It’s difficult to imagine our banks begging the Feds to make it tougher for them to lend money to their clients.
But this is precisely what Canada’s Big Five banks did recently when they petitioned Ottawa to impose stricter mortgage-lending standards on the industry.
The petition came as we learned the average price of existing homes in Canada had been on a tear as of late, rising 19 per cent year after year in February, which led many market observers to believe an asset bubble was forming in the Canadian housing market.
The current rules allow Canadians to take out a mortgage to purchase a home with little money down—as low as five per cent of the property’s value—and to spread their payments over a long amortization period (as long as 35 years).
The banks’ main concern was under these rules, many Canadian families of lesser means were being lured into the home-ownership game by the artificially-low interest rates maintained by the Bank of Canada to keep the economy going.
In the current interest rate environment, the Big Five argued, it might be easy to take out a variable-rate mortgage to buy a house.
But when rates go up, as they inevitably will at some point, many families entering the market today when rates are low won’t be able to afford their mortgage and we will end up with a real-estate market crisis of our own making.
If raising lending standards made so much sense, why wouldn’t the Big Five raise them on their own instead of asking Ottawa to beef up the rules? The reason is simple.
The Big Five, as it turns out, aren’t the only game in town. A unilateral move on their part, as beneficial as it might have been for the system as a whole, might have backfired by allowing their more venturesome competitors to fill the void and gain market share at the Big Five’s expense.
One wonders why other players in the mortgage lending market might not share the same systemic risk concerns as the Big Five.
There’s also a simple answer to that question. In Canada, more risky mortgages (those with a down-payment of less than 20 per cent) are insured by the Canada Mortgage Housing Corporation (CMHC), whose chief mandate is to “promote” home ownership.
As long as CMHC is willing to “insure” the mortgages, there’s no stopping less picky lenders from lending. Essentially, CMHC provides a back door through which low-quality mortgages can creep into the system.
And if something goes wrong and CMHC cannot absorb the losses, who will have to foot the bill? You guessed it: We will.
As long as CMHC is configured this way, the system remains vulnerable to the games that the few are willing to play at the expense of the many.
This explains why the Big Five insisted Ottawa handcuff the entire industry with tougher rules.
How did Ottawa respond? In typical political fashion, Finance Minister Jim Flaherty also agreed to meet the Big Five partway.
Effective on Apr. 16, 2010, borrowers applying for a variable mortgage will have to qualify for a three to five-year fixed-term mortgage rate.
Second, the minimum down-payment for an investment property will increase from five per cent to 20 per cent.
Third, the ceiling for home-equity loans will be reduced from 95 per cent to 90 per cent of the market value for the home.
These are all positive changes that will reduce the leverage present in the system and make it safer but Ottawa could have gone further.
Reducing the maximum amortization period from 35 years to 30 years would have been a smart move and raising the minimum down-payment from five per cent to 10 per cent would have made a great deal of sense for the system. I suspect Ottawa didn’t want to go all the way for fear that cooling down the real estate market might undermine the fragile state of the Canadian economy.
The real problem, though, is that Canadians are already overly committed financially so they need all the “help” that they can get from Ottawa.
According to Statistics Canada, consumer credit and mortgage liabilities have risen from 77 per cent in 1990 to 132 per cent of our collective personal disposable income.
Debt is addictive and we have to reduce our debt in order to be able to weather the storm that lies ahead. Two significant threats loom on the horizon.
First, although we have enjoyed a pretty good run in the housing market over the past thirty years or so, there’s no guarantee home-ownership will pay off as handsomely for the next generation of Canadians entering the market today.
Recent experience in the U.S. and Europe—especially Ireland—tells us the forces of gravity are as potent in the residential real estate market as they are in the physical world: house prices do go down.
Increasing the minimum down-payment or reducing the maximum amortization period on a mortgage would go a long way towards mitigating the financial risks facing home-owners.
Second, when central banks in Canada and elsewhere start tightening monetary policy to mop up excess liquidity in the system and stave off inflationary expectations and when capital markets start pushing back against massive government deficit funding and corporate debt rollovers, interest rates will have nowhere to go but up, so we can bet that mortgage servicing costs will go up as well.
It’s only a matter a time before we see this scenario unfold.
The best way to prepare for this is to pay our debt, not go further into it.
Therefore, in these uncertain times, leverage is out and de-leveraging is in.
We might just need an extra nudge from Ottawa to set us on the right course.
Louis Gagnon, PhD, is a finance professor at Queen’s School of Business and a former Senior Manager in Risk Management at the Royal Bank of Canada.
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