Friday, February 5, 2010

Canadian Moral Superiority - Stable Banks

From my previous post you might assume I place the blame for the current Canadian housing bubble solely on the consumer, the truth is far from that, however. While it's widely proclaimed that the Canadian banks make prudent lending decisions, and that's why Canada has avoided a housing collapse as in the US, I would differ on that assessment.

It takes both irresponsible borrowers AND lenders to create a bubble; after all, if borrowers are taking on too much risk by overextending themselves, it's the lender that's saddled with the added risk of missed payments or default.

Well, sort of. At least that's how borrowing and lending is supposed to work. But due to "financial innovation", banks have found miraculous ways to mitigate their risk, often by securitizing mortgages and selling the MBS to other people. Keep in mind that the risk is STILL there...but they've paid rating agencies to say that it has vanished! Cool eh? Some poor bagholder gets stuck holding these junk mortgage backed securities that get rated AAA, and they get to take the loss...and on top of that the banks get paid to securitize the mortgages.

So...who's buying all this crap? Among others, CMHC. And they're buying LOTS.

CMHC's charter supposedly is to provide Canadians with affordable mortgages, so if a borrower who would otherwise not qualify for a typical bank mortgage (requiring a 20% down payment) but who would still like to buy, can pay CMHC insurance on top of their rate.

Ask the majority of Canadians what CMHC insurance is for, and I assume at least half would get it wrong. Is this to protect the borrower because he's taking a risky mortgage due to the high amount of leverage? Hardly. It's so that if the borrower defaults, the lender can get reimbursed via CMHC. As such, the creditworthiness of the borrower is now made a bit pointless...since CMHC is covering their risk.

When I say CMHC is covering the risk, what I mean is that the federal government is covering the risk, which is ultimately backed by you and I, the Canadian taxpayer.

OK, so higher risk borrowers get stuck paying the CMHC insurance, and this is the risk premium they pay, right? Except if that was the case, why can't banks just charge higher rates to these sketchy borrowers? While it makes a lot of sense that the highest risk borrowers should pay the highest rates, in practice there's a tipping point where this will not work because the highest risk borrowers are the ones least able to afford the higher rates. As such there is a line where a bank simply won't lend to you because you're too big of a risk of default.

If banks could make money charging higher rates to these borrowers, wouldn't they? Or is it more likely that CMHC is charging insufficient rates for mortgage insurance for the risk of default that they're (or should I say we're) insuring. Is CMHC adequately capitalized? Or do banks even care about the counterparty risk since CMHC is backed by the taxpayer? If and when we start seeing price drops and mortgage defaults, we'll find out.

For a good description of the CMHC time bomb, I highly recommend Jonathan Tonge's blog post "CMHC-Canada's Breaking Point"

Over 1999-2008 Canada's charter banks increased their residential mortage credit from $241B to $469.6B, an increase of 94.9%. Over the same period CMHC MBS increased from $23.5B to $197.3B, a staggering 739.6% increase.

Are Canadian banks "prudent" lenders, or have they cleverly managed to offload all of their risk quietly onto the taxpayer, who is already saddled with enormous household debt from credit cards, car loans, and monstrous mortgages, not to mention the prospect of higher taxes (HST), and increased borrowing costs.

Are the banks to blame? Or have they simply been enabled by irresponsible politicians who are goosing the housing market through cheap credit? What happens when the Canadian housing market inevitably much is this going to drive up deficits (and subsequently taxes)?

Is it just me, or is this post full of unanswered questions? (yes that's another one). Seriously, I'm more agitated writing this NOW than when I started. The simple answer is, "We don't have the answers yet but the questions and potential consequences scare the shit out of me." Maybe it's time some of our elected leaders (I'm using that term loosely) started asking some of the same questions before this problem detonates. Tick tock...

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