If the buck stops at the taxpayer, CMHC needs a renovation

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Earlier this year, the Department of Finance convinced Manulife Financial Corp. to withdraw a 2.89 per cent interest rate promotion on five-year closed mortgages. The consensus seems to be that it was a misstep on the part of the Finance Minister's office to intervene on a case-by-case basis, if the goal was to avoid a low rate war.

A broader option would be to privatize Canada Mortgage and Housing Corp. (CMHC), which Minister Flaherty has twice hinted as a long-term option. Interestingly, CMHC has just appointed a new chairman with extensive private sector experience and the current CEO is stepping down.

Or we could just phase it out completely over a long period of time.

CMHC is synonymous with mortgage default insurance, but there are private alternatives as well. CMHC is a Crown corporation 100 per cent backstopped by the government, and hence the taxpayer. Private insurers are 90 per cent backstopped.

Currently, borrowers pay mortgage default insurance premiums to protect the lender in case of default on a high-ratio mortgage (where the down payment is less than 20 per cent). If the borrower defaults, and the house has dropped in price to less than the amount owing to the bank on the mortgage (known as being underwater), then the insurer would pay the difference to the lender. That guarantees the lender makes a profit.

Many people do not like the fact that the home buyer pays this premium which protects the lender. If lenders didn't have this protection, interest rates on mortgages would rise to actually reflect the creditworthiness of the home buyer.

"When you think about it, there is this perverse upside-down risk structure owing to default insurance," says Ben Rabidoux, an analyst and strategist with U.S.-based Hanson Advisers. "The risk to a lender for a 95 per cent loan-to-value borrower is the same, or less, than a 75 per cent loan-to-value borrower? Does that intuitively make sense?"

Without a guarantee from CMHC, lenders would increase rates. Because once they assume the risk, you can bet pricing would change to reflect that.

Tightening the CMHC eligibility rules back down to 5 per cent down payments and 25 year amortizations along with new restrictions has caused some market grief. But when CMHC launched, it was created in part to help soldiers returning from the war afford home ownership. When they got into the mortgage default insurance business, 25 per cent down payments were still required.

"CMHC's core mandate is inherently self-defeating. They strive to make housing more affordable, but in fact all they really do is make debt more affordable, which drives house prices higher," says Mr. Rabidoux.

But eliminating CMHC is not going to happen anytime soon.

Perhaps a more viable option would be privatization and the reduction of government backstopping down from 100 per cent. Also on my wish list would be seeing CMHC premiums change reflective of risk. The premiums are the same for Toronto condos as they are for every other real estate locale in Canada.

Even these less draconian moves are unlikely any time soon. But according to Robert McLister, editor of CanadianMortgageTrends.com, "Significantly reducing the government backstop would lead to higher rates and a reduction in credit availability. Even creditworthy borrowers would feel the impact."

Mortgage interest rates or mortgage default insurance premiums reflecting actual creditworthiness: novel concepts you won't find in Canada.

Preet Banerjee, a personal finance expert, is the host of Million Dollar Neighbourhood on The Oprah Winfrey Network. You can read his blog at WhereDoesAllMyMoneyGo.com and follow him on Twitter at @preetbanerjee.