Bill C-3 Gets Royal Assent

Bill C-3, the one I discussed here, received royal assent on June 26th. This bill includes changing and formalizing how mortgage insurance operates in Canada. Many of the provisions in the bill are not new but were administered through informal agreements now made formal through legislation, though there is much detail that is under the authority and at the whim of the government of the day. Most notably:

• The Ministry of Finance can impose additional capital reserve ratios on CMHC and private mortgage insurers
• The Ministry of Finance can effectively revoke the ability of certain lenders from applying for government-backed mortgage insurance.
• CMHC and mortgage insurers must pay fees in accordance with elevated risk levels it incurs
• CMHC must open its books to the Ministry of Finance
• CMHC's books will be available through FOI if not publicly displayed
• There is a 10% deductible to any funds that are paid by the government to backstop private mortgage insurers. CMHC is 0%

If you have time there are some interesting testimonies from the Parliamentary Standing Committee on Finance sitting on June 20, 2011. Among parties present were Finn Poschmann (CD Howe), Jane Londerville (U Guelph), and Karen Kinsley (CMHC). I highlight a few excerpts for the record, emphasis mine:

Poschmann: Private mortgage insurers, which operate, as I said, in roughly one-third of the residential mortgage insurance market that CMHC does not occupy, have their liabilities guaranteed by the Government of Canada, less a 10% deductible. We could call that a 90% guarantee. This makes it possible for the private insurers to compete in the residential mortgage insurance business with CMHC.

CMHC is a crown corporation, the liabilities of which are backed 100% by the full faith credit of the Government of Canada and therefore the federal taxpayer. This means that CMHC's cost of capital is less than it is for the private insurers. In order words, it costs the private insurers more to go to the market to raise money to underwrite the insurance premiums that they, in turn, write. It costs more because they do not have the Government of Canada's backing. But as I indicated, the system works well enough that the existing private insurers tend to hold about 30% of the market. The system more or less works, however imperfectly it may do so.

Dr. Londerville: the CMHC, as a crown corporation, has its mortgage insurance policies implicitly 100% guaranteed by the federal government under the Basel accord. CMHC-insured mortgages, then, require no capital reserves by financial institutions. Clauses 22 and 24 in this act retain the corresponding maximum protection for private companies at only 90%. At the moment, the lender decides who will insure a mortgage loan: CMHC or a private insurer.

As a consequence, banks whose loans are insured through a private firm must set aside some capital reserves against the possibility of default by the insurer, which is not a requirement if the loan is insured by CMHC. Thus, rates of return are higher on CMHC-backed mortgages.

When profit margins are thin and banks are nervous about capital reserves, as in the financial crisis that began in 2008, this makes a major difference. The evidence of this is in the growth of CMHC's mortgage insurance premium income during 2008 and the drop in Genworth's.

Because of the difference in levels of guarantee, each financial institution's treasury or risk officer determines how much of the institution's mortgage insurance business can be sent to private investors, limiting the amount because of the capital reserve requirements. The implication of this for consumers is reduced choice. This is not a competitive marketplace with consumers freely choosing which company will insure their loan, even though they are the ones who pay the large upfront fee for this insurance.

CMHC's stated plan for 2010 was to have $520 billion in insurance outstanding, which represents approximately 70% of the market. Genworth has been competing in this market since 1995 and holds most of the remaining 30%. To me, one party with such a dominant share of the market implies inadequate competition. There are now two relatively new competitors in the market to battle for the private company share of insurance. To make this a truly competitive market, changes to the 90% guarantee are necessary, either by reducing CMHC's guarantee or by raising the one for the private sector.

Poschmann: The key point, Mr. Chairman and Mr. Adler, is clarity from the point of view of parliamentary oversight and oversight by the public of the risks to which Canadians are exposed through CMHC's mortgage underwriting and mortgage insurance activities and securitization activities. Again, we have little reason to doubt that the risks inherent in these activities are well managed. However, they are very large numbers, and they're very large risks. If you think about the impact of a significant housing market shock, while CMHC is well capitalized, as Ms. Kinsley has indicated--capitalized, they say, at higher than the standards that OSFI requires, so we should be well protected as taxpayers--nonetheless a significant market shock could easily eat up the capital that CMHC has set aside.

Kinsley: The issue of the differential in our mandate and the cost of that really gets to the nub of the difference in the guarantee between CMHC and the private insurers. We are, by virtue of being a crown corporation, 100% guaranteed by the Government of Canada. Recognizing that private insurers can select the markets they choose to be in, and obviously they will not serve those that are less profitable, the government has set the guarantee for private insurers at 90%. That 10% differential in the guarantee, in order to create a level playing field between us, compensates us for that difference.

We have been able to operate successfully on that basis, as is evident by our annual returns, and the over $12 billion that we've been able to return to the government.

I see the key points from this testimony as:

• CMHC enjoys a reduced cost of capital. Londerville argued convincingly that this produces an unfair advantage for CMHC compared to private insurers who will either accept higher risks with lower premiums or give up market share. That CMHC commands 70% of the market means they set the price.
• Banks are transferring significant risk provisions onto CMHC via the 100% guarantee. This means they do not need to provision for counterparty risk on their balance sheets. As was mentioned this was somewhat helpful in 2008 when banks were scared of counterparty risk. The 100% guarantee does not show up on the balance sheets of those making the loans.
• CMHC is well capitalized and can withstand a moderate housing recession without touching government coffers. A severe recession would likely wipe them clean, and they would be asking for some of the expropriated monies back, though it's a bit funny that a corporation would be asking its shareholders for dividend clawbacks. (Imagine if RBC asked shareholders for its dividends back!)
• Kinsley opines that the 100% guarantee is necessary to compensate CMHC for providing mortgage insurance when private insurers are unable or unwilling to provide insurance in certain market segments. The problem here is that there is no condition by which an outsider can determine which markets are "distressed" enough that private insurers refuse to step up, and one major reason why CMHC commands the market share it does.

I would recommend to policymakers that CMHC's function of providing access to housing (and not necessarily mortgage insurance) in times when the private market is dysfunctional is noble but there must be limits. When its mandate starts encroaching on mainstream market functions, by underwriting 70% of a market that by all accounts is functioning as it should -- private insurers (well, insurer) are competing -- it risks usurping its mandate. In the extreme, as is potentially the case now, when house prices are high, CMHC can only fulfill its affordability mandate by taking on more risk, when it should be focused on lowering, not enabling high, prices.

The other elephant in the room is that Canada has not yet experienced a moderate or severe housing recession in 20 years, and certainly not when interest rates are so low. While we can opine that CMHC is well-capitalized and that, perhaps, making mortgage insurance fully private may help against future asset price bubbles, we do not have an example that can be reasonably used as a passable stress test. Australia was cited as a country that privatized its mortgage insurance business about 15 years ago, but Australia has not experienced a severe housing recession under this regime to validate private insurers' capital adequacy requirements. In other words, thinking that insuring against correlated risks can be privatized should be thoroughly vetted against potential housing market shocks in hundreds of years of world history. In my view, the best way to prevent governments from bailing out insurers is attempting to avoid the risk entirely, and that means using lower prices and higher yields as a fundamental gauge to set housing policy.

With Bill C-3 now emerging from the legislative sausage-maker its implementation will hopefully pave the way for recasting CMHC's important but dangerous role in Canada's housing market.