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Genworth Financial Canada Submission in Response to Finance Canada's 2006 Review of Financial Sector Legislation:
Keeping Canada's Residential Mortgage Market Safe, Fair, Efficient, and Competitive
Genworth Financial Canada
Submission to the Department of Finance
Canada's Mandatory Mortgage Insurance Requirement
Outline of this Submission
As part of its preparation for this submission, Genworth commissioned two research papers to look at the economic and public policy impacts of the statutory requirement for mortgage insurance on high loan-to-value mortgages. These papers are attached to this submission. The first is written by Dr. Susan Wachter at The Wharton School, University of Pennsylvania. Dr. Wachter is the former Assistant Secretary of Policy Development and Research at the U.S. Department of Housing and Urban Development. The second is a paper written by Dr. Frank Clayton of Clayton Research. Dr. Clayton is a Canadian economist with extensive knowledge of the Canadian housing system who has also contributed to the Bank of Canada's recent review of the Canadian Financial Sector. Many of the views, conclusions and recommendations in this submission are supported by these papers.
The complete submission consists of:
I. Genworth Submission
II. "Mandatory Mortgage Insurance in Canada; The Public Policy Consequences," by Dr. Susan Wachter
III. "Keeping Canada's Residential Mortgage Market Among the Safest, Most Efficient, Productive and Competitive in the World ," by Clayton Research Associates Limited
IV. Articles On The Subprime Mortgage Market In The United States
1. Executive Summary
As part of the review of financial services legislation proposed in Annex 6 of the Federal Budget of February 23, 2005 (entitled Consultation Document for the 2006 Review of Financial Institutions), the Department of Finance has invited comments on whether or not Canada's statutory requirement for mortgage insurance on residential mortgages where loan-to-value ratios exceed 75 percent should be removed. Genworth Financial Mortgage Insurance Company Canada ("Genworth Financial Canada or Genworth") opposes changing the current mortgage insurance requirement for reasons that relate not only to consumer benefits, but also to the efficiency of the real estate and mortgage financing industry, the safety and soundness of the financial system, broader public policy concerns and the adverse consequences of changing the current system. Genworth urges the Department to evaluate the statutory requirement for mortgage insurance in the larger context of its role in the housing market and the Canadian economy overall, as well as its impact on the entire range of consumers, lenders, homebuyers and potential homebuyers.
Consumer Benefit – Advantages of the Current System
In considering whether to change the current requirement for mandatory mortgage insurance coverage, the most appropriate and fundamental public policy question is: "Would a change result in net benefits for consumers and create more homeownership opportunities?" As Dr. Wachter and Dr. Clayton both attest, weakening the current statutory requirement would neither benefit homebuyers nor generate additional homeownership opportunities. Indeed more homebuyers are likely to be hurt by tampering with the statutory requirement for mortgage insurance than will benefit from such a change. More contentious is which consumers will be hurt. The burden of this change would fall squarely on the shoulders of low and modest income earners. Analysis performed by Clayton Research concluded that over 60 percent of consumers (Moderate and High Risk) who have low down payment mortgages could be adversely affected by a change in the mandatory requirement for mortgage insurance.
Consumer Benefit - Early Access to Homeownership at Affordable Levels
Fundamentally, most of the unique benefits of mandatory mortgage insurance flow from the ability of the mortgage insurers to spread the mortgage default risk across a large pool of loans. Risk is spread across varying borrower profiles, different geographic regions and several lenders. By pricing the mortgage insurance premiums according to only loan-to-value ratios, the current system allows Canadians to pay the same premium notwithstanding that they may live in remote areas or have a below average credit rating. This "pooling" effect has extended fairness and choice to borrowers in every corner of the country. Moreover the rule also promotes access to mortgage financing in bad economic times as well as good, and has opened the door to homeownership faster than ever before, often shaving years off the time it previously took for potential homebuyers to save for a down payment.
Consumer Benefit - Keeping Borrowing Costs Low
In theory, low risk borrowers - who make up about a third of the market - might save money if the mandatory requirement for mortgage insurance were removed. This is because under the current regime the lower risk mortgage borrowers subsidize the higher risk borrowers. If the regime were changed, individual lenders could segment the lower risk borrowers from the higher risk borrowers, thereby saving the lower risk borrowers the cost of the implicit subsidy.
In any event, the theoretical savings associated with segmenting consumers will most likely be minimal because:
- Risk premiums may be added for the increased volatility of an individual lender's smaller, less diverse pool of borrowers.
- Individual lenders currently do not have the historical performance data to segment the risk effectively.
- Market pricing inefficiencies will likely result in lenders increasing their margins over and above that necessary to cover the inherent risk of low risk borrowers.
Moreover, even if risk segmentation may hold out the promise of some savings for low risk borrowers, these savings will most likely be small in reality and would come at a substantial expense to an equal or larger group of borrowers. This change in regime would be an odd public policy choice in Canada and, if made, should be done in a manner transparent to the public.
In addition as will be discussed below, the current regime helps keep prices low for all consumers by enhancing competition and efficiency in the mortgage market.
Mortgage Industry Efficiency - Choice and Transparency
By enhancing vigorous competition among lenders, the current mandatory insurance regime encourages innovation and the creation of a broad selection of mortgage products. At the same time, mandatory mortgage insurance ensures that new products can be offered by a variety of lenders and standardized across the industry thereby driving pricing transparency and reducing complexity. On the other hand a move to more risk-based pricing by individual lenders would mean that mortgage products would become increasingly difficult for borrowers to understand as the different risk-based pricing structures segment the market. This would make it more difficult for borrowers, especially less sophisticated ones, to make informed decisions. Moreover, such a change in policy, in addition to increasing costs and reducing equity for more marginal borrowers, could subject them to the kind of predatory and discriminatory lending practices that can arise from reduced transparency and increased complexity – as has indeed been the experience with sub-prime lending in the United States.
The current mortgage system has helped supply low cost mortgage funds by reducing regulatory capital requirements and providing efficient securitization programs. It has supported the safety and soundness of financial institutions by smoothing mortgage risk across varying credit profiles, business cycles, geographic regions and lenders and has leveled the playing field between big and small lenders and credit unions. Allowing small lenders and credit unions to compete with big lenders has been particularly important for Canada, a large country in which credit unions and regional lenders provide significant services to rural areas and are a major provider of financial services in some provinces. Credit unions, in particular, understand the importance of the equitability provided by mortgage insurance in that it allows them to compete with the large financial institutions and provide fair pricing to their customers.
Safety and Soundness of the Financial Sector
Mortgage insurance virtually eliminates the risk of originating and holding low down payment mortgages by transferring the mortgage default risk to well capitalized insurers with specialized risk management expertise. Last year, approximately 45% of all mortgages in Canada – or about 500,000 home loans – were insured against losses due to credit failure. As a result of this extensive amount of credit protection written in Canada each year, Canada Mortgage and Housing Corporation (CMHC) and Genworth together now maintain record levels of capital reserves totaling approximately $4 billion in capital on over $300 billion of insured mortgages. This third-party credit protection shelters both lenders and the government from the prospect of having to incur losses or payouts resulting from economic conditions that cause mortgage defaults. History has shown us – as recently as the mid-1990s when mortgage insurers paid over $2 billion in claims – that economic conditions and real estate values inevitably experience contractions as well as expansions. When this happens, the protection provided by mortgage insurance becomes vital to protecting every lender against catastrophic losses – as well as being essential to maintaining the availability of mortgage credit at affordable interest rates during recessionary economic conditions. This protection is a significant benefit to new entrants. Because of their independence and objectivity, mortgage insurers also have the ability to calibrate underwriting standards and providing mortgage industry with "a second set of eyes," and an "early warning" detection system.
If the mortgage insurance requirement was established to protect against fluctuating property values, that concern should be heightened today rather than diminished. With property values at all time highs, now is not the time to remove the safety net provided by mortgage insurance. As noted in Section 4 of this submission, removing the statutory requirement for mortgage insurance would result in a weakening of the third party insurance protections that benefit lenders and governments and that help speed economic recoveries by keeping credit available in recessionary periods. The current statutory requirement essentially enables mortgage insurance companies on a non-subsidized basis to help stabilize the Canadian financial system by creating large pools of risk that cross lender platforms, credit profiles, geography and time so that the volatility of the mortgage system is reduced.
Broader Public Policy Concerns - Home Ownership and the Housing Industry
As this submission will demonstrate, the statutory requirement for mortgage insurance has helped propel Canada's homeownership rate to approximately 67 percent -- at the top of the world's standings and second only to the United States among OECD countries. Moreover, while the rate of homeownership in the United States currently exceeds that of Canada by approximately 1 to 2 percent, it is critical to note that this small discrepancy between the two markets is almost exclusively the result of massive federal tax subsidies provided under U.S. law.
In addition to a similar requirement for mortgage insurance on most high loan-to-value loans in the United States, the U.S. federal government made direct "tax expenditures" of $92.2 billion in 2004 to encourage homeownership by allowing U.S. citizens to deduct mortgage interest costs and real property taxes from their federal income taxes. Stated differently, the Canadian model has achieved virtually identical results - but without an annual tax subsidy of approximately $9 billion (when adjusted for population differences).
Consequently, Canadian citizens have purchased homes sooner and built wealth faster, which has resulted in stabilized and improved communities – a result that could only have been realized through the often intangible values associated with Canada's record levels of homeownership.
Adverse Consequences of Changing the Current Statutory Requirement
The most probable outcome of removing the current mandatory mortgage insurance requirement would be that moderate and high risk borrowers who currently represent 60 percent of the prime mortgage market would be faced with either higher mortgage insurance costs if the borrower remains in the prime market or with increased fees and interest rates if the borrower is moved to the subprime market. Mortgage products would become increasingly difficult to understand as mortgage pricing structures would become increasingly segmented, making it difficult for borrowers to make informed decisions. In addition, increased regulatory and legislative oversight would be required to protect borrowers from predatory and discriminatory practices and to ensure that lenders are properly pricing the risk and maintaining capital associated with the long-term nature of mortgage products. Weakening the current requirement would also create pricing disadvantages and limit the availability of funds for small and regional lenders who do not have the size or scale of the large financial institutions to price the risk or spread the over a large and diverse product portfolios.
The Government of Canada must carefully consider all the consequences of a change to a system that is serving consumers, lenders, the government and the Canadian economy well. As Dr. Wachter concludes in her analysis of the current statutory requirement:
"The removal of mandatory mortgage insurance would decrease homeownership opportunities, limit access and raise rates for low and moderate-income borrowers, and would increase loan portfolio and systemic risk. As is, whether the result of intentional policy choice or not, the current system serves public policy purposes, which the removal of mandatory mortgage insurance would undermine."
In summary, removing the statutory requirement would reduce available credit, increase the cost to homebuyers, and result in fewer homeownership opportunities. This is as much a political choice as it is an economic choice. If the current mandatory requirement is weakened, low and moderate income earners and Canadians living in rural areas would be significantly disadvantaged to benefit a small minority of affluent homebuyers. Moreover, as Canada approaches the end of one of the longest sustained periods of appreciation of real estate values in the nation's history, any attempt to undermine the vital financial protection provided by mortgage insurance would undoubtedly increase risk to the financial system and the government's financial exposure.
2. Mortgage Insurance in Canada
Most Canadian homebuyers today can acquire a home with as little as a 5 percent down payment, because mortgage insurance acts as a substitute for the borrower's down payment – enabling borrowers to buy homes years sooner than would otherwise be possible.
Mortgage insurance in Canada has been mandated because borrowers with less than 25 percent invested in their homes are more likely to default than homebuyers with substantially more equity. There is a cost associated with this risk that inevitably must be borne by the borrower. As mortgage insurers increase their levels of risk tolerance, they create new homeownership opportunities for homebuyers with increasingly challenging credit profiles. The risks associated with mortgage insurance are long-term, significant, and are not precisely predictable, so mortgage insures constantly and carefully monitor the risk in their portfolios.
Currently, approximately 45% of all residential mortgage originations are high loan-to-value mortgages that require mortgage insurance. This equates to approximately 500,000 homeowners in each and every year. The insured mortgage market is skewed towards higher loan-to-value (LTV) mortgages with 75% or 375,000 mortgages having a down payment of 10% or less. As the chart below shows, there has been considerable growth in insured mortgages since 1992 when 5% down mortgages were reintroduced.
The significant losses covered by mortgage insurance arise because of unpredictable future economic factors which can occur many years after a loan is originated. For instance, even borrowers with strong credit ratings who make small down payments experience job loss, divorce, and the loss of principal income earners. As a result, a mortgage insurer must build adequate capital and reserves in periods of economic expansion so that it can pay claims and maintain a liquid market for low-down payment mortgages in periods of economic downturns. Fortunately, the current national reach of Canada's two mortgage insurers and their ability to pool risk and accumulate significant reserves today accrues to the benefit of homebuyers, lenders and the government alike.
As the Bank of Canada found in its analysis, "Another important way that mortgage lending practices can interact with the financial system and with house-price dynamics is through the willingness of households to incur, and lenders to finance, higher leverage. In aggregate, the credit exposures that can result from higher loan-to-value ratios have the potential to stimulate the housing market, as well as to increase credit risk in the event of a deterioration in the housing market or in debt-service capacity. ... The rise in insured mortgages during the 1990s illustrates the popularity of these "high-ratio" mortgages. It also shows the increased access to mortgage financing that followed the decrease in the required minimum down payment from 10 to 5 per cent in 1992."
Mortgage insurance serves a broad spectrum of homebuyers with varying credit profiles in all regions of the country. Over time, mortgage insurers have expanded underwriting guidelines to include an increased number of borrowers with marginal credit profiles (see chart below). The analysis of Genworth's insured portfolio indicates that approximately 25% of homebuyers have credit scores below the traditional industry credit score minimum of 620 (see chart below). Based on this information, Clayton concludes that: "mortgage insurance is servicing homebuyers across the prime market credit spectrum and has expanded the prime market to include borrowers with lower credit scores than would be typically served in the prime market".
2.1 Mandatory Mortgage Insurance Exists in Canada and The United States
In terms of competition, efficiency, productivity and homebuyer advantages, the United States is the only country in the world that compares favorably to the Canadian housing market. Virtually every other country lags behind in universal access to affordable credit and resulting accomplishments in terms of the comparative levels of homeownership.
Not surprisingly, there are several fundamental similarities between the U.S. and Canadian markets and one very significant difference - the tax deductibility of mortgage interest and property taxes in the U.S.
In terms of similarities, both the United States and Canada have robust and efficient secondary markets that provide both liquidity and stability in the availability and cost of mortgage funding. Both markets are highly competitive, and both countries have national as well as provincial and state level policies that encourage homeownership.
Both markets also have mandatory requirements for mortgage insurance on high loan-to-value loans -- albeit with minor distinctions between the two.
While Canadian law directly mandates mortgage insurance on all conventional mortgages that exceed 75 percent loan-to-value, the United States has an indirect requirement that effectively achieves a similar level of credit enhancement.
In the United States, the effective requirement for mandatory mortgage insurance stems from the Congressional charters that created Fannie Mae and Freddie Mac, the massive government-sponsored enterprises, or GSEs, that are presently financing more than 70 percent of the conventional U.S. mortgage market. The federal government has mandated that both GSEs require mortgage insurance on loans that exceed 80 percent loan-to-value. In addition to the general charter requirement, the GSEs have independently required "deeper" coverage on the highest loan-to-value mortgages. (Unlike Canada, U.S. mortgage insurers only occasionally provide 100% loss coverage, and the depth of their stop loss coverage usually is between 55% to 35%).
2.2 Mandatory Mortgage Insurance Has Increased Canada's Rate Of Homeownership
Canada has increasingly become a nation of homeowners. Between 1986 and 2001, the homeownership rate has climbed from 62.4% to 65.8% and is now estimated at 67%.According to Statistics Canada, the number of occupied dwellings in our country tripled to 11.6 million units between 1961 and 2001. Of these, 65.8 percent were occupant-owned compared to 63.6 percent in 1996.
It is widely believed that low mortgage rates, strong employment growth and rising disposable incomes brought homeownership within reach of many renters during this period. However, mortgage insurance changes during the same period also reduced the minimum down payments to as little as 5 per cent—initially for first-time homebuyers and subsequently for all buyers.
Residential construction, in particular, has grown much faster than the economy as a whole in recent years. In fact, in the past five years, it has grown by about nine percent a year, which is three times the rate of the economy. This strength in the housing sector has provided a big boost to the economy, accounting for about 15 percent of growth in 2000-2004.
Genworth firmly believes that Canada's current homeownership success story, and its extraordinary contributions to the nation's economic and social achievements, have resulted from a combination of historically low interest rates, vigorous competition, an expanding secondary market as a source of mortgage funds and a prudent expansion of the mortgage market to different levels of credit risk. At least three of the four factors are directly attributable to the current statutory requirement for insuring low down payment mortgages.
Consequently, Canadian citizens have purchased homes sooner, built wealth faster and experienced the benefits of a robust national economy. With more Canadians enjoying homeownership than ever before, they have also been far more likely to maintain and improve their properties, and have taken a greater stake in promoting the quality of life in their neighborhoods and communities.
2.3 Mortgage Insurance Makes Lower Interest Rates Accessible To More People Than Ever Before.
Were Canada to weaken the current mandatory requirement, Clayton estimates that 60% of homebuyers would pay higher rates and fees. That is because the current statutory requirement on mortgages with loan-to-value ratios of 75 percent or more has been the single most important factor in opening the door of homeownership to Canadians with low down payments and creating this opportunity for all Canadians regardless of where they live.
Low mortgage rates have translated into tangible benefits to home purchasers, whether in terms of reduced interest payments, the ability to pay off their mortgages more quickly, or by enabling them to qualify for a larger mortgage to purchase the home they want. Since 2000, posted five-year mortgage rates have declined by almost two percentage points to 6.39 percent. The cost to the borrower of a five-year mortgage taken out in 2003 was consequently 24 percent lower than if the equivalent mortgage had been taken out in 2000. On a $100,000 mortgage, this would translate into interest savings of $9,500 accruing to the borrower over the five-year term.
Lower interest rates have also made it possible for borrowers to qualify for larger mortgages. Borrowers are typically allowed to borrow at a level such that the combined mortgage and property tax payments do not exceed 32 percent of their gross monthly income. The decline in posted five-year mortgage rates since 2000 has had an effect equivalent to a $4,900 increase in borrowers' gross annual income, allowing them to access an additional $18,472 in mortgage financing to purchase the home of their choice.
Yet without the presence of mandatory mortgage insurance, significantly fewer homebuyers would have gained access to the opportunities created by low interest rates. Homebuyers with average to marginal credit scores, as well as those unable to make large down payments, would undoubtedly have been subjected to higher interest rates were it not for the universal requirement for mortgage insurance. That is because mandatory mortgage insurance provides for the national pooling of the risk associated with these loans and eliminates the economic rationale that lenders would otherwise have for charging higher rates of interest to this riskier class of borrower.
The low down payment required of insured mortgages has enabled more Canadians to take advantage of homeownership sooner. This has had the spin off benefit of turning more renters into homeowners thus helping to increase the rental supply and keeping rental rate increases at low levels.
Rising real estate prices have also made Canadians increasingly richer, at least on paper. The average value of real estate assets in Canadian households has increased by 27 percent during the past four years. Scotiabank Group estimates that real estate now accounts for about 35 percent of the average Canadian family's wealth, compared to 29 percent just four years ago.
The best news of all is that housing is increasingly affordable. Despite the fact that real estate values continue to push upward, housing is actually more affordable than it has been in a long time, largely due to declining mortgage rates.
2.4 Mortgage Insurance Supports The Canadian Government's Pro-Housing Policies Without The Expenditure Of Taxpayer Dollars.
For many years, the Canadian government has wisely supported pro-housing policies that have created jobs, increased ownership, boosted personal wealth, stabilized communities and strengthened the national economy. It is unlikely that Canada could have achieved its record levels of homeownership without fiscal policies that have led to sustained periods of low and moderate interest rates. But even with favorable interest rates, the number one obstacle to homeownership for low and moderate income homebuyers has always been – and continues to be – their inability to accumulate down payments.
Conversely, the challenge for lenders dealing with low and moderate income homebuyers has been the knowledge that lower down payment borrowers default at higher rates than consumers with more equity invested. Yet, because of mortgage insurance, this additional credit risk and the cost associated with higher rates of default are largely borne by mortgage insurers. The fastest growing segment of homeowners in Canada today is in the ranks of affordable purchases.
The funding for this "credit enhancement" has been provided exclusively by borrowers (through mortgage insurance premiums) and the capital committed by Canada's mortgage insurers. Neither the national nor the provincial governments have needed to expend public monies to achieve this important public policy goal.
Equally as important, the continued presence of mortgage insurance in the marketplace has assured the continuance of available mortgage credit and helped speed economic recoveries. If the government now were to weaken the current statutory requirement for mortgage insurance, it must also assume a commensurate reduction in these benefits.
An analogy can be drawn between mandatory mortgage insurance and the mandatory provision of employment insurance. At a high level the objectives of employment insurance and mortgage insurance are similar. Both strive to set a premium rate that ensures that there will be enough revenue over a business cycle to pay for expenditures and maintain relatively stable premium rates throughout the business cycle. Reserves are built up during good times and then depleted during periods of economic stress to avoid pro-cyclical premium increases. The goal of employment insurance is the avoidance of abrupt premium rate increases at all times, but especially during a recession as premium increases would contribute to job losses and an even deeper recession. Similarly the goal of mortgage insurance is to ensure that housing financing is available at affordable levels especially during recessions. This credit risk transfer to the insurers acts as a stabilizer to the financial system by allowing banks to lend across the business cycle and thus reduces the risk of a credit crunch.
This is in contrast to a risk-based pricing system where lenders typically rely on the capital markets to take both credit and market risk through securitization. Relying on the capital markets means that at times where funds are scarce in these markets, the cost of mortgage financing will go up or in some cases not be available as credit spreads widen or capital becomes scare. In this model mortgage credit is more sensitive to current financial market conditions
2.5 The Mandate For Third-Party Mortgage Insurance Has Contributed Significantly To The Stability, Liquidity And Productivity Of Canada's Secondary Mortgage Market – An Increasingly Important Source Of Mortgage Funding Today.
Mortgage insurers have a vested financial interest in the continued viability of their lender customers and, as such, are able to exercise market-based oversight over lender operations and ensure that they follow prudential practices. This marketplace discipline provides an additional level of financial sector supervision beyond that provided by either federal or provincial regulators. This non-governmental system provides two important benefits to regulators and taxpayers alike. First, because mortgage insurers are subject to a monoline business restriction and unique capital tests, regulators are assured that there is sufficient capital in the mortgage system to manage default risk though business cycles. Second, the risk specialization of the mortgage insurers and their focus on the high risk business has the spillover benefit of helping ensure that overall mortgage credit risk and operational risk policies within the lending institutions are well managed.
For the capital markets this process provides comfort for investors by eliminating the underlying credit risk for investors who purchase mortgage-backed securities (MBS). The mandatory requirement for mortgage insurance has supported the rapid growth of securitization through the Canada Mortgage Bond program issued under the National Housing Act (NHA). The volume of MBS issued under this program has grown three-fold between 2000 and 2004.
2.6 Mortgage Insurers Now Maintain Record Levels Of Capital Reserves Totaling Approximately $4 Billion In Capital On Over $300 Billion Of Insured Mortgages. This Third-Party Coverage Protects Both Lenders And The Government From The Prospect Of Having To Incur Losses In The Event Of Inevitable Economic Downturns.
In the mid-1990s mortgage insurers paid over $2 billion in mortgage default claims resulting from recessionary pressures that significantly devalued real estate.
If the statutory requirement for mortgage insurance were to be altered, there would be fewer reserves held against such losses. Lending institutions would incur losses that could weaken or cripple their performance. There would be adverse repercussions in the secondary markets. Pressures would be brought to bear on governments for financial relief and economic recoveries would be hamstrung by tight credit.
It would be a mistake to assume that Canada's economy and residential mortgage market will remain strong for an indefinite period of time. History teaches us that overall economies, and residential markets in particular, experience contractions resulting in decreased property values and increased defaults. Based on a historical analysis of the Canadian property market, DBRS reported that "property price decreases in the 20 – 30% range are quite possible though certainly not expected. In the last 30 years, three of the four largest markets in Canada have experienced one drop in that range (Vancouver: -28%, Calgary: -25% and Toronto: -28%)."
One of the principal reasons Canada has quickened its recovery from recessions is the perpetual availability of credit following market downturns. With lenders currently sheltered from losses on residential real estate by mortgage insurance, they are able to maintain the general availability of credit even in the face of increased loan defaults.
As noted at the outset, there is a cost associated with additional risks lenders incur with high loan-to-value mortgages. At present, the additional cost accrues to the homebuyer in the form of mortgage insurance. In turn, the insurers accrue reserves against predictable future losses. But that is not what happens when the additional risk is simply priced into the cost of a loan that is not underwritten with mortgage insurance.
Absent mortgage insurance, the most common method for pricing for additional risk is higher fees and interest rates. Under those scenarios, however, the long time horizons of actuarial modeling employed by insurers is replaced with fiscal year reporting periods, and reserves for future loss are not accrued in the same way as they are in insurance models.
Plainly stated, the only consequence of weakening the current statutory requirement will be to shift this additional cost away from insurance and into more expensive loan pricing. Absent any evidence that consumers, small lenders and credit unions would benefit from such an arrangement, serious attention must be paid to the potential consequence of losing the protection benefits that are now provided by insurers.
2.7 The State-Of-The-Art Underwriting Capabilities Provided By Canada's Mortgage Insurers On An Independent Third-Party Basis Is Making A Unique Contribution To Maintaining The Safety And Soundness Of Lending Institutions In The Residential Mortgage Business.
It is a sound practice for the independent mortgage insurers to assume credit risk while the residential mortgage lenders manage interest rate risk. This diversification has provided and continues to provide the necessary safety net to keep Canada's housing market relatively stable in the event of an economic downturn.
The underwriting systems developed by mortgage insurers and in use today also provide an objective and transparent set of standards with national reach. Homebuyers and lenders alike benefit from the ease and affordability of the loan application process established by insurers.
Furthermore, those lending institutions continue to need protection from fluctuating property values, as was intended when the statutory mortgage insurance requirement originated. The future course of housing prices will depend on underlying economic conditions, inflation, interest rates, and local market factors including supply and demand and the state of local economies. We are not capable of predicting these events. The increased willingness of households to take on larger debt-to-income ratios and the growing popularity of variable rate mortgages will also contribute to the impact felt from an interest rate shock, employment shock, and possibly falling property values. The insulating layer of protection provided by mortgage insurance continues to be important in mitigating these effects.
3. The Current Mandatory Mortgage Insurance Requirement Benefits Consumers
Prior to the establishment of mortgage insurance, lenders and regulators generally required potential homebuyers to acquire substantial down payments, putting homeownership out of the reach of a majority of Canadians. Over time, data, technology and advances in risk analytics made it possible to effectively evaluate consumer credit risk and insure against credit defaults. As a result, mortgage insurance was conceived as a way to enable lenders to loosen credit standards while avoiding potential losses. First devised as a means of protection against credit default for mortgage lenders, mortgage insurance in Canada has evolved into a product that also provides homebuyers and homeowners with a number of important and valuable benefits.
3.1 Mortgage Insurance Provides Canadian Consumers With Easier And Earlier Access To Homeownership.
By providing fair treatment of all Canadians regardless of where they live, with whom they apply for a loan, or what their credit profile is, Canada's mortgage insurers open the door to homeownership faster than ever before, often shaving years off the time it previously took for potential homebuyers to save for a down payment.
Saving enough money for a down payment continues to be the single greatest barrier to homeownership for first-time homebuyers. In 2004, mortgage insurance helped 500,000 Canadian overcome this barrier and achieve home ownership homes. Canada's mandatory insurance requirement enables insurers to diversify their risk across time, geography, lender platforms, loan size and the creditworthiness of hundreds of thousands of homebuyers, mitigating or eliminating barriers to homeownership. This risk diversification is the principal reason why Canada's mortgage insurers have been able to reduce down payment requirements to as little as 5 percent and premiums by as much as 30%. While it is likely that mortgage insurance would exist for 5 percent down mortgages even without the current statutory requirement, it is all but certain the insurance premium would be more costly and fewer Canadians would qualify for mortgages.
An additional consumer-friendly byproduct of the current statutory requirement is the sophisticated automated underwriting capabilities that mortgage insurers have developed which take advantage of the large amount of information collected by the mortgage insurers. In addition to using these systems to process high ratio mortgages the mortgage insurers now allow lenders to use the same systems for their uninsured business. Today approximately half of all uninsured business goes through the mortgage insurers systems. For Homebuyers this uniformity of underwriting ensures absolutely equitable treatment and allows homebuyers to get their mortgage application approved in minutes.
The widespread use of the automated underwriting systems employed by mortgage insurers have also eliminated human error and bias and made the loan application process objective. Given the dominance and reach of the two prevailing underwriting systems in use today, its clear that no one lender could commit similar resources or achieve these results for their customers.
3.2 The Current Mandatory Insurance Requirement Has Enabled Insurers To Establish "Pools Of Risk" That Has Produced Equitable Premium Rates For All Homebuyers Making Similar Down Payments, Regardless Of Where They Live Or Which Lender They Choose To Deal With.
The large and diverse pools of insured mortgages that have resulted from Canada's current mandatory requirement have enabled both mortgage insurers to offer equitable premium rates to all borrowers making similar down payments, rather than discriminating against borrowers based on their individual credit profile, where they live, or the lender chosen. This factor is a significant benefit to homebuyers and there is nothing unique or unusual about reliance on pools of a large number of consumers for certain services.
Consumers and lenders – particularly those located in smaller centers and rural areas –all benefit from the existing system. Weakening the requirement for mortgage insurance on high loan-to-value mortgages would lead to a number of harmful consequences. In particular it would make homeownership more expensive or more difficult to achieve for Canadians least able to afford additional cost and for those who choose to borrow from small lenders or credit unions.
Pooling of risk serves homebuyers in smaller urban centers and rural communities. The chart below illustrates the many Canadians that mortgage insurance serves and where they live:
Mortgage insurance particularly helps younger age groups, in particular those under 35 years of age, which is a testament to its ability to help first-time buyers enter the market with limited equity.
Mortgage insurance also helps some lower-income households and older homebuyers to purchase a home – as evidenced by the fact that average incomes and house values among homebuyers aged 35 and older who took out mortgage insurance are much lower than among all homebuyers in these age groups.
If mortgage insurance were not mandatory, the benefits of pooling of risk across large groups of homebuyers would be lost. Opting out of the insurance pool by high quality borrowers would result in a reduction in the overall quality of the mortgages in the pool and a corresponding increase in costs for those mortgages left in the pool. Mandatory mortgage insurance effectively eliminates the problem of adverse selection and creates a balanced risk pool that lowers borrowing costs for marginal homebuyers who currently represent between 35 and 40 percent of the market. This helps meet public policy objectives of extending homeownership rates. The pool size also yields economies of scale and scope, which allow the provision of insurance at lower cost to all borrowers. The large database of information developed because of the existence of mandatory mortgage insurance, allows more accurate risk predictions and lowers borrowing costs fulfilling the policy goal of greater access to affordable homeownership.
As the chart below shows, 36% of the borrowers who currently have prime insured mortgages are considered high risk. Without mandatory mortgage insurance this group would either pay a higher mortgage insurance premium or be moved into the subprime market where they would pay an interest rate up to 200 basis points higher, as well as the fees associated with subprime loans. In addition, borrowers with average risk -25% of all insured borrowers - would also end up paying a higher premium as the lower risk borrowers are removed from the pool.
An alternative to the statutory requirement for mortgage insurance on high ratio mortgage loans could be that prime market lenders may decide to self-insure, on a risk-based pricing basis. Although it is unlikely that any financial institution currently has enough data to adopt a risk-based pricing model, the capabilities to do so would develop over time.
This would have consequences for higher-risk buyers:
- Premiums will go up for those homebuyers least able to afford it;
- Homebuyers might be forced from the market, forced into the subprime market, delayed in making a home purchase or able to purchase "less house";
- Higher-risk homebuyers might also pay an additional premium due to insurance providers needing to recoup the costs associated with reassessing risk and corresponding insurance premiums, as well as reduced economies of scale in their operations due to a smaller customer base.
While one might assume that lower-risk homebuyers would benefit from such a change, this may not occur:
- Lower-risk homebuyers might still experience an increase in premiums and fees due to the added costs to lenders associated with administering a system of self-insuring, which they will attempt to recoup from the buyer.
- Lenders may also try to recapture from lower-risk borrowers some of the gap between the low premiums justified by risk-based pricing and what such borrowers would pay under the current "pooling" model of mortgage insurance.
- Although it is unlikely that any financial institution is ready today to implement risk-based pricing, there are two long-term results that can be expected. First, only large financial institutions could develop the systems and data to price the risk. Second, there will be a market incentive for these institutions to reduce the price of a mortgage just lower than it would have been if the mortgage was insured, but not reduce it any further.
Moderate risk borrowers might also be disadvantaged under this scenario. If prime market lenders decide not to pursue this business on a risk-based pricing basis, moderate risk borrowers would be left only with the option of mortgage insurance. Pooled with the higher-risk customers, they would likely end up paying higher premiums than under the current system.
Removing the statutory requirement for mortgage insurance has the potential to disadvantage at least 60% of those homebuyers with high or moderate credit risk who currently have access to mortgage insurance. The number of homebuyers could easily reach an even higher percentage depending on the circumstances surrounding the change. Therefore, a weakening of the statutory requirement for mortgage insurance could negatively impact the housing market.
3.3 Mortgage Insurers Are Constantly Developing New Mortgage Products To Reach More Potential Homebuyers And Better Serve The Ones They Already Insure.
Because Genworth and CMHC are monoline businesses focused solely on residential mortgages, and because they engage in vigorous competition for lender and homebuyer business with CMHC, they are strongly motivated to develop new products that attract additional market share by benefiting lenders and homebuyers alike.
Mortgage insurers' constant focus on competitiveness has produced a variety of innovations over the years including expansion of loan terms, reduction of prepayment penalties, insurance for variable interest rate products, and ever-increasing loan-to-value ratios. As the following table demonstrates, borrowers are now in a position to "select the mortgage that best suits their individual circumstances and needs".
Milestones in the Evolution of Mortgage Insurance
: Introduction of the 95% First Time Homebuyer Program
: GE Mortgage Insurance Enters the Canadian Market
Introduces Portability ... MI Portable from one Property to Another
: First Time Buyer Restriction On 95% LTVs Removed
Premium Rate Increase for 95% LTV
: MI Expanded To Cover Refinance Transactions for Debt Consolidations
MI expanded To Cover Equity Take Out Refinance Mortgages
: MI Expanded To Cover Cash-Back Loans ... 5% Down Payment Requirement Provided By Lender Cash Back
: MI Expanded To Cover Limited Documentation Alt-A BFS Loans & Secured Lines of Credit as well as a Premium Rate Reduction
2004: MI Expanded To Cover Vacation & Secondary Homes
Mortgage insurance typically is in place for the 25 year life of a mortgage and has a portability feature, which allows homeowners to transfer their original mortgage to a new property without paying any additional insurance premium. Mortgage insurance is also transferable between financial institutions, at no additional cost, so that when a borrower's mortgage comes up for renewal he or she has the flexibility to shop at a variety of financial institutions for its renewal. This opportunity could be lost if the statutory restriction were to change.
3.4 As The Party At Greatest Risk From Potential Mortgage Defaults, Mortgage Insurers Have An Extraordinary Financial Incentive To Help Reduce Potential Losses By Helping Homeowners Through Periods Of Financial Hardship.
Genworth has an established loss mitigation program called "WorkOut" that has a proven record of success in converting troubled loans into "cures," that allow homeowners to avoid defaulting on their mortgages and to stay in their homes. Even though this program is most effective in times of economic trouble, Genworth's experience in the recent strong economy shows how effective the Workout program can be. To date, Genworth has successfully used this program to keep 300 families in their home.
Workout is successful for all parties involved because Genworth manages each step of the important loss mitigation process.
We first identify the borrower difficulties. Our first priority is to reduce the risk of default and deal with problems as soon as they occur. There are many situations where Genworth has stepped in with workout plans that help Canadians remain in their homes. Genworth has helped homeowners facing:
- Health issues, such as injury and illness;
- Work challenges, such as unemployment, strikes, maternity leave or reduced income;
- Life developments, such as marital splits or death or illness in the family; and
- Home demands, such as repairs or delinquent tenants.
We do an assessment of the potential for a workout by completely evaluating the borrower's obligations. Working together, lenders and Genworth search for a solution with the greatest potential for success. Potential workouts are tailored to suit individual circumstances and challenges. Some examples of workout solutions Genworth has arranged for borrowers include:
- Arranging a partial payment plan
- Increasing the amortization period
- Arranging an interest rate buy down
- Capitalizing the arrears and costs
- Deferring payments
- Sharing payment through the use of a second mortgage
- Genworth absorbing the arrears and costs
- Shortfall sale
- Voluntary conveyance
The success stories of Genworth's workout process are numerous. In one case a borrower had just been diagnosed with cancer and did not have any compensation for the hours of work he would miss getting treatment. The lender initiated contact with Genworth, and Genworth immediately implemented a workout plan. Genworth advanced funds under a forgivable promissory note that would be reduced to nil after two years.
In another success story, a borrower was severely injured playing hockey and unable to work for 6 months. The lender initiated contact with Genworth and a workout was implemented that included capitalization of 3 months payments, following 2 months of interest-only payments. The borrower was able to keep his home, and wrote to Genworth calling it "the company that still believes in lending a helping-hand and caring for those who need help until they get back on their feet".
Workouts benefit everyone involved in the home buying process. We discuss some of the benefits to lenders in the next section. But most fundamentally, the borrowers remain in their homes. The workout process produces tangible cost savings for the borrower and the lender. The process also builds strong loyalty between the borrower and the lender and between the lender and Genworth.
Genworth has a deep commitment to loss mitigation and is uniquely positioned to continue helping many Canadians remain in their homes despite periods of individual economic stress.
3.5 Mortgage Insurance Increases Consumer Choice By Allowing Small Lenders To Compete With Large Lenders On A Leveling The Playing Field.
Mortgage insurance enables smaller lenders to compete with the larger lenders for mortgage business even though they do not have the balance sheet to take on higher risk mortgage business. Many of the small lenders get their funding from conservative institutions like pension funds and insurance companies which do not have a high tolerance for investing in higher risk mortgages unless they have the default protection provided by mortgage insurance.
Mortgage insurance benefits borrowers by allowing more lenders to compete in the mortgage market and lowering the cost of a mortgage. Since Genworth came into the mortgage insurance market, borrowers have benefited from competition between the private and public insurers. This competition has resulted in more mortgage products being available to borrowers and dramatically faster response times.
In particular, rural homebuyers benefit from the participation of regional lenders and credit unions in the mortgage lending market. Consumers in 40 communities in British Columbia and 64 communities in Manitoba rely on credit unions alone, as they are the only financial institutions in their area. In Alberta, over 90% of credit union branches are in rural areas. In Saskatchewan more than half of the population are members of one of the 60 plus credit unions across the province.
3.6 Competition Between Lenders And Competition Between Insurers Ensures Low Cost Process For Lenders And Consumers
It is a sound practice to separate managing credit risk and interest rate risk. Mortgage insurance providers are uniquely positioned to provide credit enhancement to low down payment loans at the lowest possible cost and to offer that protection on an equitable basis across the entire country. Separating interest rate risk from credit risk, combined with competition among lenders and competition between CMHC and Genworth, results in the best possible situation for borrowers: lower rates, lower fees, and more innovative products.
3.7 Mandatory Mortgage Insurance Makes Mortgage Costs Transparent To Borrowers By Having A Simple Pricing Structure That Is Based Only On The Loan-To-Value Ratio Of The Mortgage
The current mandatory mortgage requirement creates a standard mortgage pricing environment. With mandatory mortgage insurance borrowers are not charged different rates based on their credit profile or area of the country in which they live. Rather they are charged a mortgage insurance premium based only on the loan-to-value ratio of their loan. With mortgage insurance, a borrower also obtains the lender's regular interest rate for a loan. This is a significant difference from the risk-based pricing model where lenders vary the fee and interest rates that they charge based on the borrowers credit rating, the size of the loan being obtained and the location of the property. In a risk-based pricing environment it will be very difficult for an unsophisticated borrower to understand what the true cost of the mortgage is and properly compare the offerings of different lenders.
3.8 Mandatory Mortgage Insurance Helps Marginal Borrowers Get Into Homes Earlier At Affordable Rates
It is important to note that under the current mandatory requirement the mortgage insurance pool has grown to include borrowers whose credit rating is marginal and who may have traditionally been able to obtain financing only in the subprime market. For these borrowers this means a lower interest rate charge and lower administration fees, which can make the difference between being able to purchase a home today at affordable levels and having to wait years to be in such a position.
4. Advantages of Third Party Coverage to the Financial System
As previously noted, low down payment mortgages default at higher rates than mortgages where the homebuyer invests a more significant amount of equity in a property. Consequently, there is an additional cost associated with this riskier form of lending, both in terms of the regulatory capital and claims payments. Under the current mandatory mortgage insurance requirement, neither the additional risks nor the added costs of low down payment lending are borne by the lender.
Another critically important advantage of the current system is the equitable way that it serves all lenders, regardless of size or geography. This is extremely important for smaller lenders, credit unions and regional mortgage lenders that have limited resources yet are vital to serving Canadians, often in rural areas and small towns. These institutions could not possibly compete with Canada's largest financial institutions on a level playing field in the residential mortgage business without the mandatory mortgage insurance requirement, and the homebuyers they serve would be disadvantaged as a result.
As a matter of public policy, Canada has effectively chosen to separate the management and coverage of interest rate risk and credit risk in mortgage lending, allowing lenders to focus on the former and mortgage insurers the latter. With mortgage insurers focused exclusively on credit risk, and because they have the ability to spread risks across multiple lenders and homebuyers in every corner of the country, they have produced the most efficient and equitable coverage possible.
This arrangement has also enhanced the safety and soundness of Canada's financial institutions and indeed the entire financial system.
4.1 The Current Statutory Requirement For Mandatory Mortgage Insurance On High Loan-To-Value Mortgages Has Leveled The Playing Field Among Lenders, Allowing Smaller, Regional Lenders And Credit Unions To Compete On A Level Playing Field With Larger Lenders.
Small lenders, regional lenders and credit unions typically are unable to assume as much risk as larger financial institutions, as their risk is pooled over a much smaller regionally base and they are less able to absorb costs associated with advanced internal risk management systems. Under the current mortgage insurance mandate, however, lenders big and small, as well as credit unions that are vital to housing markets in rural areas, all receive equitable treatment and premium pricing by the country's two national mortgage insurers.
The important role of regional lenders and credit unions in rural areas of Canada becomes clear when you consider the customers they serve. There are 40 communities in British Columbia and 64 in Manitoba where credit unions are the only financial institutions. In Alberta, over 90% of credit union branches are in rural areas.
If the added risk of this type of lending was not concentrated in mortgage insurance companies with national reach, the equitable pricing in the current system would be replaced with geographical disparities in the pricing of low down payment lending, with credit unions and small lenders – and the people they serve – significantly disadvantaged.
Furthermore, the unbundling of the mortgage process has enabled several new entrants in the Canadian residential mortgage industry. Specifically, the statutory requirement for mortgage insurance on high LTV mortgages and the growing share of residential mortgages originated through independent mortgage brokers have opened the Canadian residential market to new players. Mortgage insurance provides protection against default risk on low down payment mortgages effectively eliminates the required capital and provides the necessary credit enhancement needed for securitization or whole loan sales.
In essence, the statutory requirement for high LTV mortgages reduces the barriers to entry and enables smaller lenders to compete for residential mortgage business. This increased competition reduces the cost of obtaining mortgage financing and increases the choices available to consumers as evidenced by rate discounting and the proliferation of mortgage products.
4.2 As "Risk Partners" To Lenders, And Because Genworth And CMHC Compete For Lenders' Business, Both Insurers Are Strongly Motivated To Develop New Products That Benefit Lenders And Homebuyers Alike.
By constantly developing new mortgage products to reach more potential homebuyers, Genworth has helped lenders grow their business. [See Section 3.3 Milestones in Evolution of Mortgage Insurance for a complete list of recent products and innovations.] With the coverage provided by mortgage insurers, lenders have been able to expand loan terms, reduce prepayment penalties, introduce variable interest rate products and increase high ratio mortgages. Dr. Wachter argues that the mandatory mortgage insurance requirement provides an incentive for mortgage insurers to grow prudently, which leads to sustainable innovation.
"Given their commercial mandate, the mortgage insurers both have incentives to grow the size of the insured market (through expanded underwriting guidelines and price reductions to reflect positive long term performance) and prudently manage mortgage default risk over economic cycles. With a vested interest in loan performance, mortgage insurers monitor lender underwriting practices to ensure that they are prudent. The end result is that the mortgage insurers are both able to see the benefits of its innovations and underwriting practices and pass on lower costs to borrowers. The fact that the insurer is able to realize the benefits of its innovation leads to a virtuous cycle of improvement and positive public policy."
4.3 Mortgage Insurers Have The Best Loan Performance Data And The Greatest Financial Incentives To Mitigate Losses Resulting From Mortgage Defaults. Because Of Their Independence And Objectivity – Mortgage Insurers Also Have The Ability To Calibrate Underwriting Standards During Economic Downturns Or Weakening Housing Markets – Providing Lenders With "A Second Set Of Eyes," And An "Early Warning" Detection System.
As noted above, the monoline business focus of mortgage insurers on credit risk, their historical claims payment experiences, their actuarial databases and their highly sophisticated risk analytics simply could not be duplicated by financial institutions using other forms of credit enhancement if the current statutory requirement were weakened.
The operational efficiency and financial performance of Canada's mortgage insurers – and their superior underwriting technologies – have taken years to develop and have required significant investments of human and financial capital. This provides an added level of stability to the financial system due to the mortgage insurers' focus on only the mortgage business. This focus allows the mortgage insurers to examine mortgage data and spot issues early in the process so that timely actions can be taken by the mortgage industry.
4.4 The Automated Underwriting Systems Developed By Canada's Mortgage Insurers, And In Widespread Use Across The Country Today, Have Provided Lenders With An Efficient, Accurate And Cost-Effective Risk Management And Customer Service Tool.
Canada's mortgage insurers have developed sophisticated computer systems to help them underwrite mortgage insurance applications. In recent years the mortgage insurers have provided lenders with access to these systems so that today, in addition to underwriting approximately 500,000 insured loans in 2004, mortgage insurers' systems were used to underwrite nearly 50 percent of uninsured loans. The expansion of these systems has occurred as lenders today recognize the ease, efficiency and cost effectiveness and value of the mortgage underwriting systems developed and maintained by mortgage insurers.
It requires significant amounts of human and financial capital to continuously improve and maintain this technology. The efficacy of the systems is also largely dependent upon the access to the vast amounts of data they gather from the volume of loans they process. For instance, because these two systems underwrite so many loans they have also been able, in most cases, to automate the appraisal process, speeding and reducing the cost of the loan application process.
4.5 By Assuming Virtually All Of The Credit Risk Associated With High Loan-To-Value Mortgage Lending, Mortgage Insurers Not Only Shelter Lenders From Default Losses, But Their Coverage Also Provides An Added Layer Of Protection Against The Earnings Volatility That Typically Occurs In Economic Downturns.
This "smoothing" effect allows lending institutions to better manage their balance sheets, commit their capital to additional banking activities, and continue making credit available to low down payment homebuyers even during economic downturns.
4.6 The Securitization Of Mortgage Portfolios Has Become Increasingly Important – Perhaps Even Vital – To Maintaining The Liquidity Of The Canadian Residential Mortgage Market And For Providing Investors With A Predictable And Secure Source Of Investment Vehicles.
It is now a well-established fact in the secondary markets that mortgage portfolios comprised of individually insured mortgages reduce the cost of the securitization process and enhance the marketability of the securities. It therefore stands to reason that the greater the number of loans that are insured, the greater the efficiency and the liquidity of our secondary markets will be.
This is because investors in mortgage-backed securities (MBS) have two fundamental concerns: prepayment speeds and loss risk due to delinquencies and defaults. Mortgage insurance both assures investors that mortgages are consistently underwritten and also provides a tool to mitigate the risk of homeowner default. Thus, while investors need to understand the nature of default (to understand the timing of payments), they do not need to factor into their investment decision the possible loss of principal from this type of risk.
The growth in the Canada Mortgage Bond (CMB) program since its inception in June 2001 attests to the importance of mortgage insurance in this area. At the end of 2004, there were $54.4 B outstanding CMB securities back-stopped by insured mortgages. This represents 9.25% of all mortgages outstanding, a significant achievement after only three and a half years.
5. Adverse Consequences of Changing the Current System
As stated at the outset, Canada enjoys one of the highest rates of homeownership in the world. Our primary and secondary mortgage markets are among the most efficient, competitive, productive and safest of any developed country. And, because this success is built upon an interdependent set of factors shared across the government, lenders, insurers, investors and homebuyers, it is absolutely vital that public policy preserve the strength of our system.
In the words of the Bank of Canada "overall, the analysis ... suggests that mortgage-lending practices are becoming increasingly flexible. At the current time, these developments are also found to support financial stability." Accordingly, Genworth Financial strongly recommends the government not contemplate a change to this successful model.
Genworth believes that all of the evidence indicates that weakening Canada's current mortgage insurance requirement would substantially erode the premium equalization benefits that derive from the pooling that is embedded in the current system. Presently, mortgage insurers have a one-price policy for all qualified applicants who make similar down payments, regardless of their credit profile (assuming the individual has the threshold level of credit to qualify for a prime loan). If Canada were to reduce its current mortgage insurance requirement, particularly for applicants with the best credit scores – as suggested in the Department of Finance's request for comments – the only possible result would be a further concentration of risk among the remaining pool of insured mortgages, leading to cost increases for those least able to afford them and an adverse impact on their ability to purchase a home on affordable terms. It would also adversely impact and disadvantage small lenders and regionally based lenders such as credit unions that lack a large, diversified customer base and are often the only financial institution in small communities.
Allowing for greater "flexibility" in lending in Canada's highly evolved mortgage market, particularly among high LTV borrowers, may – but is unlikely to – result in cost reductions for the highest qualified borrowers. What is certain is that costs would increase for the least qualified borrowers. Moreover, it's also likely that new categories of subprime lending would emerge among groups of homebuyers with lower credit scores, but who presently qualify for mortgage insurance because of the beneficial pooling effects. That is because the opposite of the pooling that underlies the current premium-pricing model is risk-based pricing, which is the prevailing risk model underlying the non-regulated subprime lending market. The subprime market is well served and is already experiencing rapid growth in Canada.
As previously noted, mortgage insurance premiums in Canada today are priced to the loan-to-value of the mortgage, not the credit of the individual. If the current statutory requirement were weakened, the likely result would be that potential homebuyers would then be subjected to pricing based on both the loan-to-value ratio of their mortgage and their credit profile. When this happens, it is inevitable that more homebuyers would be placed into the subprime market where it will cost the homebuyer more to get mortgage financing and it will be more difficult for the homebuyer to fully understand the costs of their financing options.
5.1 The Most Illustrative Example Of What Happens In A Market Where Lenders Have Increasing Flexibility In Determining Whether A Borrower Is Offered A Prime Loan Or A Subprime Loan Is The United States.
Non-regulated and uninsured sub prime lending in the United States is not only characterized by high rates and fees, but also compares unfavorably with conventional mortgage lending in several ways. The additional unfavorable factors include: excessive pre-payment penalties, high debt-to-income ratios that significantly increase default ratios, "loan-flipping" that results in the "equity stripping" of the consumer, charges for payoff quotes, and lending on subprime terms and conditions to borrowers with prime credit profiles.
While the United States, like Canada, has a demand for legitimate subprime products, the U.S. experience has shown that the "free market" expansion of non-regulated subprime products has led to a proliferation of the "predatory lending practices" described above.
As discussed in section 2.1, one of the most startling findings in the United States regarding subprime lending is that Fannie Mae, Freddie Mac and others have estimated that up to half of all borrowers with higher cost subprime loans could qualify for a lower cost prime loan. This is the clear danger of pricing the added risk of high loan-to-value mortgages on risk-based, rather than loan-based, factors. It is also the consequence of the marginally weaker requirement for mandatory mortgage insurance in the United States.
5.2 Weakening Canada's Current Statutory Requirement For Mortgage Insurance On High Loan-To-Value Loans Would Be The Wrong Policy At The Wrong Time Given The Heightened Valuations Of Canada's Residential Real Estate Market And The Impending Implementation Of Basel II.
All economic expansions ultimately experience corrections. As recently as the 1990's, Canada's mortgage insurers paid out approximately $2 billon in claims resulting from a steep decline in housing prices and resulting defaults. If Canada is not presently at the top of the current economic cycle, we are certainly rapidly approaching it. If the mortgage insurance requirement was established to protect against fluctuating property values, that concern should be heightened rather than diminished today. Now is not the time to remove the safety net. As noted in Section II of this submission, this would result in a weakening of the third party insurance protections that benefit lenders and governments and help speed economic recoveries by keeping credit available in recessionary periods.
Canada's financial institutions are also about to implement the new Basel II capitalization rules.In addition to the operational challenges that implementing these new rules will pose for mortgage lenders, there is considerable uncertainty about how the new risk standards will perform when the inevitable economic correction occurs in residential real estate and other markets. Basel II was developed during a decade of relatively stable economic conditions, resulting in a further liberalization of several risk-based capital requirements. This change may, in fact, prove highly beneficial to financial institutions and lenders. However, until Canada's economy – and our residential real estate market in particular – has a chance to fully test the resiliency of these new rules, this would not seem like a prudent time to weaken the current statutory mortgage insurance requirement.
U.S. experience indicates that lenders often under-price the long-tailed mortgage risk to maximize their immediate competitive position in good economic times with strong home price appreciation. It only takes a handful of lenders trying to maximize short-term market share and profits before the entire market is driven to follow, resulting in a race to the bottom of prudent lending practices. Dr. Wachter points out that "This is not a theoretical outcome only, as the Asian financial crisis of 1997, which disproportionately involved mortgages and bank lending demonstrates"
5.3 Reduction of Competition and Tilting the Playing Field
Mandatory mortgage insurance ensures that financial institutions have effectively the same capital charge for mortgages – they become near zero-risk weighted assets. Without mandatory mortgage insurance there will be a greater tilting of the playing field against smaller financial institutions. In an environment where mortgage insurance is not mandatory, diversified banks will probably adopt the Advanced Internal Risk-based (AIRB) approach under Basel II and choose to self-insure their highest quality mortgages. Thus smaller regional lenders will not likely be able to adopt the AIRB approach and will therefore be at a pricing disadvantage for loans made to low risk borrowers. In turn, this will increase the risk profile of a small lender's mortgage portfolio by reducing the number of low risk loans in it. On the other hand, if mortgage insurance remains mandatory when Basel II is implemented, there should be no effect on the competitive landscape of the mortgage market due to the near zero-risk weight.
Wachter concluded that "in this case (Canadian market) it is not the GSEs (Fannie Mae and Freddie Mac) that level the playing field but mandatory mortgage insurance".
5.4 Canada's Automated Mortgage Insurance Underwriting Systems Today Assure Homebuyers Of An Objective, Fair And Transparent Loan Application Process. Diverting Loan Applicants From These Systems To Unregulated Lenders May Not Result In The Same Protections For Consumers.
The purchase of a home, especially for first-time homebuyers, is often the most important financial investment in a person's lifetime. Despite considerable improvements in the loan application and closing processes, the experience is still a challenging one for most homebuyers. Fortunately, since most insured (and 50% of the uninsured loans) in Canada today are underwritten by using the two mortgage insurers' systems, Canadians are assured of an objective, fair and transparent process. Previously, when loan applications were not automated, there were simply too many instances of human error and bias, with the most vulnerable in our society paying the highest price for the inherent flaws of a subjective process.
A change in the current system would almost certainly weaken the consumer protections that result from having two underwriting systems with national reach and application. One perilous consequence, as noted above, is the experience in the United States where many prime creditworthy loan applicants are directed into subprime products. Another possible consequence is a proliferation of inferior, under-funded underwriting systems that either approve inappropriate amounts of risk or unfairly deny credit to worthy applicants. The chance that either manually underwritten loans or smaller, less developed underwriting systems will mimic the beneficial protections and results of the two mortgage insurance systems is highly improbable.
Inevitably, some lenders – especially smaller and unregulated institutions – would be compelled to pursue riskier strategies in order to compete with larger players in the marketplace. Were that to occur, and lead to failures, the government would take the place of mortgage insurers in providing recourse for losses – if only through increased demands on the deposit insurance system.
5.5 Regulators Would Have To Closely Monitor For Financial Prudence And Ability To Manage High Risk Mortgages
As demonstrated throughout this submission, a weakening of the current statutory requirement for mortgage insurance would almost certainly lead to a proliferation of non-regulated mortgage products. Presently, there are an increasing number of new financial institutions entering the market, with several clearly stating their intention to aggressively market subprime mortgage products. Though these lenders increase consumer choice and competition, they also present increased risk to the financial system, primarily because of their size and untested business strategies and risk management practices.
Traditionally, housing and economic policies in Canada have prudently sought to expand credit risk and increase homeownership opportunities through the safety and soundness of the country's mortgage insurers. In addition to proven underwriting standards and equitable premium pricing practices, Canada's two insurers today maintain reserves of more than $4 billion, providing the government with a high degree of confidence in their financial viability, even in the event of catastrophic losses. If the mandatory requirement for mortgage insurance were removed, Dr. Wachter argues that increased regulatory oversight of mortgage risk, especially the risk of high ratio mortgages, would be necessary to assure the safety and soundness of the overall financial system.
"... self-insurance by banks or their subsidiaries that provide subprime mortgages undermines the security provided by monoline insurance and the prudential oversight provided by regulatory authorities, as discussed further below. ... Over the long term, the business cycle and macroeconomic downturns have potentially major impacts (especially when downturns are accompanied by interest rate increases) on mortgage markets. The potential feedback effects of mortgage default (foreclosure, forced sales, property price declines and upwards re-pricing of mortgage risk after the fact with adverse impacts on housing and the overall economy, and the reinforcing effects on default risk) is an important factor that differentiates mortgage insurance from other insurance products. It is the risk of these reinforcing effects, exacerbated by the potential risk to banks and the liquidity of the overall financial system that heightens the need for transparency of mortgage risk and mortgage lending products to assist in regulatory oversight.."
With the growing number of new entrants into the Canadian residential mortgage market, the need for the expanded regulatory oversight by the government of both lending practices and prudent capital standards increases every day. Weakening the current mortgage insurance requirement would only further fuel this situation and place further demands on government resources and regulators.
To conclude, removing the statutory requirement would reduce available credit, increase the cost to homebuyers, and result in fewer homeownership opportunities. This is as much a political choice as it is an economic choice. If the current mandatory requirement is weakened, low and moderate income earners and Canadians living in rural areas would be significantly disadvantaged to benefit a small minority of affluent homebuyers. Moreover, as Canada approaches the end of one of the longest sustained periods of appreciation of real estate values in the nation's history, any attempt to undermine the vital financial protection provided by mortgage insurance would undoubtedly increase risk to the financial system and the government's financial exposure.
1. Genworth Financial Canada, a subsidiary of Genworth Financial, is the only private sector supplier of default mortgage insurance in Canada. Genworth Financial (NYSE: GNW) is a leading insurance holding company, serving the lifestyle protection, retirement income, investment and mortgage insurance needs of more than 15 million customers in 20 countries, including the U.S., Canada, Australia, the U.K. and more than a dozen European countries. Genworth works with lenders, mortgage brokers, real estate agents and builders to make housing more affordable and home ownership more accessible anywhere in Canada. The company combines global experience in mortgage default insurance with strengths in technology and Six Sigma Quality to deliver innovation to the mortgage marketplace. Genworth competes with Canada Mortgage and Housing Corporation, a crown corporation, in the provision of residential mortgage default insurance on low downpayment mortgages. [Return]
6. Genworth Financial Canada data and Canada Mortgage and Housing Corporation, "2004 Annual Report," May 27, 2005. <http://www.cmhc-schl.gc.ca/en/About/anre/index.cfm> [Return]
9. Conference Board of Canada, "Metropolitan Outlook 1: Economic Insights into 25 Canadian Metropolitan Economies: Winter 2005," Dec. 2004. http://www.conferenceboard.ca/documents.asp?rnext=1109 [Return]
33. Credit Union Central Alberta, "Credit Unions Today," Apr. 27, 2005. <http://www.albertacreditunions.com/public/bins/index.asp> [Return]
34. Saskatchewan Credit Unions, "About Us," Apr. 27, 2005. <http://www.saskcu.com/pages/aboutus.html#Anchor-What-49575> [Return]
38. California Reinvestment Coalition, "Who Really Gets Home Loans? Year Eleven," Mar. 2005. <
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