My nomination for the understatement of the year goes to Finance Minister Jim Flaherty, who in early December observed that “regrettably, CMHC became something rather more grand I think than it was intended to be.”
Indeed. The Crown corporation, which originally had a humble mandate of helping first-time buyers obtain favourable financing, now insures $560-billion of some of Canada’s riskiest mortgages, more than double what it insured in 2005.
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To their credit, the current government has implemented several measures since 2010 aimed at reducing taxpayer exposure to the Canadian mortgage market, but some structural issues remain. Below are four changes that the government should consider making in 2014.
1) Increase income documentation requirements on insured mortgages
Canadians are rightfully proud of the stricter mortgage underwriting that spared us from some of the particularly egregious lending practices seen stateside before their real estate bust.
However, most Canadians would be surprised to learn that “prime” Canadian mortgages, particularly high-ratio mortgages insured by Canada Mortgage and Housing Corp., involve far less documentation than comparably-labelled “prime” loans in the U.S. … and this was true even during the subprime years.
Today, a borrower can obtain a prime, CMHC-insured mortgage with as little as a pay stub and a job letter, which would make it a low-documentation Alt-A mortgage by U.S. standards. RBC recently tweeted about this, noting that securing a mortgage in the U.S. requires more documentation than in Canada.
Interestingly, CMHC places the integrity of the underwriting primarily with the lenders themselves who profit from the mortgages, as the insurer seldom sees the physical documentation and very rarely spot checks mortgage applications at origination.
This relatively low standard for mortgage documentation coupled with a very obvious moral hazard leaves the door open for what the mortgage industry calls “soft fraud” or “fraud for shelter,” which typically involves the applicant (often with the knowledge of the lender) misrepresenting their financial circumstances, usually related to their income or job status.
There’s really nothing “soft” about this form of fraud, particularly when it’s a CMHC-insured mortgage where taxpayers are holding the bag. And while it’s impossible to know the true extent of the problem, one highly respected Canadian mortgage website suggested that it is “one of the most widespread and under-reported problems in mortgage lending” and that it is “surprisingly common these days.”
Regardless of the scope of the problem, the solution is relatively simple: CMHC should demand Canada Revenue Agency notice of assessments (NOAs) for all mortgage applications. This is common practice for prime mortgages in the U.S. and is a simple way to ensure that income or employment has not been significantly misrepresented given that NOAs are very difficult to alter or forge.
Interestingly enough, many lenders insist on seeing NOAs for conventional mortgages that aren’t being insured. This suggests, not surprisingly, that their underwriting is more stringent when they are forced to bear the risk for the mortgage they originate rather than insuring the mortgage through CMHC and passing the risk on to taxpayers.
2) Reinstate the regional mortgage cap
Prior to 2003, CMHC had a regional mortgage cap that set a maximum dollar amount on the size of mortgage they would insure. This made a lot of sense given that CMHC’s original mandate was geared toward helping first-time buyers get into entry-level housing. The logic here is simple: If a buyer can afford a home that is priced significantly above the local average, they shouldn’t need what effectively amounts to a taxpayer-backed subsidy to do so.
In what can only be described as a massive policy blunder, this cap was eliminated in 2003. For nearly a decade, CMHC would insure mortgages of any size, from simple starter homes to opulent mansions, a truly epic case of “mandate creep.” In 2012, a nationwide limit was re-established; CMHC will no longer insure mortgages on homes that are purchased for more than $1,000,000.
This is a step in the right direction, but it ignores the fact that a million-dollar home is well above a starter home in nearly all parts of Canada. This should change. One possible solution would be to set the maximum mortgage cap to the average resale price in each census metropolitan area and have that cap change annually to reflect changing house prices.
3) Eliminate the second home program
CMHC currently has a program that allows buyers to purchase a second home with as little as 5 per cent down. This program is most commonly used for purchasing recreational properties such as cottages, but can also be used to purchase a “pied-à-terre” for those who have to often travel to another city for work, or to purchase a home for children while they are attending college or university.
In the context of CMHC’s original mandate, this program is simply indefensible. If someone is fortunate enough to have the income and assets to purchase a second home, for recreational purposes or otherwise, they should not require taxpayers to bear the risk, particularly considering that the majority of Canadians are not fortunate enough to own multiple properties themselves. This program needs to go.
As an aside, contacts in the mortgage industry suggest that some investors are also currently abusing this program. In 2010, the government wisely changed the rules so that investors must put down 20 per cent on investment properties. However, the door has been left open to purchase investment properties with 5 per cent down through the Second Home Program, with taxpayers bearing the risk. Of course, the applicant can’t state up front that the home will be rented out, but they are free to quietly rent out their second home after the deal closes.
4) Increase transparency and oversight
The ironic part about Mr. Flaherty’s comments that CMHC has become something more “grand” than it was intended to be is that Canadians still have no idea just how “grand” CMHC has actually become since we still don’t know exactly what is included in that $560-billion in insurance in force.
This was driven home to me last year when a developer told me that CMHC recently had a program (and perhaps still does) that allowed developers to get insurance on loans for their condo developments. This is unbelievably bad policy. This effectively lowers the interest rate the developer would pay, but you can be assured that those cost savings would not be passed on to consumers at the other end. In essence, taxpayers were assuming risk on these development loans to pad developer pockets.
Dr. Ian Lee from Carleton University’s Sprott School of Business has in the past been an outspoken critic of CMHC’s lack of transparency. He recently told me via e-mail that “CMHC is the least transparent of all Canadian Crown corporations concerning its numerous activities and detailed breakdown of its insurance guarantees.”
This needs to change. Canadians have a right to know exactly what is in CMHC’s insurance portfolio considering that all taxpayers are collectively on the hook if these insured loans were to sour.
As we enter 2014 with Canadian households having higher debt loads than ever and house prices in most Canadian metropolitan areas at all-time highs relative to local incomes, Canadians should increasingly be asking if CMHC, in its current form, is serving and protecting their best interests.
Ben Rabidoux is president of North Cove Advisors Inc., a market research firm providing services to institutional investors. He is the author of the weekly Canadian Housing, Macro, and Credit Newsletter.
