Screws tighten on Canadian housing market

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By Leith van Onselen

Last month, in Canadian bubble trouble, I described in detail how the government-owned Canadian Mortgage Housing Corporation (CMHC), which has been the “great enabler” behind Canada’s debt-fuelled housing bubble, risks losing billions of taxpayer dollars in the event that the housing market experiences a severe correction:

CMHC works by acting as the guarantor for mortgages where the purchaser is unable to pay a specified amount as a down payment (20% for residential properties). The CMHC also assists the financial sector by buying pooled mortgages and reselling them to investors as AAA government-backed bonds, giving banks and other institutions an immediate source of cash that they can re-lend…

You can see from the below chart that the value of guarantees provided by the CMHC – both from its role as mortgage insurer and securitiser – has exploded and were valued at $541 billion CAD as at 30 September 2011:

It’s also not hard to see from the above discussion that Canada’s mortgage system contains high levels of moral hazard… [W]ith their default risks removed via the CMHC, Canada’s banks are more willing and able to lend to people with little money, a poor savings history and little prospect of repaying their loans. Put another way, CMHC enables the banks to provide the cheapest, lowest mortgage rates to those with the highest default risk.

Sound familiar? The CMHC is in effect similar to the United States government-sponsored Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corporation (Freddie Mac), which provided insurance against default risk to a large proportion of risky low-deposit loans in the United States and whom required massive taxpayer bail-outs following the bursting of their housing bubble…

With mortgage rates in Canada near cyclical lows [click to see chart], with nowhere to go but up, there is potential to generate significant mortgage stress and a wave of defaults amongst recent highly leveraged buyers, particularly the 30% of CMHC-insured borrowers with less than 20% equity in their homes [click to see chart]. There is also the risk that many recent buyers could find themselves in negative equity, whereby home values fall below borrowings, leading to a sharp drop in consumer spending, a reduction in economic growth, and job losses…

However, perhaps the most worrying aspect of Canada’s mortgage system is that the CMHC appears to be significantly under-capitalised, potentially exposing Canadian taxpayers to significant losses should Canada’s housing market enter a protracted down-turn. As at 30 September 2011, the CMHC had only $11.5 billion CAD of shareholder capital but a whopping $541 billion CAD of outstanding insured loans, which works out at only 2.1% equity against its overall exposure. In fact, the CMHC’s capitalisation is only slightly better than the US Government-sponsored Fannie Mae, which in 2007, at the peak of the US housing bubble, backed up US$2.7 trillion of mortgage-backed securities with US$40 billion of capital, or 1.5% equity against its overall exposure.

Should a severe housing correction occur, and significant defaults take place, there is very little capital available to absorb losses. Rather, like in the United States, Canadian taxpayers might be called upon to stump-up funds to bail-out the banks for their risky mortgage lending.

Now it appears that the Canadian authorities have finally caught-on to the huge risks facing Canadian taxpayers, with the CMHC agreeing to slow the growth of insurance-in-force (currently valued at around $540 billion CAD) and the Canadian Government signalling that it would not increase the $600 billion CAD cap on total outstanding CMHC insurance:

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Finance Minister Jim Flaherty finds himself walking an incredibly thin tightrope…

This week the Canada Mortgage and Housing Corp. signalled that it’s going to do what it can to blow some cold air on the overheated market by keeping a lid on the amount of mortgage insurance it makes available over the next few years for higher-risk borrowers…

Flaherty is being driven by three legitimate concerns, says Jim Murphy, president and CEO of the Canadian Association of Accredited Mortgage Professionals: extraordinarily high levels of household debt, fears of rising interest rates and the exposure of Canadian taxpayers, through CMHC insured mortgages, in the event of a housing downturn.

The federal government now has a $600 billion cap on the amount of mortgage insurance CMHC has outstanding, but it has increased that cap twice since 2007 when it stood at $350 billion.

Ottawa recently hinted that it’s not prepared to lift the cap again and this week CMHC tabled a corporate plan with Parliament that anticipates a much slower increase in the amount it insures between now and 2014.

Tightening lending requirements, and availability of CMHC insurance, too much risks sending the economy into a tailspin, as the Canadian Association of Accredited Mortgage Professionals recently warned Flaherty.

According to a study they recently prepared for the finance minister, 18 per cent of the jobs created from 2006 to 2011 were in the real estate financing and housing/construction sectors and helped insulate the country from the global economic downturn, stressed Murphy…

The below chart, created by Ben Rabidoux, puts the scheduled growth of CMHC insurance into perspective:

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Clearly, the forecast growth of CMHC insurance to 2016 is anaemic, signalling a sharp slowing of Canadian mortgage credit growth, particularly amongst higher risk borrowers reliant upon CMHC insurance in order to obtain a mortgage.

We all know that the growth and availability of credit is the lifeblood of any housing market. When credit growth is strong, house prices are more likely to increase in value as home buyers bid-up prices. By contrast, weak credit growth is typically associated with falling house prices.

With the CMHC tightening the screws on new mortgage lending, it remains to be seen whether mortgage credit growth will be sufficient to maintain Canadian house prices at their current elevated levels.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.