The Canadian Moral Hazard Corporation

The Canadian Moral Hazard Corporation
Profile photo of Chris Horlacher

On January 17, 2011 Finance Minister Jim Flaherty and Natural Resource Minister Christian Paradis announced that they would be making ‘prudent adjustments’ to the rules for government-backed mortgages.[ref][/ref] The press release was laden with the usual self-congratulatory fanfare and statements obviously designed to assure the reader that Canada has a ‘well-regulated housing sector’ and that the government ‘will continue to take the necessary actions to ensure stability and economic certainty in Canada’s housing market.’  Either Mr. Flaherty is unaware of the issues facing the Canadian mortgage industry, or is simply trying to create the illusion that the government is doing something about it.

The Canadian mortgage market is dominated by the Canadian Mortgage and Housing Corporation (CMHC) and this government-owned company operates in much the same way as Fannie Mae and Freddie Mac.  The CMHC insures and guarantees mortgages as well as buys mortgages from banks in order to issue mortgage-backed securities that trade in the secondary market.  In comparison to Fannie Mae though, the prognosis of the CMHC is notably worse.  For instance, at the height of the housing boom in 2007 Fannie Mae had guaranteed over $2.3 trillion in mortgages[ref][/ref], nearly a quarter of the market.[ref][/ref] As of 2010 the CMHC guaranteed about $840 billion in mortgages, about 90% of the market.[ref][/ref]  Fannie Mae had approximately $44 billion in net assets to cover those guarantees, giving them a leverage ratio of about 50:1.  The CMHC has about $11 billion in net assets to cover theirs, with the ratio working out to a staggering 75:1.  To make matters even worse, 74% of the CMHC’s assets are invested in those very same mortgage-backed securities.  If the Canadian housing market ever took a dive the CMHC would be bankrupt in the blink of an eye.

The measures announced last January by the government are clearly geared towards ensuring that the CMHC doesn’t implode.  To put things in perspective, the CMHC’s guarantees are nearly twice the entire national debt.  It’s highly unlikely that every single mortgage would go into default, but even having to cover 10% of them would grow our national debt of $560 billion by nearly 17%.[ref][/ref]

The first of the new measures reduces the maximum amortization period from 35 years to 30 on new government-backed mortgages.  The government correctly says that this will reduce the total interest payments Canadian families make.  However the problem isn’t with mortgages that are going to be made, but with the mortgages that have already been made and this measure does absolutely nothing to address it.  While it will reduce the total amount of interest paid, monthly payments will necessarily rise.   A family obtaining a $350,000, 5% mortgage will pay $113 more per month once these changes go in to effect compared to the same mortgage being amortized over 35 years.

The second measure reduces the amount Canadians can borrow out of the value of their home from 90% to 85%.  I’m really curious as to how much effect Mr. Flaherty really thinks this is going to have.  A 5% change is an empty gesture.  After all, it only means that a person would be able to borrow $85,000 instead of $90,000 out of the value of their $100,000 home, hardly a difference that would make or break someone’s decision.  Flaherty claims that this will ‘promote saving through home ownership’ but this only reveals that our government is still completely ignorant of one of the main causes of the failure of the US housing market; homeowner’s ability to use their houses as piggy banks in the first place!

Thirdly, the government is eliminating its insurance backing on lines of credit secured by homes.  The fact that the government only marginally reduced the amount of credit a customer could obtain, while simultaneously completely withdrawing their guarantees on that line of credit is telling.  It means that there is a fear in the government that a default is coming.  The government is already guaranteeing the house, why further guarantee their home equity line of credit?  They’re removing an exposure to losses that they’ve deemed too risky.  There is a silver lining to this measure though.  Now that the guarantee is gone, banks will be more cautious in giving out loans secured by homes in the future since they’re playing with their own money now and not the governments.

The activities of the CMHC have, much like its American cousins, been taken to reckless excess.  Even a slight increase in the default rate in Canada will devour the company whole.  With the increasing risk of losing the U.S.A. as our major export partner and significant source of our GDP as they further endanger their currency and economy, the likelihood of this event is looking ever more probable.  The actions taken by Mr. Flaherty and Paradis show that the government is only marginally aware of these problems and clearly do not see a solution except to try and curtail further damage.  Too little, too late has been the drumbeat of every government when it comes to undoing bad policy and January’s announcement only shows that Canada is no exception.

We have long heard shouts of denial from the media and other ‘experts’ that Canada is in a housing bubble, or could wind up experiencing a string of defaults like what happened in the U.S.A. beginning in late 2007.  Unfortunately for these deniers facts can be stubborn things, for indeed our housing prices have been rising exponentially over the past years.  A story that ran in the Financial Post last August identified a report issued by the Canadian Centre for Policy Alternatives where they argued that the residential real estate market, particularly in Toronto, Vancouver and Calgary, is “an accident waiting to happen.”[ref][/ref] If the following chart is any indication, they’re not exaggerating.

Compared to the United States we have experienced nearly an identical boom in real estate.  The signs were, of course, everywhere.  House-flipping shows were airing practically 24/7 on television and no money down mortgages became a common sales pitch with mortgage brokers.  The availability of these loans was a direct result of the backing the CMHC was handing out like candy.

The article later notes that the strength of the mortgage market in Canada is the reason why Canadian banks have performed so well when compared to foreign banks during this crisis.  Households in Canada have managed to meet their mortgage payments because employment levels have stayed relatively healthy.  The reality though, is that Canadians are just as leveraged as their American counterparts.

The average Canadian of 2011 looks exactly the same as the average American of 2007, and the average American lost their shirt.  They have borrowed out all the equity in their homes in the form of HELOC’s and other lines of credit and went on a spending spree.  Likewise, our savings rate has strayed dangerously low.

The same events happening all over the globe will happen here as well.  For a number of years now Canadians have been on a debt-fuelled spending binge.  Wiley Coyote has already ventured off the cliff and it’s only a matter of time before he looks down.  The trigger could come in any number of ways.  In the U.S.A. the central bank began raising rates as a wave of mortgage resets swept by.  Debtors could no longer afford their new monthly payments and wound up defaulting.  In Canada, our central bank has said that it would not raise rates until 2012.[ref][/ref] The reasons why could not be more clear.  The government is well aware of the problems inherent within the mortgage market, but like all good Keynesians think that they can delay the pain forever with low interest rates.

The only problem is that our economy is closely coupled to that of the U.S.A.  About 73% of our exports or 22% of our GDP comes from doing business with our southern neighbours.[ref][/ref] When they can no longer afford to buy our exports, what will happen to our export industry?  More than likely there will be a series of layoffs as firms restructure themselves in an attempt to find new customers.  Many others will simply go out of business.  The unemployment resulting from this could easily be the pin to pop our housing bubble.

Whatever the trigger may be, our government’s reaction will likely be the same as the U.S.A.  They will sweep in to support the CMHC with bailouts and guarantees.  The Bank of Canada will continue to do everything they can to keep interest rates low in order to forestall the defaults.  These actions will only paper over the problems that are now deeply-rooted in our financial system and further debase the currency.  Furthermore, with nothing behind the Canadian dollar except for US dollars and Euros, this could happen much quicker than expected as well.[ref][/ref] For the moment though, our government seems content to continue staring in to the abyss.  They may feel differently when it begins to stare back.

  • Andrew

    Chris, thanks for that and the great article as well. Yes, that would be the issue with credit derivatives and illiquid reference assets, there will be a significant lag until the full scope of liability is uncovered and the market has more time to deteriorate until the insurer passes the asset on.

    I am aware of the soft landing argument as it's commonly presented: regulators tighten credit slowly at the top of the market giving sufficient time for those who bought in at extended valuations and with the cheapest carrying costs to improve equity positions and stay in their homes. There is thus not a lot of selling or demand at the top and organic demand builds slowly over the longer term as real estate stagnates and other other relative price points inflate up to that supporting level. Ceteris paribus, this seems plausible, but we are facing cyclical over investment into the sector as a whole and it may be that which pierces the optimism as slowing in real estate causes increased unemployment overall. That and with the general arguments about indebtedness and the total lack of affordability at higher carrying costs for a portion of the market and a soft landing seems unlikely.

    That said, I cannot completely countenance a full blown melt down at this point due to the effect of recourse mortgages on defaults. Reality may be a lot more bitter for Canadians who opt to stay in their negative equity homes knowing they cannot escape liability as their American counterparts could. This could build more support into the market and prevent steeper declines as property comes back on slightly longer terms averages without breaking down completely, say 15-25% compared to 30% plus. The market doesn't need new buyers to maintain more recent valuations, just for slightly more recent buyers to continue serving their debt.

    Altogether, very interesting stuff!

  • Andrew

    So, I recognize this is an old article, but, I have a question. After looking at the CMHC financial statements, I can see net assets in respect of the amount indicated here, roughly 9 billion. Also, I see two values given for insured products: 1) total insured volume and 2) insurance in force. These are significantly different. What is the true metric of potential liability? Further, I would like to know how it is appropriate to equate insurance liability with actual liability given a default. The author states a 10% would lead to an increase of 17% in National Debt due. Yet, this would be based on a total non recovery from the properties with those insured mortgages, e.g., at a 10% default rate the banks will be forced to sell those repossessions at a loss. This loss however will not be 100%, thus, is it not incorrect to say a 10% default rate will result in a 100% of the dollar value of 10% of insured mortgages?

    • Chris Horlacher

      Hi Andrew,

      From the 2010 financial statements:
      Insurance in force = $514b
      Guarantees in force = $326b
      Total exposure = $840b

      Insurance relates to the CMHC mortgage insurance that cover creditors in case of a mortgage default, guarantees relate to the CMHC MBS coverage the makes creditors whole in the event that the MBS defaults. So if CMHC has to cover 10% of these (i.e. 10% of outstanding mortgages go bad) the CMHC would have to come up with $84b in order to meet their contractual requirements under these guarantees.

      The CMHC may be able to recover some of that $84b by selling the homes, but remember that doesn't happen right away. It could take many months or even years before the CMHC is able to sell those homes and in the meantime, they have to pay out the $84b right away. So taking possession of the homes will not help at all. The government will still have to bail them out in order to cover that loss.

  • Redmond Weissenberger

    Check out Larry Solomon's article on the subject –

    He agrees with Chris!

  • JKM

    Great article, but how does the CMHC come to insure such a huge portion of the market (90% according to the article) if it is only required for highly leveraged purchases (i.e. less than 20% down)? I did look at the cmhc site and see that they have $900B insured and only $10B in assets after liabilities, but i still can't wrap my head around it. 90%??? What sort of default rate would send them down the path of Fanny Mae?

    • Chris Horlacher

      You'll have to check out the references in the story. The mortgage market is $1T, CMHC guarantees are $900b, with only $10b in equity to cover it. If a penny out of every dollar insured goes bad, the CMHC is a goner.

      • Abdel H. Bioud

        One reason it could be delayed is immigration. For example, here in Montreal, we receive +40,000 new immigrants/year.

        2000 to 3000 of them are rich immigrant investors. And what they do when they get here? Buy real estate, taxi licences etc. That's what keeping the pressure on prices.

        Other side of the medal is that social/racial tensions are rising.

  • JKM

    Super interesting article – and kinda scary. But i don't think i fully follow the numbers. Why is the CMHC insuring %90 percent of the market if the insurance is only required for mortgages with less than %20 down?

    • Chris Horlacher

      Why put 20% down on only one home when you could put 5% down on four homes and keep all the gains to yourself?

  • Mandeep Singh Rayat

    A very well written and comprehensive article Chris!

  • judith branden

    Another precious metals charlatan putting down real estate. For those with the stamina to hold in, housing as an investment has done very well in Canada. In Winnipeg, (St Norbert area) not exactly seen as the leader in real estate gains, row houses which sold in the early eighties for 11-13,000 are commonly sold for 10 times that amount, while many homes in rural Ontario towns have at least quadrupled at the same time……………… so its not just Vancouver, Calgary and Toronto.
    Housing has real value, you can occupy it; you have to live somewhere.
    Gold is just another piece of crap to pay storage fees on. It has no intrinsic value, despite what the conspiracy theorists want us to think. Want to get rich; short gold at $1600.

    • Chris Horlacher

      Gold has real value, you can trade with it, use it in electronics, heat reflecters etc, you have to trade with something.
      Housing is just another piece of crap to pay upkeet on. It has no intrinsic value (nothing does), despite what the real estate agents want us to think. Want to get rich; short MBS's right now.

    • Redmond Weissenberger

      In Winnipeg, (St Norbert area) not exactly seen as the leader in real estate gains, row houses which sold in the early eighties for 11-13,000 are commonly sold for 10 times that amount, while many homes in rural Ontario towns have at least quadrupled at the same time……………… so its not just Vancouver, Calgary and Toronto

      Dear Judith

      How does a ten fold increase in the prices not seem like a bubble to you?

  • Chris Horlacher

    Prepare for the worst, hope for the best. There's no reason to think things won't play out here exactly the way they did elsewhere. We're in for an even bigger potential fall than the USA. Fannie Mae and Freddie Mac's combined guarantees were about 60% of the national debt at the time they went under. The CMHC's guarantees are 160% of the national debt. It very well could get a lot uglier here.

  • Redmond Weissenberger

    "The government has gotten itself into a mess where too many Canadians have too much debt, too much debt spending, too high house prices and too little savings."

    Seems to me it is the Other way around – certain Canadians have too much debt because of the actions of the government.

    Not all Canadians took on the debt loads – those that acted wisely should not have to shoulder the burden of those who did not.

    Time to take a hard look at the BoC and it's future in a free society.

  • Allen Graham

    As much as I agree with Horlacher on the state of the Canadian mortgage market and the balance sheet information readily available on CMHC's website, I take exception to his strongest point.
    We can not be compared to the US market. In no way. First, mortgage brokers arrange refinancing in the US, and that aspect is fraught with problems, them "shop" for the best rate, but actually just trying to find a buyer. Overvalued properties are, and always have been a big problem. Walk-aways are all too common, because the borrower is mortgaged out. And yes, I have worked with US mortgage brokers.
    The US Government a long ago allowed the taxpayer to use the mortgage interest as a tax deduction, good for the borrower, not so good for revenues.
    No question that the housing market is oversold. To review the collapse in 1990 is critical. Will it happen again, absolutely.
    But, again, Horlacher is in error.
    Canadians compared to their US counterparts have far more real equity. There are many investors hoping for another scenario as happened in 1990, again to buy up properties.
    And the myth of 5% down. In broad terms how many homeowners have only 5% equity, or 10, or 15 or 20%. Surprise, very few. Yes debt is rising, along with inflation, not a new phenomena.

  • Pete E

    Chris is right to be worried about Canada's mortgage market but wrong to complain about the government response.
    The government has gotten itself into a mess where too many Canadians have too much debt, too much debt spending, too high house prices and too little savings.

    To correct the situation immediately means a rapid drop in perceived wealth which (along with being politically suicidal) means a rapid drop in house prices. That means a lot of CMHC mortgages would go under water and default, thus triggering the domino effect we all fear.

    Instead, the government is taking steps to ensure that in the future less high-risk mortgages are written, and current CMHC borrowers can't take on further risks. Every month, the overloaded will pay down their debt load and we will ease away from the brink. Once the risk has abated, would be a good time to debate more conservative lending rules.

  • SAD

    Good article. The plan was to replace lost manufacturing jobs with construction jobs and increase credit markets. Globalisation at its best. It works for a while. Hope people are prepared for the adjustment coming. Our quality of life lowers while the new export countries was to rise. Of course greed got in the way and those countries are not rising like they should of. Greece defaulting will bring things to a conclusion.That is why the world bank will paper this problem over. There are going to be whole lot of band aids applied throughout the world. The economic system is unhealthy and broken. Too big to fail.

Profile photo of Chris Horlacher

Chris began his career as an auditor at a Big 4 firm and before the age of 30 was the CFO of a start-up stock brokerage that now manages over $4 billion in assets. He went on to found his own management consulting firm and has been instrumental in numerous successful multi-million dollar start-ups and strategic initiatives for Canada’s largest companies, SME's and non-profits. Possessing Chartered Accountant and Chartered Professional Accountant designations, Chris is also certified by the Canadian Securities Institute as a partner, director and chief financial officer. His company website is

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