Hybrids – The Safe MortgageJune 15, 2010
Closing Costs – The Stomach Punch of the Home Buying ProcessJune 29, 2010
When lenders receive applications from mortgage borrowers who have down payments of less than 20% (who are also known as high-ratio borrowers), they must secure high-ratio mortgage-default insurance from one of three insurers: CMHC, Genworth and Canada Guaranty. (CMHC is by far the biggest, so high-ratio default insurance is often loosely referred to CMHC insurance).
Every high-ratio mortgage application must pass through the insurer’s filter, and as such, they set the rules that every high-ratio borrower (and lender) must comply with. (In reality, because mortgage default insurance comes with a government guarantee, insurer policies are also heavily scrutinized by our Federal Ministry of Finance.)
High-ratio mortgages are held to tougher standards that are designed to ensure that banks do not expose their depositor’s money to undue loan risk. After all, if we worried that our bank might lose our chequing account money to bad mortgage loans, it would undermine our confidence in the entire banking system. And well, we can’t have that.
This lending structure helped us fare well during the global financial crises in 2008, and it has been held up to the world as a model to be copied. So kudos for that. But as with every system, it also has its drawbacks. For example, every lender offers the same high-ratio products using different names and different-coloured pamphlets.
Ideally, CMHC (which is government owned and run) would act as a ‘market maker’ to ensure a minimum standard for high-ratio borrowers. Then, its private-market competitors (Genworth and Canada Guranty) would augment CMHC’s offerings with more flexible solutions that find a balance between risk-based pricing and investor demand that ebbs and flow in response to market conditions. But we’re getting ahead of ourselves. Let’s start with the basics.
As mentioned above, if you want to buy a house with a down payment of less than 20% of the purchase price, you are required to buy insurance that protects the lender against loss if you default on your payments. (This coverage doesn’t relieve you of your debt obligation if you default, but it ensures that the lender is made whole.)
You can roll the fee into your mortgage but you have to pay any associated provincial sales tax upfront, as part of your closing costs.
The default insurers have programs for self-employed applicants, new immigrants and a whole host of other groups (see links provided in the opening paragraph for further details).
Your mortgage loan insurance is fully transferable to a different lender if you find a better deal at renewal, and if you want to increase your original loan amount at some point in the future, you only have to pay an insurance fee on the additional amount borrowed (subject to qualification).
Now how can we make default insurance better?
CMHC is a crown corporation and it competes with Genworth and Canada Guaranty, which are privately owned.
In a perfect world, the private insurers would be allowed to be more innovative and to offer borrowers more flexibility, but in reality, CMHC has discouraged this by matching every innovation made by Genworth and Canada Guaranty in order to protect its dominant market share in much the same way that a private company would.
Examples in recent years include stated income lending for self-employed borrowers, mortgages for new immigrants, and loans for borrowers with lower credit scores.
Unlike a private company, when CMHC copies a new-product innovation, they also commoditize the pricing. Then, with profit margins reduced for the private insurers, the attractiveness of taking on incremental risk diminishes. While on the surface that sounds like a good deal for consumers, in reality, it discourages innovation. After all, why would a private insurer spend time and effort coming up with a new product when it will just be copied and commoditized by the government-run hegemon?
Having a centralized policy for high-ratio underwriting risk has given the government no small amount of control over our residential market. Given the US example of what happens when lending runs amok, maybe that’s not entirely bad. Especially when you consider that since CMHC started assuming the risk for high-ratio mortgages, it has opened up home ownership to a huge swath of middle-class Canadians and was an important catalyst for the democratization of Canadian credit. Since that time (1954), our home ownership levels have been rising steadily and are now among the highest in the world.
It’s just too bad that CMHC’s influence also serves to discourage private-market innovation.
In the end, a more innovative default-insurance market that more fully embraces risk-based pricing is the ideal we should be shooting for. CMHC’s policies should establish a baseline standard, but then our private insurers should be left to find innovative ways to ensure that every willing investment dollar is matched with borrowers who need additional flexibility to qualify (and who are willing to pay more for the privilege).
Just like with any government-run market-making institution, CMHC should try to foster an environment where private-sector companies can innovate without being overwhelmed by their public-sector competition.