, and the immutable laws of supply and demand will win out at some point. In the case of our CMHC-aided housing bubble, that point is now here.
Cheers and blessings
UPDATE: This post has now been turned into a video primer.