Is CMHC putting our money at risk? Rob McLister, Canadian Mortgage Trends Feb 2, 2012 - 9:23:43 AM RSS?

CMHC’s Wherewithal

CMHC has continually been accused, in the media, of creating undue risk for Canadian taxpayers. A few weeks ago, we spoke with Pierre Serré, Vice- President, CMHC Insurance Product and Business Development, to try and get a sense for that risk.

He stated: “…We focus on prudent underwriting practices and the adequacy of our capital levels. CMHC is well positioned through its available capital to handle even extremely adverse economic conditions.”

He noted that CMHC has a total of $17.4 billion that could be used to back-up its insurance business and pay claims.  CMHC's actual losses on claims have been much lower. They were $454 million for the first nine months of 2011, for example. That coincides with a 0.42% default rate.

CMHC has   38 times  that $454 million in capital and reserves to cover adverse housing shocks. It can handle some pretty devastating housing scenarios, especially given that the average mortgage in its portfolio has equity of 45%.  Net of all claims and expenses, CMHC’s insurance business earned a total of $1.042 billion in Q1-Q3 2011. Moreover, contrary to many critics, CMHC’s core mortgage insurance business has never needed to be bailed out.

“…There has been no reimbursement of funds by the Government of Canada with respect to CMHC’s commercial mortgage insurance operations,” said Serré. “The losses CMHC experienced in the early 1980s (shortfalls totaling $555.6 million) were a result of costs under two specific government programs, the Assisted Home ownership Program (AHOP) and the Assisted Rental Program (ARP).” “CMHC's mandate for its mortgage insurance business was changed in 1997 to allow it to operate on a commercial basis without having to rely on the Government of Canada for support,” Serré said, “even in less favourable economic times.”  (If you’re interested, see page 99 of   this report  for CMHC’s estimates of losses given a 100   bps  rate increase, adverse unemployment, or slowing home prices.)

In a bad-case scenario (e.g., severe prolonged unemployment or a dramatic spike in rates), you can darn well bet our housing market would get butchered. The harshest critics we’ve spoken with say you could take today’s average loss numbers and multiply them by 15-20.  Well, if you do that, it would be far beyond any insurance losses Canada has ever experienced. Yet, in that scenario, CMHC would still have billions in capital left over before asking for government handouts.

Potential Outcomes

Looking forward, CMHC’s cutback on bulk insurance has numerous potential repercussions. No one has the answers yet because we're still waiting to see how things shake out.

That said, here's our best guess. Barring a CMHC announcement that it's raising its portfolio insurance limits, then:

1. Smaller lenders may be forced to pay more for conventional mortgage funding (for some period of time).
   • This could kill off rate competition from many non-bank lenders in the conventional mortgage market (Banks are probably licking their chops at this prospect.)
2. Bank capital costs could potentially increase.
   • That would impact earnings and/or lift mortgage rates somewhat (to what extent we don’t know.)
3. It would discourage new non-bank lenders from entering the market,
   • Resulting in less choice for mortgage shoppers.
4. It would force lenders to find alternative, uninsured funding sources for conventional mortgages.
   • That’s largely a positive long-term—to the extent it would cut government exposure in the unlikely event of mass conventional mortgage defaults.
5. It may kick-start the uninsured covered bond market.
   • Uninsured covered bonds transfer risk from the government to major financial institutions.
   • “…We believe there is a high probability that Canadian banks will not be permitted to use CMHC-insured mortgages” as collateral for future covered bond issuance, BMO Capital Markets analyst, George Lazarevski,   told  the Financial Post.
   • So far in Canada, only RBC has issued uninsured covered bonds. Those bonds are   rated AAA  and mostly consist of 5-year fixed mortgages with a typical   LTV  near 72%.
   • Unfortunately, most smaller lenders have almost no access to covered bond funding.
   • These developments may very well encourage the government to lift its current bank limit on covered bond issuance (which is 4% of bank assets). If the government doesn’t, and it continues to restrain bulk insurance, lenders tell us it could seriously harm conventional mortgage liquidity.
6. Given their reduced access to portfolio insurance (and thus the reduced potential for low-ratio mortgage business), smaller lenders may now get even more choosy on which conventional borrowers they lend to.
   • This could limit conventional mortgage options somewhat, unless you were a top-qualified borrower
7. Brokers may be increasingly forced to rely on banks for conventional financing.
   • It’s not unthinkable that banks respond with higher pricing on conventional mortgages, given the greater funding costs and demand from brokers.
   • Some industry observers doubt that banks would price quite as high in their retail channels (since they favour those channels).
8. Private insurers may realize benefits from all this for a year or so, as lenders shut out by CMHC turn to   Genworth  and   Canada Guaranty.
   • That could allow private insurers to charge more for bulk insurance
   • Pretty soon the privates themselves could run out of insurance space.

The End Result

Mortgage insurance  is a business. By participating in that business, the government takes risk, but it gets paid well for that risk. The government of Canada has earned $14+ billion in profits over the last decade from CMHC alone.

But the past is the past. Today we’re facing new realities (not the least of which is a hyperactive housing market). We're therefore compelled to ask:

• Which is the bigger risk, limiting portfolio insurance or staying our present course?
• Instead of curtailing bulk insurance, should underwriting criteria be tightened more?
• Or should the government simply force insurers to boost premiums (or levy surcharges of some sort), thus padding insurers’ buffers in the event of adverse default scenarios?

These are questions that policymakers have been asking themselves in private for a while now

http://www. canadianmortgagetrends.com/ canadian_mortgage_trends/2012/ 02/changes-coming-due-to-cmhc- mortgage-insurance-limit.html

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