CMHC feeling the heat

CMHC feeling the heat

If you’ve read this blog for any time now, you’ll know my position on CMHC policies:  They are inherently self-defeating and act as the enabler to Canada’s housing addiction.  Most concerning, CMHC guarantees over half a trillion dollars in mortgages.  But as they are a quasi-government agency, it is more appropriate to say that Canadian taxpayers are on the hook for these liabilities.  Whether or not these scenarios play out is far from the main issue.  While still a highly profitable entity (it had net income of an estimated $1 billion last year), I am fundamentally opposed to its stated mandate and frankly its very existence.

At its root, CMHC is a government agency created to guarantee bank profits while ensuring artificially low interest rates to those who would not otherwise qualify for them, creating excess credit in the process, and exposing the Canadian economy to adverse shocks in the event that this credit creation slows or God forbid goes negative.

Now we find that the mainstream media is shining this same light on the issue:

The CMHC: Canada’s Mortgage Monster – Macleans

This is an interesting article.  I was a bit surprised to find that Macleans would suggest that CMHC is actively intimidating bank-employed economists who dare to speak out against CMHC policies.  I find this a bit of a stretch, but nevertheless, here’s the quote:

“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.”

The Macleans article also discusses the apparent lack of oversight on the part of the CMHC, a topic examined in a Globe and Mail article earlier this week as well, which we’ll look at in a moment.  From Macleans:

“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.”

While lending practices between Canada and the US are certainly fundamentally different, I’ve long been highly skeptical of the ‘conservative Canadian bank’ mantra, a theme I discuss often.  On this topic, the Macleans article had lots to say:

“The Canadian government mortgage apparatus echoes uncannily our experiences down here (in the US -ed.) 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.”

“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.”

And of course, CMHC’s predictable response to such allegations:

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.”

I’ve spent so much time debunking these ridiculous assertions that it pains me to regurgitate them again here.  Yes our banking system is fundamentally different.  But we did have (and continue to have) subprime mortgages which are fully insured by CMHC based on the widely held definition of the term ‘subprime’.

Our banks are far from conservative.  We still have zero equity mortgages fully insured by CMHC, though they are now structured as 5% cash back mortgages by all of the big banks (5% is the minimum down payment, conveniently enough).  The recourse system mentioned by CMHC whereby lenders can pursue borrowers has been shown to reduce defaults by 20%.  By far the greatest predictor of default is negative equity…..which the US found out as the element of recourse available to lenders in more than half of all US states has done little to stem the tide.

For more on all of this, check out these posts:

Bank of America Merill Lynch weighs in on Canadian real estate

More media nonsense: “Our housing market to side step U.S. style bubble”

Who’s the hare-brained one?

Is Canada immune from a foreclosure wave?

Canada’s credit bubble

Perhaps the quote that should bother you most in the enitre Macleans article is the following:

“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.”

So it’s at least a half a trillion dollars, or over a third of our GDP, but taxpayers don’t get to know the details?  Ridiculous!  It’s this lack of transparency and oversight that led the Globe and Mail to run a story on CMHC earlier this week:

Time to step up the oversight of CMHC operations– Globe and Mail

Who is minding this huge, crucial beast that puts taxpayer money on the line? The answer is Canada’s Minister of Human Resources – not Mr. Flaherty, despite his sway over items such as mortgage rules – and a board of directors that is largely drawn from the real estate and building businesses, with little background in banking or insurance.

That arrangement may have made sense when CMHC was primarily engaged in tasks like providing low-income housing, but now the mortgage insurance side of the business dwarfs other components and requires new gatekeepers.”

There’s very little to argue with here.  CMHC insurance of residential mortgages remains the biggest factor in allowing and encouraging the current, significant overvaluation in the Canadian real estate market.

As a final note, perhaps one of the handful of CMHC economists who are email subscribers of this blog would like to weigh in with their opinion on this topic.  I’m sure there’s much that has been written here that doesn’t sit well with you.  We’d all love to hear your take.

Cheers,

Ben

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32 Responses to CMHC feeling the heat

  1. Sams Mango says:

    The CMHC has 45-55% LTV, they are going to be fine Ben. What situation can you see that homes values drop by that much? That would win any stress test, the government is not going to get a margin call.

    The fact they have overstepped the original purpose might be for an issue for some, however this is how it has worked for sometime and the low LTV’s embedded on the books make me sleep better at night. I don’t think you have anything here Ben for an “a ha” moment.

    • That’s not how it works at all Sam/Mango. The LTV ratio you mention is the aggregate equity position of all mortgages held by CMHC. That’s not the important number. The important number is how much of a buffer do they have in the event of a rise in delinquencies which, as described in the Macleans article, is far, far less.

      Remember that all you need to do is squeeze the margins to experience a lot of pain. All those new 5/35 mortgages or the 0/40s still hiding on their books will be all you would need to pressure to rapidly exhaust that thin buffer. A drop in prices of only a fraction of the 45% -55% you cite would be sufficient to cause some pain.

      But perhaps more fundamentally you might want to take a stab at justifying the basic existence of CMHC. What is their purpose?

      • Sams Mango says:

        use the mid of 50% LTV

        V= 100
        L = 50

        Housing prices drops by 30%, now V=70, L = 50
        still ok? Every insurance company has questionable liabilities, but as long as the core book is fine, take a few hits of this margin loans is not going to take the CMHC down.

        Remember Ben, don’t confuse HOUSING DROP with HOUSING DEFAULT.

        prices can drop, it’s OK. People have to stop paying mtgs, banks will then re-structure, long periods of Unemployment wiping out EI and savings, then selling home underwater, filing for Chapter 11 and an outstanding claim from lender to CMHC starts. Not instant. They are a good distance apart.

        Remember, the US loans were teasers to people with no income or jobs, that is what took that sucker down.

        You don’t have that in Canada, and you very know that.

      • UnagiDon says:

        There are teasers intended for those with little income and precarious jobs. This is just a stone’s throw from no income and no jobs. For an example, see these stories:
        http://www.greaterfool.ca/2011/03/17/different/
        http://www.greaterfool.ca/2011/03/21/mea-culpa/

  2. Sams Mango says:

    This is a great read from Financial Times on Canadian Housing

    http://ftalphaville.ft.com/blog/2011/03/21/521346/why-no-canadian-australian-housing-busts/

  3. Squish says:

    One thing I can’t seem to get a clear answer on (from CMHC, though anecdotes and blogs have offered some info) is what the liability of the homeowner is after CMHC pays any deficiencies to the bank, in the event of a foreclosure and subsequent sale. It seems relevant to a conversation about taxpayers being on the hook in a dropping market… this assumes that CMHC simply pays the money out, and that’s the end of the transaction.

    If your house is foreclosed on, eventually sold at a loss, and CMHC must pay the lender the difference, can the CMHC legally come after the former homeowner for that sum, or any part of it? Is that money technically owed to the CMHC? I have certainly witnessed them attempting to extract money in this type of situation, but not consistently. There doesn’t appear to be a hard and fast rule here, though it seems like the sort of information that should be clearly laid out.

    If it is the case, and CMHC can legally take measures to retrieve the money from homeowners, then the CMHC’s role seems even stranger to me. At that point, they appear to be essentially a collections service for the banks, with premiums funding the process, not the potential pay outs.

  4. Gman says:

    I am not surprised about CMHC bullying economists Ben. I am in the mortgage business Ben and it is well known they also cut back room deals to ensure the lenders do not send business to Genworth or Canada Guaranty. CIBC is a great example of this.

    They do not play on a level playing field and use very unsavory business tactics to squeeze their competitors.

  5. jesse says:

    I went through a CMHC “stress test” before and, based on their notional at-risk amount it was clear to me they were marginally capitalized with a nation-wide 20% drop in house prices and minor payment distress — at that point they would need to be seriously talking to the government about interest rates on bailout money.

    The big question to me in the medium term is, if price drops look cast, they will be taking on another wave of MI applications that look much more risky than previous policies, as those whose equity erodes are required to purchase MI on renewal. Will they continue apace with current premium schedules or reprice the risk?

    Still it is hard to put 100% of the blame on CMHC. The premiums are willingly paid by buyers and the loans are mostly recourse. Recovery rates look good for existing loans anyways. Further, is Genworth a viable private model or are they being crowded out by CMHC? Are they underwritten by taxpayers as well, or do they have huge systematic risk on their balance sheet (ie are they a reasonable proxy for a sustainable free market mi business)?

    • rp1 says:

      Oops, that $160B is an estimate from June 2010. The most recent numbers I found were $135B paid out, with $259B estimated final cost:

      http://news.yahoo.com/s/ap/20110225/ap_on_bi_ge/us_earns_mortgage_giants

      These are prime loans gone bad simply as a result of unemployment after a nasty credit bubble. If CMHC losses were 5% of this (i.e. half as severe, adjusting for size) it would wipe them out.

      • jesse says:

        There will likely be liquidity issues with CMHC recovery efforts. That would be a big problem for their balance sheet.

        A few 10s of billions of dollars net loss after recovery isn’t out of the question. And it could take many years to play out with significant bridge loans from the gov’t in the interim to handle liquidity. (The costs of these loans is extra).

  6. @ Sam/Mango

    “use the mid of 50% LTV

    V= 100
    L = 50

    Housing prices drops by 30%, now V=70, L = 50
    still ok? Every insurance company has questionable liabilities, but as long as the core book is fine, take a few hits of this margin loans is not going to take the CMHC down.”

    Still not the issue at all. It’s not the LTV that is the big question but rather how much of a cushion do they have in the event of a rise in defaults. That has nothing to do with LTV.

    Further to that point, you are assuming that the LTV ratio is evenly dispersed across their mortgage base. It is not. We know there are many people with only marginal equity positions. It is these people most at risk of default in the event of a correction. The question again is how many of these people need to default before CMHC has exhausted their ability to cover the losses to the banks?

    • tw says:

      A review of the structured mortgage products created in the US would be instructive here. Although the rating agencies blew it on these big time, it was a perception that the marginal part of the package would be of little concern if it failed. However the net result was quite different, the marginal part of the product turned out to be the equivilent of a weak foundation, destroying the entire structure, and it’s holders when it failed.

      The big assumption: housing has never declined in the past…..

      There are significant assumptions underpinning all finance, and knowing which ones the CHMC adhere to would be interesting and insructive in this matter.

    • jesse says:

      Ben, I actually think the big issue in the interim is liquidity. CMHC may be close to adequate in net, but housing downturns are known for low sales volumes and sticky prices. Their loss recovery efforts will be hampered by this and will need to finance the bridge. This could be many tens of billions of dollars in the interim.

      The huge $s floating around the US and in the media were from such bridge loans given to handle this. The NET exposure will be less than the bailout monies but the number will shock the public something fierce. From that POV I think CMHC is going to be a millstone for the next government.

    • Sams Mango says:

      Ben you keep missing and confusing drop and default “”

      Remember Ben, don’t confuse HOUSING DROP with HOUSING DEFAULT.

      prices can drop, it’s OK. People have to stop paying mtgs, banks will then re-structure, long periods of Unemployment wiping out EI and savings, then selling home underwater, filing for Chapter 11 and an outstanding claim from lender to CMHC starts. Not instant. They are a good distance apart.

      • I’ll restate what I’ve explained many times and what every empirical study has concluded: Negative equity is the number one predictor of default in both recourse and non-recourse states. With that in mind, perhaps you want to reword your prior point.

      • Financial Newbie says:

        Sigh.

        I love how people always seem to think housing pricing drops will be fine, and everything else will be rosy. Like if housing prices fall 30% in Canada tomorrow I’ll also get a 50% raise and accidentally discover a cheap an unlimited source of energy to save the world…

        I constantly try to explain to friends “what if housing prices fell, your loan remained the same, and either you or your wife lost your job? How much of a crunch would that be on your finances? Are you at all prepared for this?!?”

        But time and time again I get blank stares, like it could never happen. Apparently I’m a nut – everything in Canada has been great for 15 – 20 years, and anyone who says different must be from Mars.

        Ben, you’ve got great stuff on your blog. I can understand why people pick holes at a granular level – that’s what people do. But if you string most of your arguments together, you paint a strong picture of a potentially (and very plausible) disastrous future for Canucks.

        Kudos to you for trying so hard to spread the word of the wise (or at least the cautious), but there are some that will never *ever* heed your warning. Hopefully you recognize there are those who do hear you and are grateful for your insights!

      • Sams Mango says:

        @Ben, again, negative equity in a low LTV just can’t be that bad and takes a very long time with a 50% LTV! Nothing to re-word Ben, you need to take a break and accept that a low LTV, CMHC argument is not the “tipping point” here. You have not shown or demonstrated otherwise.

        Your angle from >low retail sales, etc is a better approach.

  7. Jeanne says:

    “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.”

    Definitely keep going after these people – I think they are primarily responsible for our completely crazy house prices – which the majority of us cannot afford.

  8. @Sam
    “negative equity in a low LTV just can’t be that bad and takes a very long time with a 50% LTV! Nothing to re-word Ben, you need to take a break and accept that a low LTV, CMHC argument is not the “tipping point” here.”

    Sam, do I really need to explain that the average LTV is not indicative of every mortgage? With an average LTV of 50%, it still implies that you have many mortgages with LTVs of less than 10%. If CMHC has a buffer of only 2% of mortgages (its equity stake….as indicated in the Macleans article), that is VERY problematic if you had even a 15% correction as it implies that you now have less than a token amount of mortgages under water, which as you know is the number one predictor of default.

    Let me repeat: A 50% average LTV is not the same as saying that every mortgage in the portfolio has 50% equity in it. If it were the case that every mortgage had 50% equity, you would be right. As it is, you are completely wrong my friend.

    • Sams Mango says:

      But Ben, my dear friend, What I am saying that with a low LTV, and even assume Payments Stop>Underwater>EI runs out>Large UnEmp Increase, etc…..surveys have shown that people will pay mtg first b4 cars, credit cards etc, cause they don’t want to homeless. It is basically the last mezz slice to get taken out of the individuals balance sheet.

      • True to a point. When people begin to lose the illusion that house prices rise in perpetuity and instead begin to view housing as a wealth trap, will they still pay a mortgage worth considerably more than they can sell the house for if they can’t see themselves recouping the loss in the foreseeable future?
        Strategic defaults my friend. And with regards to the “they don’t want to be homeless” comment, it’s funny how quickly people’s view of what constitutes a home changes in the aftermath of a housing bust. Renting loses its stigma in a real hurry.

      • Lumpen says:

        For the sake of argument, if someone is 30, earns $100k/yr and bought a $500k condo with nothing down on a 30yr amort – just brought enough to the table to handle closing costs. (You could make it 5% if you want – doesn’t materially change the outcome, just makes the numbers slightly messier in a post)

        Next year, the condo drops 20%. Now the buyer is $100k underwater. That’s probably 4-8 years of scrimping and saving to get that back from salary alone after food, shelter, clothing, taxes, etc. If the buyer doesn’t have a cheery outlook on the property market and it’s near-term recovery, it’s going to be mentally stressful.

        Options? Stick it out, as you say. Or consider bankruptcy.

        Results:
        – start renting, probably for less than mortgage payment+taxes+condo fees. Put the difference in an RRSP.
        – RRSP is shielded, other than last 12 mos contribs
        – if there’s a pension, it’s shielded
        – credit damaged for a number of years
        – wipe out student loans while you’re at it
        – ineligible for certain jobs, potential social stigma

        Great outcome, no. But seems like a reasonable alternative if the mindset is that the buyer will have to scrimp and save every dime and have no fun for 4 years just to get even, or 8 if there’s any kind of fun in life along the way. And if you need to sell and move for a job, family, etc., think of what kind of cheque would be needed at the close. Where does the cash come from?

        Fiddle with the numbers and the bar moves to 3-7 years. That’s a long time to carry that kind of burden, and even then, a 20% drop in condo prices doesn’t get rational investors excited on a CF basis. And if investors don’t think there are easy cap gains to be had, they’re going to want cash flow.

        That’s where the risk is, IMHO. Don’t even need a job loss in this kind of a situation. That’s why people walk away – coming home every night to an asset that’s a millstone around their necks. The stress just starts to eat away at someone in that position after a while and some portion will want out.

        FWIW, the arbitrary 20% decline I used in the example shouldn’t be taken as my view on what I perceive the aggregate market is over-, or in some cases, under-valued by. But I think it’s a reasonable scenario to consider for condos, which historically have pricing that is driven more by fundamentals than detached dwellings. Adjust it as desired.

  9. Sams Mango says:

    I had written so much more, not sure why it didn’t show up

    But my point was that our debate can only be solved by going into the NHA mtg pools that support the semi-annual paid CANHOU bonds. I have done this exercise, I couldn’t find one series that had all or even more than 10%, <5% (95%) LTV's backing them. These pools are supported by the issuer who is makes sure enough loans are printed to keep the pools active with payments to support the bonds.

    Have a go at the website and download the data and test it for yourself. This is how Paulson and others (read The Big Short by M Lewis) found the holes in the US market. As I have repeated before, nothing on the tipping point or breaking point in the Canadian housing market that would have any serious investor or speculator believe that collapse is close to happening.

    • I didn’t edit it and it’s not stuck in a spam filter. Sorry….not sure what happened there.

      “A mtg pools that support the semi-annual paid CANHOU bonds. I have done this exercise, I couldn’t find one series that had all or even more than 10%, <5% (95%) LTV's backing them."

      Gee….imagine that AFTER a housing crash! This is an exercise in futility. What were the LTVs before the crash?

      "As I have repeated before, nothing on the tipping point or breaking point in the Canadian housing market that would have any serious investor or speculator believe that collapse is close to happening."

      Careful with your words here. Just what do you mean by a 'collapse'? Those aren't my words. Let's remember that the original discussion began with you stating that since the LTV of the CMHC portfolio is over 50%, no defaults would happen and CMHC would be fine. I think I've shown you why that logic is faulty. At no point did I indicate that CMHC held assets anywhere near as risky as some of the MBS tranches that were sold off in the States. Red herring!

      • Sams Mango says:

        For clarity. I mean that no bond pool looks to breaking into all weak mortgage pools that would have me excited to be short bonds for a collapse.

  10. rp2 says:

    The Canhou bonds are full faith and credit of Canada. Even if the mortgages blow up the bonds will be fine. Try Genworth bonds.

    • Sams Mango says:

      gen is doing small change in the Canadian Market. Of course CMHC bonds are backed, we are looking at the pools of mtg’s in the bonds, and they are not as bad as one would think.

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