Ottawa eyes ‘risk-sharing’ option for lenders in hot housing market

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Ottawa is reviving a proposal that would force lenders to shoulder more risk in Canada's heated housing market.

In a briefing note to Finance Minister Bill Morneau and released under Access to Information, department officials say they are studying an option to introduce "risk-sharing" for lenders, a move that would likely mean a deductible payable by the banks on the mortgage insurance provided by Canada Mortgage and Housing Corp. (CMHC) and its private-sector competitors.

Paul Duchesne, a spokesman for Finance Canada, confirmed to The Globe and Mail in a statement Monday that risk-sharing is among the policy options under consideration as the federal government undertakes a broad review of Canada's housing market.

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"As recommended by the International Monetary Fund and the Organization for Economic Co-operation and Development, the implications of lenders bearing a portion of losses on insured mortgages that default (also referred to as lender risk-sharing) is one area, among others, where work is being done by the department," Mr. Duchesne said in an email. It's part of the government's "analysis of housing-related vulnerabilities" he added.

Organizations such as the OECD and the IMF have previously urged Canada to follow the model used in other countries, in which mortgage insurers typically cover the first 10 per cent to 30 per cent of losses, but require lenders to shoulder the rest. Under the current Canadian system, virtually all of the risks of mortgage defaults have been shifted to government-backed insurers.

CMHC chief executive officer Evan Siddall first publicly floated the idea of requiring lenders to share in the risks of insured mortgages in 2014. At the time, former finance minister Joe Oliver ruled out any "major moves" to introduce a deductible to mortgage insurance, saying the government aimed to curb taxpayers' exposure to the housing market through more gradual measures.

Mr. Siddall has remained a vocal proponent of risk-sharing. In an interview with The Globe, Mr. Siddall reiterated his call for risk-sharing and said he expected federal officials to begin talking more actively about the proposal later this year. "It's a better system if the people who are managing the risk day to day, banks, lenders, have some exposure to that risk," he said.

Finance Canada conducted consultations with the mortgage industry several months ago, floating a proposal that could see lenders taking the first loss on a defaulted mortgage up to a fixed percentage, a source familiar with the discussions said.

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However, a major challenge for Ottawa is to decide how large of a share of any losses lenders should bear. Another issue is that many lenders securitize their insured mortgages through CMHC's securitization programs and then sell them to investors. Federal officials still have to work out whether it would be the lenders that sold the mortgage, or the investors that bought it, that would take the loss if the government introduces a deductible, the source said.

A mortgage-insurance deductible would also likely lead to higher costs for banks and other mortgage lenders, which currently have to hold no capital against their insured mortgage portfolios since they are considered to be essentially risk-free.

Such a move would also make it more difficult for smaller non-bank lenders, which aren't able to raise funds through deposits and therefore rely more heavily on the money they raise from securitizing and selling insured mortgages.

A deductible could potentially lead banks to raise their mortgage-interest rates, cause lenders to scale back their volume of new mortgage loans or lead to different mortgage rates depending on whether a borrower lives in an area of the country that has a higher propensity to default.

Terry Campbell, president of the Canadian Bankers Association, warned that a deductible on mortgage insurance would have unintended consequences for banks, likely requiring them to hold more capital and would also require more consumer education to help customers understand the changes.

"It's our view that lender risk-sharing, for instance through a deductible on mortgage insurance, would represent a significant structural change to the way the housing finance system currently works," he said. "And we think it could make it more complicated and more uncertain."

He added that the current system has worked well, with prudent underwriting standards among the banks leaving just 0.28 per cent of mortgages in arrears.

Peter Routledge, an analyst at National Bank Financial, said banks would likely face higher funding costs related to the securitization of insured mortgages. "Because mortgages are such a thin-margin product, the banks would have to push up their mortgage rates," Mr. Routledge said. "But I think the government, particularly Finance, understands the market and won't do anything disruptive. It would be more gradual."

In its heavily redacted internal document, dated Nov. 20, 2015, Finance Canada describes the risk-sharing proposal as "longer term in nature," warning that it would have "potentially far-reaching impacts on lenders, borrowers and mortgage insurers."

Just weeks after the document was presented to the minister, Mr. Morneau did act on one of the recommendations from officials by increasing minimum down payments for insured properties above $500,000.

CMHC has also since introduced new restrictions on how lenders use its portfolio insurance, a type of bulk insurance that lenders can take out on uninsured mortgages, and raised fees for lenders that use its securitization programs. The Office of the Superintendent of Financial Institutions also announced a plan to require lenders to hold more capital against mortgages in cities where the regulator feels house prices are unaffordable compared with incomes.