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Thursday, May 25th, 2017

CMHC Insurance Limits: A Wake-up Call for Lenders

Many have now seen thisNational Post article.

The gist of it: CMHC is approaching its $600 billion government-imposed limit on issuing mortgage default insurance. That’s happening largely because of lenders’ enormous appetite for something called portfolio insurance (a.k.a., “bulk insurance”).

No one fully grasps the repercussions yet, but our sense is that the news is not great (at least in the short-to-medium term) for mortgage consumers, smaller lenders and brokers.

On the other hand, it may be healthy long-term for the housing market. Here’s why…

What is Portfolio Insurance?

Mortgage default insurance is typically only “required” when someone with less than 20% equity gets a mortgage.

Despite that, almost three-quarters of CMHC’s outstanding mortgage insurance is low-ratio (i.e., 20% equity or more). That’s largely because banks have been buying portfolio insurance in gobs to insure against defaults on low-risk conventional mortgages.

Banks do that because, even though the risk is low, there is still risk. Investors who buy these mortgages like to know that the government is behind them, if borrowers default and the lender can’t pay up. Because of regulatory capital rules, bulk insurance also enables banks to lend more with the precious capital they have.

CMHC summarizes portfolio insurance as follows:

“Portfolio insurance helps lenders manage their capital more efficiently and small lenders to compete on an equal footing with large lenders. It allows more lenders to compete in the mortgage loan insurance market by lowering entry barriers, thus expanding consumer choice.”

Note: Nothing is changing with high-ratio insured mortgages. So if you’re getting a mortgage with less than 20%, this news probably won’t impact you (for a while at least).

CMHC’s Insurance Limit

CMHCDespite the above benefits, we’re hearing that CMHC has announced it is slashing the amount of bulk insurance lenders can access. That’s because CMHC is limited by law to writing no more than $600 billion worth of policies.

Normally, every 3-5 years as the mortgage market grows, CMHC has asked for, and received, approval from parliament to raise this limit. It was last raised by $150 billion in 2008.

Now media frenzy has politicians scurrying to offload mortgage risk from the government back to the private sector. (The government guarantees CMHC’s liabilities, so public concern is certainly understandable.)

As a result, many question whether CMHC will get its $600 billion limit raised anytime soon.

Here’s some reaction on that:

  • TD Bank economist Sonya Gulati tells CBC that not increasing the limit “may serve to tighten the housing market.”
  • RBC economist Robert Hogue told Global News that increasing the limit “…would be, policywise, a very delicate balance to strike.”
  • The Post quoted an unnamed industry source as saying: “…What will the government do, not increase (CMHC’s) limit? This could kill the entire housing market.”

Who Uses Portfolio Insurance?

Portfolio insurance is widely relied on by many smaller lenders who must resell their mortgages (as opposed to fund them from deposits).

More commonly, portfolio insurance is used by the Big 6Banks. That’s because insured mortgages have virtually a “zero-risk” weighting in regulators’ eyes, allowing banks to lend more, earn higher returns, and keep mortgage rates lower than otherwise possible.

(One fast-growing use of bulk insurance is for guaranteeing covered bonds. Covered bonds are a relatively new source of mortgage funding in Canada. More on that here.)

In any event, spokesperson, Charles Sauriol, says CMHC “has recently received an unexpected level of requests for large amounts of CMHC portfolio insurance.” That insurance is using up CMHC’s capacity.

(Incidentally, the biggest bulk insurance customer recently has been Scotiabank, which reportedly had anabnormally large and predominantly insured $17+ billion mortgage-backed securities issuance in December.)

The Risk of Portfolio Insurance

Risk-of-MortgagesPortfolio insurance can sell like hotcakes indefinitely, and there will never be a problem…unless the unthinkable happens: mass defaults.

The question then becomes: Are insurers taking in enough in premiums to offset potential claims—thus avoiding a federal bailout?

In exploring that question, it’s important to remember that there’s a relatively strong relationship between default risk and loan-to-value (LTV). In other words, the more equity a mortgagor has, the less likely they’ll stop making their payments.

That said, if housing were to crash, insurer claims on portfolio insurance would soar. The premiums they’ve collected from lenders are their first line of defense in that case (unlike high-ratio insurance, lenders usually pay the premiums on portfolio insurance themselves, not the borrower).

According to a very good source, however, there is a problem with these premiums. Major banks have negotiated the premiums down to levels that may not be enough to cover extreme conventional default rates.

(We haven’t found any current data on conventional mortgage default rates, but they’re ostensibly less than the 0.38% for overall arrears—a number which includes higher-risk, high-ratio mortgages.)

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.

Capital-reservesCMHC 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 totalling $555.6 million) were a result of costs under two specific government programs, the Assisted Homeownership 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

Mortgage_questions-and-answersLooking 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 arerated 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.


Rob McLister, CMT

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