Ottawa’s recipe for housing froth
Continuing concerns over bubbles in a couple of Canadian housing markets have spurred calls for further interventions by the federal government. Federal Finance Minister Bill Morneau has said his department is doing a “deep dive” into the data to evaluate considerations for “change” to the market. Proposed interventions have included further tightening mortgage rules, surtaxes on foreign buyers, and measures to improve supply such as easing zoning restrictions. One option missing from the debate is not an intervention but a reduction — and ultimately the elimination — of a longstanding interference in the market by the government that has likely been a significant contributor to whatever frothiness housing markets have seen. It’s the subsidy called mortgage insurance.
Does mortgage insurance create a subsidy? Intuitively, it seems likely. Although the U. S. has a very different system of housing finance, empirical evidence from before the 2008 financial crisis provides some evidence that we, like the U.S., have an implicit mortgage insurance subsidy in Canada. In the U.S., Fannie Mae and Freddie Mac were perceived by credit agencies to have implicit government backing, which ultimately turned out to be explicit when these agencies were taken into conservatorship by their regulator. In contrast, in Canada, the CMHC and private mortgage insurers enjoy an explicit guarantee. The debate in the U. S. over the subsidy created by Fannie Mae and Freddie Mac prior to the crisis was not whether there was a subsidy, but the size of it. Various studies came up with estimates that it ranged from a 16 to 25-basis-point re- duction in mortgage costs.
What role is the mortgageinsurance subsidy playing in Canada’s current housing boom? The IMF’s April 2011 Global Financial Stability Report included a chapter on housing finance and financial stability that discussed the implications of government participation in the housing sector. Based on an empirical analysis of the mortgage systems in a number of countries, the authors found that government participation in housing finance exacerbated price swings and amplified mortgage credit growth, including during the run- up to the recent financial crisis. The authors also found that the countries with more government involvement experienced deeper declines in housing prices. Their analysis indicated that the types of government involvement in the mortgage sector that tend to amplify price swings by exacerbating both the boom and the subsequent bust included subsidies to first-time home buyers, tax deductibility of capital gains on housing, and government provision of mortgage guarantees or credit.
In a March 2016 speech that discussed CMHC’s “fi- nancial stability role,” Evan Siddall, the CEO of CMHC, reiterated the justification for the ongoing presence of CMHC in the mortgage insurance market, noting the role CMHC plays in contributing towards financial stability as a “macro-prudential tool.” Macro- prudential tools are in vogue with central banks and regulators as a mechanism to address risk in the financial system as a whole rather than individual institutions. But the concept is new and unproven. The objectives are warm and fuzzy compared to traditional goals of financial regulation, such as the solvency of individual institutions and protecting consumers from abusive practices. And in Canada’s case, past adjustments to the rules surrounding government- guaranteed mortgage insurance have been shown to be ineffective, which is why there are calls for further government interventions. But even if Canadian regulators are wedded to a macro- prudential tool, they could design one that does not require billions of dollars in government guarantees.
Where there is any evidence supporting the notion that CMHC and government- guaranteed insurance contribute to financial stability is a mystery. The IMF findings and the fact that Australia sailed through the financial crisis with a fully privatized mortgage-insurance industry, with that government implementing no initiatives other than implementing some targeted short-term interventions, indicate the exact opposite.
In his March 2016 speech, Siddall briefly outlined possible future reforms such as increased risk- sharing with lenders and a greater focus on government- guaranteed mortgage loan insurance on tail- risks alone. It is time to proceed with this type of reform as the next step in extricating taxpayers from this market. While there is a very valid case that this is a reform the federal government should proceed with slowly and cautiously, it should make clear its commitment and timetable.
Whether or not there are bubbles in some Canadian housing markets, empirical evidence suggests government participation in mortgage finance through guarantees such as mortgage insurance exacerbates problems, despite the claims of some who argue otherwise. Reducing the subsidy will ultimately result in pressure on mortgage rates as lenders will need a larger spread to compensate for the higher costs associated with holding more capital. That would serve as a check on the appreciation of housing prices as the subsidy declines and will help reduce the risk of any further bubbles in the future. That’s an added benefit to the lower bill taxpayers risk facing when the government guarantees against adverse developments in the mortgage market.