The only reason a great many American families don’t own an elephant is that they have never been offered an elephant for a dollar down and easy weekly payments.
~ Mad Magazine
Update: This article was included in the Carnival of Financial Planning #142 posted at The Digerati Life. Thanks!
I’ve heard a lot of people on both sides of the border extolling the virtues of the Canadian mortgage and banking system over the past year. Our mortgages are recourse loans, mortgage interest is not tax deductible, and our banking regulations are more stringent. We crafty Canucks have even managed to inflate a housing bubble during the worst recession since the Great Depression. Wait. Is that good?
If it sounds like that makes no sense, maybe it’s because it shouldn’t. Recessions are supposed to be a pause that refreshes our capitalist economy. Without failure, there is no capitalism. Recessions are like forest fires that clear dead wood and lay the foundation for new, more vibrant growth.
Controlled Burn or Dead Wood Rising?
When the credit crisis threatened to burn down the global economy, governments worldwide poured buckets of money on the fire. The U.S. government, firefighter in chief, rescued Fannie Mae, Freddie Mac, AIG, GM (click for a rebuttal to the latest feel-good ad), Chrysler, and many others. Although Canada’s housing market and economy didn’t suffer to the extent of other nations, our government stepped in to provide additional backing to the Canadian mortgage market through the Insured Mortgage Purchase Program.
While the Canadian government didn’t need to rescue the CMHC (Canada Mortgage and Housing Corporation), they did raise the limits on the amount of mortgage debt that it could insure. These supportive measures encouraged banks to lend by effectively offloading the risk of losses onto the taxpayer. To provide further stimulus, the Bank of Canada lowered interest rates to rock bottom levels.
The goal was clear: control the burn. The likely result is not yet clear, but will become so in the near future: we saved the dead wood. With all that dead wood still standing, there’s no way that healthier trees will have a chance to take root and grow. Further, it serves as a huge tinder box that could make a controlled burn impossible should the right spark ignite it.
Potential Sparks
If I’ve lost you in the forest with all of this, let me spell it out here. The CMHC issues mortgage-backed securities, which are basically pools of mortgage debt, and sells them to large financial institutions and pension funds. CMHC underwrites the risk, so that if borrowers default on their mortgages, the lender is not on the hook for the losses. CMHC is. Since the government backs the CMHC, that means taxpayers are on the hook for those losses. (Yep, that’s you and me and our money.)
So far, none of this has come to pass. There’s been no housing crash in Canada and no mass mortgage defaults. On the contrary, many people believe we have a housing bubble in Canada. But they also think that it is on the verge of popping and perhaps triggering the aforementioned price depreciation and defaults. There are a few factors that could spark a housing-led economic crisis in Canada:
- Tighter Lending Standards: Low interest rates, long amortization periods, and low down payments have caused housing prices to rise beyond affordability. When these factors reverse, many homeowners may find it difficult to afford their mortgage payments.
- Low Savings: Canadians have very little money saved, so there is no cushion in case of financial pressure due to high unemployment and higher interest rates.
- High Debt Levels: With debt levels at record highs, Canadians have limited or no access to more credit should they need it. If lending standards tighten further (as they should), this situation gets worse, causing a slowdown in consumer spending.
- Moral Hazard: Banks have been encouraged to lend to unworthy borrowers (dead wood) because they will not suffer the losses if these people can’t pay their mortgages.
No Country for Old Men
Although Canada is often seen as The Country of Fiscal Prudence, many of the statistics belie that image. From 1999 to 2010:
- Credit card balances are up 458% from $12 billion to $55 billion
- Outstanding residential mortgage debt has grown 242% from $399 billion to $965 billion.
- Personal lines of credit are up 820% from $25 billion to $205 billion.
Like Fannie Mae and Freddie Mac, the CMHC was originally formed to help first-time homebuyers enter the market. Over the years, it has morphed into “a mortgage slush fund which distorts the market. It allows banks to lend recklessly without consequences and pushes up the price of housing for everyone. It rewards those willing to speculate with leverage and discriminates against those who are prudent.” That is a quote from a Financial Post article written by Diane Francis back in October of 2009.
I’m afraid we might be on the cusp of finding out just how true those words might ring. If interest rates begin to rise, housing prices will fall, and those who have borrowed beyond their limits will feel the heat. The dead wood will ignite and those who have been prudently saving will pay the price for the profligacy of their fellow Canadians.
How can we avoid this scenario?
Great article 2 Cents. Sadly, we can’t avoid this scenario. Any person who does take the time, and looks at our monetary system with a clear mind, will see it does not work.
How long before it all crumbles? 10,20,50 or 100 years? Are we to solve it with more consumption, that’s all we have right now. I hope more people will see how silly the whole system really is.
I hear you Ryan. We are trying to solve a debt crisis fueled by hyper-consumption with with more debt and more consumption. I don’t get it. Thanks for stopping by!
It might take a whole generation of great teaching, but I wonder if we’d have the desired effect if we taught financial literacy and financial prudence superbly in Canadian schools. Actually, it might take more than a generation. But it might be the answer—-if it’s taught superbly, regularly, and reinforced.
Nice article 2 cents.
Andrew
.-= Andrew Hallam´s last blog ..Losing Stocks Continue Their Winning Ways =-.
A generational change in mindset is just what we need. I’ve often advocated for teaching the basics both at the elementary and high school level, but I think fiscal responsibility begins at home. Young people are more likely to consciously or unconsciously fall into the mindset of their parents. Modeling good financial practices is just as important as verbal teaching. Thanks for your input Andrew!
Good post. I also see the danger signs in the high housing prices; however, I still believe you can purchase in the market if you hold to a few constraints:
* Do not spend more than 33% of your net income on total housing costs.
* Don’t buy just to flip or speculate unless you really know what you are doing.
* Don’t buy if you plan on selling within a few years.
Why #1? This provides buffer room in case interest rates go up. In fact, it’s good to calculate the 33% on a 5% or 6% mortgage rate.
As for the other two points, in the end, you need somewhere to live. If you buy a home for the longer term, then you will ride the ups and downs of the market. Over the long run it should be comparable to renting or better.
I don’t know about a popping bubble, but higher rates are going to make it tough for overstretched families…
.-= Kevin´s last blog ..Have a Lump Sum? Should You Pay Off the Mortgage Faster or Invest It Instead? =-.
I always say that the roof over your head is a great investment – so long as you are prepared to stick to the kinds of rules that you outlined in your comment. Buying what you can afford, sticking with it for the long term, and paying down the mortgage are the keys. In this environment of record low interest rates, you’re wise to allow some wiggle room. Thanks for stopping by!
Privatize CMHC!
There have been a lot of calls to privatize CMHC. That would certainly eliminate the risk to taxpayers and the regulatory advantages that CMHC enjoys in the marketplace. The financial post had an article from Brett Skinner of the Fraser Institute a couple of months ago that made a case for privatization. Apparently Australia has successfully privatized mortgage insurance.
http://www.financialpost.com/Story.html?id=2543597
Would the Canadian government consider this?
Thanks for stopping by Kelso.
I heard that few years ago before the US credit problem, CMHC proposed to allow 0-5% downpayment for “investment” properties, as they had to compete with other mortgage insurance companies.
Luckily this proposal had not been approved.
I believe that the mortgage insurance competition that was driving the 0-5% downpayment desire were companies (AIG, I think?) out of the states that quickly pulled their operations out of Canada once they started having trouble down south.
I don’t have quotes for this, but it is a familiar story I believe I read in the news.
The system needs appropriate checks and balances in order to function; what we’ve had in North America has had no controls in place. Following what Obama is recommending in terms of regulation introduction on Wall Street is another interesting story to follow related to this topic.
Excellent post, and I love the forest fire metaphor. This is hands-down the biggest single risk to Canada as a nation at this point in time. For the most part the mainstream media is negligent in discussing this critical topic. Bravo!
Thanks very much Paul. I think you’re right. This topic needs more attention. To be fair, I know that a few columnists at the Financial Post have written about this and Larry MacDonald had a good article on the CMHC back in February:
http://blog.canadianbusiness.com/cmhc-out-of-control/
I think I highlighted that one in my 20 Cents from February 2010 post.
…and don’t forget the role of the Harper government in exacerbating our collective indebtedness. Harper took 70 billion off the banks books to facilitate continued mortgage lending in 2008. He provided tax write offs for new owners and offered to insure 40 year sub prime loans right when those same policies were clearly throwing the US down the tubes. His stimulus plan, when the recession hit, was not towards infrastructure but on inflating the housing bubble even more due to a series of initiatives in his economic action plan.
Watch out- an election is coming! Harper is sure to use some bogus excuse to go to the polls before the looming meltdown. Moreover the euphoria created by the bubble may give him the majority he so craves.
It looks like another meltdown has been temporarily averted. Let’s see what happens before the next one! Thanks for your comments!
CMHC Insurance (example)
The nominal mortgage insurance premium is a fraud within a fraud. The premium is a disguised interest charge illegally capitalized in advance (contrary to s. 347(1)(a) and (b) of the Criminal Code), and the charge for Provincial Sales Tax (PST) constitutes multiple prima facie frauds by the Crown.
There is no commercial “security” peril to insure against. Even if the Bank were
to advance some third party’s existing funds, the real estate security is mutually
assessed at a given amount, meaning that the maximum exposure to loss is about
minus 10% at the outset and then rapidly declines with every payment
made. It would be like you or me insuring a fictitious structure on a vacant lot for
$800,000 against fire. The first crime is complete when you take out the
insurance policy and not when you make or don’t make a falsified claim against
it.
A legitimate insurance undertaking (i.e., business) will generally pay out about
70% of premiums collected, in claims. CMHC pays out less than 5%. Prima facie
CMHC is not an insurance undertaking.
The thing being insured is the commercial profitability of a credit contract, which
is interest by definition. The federal government knows this, and is regardless
reasonably expected to know this. The nominal premium is expressly excluded
as an insurance charge under ss. 347(2) of the Criminal Code by the very act of
adding/compounding it to the nominal credit advanced:
“insurance charge” means the cost of insuring the risk [i.e., and not the income]
assumed by the person who advances or is to advance credit under an agreement,
where the face amount of the insurance does not exceed the credit advanced;
You cannot add the insurance Premium on top of the principle it is a violation of the criminal code of canada
Because the payments start right away and are overwhelmingly interest, the
thing being insured-in-fact is the business profitability of the credit, even if it were
The Banks own equity being invested instead of yours.
What is needed is a criminal investigation of the entire CMHC operation to determine how they deal with the fact that it is a purported “insurance company” that allegedly receives billions in alleged premiums while virtually never paying out on any claims.
Just thought you should know…not everybody is stupid
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