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Wednesday, July 27th, 2016

10% Down Payments & Other Policy Debates

Housing accounts for an immense 1/5th of Canada’s GDP. That makes mortgage debt and housing policy enormously important topics from an economic standpoint.

With the stakes so high, it’s painful to watch critics exhort blanket changes to mortgage rules, based primarily on their opinions in lieu of credible data.

Case in point is this editorial on down payment size.  The author, Ted Rechtshaffen, advocates a move to 10% minimum down payments because 5% downpayments are riskier. Interestingly, Rechtshaffen sprinkles the word “risk” 10 times throughout his article, without ever attempting to quantify that risk.

His story leads off by proclaiming that CMHC poses a “big risk” to taxpayers. Rechtshaffen asserts, “CMHC would be put in a significantly lower risk position than it is in today (with 10% down payments).”

  • This, of course, begs several questions, including:
    • How “significant” is the risk? The latest figures demonstrate that only 2% of mortgagors have less than 5% equity (Source). Only 9% have less than 10% equity. If home prices fell and those numbers doubled, that alone would not cause widespread defaults. The large majority of insured mortgages have strong covenants, with 680+ Beacons and sub-40% TDS ratios. Regardless of what home prices do, Canadians are not keen on ruining their lives by defaulting on mortgages and having a judgement against them. Borrowers cannot escape insurers like Americans can with their strategic defaults. As they’ve done in many past corrections, Canadians with negative equity will stay in their homes until they build enough equity to move.
    • What is the economic cost of eliminating 95% financing? 5% down payments have been around, off and on, since the 1960s—most recently reintroduced almost twenty years ago. What exactly would eliminating them do to home sales, home prices, employment, consumer spending, and the endless other economic variables linked to housing?  Proposing stricter down payments without addressing these issues is like taking an experimental drug without researching the side effects. Rechtshaffen says eliminating 5% down payments would cause “short-term pain.” You can say that again. But that’s not exactly the thorough analysis such a far-reaching policy recommendation should rely on.
    • Is the risk offset? Insurers love to be profitable, but they care more about avoiding losses. Anyone can find isolated cases where insurers over-exposed themselves, but exceptions don’t make the rule in this case, especially with insurers being under the Finance Department’s microscope. The reality is, Canadian insurers calculate default probability with precision (Canada has the lowest default rate of any major country), and are paid exceedingly well for any risk they assume. If borrowers want to put down less than 10%, they pay 37% higher insurance premiums to do it. If regulators or insurers believed this surcharge was insufficient, they could increase premiums and/or reserve requirements at any time.

Rechtshaffen writes that banks prefer insured 5%-down mortgages versus 25%-down conventional mortgages.

  • Which raises the questions:
    • How accurate is that? Don’t lenders lose money in both cases? The fact is, while default rates are low in each case, they are notably higher with 95% financing than with 75% financing. Moreover, lenders incur meaningful mortgage default losses in either case. Insurance may reduce risk on individual mortgages, but that reduction doesn’t eliminate a lender’s exposure, and by no means does it encourage questionable lending across a lender’s entire portfolio.

Rechtshaffen says buyers with 5% down “can least afford…to take on home ownership…those with only 5% down payment might default on their mortgages.”

  • Which begs the question:
    • Is down payment size all that matters? Of course…it’s not. Would you rather lend to a Doctor/Dentist/Lawyer/Accountant/Engineer just out of school with 5% down, an 800 Beacon score and 35% TDS, or an unskilled worker with 10% down, a 620 Beacon and 43% TDS? Other things being equal, the former is lower risk despite his/her lower equity. There is so much more to underwriting than down payment size. Critics continually ignore this vital point and lump all borrowers into one bubbling cauldron of “risk.”

Rechtshaffen adds: “A significant number of home buyers, who are on the borderline of being able to afford a house, might be saved from a financial disaster” if 5% down payments are eliminated.

  • To which one should ask:
    • How “significant”? According to CIBC, just 4.1% of homeowners have high debt ratios (TDS over 40%) and less than 20% equity. (Click for chart) These, it says, are Canada’s higher-risk borrowers. Yet, given that only a portion of these individuals would default on their mortgages, the ratio of borrowers with high default risk cannot be considered extreme.

*************

It’s easy to pen an essay on “risky mortgages” and play to the hype being propagated in so many news stories these days. It’s not so easy to do honest research and attempt to shape public policy in a way that penalizes bad behaviour and rewards deserving borrowers.

For that reason, the housing finance debate would be more productive if critics, especially ones that have a national media source as their soapbox, would come to bat with research and data.

Many, like Rechtshaffen, are good people with good intentions and we wholeheartedly agree that risky borrowers should be forced to put down more than 5% (in some cases, significantly more). But not everyone should.

The economic and social benefit of permitting well-qualified purchasers to buy with smaller down payments is measured in billions. Roughly half of home buyers, according to CAAMP data, are first-timers—many who haven’t had an opportunity to amass large down payments. These folks account for a vast slice of the $307 billion in real-estate-related spending.

Media outlets should start recognizing their duty to readers and pressuring their columnists to back up influential claims with hard data. Before commentators throw around alarming words like “risk,” editors should make them quantify the risk.

When it comes to mortgage policy, borrowers with high-default probability must be isolated from strong and deserving borrowers. The latter should be left with as many government-supported financing options as possible. Doing so promotes jobs and economic growth with no risk to taxpayers.


Rob McLister, CMT

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