Wake up call for lenders Rob McLister, Canadian Mortgage Trends Feb 2, 2012 - 9:20:02 AM RSS?

CMHC Insurance Limits: A Wake-up Call for Lenders

Many have now seen this   National 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

  Despite 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 6  Banks. 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 an   abnormally  large and predominantly insured $17+ billion mortgage-backed securities issuance in December.)

The Risk of Portfolio Insurance

  Portfolio 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.)

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