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Présentation de « Susan M. Wachter » en réponse à la consultation sur l’Examen de 2006 de la législation du secteur financier du ministère des Finances Canada :
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Mandatory Mortgage Insurance in Canada: The Public Policy Consequences
Susan M. Wachter
Dr. Wachter reviewed Annex 6, An Effective and Efficient Legislative Framework for the Canadian Financial Services Sector (A Consultation Document for the 2006 Review of Financial Institutions Legislation) on behalf of Genworth Financial Canada, Inc. Dr. Wachter is currently the Richard B. Worley Professor of Financial Management and Professor of Real Estate and Finance, The Wharton School, University of Pennsylvania and previously served as Assistant Secretary of Policy, Development, and Research from 1999 to 2001 at the US Department of Housing and Urban Development.
I. Introduction and Executive Summary:
Currently, Canada has one of the most efficient and accessible housing finance systems in the world. Particularly impressive are the market's characteristics of low-cost mortgage finance and high levels of homeownership. The economic underpinnings of the current housing finance system have helped to achieve important social outcomes: equitable access to mortgages for potential homebuyers throughout Canada, in both rural and urban areas, first-time ownership for Canadian homebuyers on the margin, and protection for the financial system throughout the economic cycle.
These successes are made possible, in part, due to the provision of mandatory mortgage insurance. This provision has enabled, through gradual expansion of underwriting guidelines and price reductions for high risk loan categories, the extension of the market to marginal homebuyers who otherwise would not be able to afford homeownership, or would do so at higher cost. The requirement for mortgage insurance, as currently structured in Canada, helps prevent the pervasive segmentation of mortgages by credit risk. This market segmentation can lead to a lack of transparency in mortgage pricing and lending abuses, which undermine efficient mortgage choice and sustainable homeownership. Thus the current system provides access to affordable homeownership at the same time as it minimizes mortgage portfolio and systemic risk. Furthermore, mandatory mortgage insurance supports the provision of mortgages by large and small lending institutions throughout Canada.
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.
Section II, which follows, examines the broad conceptual basis and economics of mortgage insurance and, specifically, the risk pooling and economies of scale and scope that follow from the mandatory provision of mortgage insurance and the resulting socially beneficial outcomes and links these to the framework outlined in Annex 6. Sections III, IV, and V apply the analysis to particular policy relevant outcomes: the increase in low cost homeownership, maintenance of the current diversified industry structure, and limitations on potential predatory lending abuses. Section VI provides overall conclusions concerning mandatory mortgage insurance and public policy. The principle conclusion is that the mandatory requirement for mortgage lenders to obtain mortgage insurance serves important public policy purposes.
II. Mandatory Mortgage Insurance: Economic Concepts and Public Outcomes
The sunset clause in the Bank Act, Insurance Companies Act, Trust and Loan Companies Act and Cooperative Credit Associations Act requires the automatic five-year review of legislation. This analysis is written in response to the request for comments to inform the review of mandatory mortgage insurance and is based on economic models and the experience of market outcomes under different institutional settings.
Annex 6, "An Effective and Efficient Legislative Framework for the Canadian Financial Services Sector," states that the government is seeking views on measures to improve the federal legislative regulatory environment in regards to "the requirement to have insurance in every case when a mortgage exceeds 75 per cent of the value of the property [which] may have increased the cost of homeownership to some Canadians. The Government is seeking views on providing more flexibility to residential mortgage lenders and homebuyers by removing the statutory restriction on residential mortgages exceeding 75 per cent of the value of the property."
Broad directives for legislative review are also set out in Annex 6: "The Government is considering making selective changes to the financial institutions' statutes, aiming to achieve three principle goals:
- Enhancing interests of consumers.
- Increasing legislative and regulatory efficiency.
- Adapting the framework to new developments."
Specifically, the Government states that it "is committed to providing a fair and balanced framework that preserves the health and strength of the sector and, at the same time, allows its evolution to benefit all Canadians. To strike that balance, it is important to ensure that consumer rights are adequately protected." Thus, as part of this review, specific attention is paid to consequences for consumer rights including mortgage pricing transparency. Also Annex 6 asks for "views on measures to improve the federal legislative and regulatory environment as it applies to credit unions and caisses populaires." This analysis addresses this set of issues in Section IV below. In addition, the analysis examines the broad issues of regulatory efficiency and the role of the existing framework in the evolution of the mortgage market in Canada.
The current system of mandatory mortgage insurance delivers broad benefits for Canadian mortgage borrowers, for potential homebuyers, for a diversified industrial structure and for overall economic stability, even though these benefits may not have all been explicitly intended or envisioned when the requirement
was originally implemented. Major benefits of the current system of mandatory mortgage insurance include risk pooling, geographic diversification, standardization of mortgage products, economies of scope and scale, and incentives for innovation and growth. The basis for these outcomes is the mandatory nature of mortgage insurance. In the absence of this regulatory provision, these benefits are likely to be significantly eroded over time. These outcomes have positive implications for expanding homeownership, for limiting loan portfolio and systemic risk, and for maintaining a competitive environment in which regional and smaller lenders are active.
The classic case for mandatory mortgage insurance (i.e. pooling across homebuyers) is the Stiglitz and Weiss (1987) argument that without mandatory pooling information, asymmetries between the lender and the mortgage insurer lead to adverse selection and high-quality borrowers opting out of the insurance pool. As a consequence, the quality of the risk pool decreases leading to a lower share of insured borrowers, higher borrower costs, and constraints upon an increased number of low-income borrowers on the margin. Mandatory mortgage insurance effectively eliminates the problem of adverse selection and creates a balanced risk pool that lowers borrowing costs for marginal homebuyers.
Without mandatory mortgage insurance, market incentives are likely to result in mortgages being priced based on individual borrower credit quality. As an unintended effect of the removal of mandatory mortgage insurance, the subprime market will expand at the expense of the marginal buyers who are currently being served by the prime market. In addition the market is likely to become fragmented, leading to multiple pricing points and proliferation of products. This has the potential unfortunate effect of increasing borrower confusion due to limitations in pricing transparency and effective choice. This tendency over time to price pervasively on risk would also eliminate the possibility of crosssubsidization which currently exists. This cross-subsidization meets public policy objectives of extending homeownership rates. The large pool size resulting from the current system also yields economies of scale and scope, which allow the provision of insurance at lower cost to all borrowers. Information economies developed due to the existence of mandatory mortgage insurance, allow for lower borrowing costs fulfilling the policy goal of greater access to affordable homeownership.
A second economic rationale for mandatory mortgage insurance is the relationship between default risk and geographic diversification. Since housing price declines tend to occur simultaneously in a geographic region, geographic diversification is crucial for mortgage insurers. (As Jaffee, 2004, points out, mortgage insurance is unlike traditional casualty insurance such as automobile insurance and is more comparable to catastrophe insurance such as that for terrorism or earthquakes.) This diversification has important implications for minimizing the volatility and probability of high unexpected losses, as shown in Figure 1. Due to diversification, portfolios for a national market tend to have lower default rates than portfolios of individual markets, as seen in Figure 1 which points to the small national impact of large regional losses.
The mandatory mortgage insurance requirement results in exactly this diversification of geographical risk. The removal of a mandatory requirement would very likely lead to mortgage industry outcomes where large, diversified financial institutions choose to self-insure their less risky mortgages in an attempt to out-compete other lenders for their business. It becomes evident that this may be problematic considering the fact that large financial institutions dominate most of the Canadian market and their competition consists of smaller and regionallybased lenders (independent mortgage lenders, credit unions and caisses populaires with limited geographic and borrower diversification). Removing the mandatory mortgage insurance requirement would undermine these institutions' ability to reliably access funding or offer competitive terms and thus adversely impact the borrowers that they serve.
Another economic rationale for the requirement for mandatory mortgage insurance derives from the relationship of default risk to the business cycle and the objective of maintaining stability of the financial system and the overall economy. The purpose of the regulatory framework under review is to ensure the prudential supervision of the financial services industry, not only banks but also, insurance companies. Its prime objective is to minimize financial loss to depositors and policyholders and to develop prudential policy standards and guidelines that assure stability in the financial system. The current system serves this goal by providing incentives for insuring over business cycles. For long- or indefinite-term insurance, such as mortgage insurance or deposit insurance, expected premiums over the life of the insurance must be compared with the corresponding long-term losses.
The current system supports this provision with a view to managing long-term risk. Due to the cyclical, catastrophic and long-tail nature of mortgage default risk, maintaining the mandatory nature of mortgage insurance furthers the principal objective of protecting the interests of depositors and policyholders. In this way the goals of mandatory mortgage insurance are similar to those of 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 insures that there will be enough revenue over a business cycle to pay for expenditures and maintain relatively stable rate levels throughout the business cycle. Reserves are built up during good times and then depleted during periods of economic stress to keep the premium being charged from fluctuating pro-cyclically. A goal of employment insurance is the avoidance of abrupt premium rate increases, 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 assure that housing financing is available at affordable levels at all times especially during recessions. This credit risk transfer to insurers acts a stabilizer to the financial system by allowing financial institutions to lend across the business cycle and thus reduces the risk of a credit crunch.
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.
This vested interest to monitor lenders and ensure prudential practices has benefits for federal and provincial regulators. First, through the business scope restrictions, prudential regulation and oversight of the mortgage insurers the regulators are assured that there is sufficient capital to manage default risk though business cycles. Second, the incentives for the insurer to closely monitor lenders ensures that there is a second pair of eyes that brings market discipline oversight to mortgage lenders' operations. This risk specialization helps to assure that overall mortgage credit risk is properly capitalized and that operational risks within the lending institutions are well managed.
There remains a strong economic and regulatory basis for maintaining the mandatory nature of mortgage insurance. Allowing banks to give up mortgage insurance inevitably will result in increased risk of banks' mortgage portfolios and less attention to minimizing pro-cyclical pricing of risk, thus requiring more reserves and more regulatory oversight.
This perspective is supported by global best practice and experience. Canada's current system is consistent with theory and best practice and economic experience; removing the mandatory mortgage insurance requirement would undermine economic efficiency, the current diversified industrial structure, affordable access to homeownership and systemic stability.
We turn in the following to a discussion of the specific mandatory mortgage insurance benefits of access to homeownership, the maintenance of a housing finance system served by a diversified group of financial institutions, and the prevention of increased household and economy-wide, systemic risk.
III. Homeownership Benefits
Providing access to homeownership is an important public policy objective in many countries as it is in Canada. This outcome is supported in Canada by mandatory mortgage insurance.
All borrowers benefit from a mandatory mortgage insurance system since it achieves better diversification of risk, standardization, and economies of scale and scope. The efficiencies that result from pooling produce direct private benefits for all Canadian mortgage borrowers. Pooling also produces social benefits, including, importantly, increasing access to homeownership. The public policy goal of extending homeownership is supported by the current system. If mandatory mortgage insurance is removed then the downpayment requirement, the borrowing rate, or both will go up for marginal borrowers having negative effects on their ability to become homeowners. As demonstrated in Exhibit 2 and discussed further below, as many as approximately 20% of borrowers, who today have access to homeownership at affordable rates, could be precluded from homeownership or burdened by mortgage rate increases of more than 50%. As a result, homeownership would be less attractive and less attainable. The removal of mandatory mortgage insurance will harm younger and lower income households, in particular; and will increase homeownership gaps across income groups.
Data on current homeownership outcomes and the credit quality of homeowners served by mandatory mortgage insurance in Canada points to the potential large impact of the removal of mandatory mortgage insurance on homeownership outcomes. The high current rate of homeownership, 68%, has been achieved in recent years along with market innovations provided by mortgage insurers and enabled by mandatory mortgage insurance. As shown in Exhibit 1, from the 1991-1996 census period to the 1996-2001 census period the average annual growth in home-owning households increased from 121,000 to 147,000 while the number of renter households increased by 40,000 and 2,000 respectively. Data gathered by CMHC demonstrates that homeownership rates increased across specific age groups in this time period. Thus the increase in home-owning households was not driven only by demographics.
Research has shown the importance of credit constraints in limiting access to homeownership, and the role of downpayment requirements as a constraint to homeownership (Wachter et. al. 1996). In 1992, the minimum required downpayment in Canada was reduced to 5%. The provision of mandatory mortgage insurance allows lower down payments than otherwise would be possible without substantial increases in risks, and, therefore, rates. The result of the possibility of lowered down payment without increased risk and mortgage rates derives from the risk pooling effects achieved by the provision of mandatory insurance. Thus, insurance completely transfers credit risk from the lender to the insurer and, at the same time, through pooling, results in lower risks and rates, which allows lenders to offer loans with lower down-payments.
Decreasing down-payments allows increased homeownership which serves public policy goals. Higher homeownership rates have been found to be beneficial due to positive externalities that accrue to the community, in addition to the benefits, which the homeowners themselves receive. The owner-occupier cares more about the neighborhood and may be more "socially-minded" resulting in externalities to neighbors such as less crime. In addition, empirical findings have shown that family ownership has a positive impact on a child's educational attainment and earnings in early adulthood. Further access to housing finance and home equity provides a means of low cost borrowing for human capital and small business investment as well as an economic cushion, supporting households through financial adversity and throughout the business cycle.
A conservative estimate of the impact of decreases in access to homeownership, based on an analysis of households served by the Genworth program alone would indicate a potential loss of more than 40,000 households per year (see Exhibit 1). These are the potential buyers whose credit rating marginally qualify them for insurance and who would likely be rationed out of the market with the withdrawal of mandatory mortgage insurance.
Access to homeownership has been encouraged by a wide array of insurance products and terms together with the automated underwriting innovations of the 1990s. According to the Conference Board of Canada, the volume of insured high ratio residential mortgage loan approvals totaled about $64 billion in 2003. And, nearly half of all residential mortgages in dollar terms in Canada in 2003 were insured high ratio loans. The number of homeowners protected by mortgage insurance climbed sharply through the 1990s with the introduction of mortgage insurance on loans with 95% loan-to-value ratios and the entry of Genworth into the market. Moreover, in 2002, Genworth expanded its insurance to cover applicants with good credit ratings but who cannot provide traditional income verification (i.e. self employed borrowers), and in 2003, both Genworth and CMHC reduced mortgage insurance premiums by 15% and eliminated homeowner price ceilings. A further premium rate reduction of 15% reduction on 95% loan-to value mortgages took effect April 22, 2005. Each of these innovations has contributed to making homeownership affordable to potential homebuyers throughout Canada.
Beyond allowing access to homeownership for more potential homebuyers both CMHC and Genworth have loss mitigation programs to help borrowers keep their homes during temporary financial adversity. Both the gains in homeownership and the sustainability in homeownership depend on the current mandatory mortgage insurance system. The goal of providing access to homeownership to all Canadians would be undermined and the disparities in homeownership access across income groups would be exacerbated if support provided by mandatory mortgage insurance to homeownership were removed. We turn to the issue of sustainability of homeownership and the role played by mandatory mortgage insurance in Section V.
IV. Industry Structure Impact
Mortgage insurance exhibits several common fundamental characteristics which cut across international boundaries: (1) the insured risk covers random individual events and economic adversity, the latter of which results in clustered regional defaults and (2) both the exposure period and the loss cycle are unusually long compared to other insurance lines. These key characteristics of mortgage insurance which are distinct from other insurance lines mean that the regulatory provisions and analytical approaches needed to assure long-term strength and solvency need also to be distinct from other insurance lines.
These characteristics which derive from relationships between default risk and geographic diversification and default risk and the business cycle have major implications for the maintenance of the current mortgage lending industry structure and for the overall stability of the economy. As Jaffee (2004) points out, mortgage insurance is unlike traditional casualty insurance such as automobile insurance and is more comparable to catastrophe insurance such as that for terrorism or earthquakes. Since housing price declines tend to occur simultaneously in a geographic region, geographic diversification is a crucial necessity for mortgage insurers. The mandatory mortgage insurance requirement results in exactly this diversification of geographical risk. The removal of a mandatory requirement would adversely impact lenders unable to achieve diversification on their own and would very likely lead over time to mortgage insurance outcomes where large, diversified financial institutions choose to selfinsure their highest quality loan to value mortgages. In the US such "selfinsurance" can take the form of offering second (often) interest only mortgages which increases the overall risk of the combined mortgage loans.
The incentive for large financial institutions to self-insure would have critical implications for the diversified industrial structure that now prevails in Canada. It becomes evident that this may be problematic considering the fact that large banks dominate most of the market. Subsequently, the smaller lenders would be too undiversified to self-insure. Thus removing the mandatory mortgage insurance requirement would undermine these institutions and the borrowers that they serve.
National banks do not need to be as concerned about the loss of credit risk diversification provided through mandatory mortgage insurance while smaller institutions such as credit unions and caisse populaires do need to be concerned. Moreover new international regulatory efforts commonly known as Basel II will likely exacerbate these effects. The Basel II Accord is an agreement which updates the 1998 accord, Basel I. In June of 2004, the Basel Committee on Banking Supervision published the outcome of its work to produce more risk sensitive regulatory minimum capital requirements for internationally active banks. The Basel II Accord is build upon three pillars: credit risk, market risk and operational risk. While the framework for market risk is unchanged, there have been significant changes to how credit risk will be measured. In addition the framework introduces a new risk - operational risk. Of concern are the changes to the credit risk framework.
The most advanced set of rules that define minimum capital requirements under Basel II, called the Advanced Internal Ratings Based (AIRB) approach, places substantial reliance upon the internal data and risk measurement and management processes of those banks that use it. Two alternative sets of rules - the Foundation approach and the Standardized approach - incorporate more risk sensitivity than Basel I but stop short of the variations in risk sensitivity of capital requirements associated with the AIRB approach. It is expected that all major Canadian banks will adopted the AIRB approach.
Under these rules AIRB banks will have to hold significantly less capital against their mortgage loans. As demonstrated by researchers for a U.S. banking regulator, the Federal Reserve Board, the original thinking that industry impacts would be limited may be wrong. "[AIRB] adopters will be granted a potential cost advantage for particular residential mortgage products because regulatory capital for these products under Basel I generally exceeds the economic capital for such products. Second, since bank investments in residential mortgages are quite large and varied in terms of economic capital, especially among mortgage specialists, the disparate regulatory capital treatments will likely have substantial impacts on the profitability of non-adopters with large residential mortgage portfolios (Calem and Follain, page 3, January 14, 2005)." However, with a mandatory mortgage insurance system most of the distortions are removed and the playing field for lenders is not tilted too far in any direction.
Calem and Follain make the argument of what happens under Basel II when the playing field gets tilted in favor of the major banks-the smaller mortgage lenders will either need to operate with expectations of lower profitability or move into riskier markets, such as subprime, where they can potentially earn a higher return.
In an alternative analysis by Passmore et al., (2005) they refute this conclusion. Stripped down to its core, a key assumption of Passmore et al. argument is that because there is a universal mortgage purchaser, the Government Sponsored Enterprises (GSEs), Calem and Follain's result should not hold; in essence they argue that the GSEs level the playing field and thus Calem and Follain's result should not hold.
In Canada, there is a similar situation, but working through a different channel. Mandatory mortgage insurance ensures that financial institutions have effectively the same capital charge for mortgages - they become near zero-risk weighted assets. In this case it is not the GSEs that level the playing field but mandatory mortgage insurance. Turned on its head, Passmore et al. provide the argument for a world with mandatory mortgage insurance. Without mandatory mortgage insurance we would have the results of Calem and Follain, and a greater tilting of the playing field against smaller financial institutions.
Given the growth of banks' share of the mortgage lending market and the current large share held by the top 5 banks (see Figures 2 and 3), market advantages deriving from size and penetration appear to be substantial. The implications of removal of the leveler of mandatory insurance for further consolidation of the financial sector and the threat of elimination of smaller institutions is likely to be significant. Creating such an industry structure clearly contradicts the goal discussed in Annex 6 of improving the federal legislation and regulatory environment for credit unions and caisses populaires which would be adversely affected by this change.
Removing the mandatory nature of mortgage insurance may also create greater barriers to entry into the mortgage market. Smaller firms trying to penetrate the market would find it difficult to compete with the major lenders because of the cost advantage the latter would have. Larger foreign banks would face similar barriers. They would not have the historical data to operate as an AIRB bank and have to operate with a higher cost structure. This could limit the value of the mortgage franchise for banks post-merger if they were required to divest of part of their mortgage business because of competition issues. More generally, it could limit the number of potential entrants into the market.
Finally, 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.
V. Risk Based Pricing, Long-Term Lending, and Potential Abuses of Predatory Lending Practices
As noted in Annex 6, "consumers are best served in an environment where they have access to sufficient information to make educated choices." At a minimum, current disclosure requirements would no longer be adequate and US experience indicates it is very difficult and nearly impossible to develop disclosure policy in the presence of the multiple and complex products that are likely to be offered in the absence of mandatory mortgage insurance.
Experience also indicates that the providers of risk based priced mortgage products often underestimate the ex post risk, an outcome that may be driven by competition for market share or by short-term time horizons, or both. Many subprime lenders in the US have gone into bankruptcy after lending in markets where risk proved greater than anticipated.
The financial viability of a private insurance pool depends on the balance between premium income and losses. If losses are consistently greater than premium income, a private insurer may default on the contract. While the provider of risk based mortgage products may self-insure with seemingly no loss to any but the firm itself or its investors, even if as may be the case some firms so misestimate risk that they are forced into bankruptcy, the defaulted mortgages and foreclosed properties continue to have negative impact on communities and the individuals who have lost their homes. Increasingly risky mortgage products put the sustainability of homeownership at risk. For example, of the subprime book of business originated in the City of Philadelphia in 1997, approximately 40% of these loans are currently in default (Goldstein, 2005).
This is not a totally surprising outcome. Working with a borrower in financial distress is not a practical solution for a subprime lender. Pricing risk and ruthless foreclosure at the first sign of a problem is a better economic model. This is in contrast to the mortgage insurance model where there are incentives to provide a workout. Moreover, with risk based pricing, lenders are favorably compensated for risk and have fewer incentives to lend prudentially.
Moreover even without subprime lending, in the absence of a strong regulatory framework and incentives for prudential lending, Pavlov and Wachter (2004) demonstrate the likelihood of the under-pricing of mortgage risk. As Pavlov and Wachter show, incentives exist for managers to under-price mortgage risk in order to maximize the provision of loans and fees, in the absence of rigorous prudential oversight. Institutions with demand deposit insurance or investors with short-term time horizons are particularly subject to this drive to under-pricing of risk. Even if only some managers and some firms underestimate and under-price risk, Pavlov and Wachter demonstrate that the entire market may be driven to follow, in a race to the bottom of prudent lending practices to try to increase or maintain market share. This is not a theoretical outcome only, as the Asian financial crisis of 1997, which disproportionately involved mortgages and bank lending demonstrates (see Koh et al.).
The pricing of risk over the cycle for sound long term lending is encouraged by requiring the provision of mortgage insurance to cover risk that may otherwise be under-estimated and underinsured. Moreover the monoline structure provides incentives to the insurer who must maintain the solvency of their sole business for the long term to remain in business, thus encouraging adequate funding for insurance over the business cycle. On the other hand, the catastrophic long -tail risk of mortgage lending increases the likelihood of bankruptcy for associated non-mortgage business in a non-monoline structure, for example, self-insured banks.
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. In the absence of mandatory mortgage insurance, nonstandard and complex mortgage products will proliferate with adverse consequences for identifying and monitoring risk.
In order to understand mortgage insurance markets, there is a second overarching aspect of mortgage insurance that must be recognized. While the distribution of mortgage insurance expenditures is highly skewed, meaning that a small fraction of individuals account for a large share of total mortgage insurance expenditures there are ways to generally identify these risk groups ahead of time and broadly adjust premiums appropriately. Because of this fact, there are gains to insurers of including higher cost borrowers. The incentives for insurers to insure high cost/high risk homeowners are therefore manageable when risk can be spread across a broad population.
Increases in risk segmentation are appealing to some because they appear to promise, and sometimes deliver, lower premiums for currently lower risk borrowers. However, gains from segmenting groups can occur only if premium costs for the higher risk groups are increased, and may result in increased premium costs for lower risk groups as well. It is not sufficient to spread risks only within a particular insurance pool. As each pool becomes smaller the average variance of the risk increases. And, in markets, where differences in actuarial value of plans can be quite large, and where people have the opportunity to opt in or out of the market, risk adjustment (other than by pricing) becomes substantially more difficult.
The result of these various strategies is to create a market that is segmented by mortgage default risk. This leads to markets in which premiums faced by generally lower-risk borrowers are determined as a function of the expected costs of a similarly low risk population, and the premiums for the riskier borrowers are determined as a function of the expected costs of the similarly riskier borrowers. The markets with the greatest risk segmentation are those for high-risk borrowers. While market segmentation may benefit the low risk/low loan-to-value (LTV) borrowers by providing them lower premiums than they would face otherwise (although the decreasing size of the pool increases the average variance for this group as well), it increases the premiums faced by the relatively riskier, and sometimes excludes them from the insurance market entirely. Risk segmentation may make insurance more affordable for the less risky but does make the insurance less affordable to the higher risk groups, consistent with the classic theory posited by Rothschild and Stiglitz (1976 ) Moreover, as noted by Rothschild and Stiglitz in an financial market with informational asymmetries the removal of mandatory pooling will lead to risk based pricing.
Equity judgments inevitably arise in any discussion of the optimal level of risk pooling. Many would consider lack of available coverage for high-risk households as inequitable, while others consider it inequitable to force riskier persons to pay higher premiums than they would under stronger market segmentation conditions.
However, if Canada wishes to move to a market segmented by risk it is useful to look at how those markets have performed in other countries. The best example is the US where there has been a growing subprime market.
The main stylized facts that characterize the subprime market (relative to the prime market) are:
1. High interest rates.
2. High points and fees.
3. Prevalence of prepayment penalties.
4. Lending based on asset value, rather than borrower characteristics, with low loan-to-value ratios.
5. Specialized subprime lenders who cater only to subprime borrowers and who have limited access to secondary mortgage markets.
6. Large rate differences between marginally prime and marginally subprime borrowers.
While currently there may be less of a transparency argument relative to the US market, the subprime pricing is still not as transparent as the prime market today.
Subprime lenders pay higher commissions to mortgage brokers up to 150 basis points compared to commissions of 100 basis points for prime mortgages. As well, less financially astute borrowers have a more difficult time comparing mortgage offerings given the potential myriad of choices It is far more difficult for consumers to make informed decisions in the subprime market since the product is likely to be a complicated package of fees - both up front and contingent, contractual prohibitions, and rate. A financial engineer would be hard pressed to value the effective cost offering correctly let alone a typical consumer.
Moreover, it is not likely that large financial institutions can easily enter the subprime market as part of their core business activity. A key feature of industry structure in the US is a rapidly developing subprime market that is segmented from the prime market.
US mortgage markets have evolved radically in recent years. An important part of the change has been the rise of the subprime market, characterized by loans with high default rates, dominance by specialized subprime lenders rather than full-service lenders, specialized subprime brokers, and little coverage by the secondary mortgage market. Studies have shown that there are clear economic reasons for this segmentation to develop.
Cutts and Van Order (2005) demonstrate that underwriting effort will vary across these two groups as each group develops a business model specializing in either subprime or prime lending. As their study shows, if a subprime lender sets lending standards too close to the entrenched prime market, then application cost become so high that it becomes less costly to lower credit standards and accept more high-risk applicants. This result is driven by the costs associated with processing rejected applications. When a higher proportion of applicants are rejected, this can overwhelm any benefits associated with the lower risk borrowers. An optimum distance in credit quality space is then found, thus motivating the need for a segmented high-risk or subprime mortgage market. This result implies that economies of scope do not derive from offering both prime and subprime loans as part of the core business activity in the same lending institution.
The growth of specialized subprime lending institutions in the US over the past decade (Hershaff, Russo, and Wachter, 2005) and, even more rapid current growth, are deepening concerns about the predatory practices that arise in the subprime market. According to SMR research: "Based on hard numbers from SMR's annual survey, we now know that subprime mortgage origination volume leaped by nearly 60% in 2004! It was the sharpest rise in the history of the industry. And it happened in a year when prime-quality mortgage production tanked. This means subprime mortgage lending is now by far the fastest-growing business in the entire world of consumer finance." As discussed in a recent Wall Street Journal article (April 28, 2005):
"The surge in subprime lending during the past decade has led to complaints of abuses, partly because such loans typically are targeted at people who have little experience with the complexities of comparing offerings by various lenders. Many of the loans are made through brokers, who aren't employees of the lenders and can be difficult to police. Two bills recently introduced in Congress would crack down on so-called predatory lending practices, and the Department of Housing and Urban Development is preparing to propose new regulations on disclosures that must be made by mortgage lenders."
Thus currently there is a call for solutions to concerns raised by predatory practices, which derive from the fragmentation of the prime market from both sides of the political spectrum in the United States. The potential of a housing bubble interacting with risky mortgage instruments makes these concerns more salient (Wall Street Journal May 17, 2005). Canada would be faced with similar outcomes in the absence of mandatory mortgage insurance.
The federal government on a regular basis reviews the legislation for the federally regulated financial institutions. Annex 6 has called for the review of the current Canadian system for mandatory mortgage insurance, with a view to make selective changes "aiming to achieve three principle goals: enhancing interests of consumers; increasing legislative and regulatory efficiency; and adapting the framework to new developments."
The provision for mandatory mortgage insurance is a key part of the current Canadian successful housing finance structure. Changes that remove this key foundation to the current system far from achieving the set of goals stated in Annex 6, rather have the potential to seriously undermine existing benefits in each of these areas. The current system has provided low cost mortgage funding, access to affordable homeownership, and historically high homeownership rates. Consumers who today have access to mortgage financing may either be precluded from homeownership or burdened by significantly higher borrowing costs. If financial institutions are allowed to give up insurance loan portfolios will be riskier and the need to identify and monitor risk through regulatory oversight will be far more difficult. Canada is strikingly free of the abuses of predatory mortgage lending, which can occur in subprime lending markets, as shown by the U.S. experience. Thus this is a proposal that could have significant negative impacts on mortgage funding, the housing sector, and the overall economy of Canada.
Federal financial legislation requires mortgage insurance on loans with loan-tovalue (LTV) ratios above 75 percent. This restriction has helped to keep the mortgage lending financially sound and secure. An unintended benefit is that it has helped to keep the mortgage market accessible to borrowers and to all lenders by creating a common framework for credit risk. The implications of these changes for financial institutions must be seen in the context of other regulatory changes proceeding, in particular, Basel II. The competitive footing of smaller financial institutions will be undermined by the likely outcome that larger institutions will target their lending and self-insure loans with lower risk borrowers, leaving smaller providers with a less diversified and riskier portfolio. Incipient growth of securitization is likely to be undermined as fragmented mortgage products reduce pools, and as smaller institutions' access to the means to bundle their loans, in a common insured pool, is lost.
The Canadian housing market has much to offer as a model for the world. It has supported the dream of homeownership and has been a key factor in Canadian's having one of the highest homeownership rates across nations. This model cannot be viewed simply as a system of bank mortgage lending. Canadians will not be well served if all lenders, small and large, regional and national, cannot compete for their business. Canada's mandatory mortgage requirement has created a level playing field among lenders. Without a level playing field in the
mortgage market, Canadians will suffer because in the longer term the financial system will be less competitive and the innovation that credit unions and smaller lenders bring to the market will be curtailed. If our understanding of the economics of what is being proposed holds, the government is creating the foundation for a housing finance market that will be certainly less equitable and likely less efficient and financially sound that the current framework.
The current system delivers benefits in the form of low cost mortgages to households who otherwise would pay more to own or postpone ownership. Benefits also derive from a diversified industrial structure with a variety of lending institutions of all sizes providing mortgages throughout Canada in urban and rural markets. While there is a possible gain to some in the form of the risk based pricing of mortgages, the fragmentation of the pricing of mortgages and the undermining of transparency mean the certainty of loss to many others. These losses undermine social outcomes in housing and mortgage markets which matter for the financial well being and stability of individual households, communities and the overall economy.
Calculation of Increase in Borrowers Subject to Subprime Lending
|1991-1996 Census||1996-2001 Census|
17% customers under 620 credit score, 18% under 659, or 35% in total
The number of marginal buyers would have been subject to subprime pricing in the past decade.
35% of 121,000 = 42,350
42,350 * 10 years = 423,500 over a decade
Data derived from Clayton Research Associates based on data from Genworth Financial Canada
Calculations of Rate Differentials Based on Prime and Subprime Rates Non-Conforming Lender 5 Year Fixed Rate Sheet March 7, 2005
|LTV||Beacon Scores 675+||Non-Conforming Lender Standard Pricing
(Ave Score of about 635)
|Pricing for Beacon Scores below 600|
|High Beacon & Non-Conforming Lender Average||6.59%|
|Low Beacon and Non-Conforming Lender Average||7.19%||618.75|
|Ave Score for High Beacon & Non-Conforming Lender||655|
|Ave Score for Low Beacon & Non-Conforming Lender||618|
|ING March 1 Rate:||4.74%|
|Likely Increase if NO Mandatory Mortqaqe Insurance:|
|Difference for High Beacon & Non-Conforming Lender Average (655 Score)||1.845%|
|Difference for Low Beacon & Non-Conforming Lender Average (618 Score)||2.450%||= Total rate of 7.19%
(51.6% Higher than previous rate of 4.74%)
"Annex 6 An Effective and Efficient Legislative Framework for the Canadian Financial Services Sector." A Consultation Document for the 2006 Reviewof Financial Institutions Legislation
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Barakova, Irina, Bostic, Raphael, Calem, Paul, & Wachter, Susan M. "Does Credit Quality Matter for Homeownership?" Journal of Housing Economics, Vol. 12, Issue 4, December 2003, 273-356.
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Calem, Paul, Hershaff, Jonathan E., & Wachter, Susan M, "Neighborhood Patterns of Subprime Lending: Evidence from Disparate Cities," Housing Policy Debate, Volume 15 Issue 3, 2005
Calem, P.S and J.R. Follain (2005) "An Examination of How the Proposed Bifurcated Implementation of Basel II in the U.S. May Affect Competition among Banking Organizations for Residential Mortgages" Board of Governors of the Federal Reserve System, January 14
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Spitzer Staff Probes Mortgage Fees; Banks Including Citigroup, HSBC Are Asked for Data on Subprime Loan Practices
James R. Hagerty. Wall Street Journal. (Eastern edition). New York, N. Y.: Apr 28, 2005. pg. A.3
NEW YORK -- The staff of New York Attorney General Eliot Spitzer has launched an investigation into possible discriminatory practices in the interest rates and fees charged on mortgage loans, according to people familiar with the situation.
The attorney general's civil-rights bureau recently sent out letters to a "handful" of large lenders with operations in New York State, asking for information on their lending practices, according to a person briefed on the situation. The bureau also is examining loan- pricing data recently disclosed by mortgage lenders under the Home Mortgage Disclosure Act, this person said.
This person declined to identify the lenders, but representatives of both Citigroup Inc. and HSBC Holdings PLC said the companies had received the letters from Mr. Spitzer's office and are complying with the requests for information. A Citigroup spokesman added, "We briefed the Attorney General's office on our data last month as a courtesy, and we are working with the staff to provide follow-up information."
It wasn't clear which other lenders received letters. A spokesman for J.P. Morgan Chase & Co., another big lender based in New York, said the company doesn't comment on communications with regulatory agencies and officials but that "it is our policy to cooperate."
Mr. Spitzer's investigations in recent years have led to major changes in practices at Wall Street investment banks, mutual-fund operators and insurance companies, among other things.
"We're in the early stages" of the inquiry, this person said, adding that the bureau is looking at whether minorities, the elderly and other "vulnerable groups" are being targeted by questionable lending practices. The letters went to lenders with large numbers of subprime loans, ones for borrowers considered less creditworthy because of past payment problems, high levels of debt in relation to income or other factors.
HSBC's HFC and Beneficial consumer-finance units serve many subprime borrowers, as does Citigroup's CitiFinancial subsidiary. Citigroup last year agreed to pay $70 million to settle Federal Reserve Board allegations of abuses in its consumer-lending operations, which were expanded by the 2000 acquisition of Associates First Capital, a big subprime lender.
The surge in subprime lending during the past decade has led to complaints of abuses, partly because such loans typically are targeted at people who have little experience with the complexities of comparing offerings by various lenders. Many of the loans are made through brokers, who aren't employees of the lenders and can be difficult to police. Two bills recently introduced in Congress would crack down on so-called predatory lending practices, and the Department of Housing and Urban Development is preparing to propose new regulations on disclosures that must be made by mortgage lenders.
The release of data under the Home Mortgage Disclosure Act, known as HMDA, showed that African-Americans are more than twice as likely as whites to receive high-cost subprime mortgage loans at the nation's largest lenders, according to a Wall Street Journal analysis of the disclosures.
The data are difficult to interpret because lenders must report each loan with an interest rate above a certain level but aren't required to give details on the borrower's credit record, wealth or other factors that influence the rate. Even so, the data raise questions about whether lenders are doing enough to ensure that all borrowers have access to information that would help them decide whether the loan terms being offered are reasonable.
Edward M. Gramlich, a member of the Federal Reserve Board, said in an interview yesterday that the Fed is still sifting through the data and that it is too early to draw any conclusions. The data may provide "an indicator of where the [bank] examiners would want to look a little harder" at lending practices, he said.
Critics say competition among lenders is weaker in some low-income neighborhoods, making it less likely for people there to figure out whether they might qualify for a lower-cost loan. They also say banks should do more to educate consumers about their options. In addition, critics say, mortgage brokers and loan officers often have no incentive to tell people they could get better terms by trying a different type of loan. Higher-cost loans often result in more compensation for the broker or loan officer.
Mortgage lenders were required to disclose new information about pricing of loans in March as part of their filings under HMDA. That federal law, enacted in 1975, requires all but the smallest lenders to make annual disclosures to their regulators on all mortgage applications, broken down by the race and gender of the applicants. Beginning with the disclosures for 2004, new regulations require the lenders to report additional data when the interest rate exceeds a threshold.
Explaining the HMDA data, lenders say the pricing of loans depends on risks and that AfricanAmericans tend to have less income, more debt and poorer credit histories than do whites.
The HMDA data showed uneven patterns among major lenders. For instance, at Washington Mutual Inc., African-Americans were about 4.4 times as likely as whites to pay rates above the threshold. That compares with 2.5 at Citigroup and 2.8 at Countrywide Financial Corp. When asked to explain the data this month, Washington Mutual said the results reflect a disparity between applicants to its prime-lending unit, who are overwhelmingly white, and its subprime unit. The company said it is working to get more African-Americans to apply for prime loans.
1. The same holds true for Canada as reflected by the results of property market analysis done by Dominion Bond rating Service. Large regional property price decreases in the 20 - 30% range are quite possible, as the data indicate. 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%). Geographic diversification can provide significant benefits in terms of downside protection, since sudden shocks affecting one market do not necessarily affect the others to the same degree (or at all). For example in Canada, Toronto and Montreal were not adversely affected by shocks in the early 1980s but Calgary and Vancouver were. Similarly, in the early 1990s, Toronto was adversely affected but Vancouver's price correction was relatively modest. [Return]
2. The Chief Actuaries Report on Employment Insurance in Canada, 2001, states that "the Commission shall select a rate that it considers will, to the extent possible, (a) ensure that there will be enough revenue over a business cycle to pay for expenditures and (b) maintain relatively stable rate levels throughout the business cycle." The Commission goes on to state that, "the objective of relative premium rate stability over a business cycle will be taken as one of planning to cover the variations in Employment Insurance program costs that occur as a result of fluctuating employment rates," and that "the goal would be the avoidance of abrupt premium rate increases at all times, but especially during a recession." [Return]
3. The state of the macroeconomy is a key driver of the degree of mortgage default risk. Higher interest rates and unemployment rates will influence the level and severity of mortgage insurance claims. The nature of these unhedgeable risks which are typically regionally sensitive is very similar to the nature of the risk covered under mandatory employment insurance. [Return]
4. This Program is a federal program that charges the same premium to all employed people across Canada. There is nothing in the calculation of the premium that refers to the risk associated with any particular region or individual, thus regions and individuals are cross-subsidized by this program. [Return]
5. To be meaningful, the measure of financial balance for an insurance program must cover the entire period the insurance is in force. For short-term insurance contracts, such as fire or flood insurance that usually covers losses for one year, the appropriate comparison is between the premium fixed when the insurance is issued and losses in that year. For long- or indefinite-term insurance, such as mortgage insurance or deposit insurance, expected premiums over the life of the insurance must be compared with the corresponding long-term losses. This is a key characteristic of mortgage insurance. [Return]
8. "The strength of the rise in the ownership rate between 1996 and 2001 in comparison to previous periods suggests that the increase was not solely attributable to the ongoing maturation of baby boomers. It is estimated that the aging of the population accounted for slightly under half of the increase. In other words, if only the age makeup of household maintainers had changed during the period, the national ownership rate would have risen by less than half the actual increase. Widespread increases from 1996 to 2001 in age-specific ownership rates occurred at a time when a range of conditions favoured ownership. Low mortgage rates, strong employment growth and rising disposable incomes brought homeownership within reach of many renters. So, too, did mortgage insurance changes during the 1990s that reduced minimum down payments to as little as five per cent initially for first-time homebuyers and subsequently for all buyers". [CMHC, Canadian Housing Observer 2004, p.22] [Return]
9. Mortgage insurance in Canada is typically a single upfront premium that is financed into the mortgage. The financed mortgage insurance premium only adds $20 to the monthly mortgage payment and has a minimal impact on affordability. [Return]
10. See, for example, Rohe and Stegman (1994), Rohe and Stewart (1996), Rossi and Weber (1996), Green and White (1997), DiPasquale and Glaeser (1999), Aaronson (2000), and Galster et al. (2003). [Return]
11. Alternatively, these households would be forced into the subprime market and would be subject to an interest rate increase of almost 200 basis points. (See Table 2.) This interest rate increase would raise the cost of homeownership constraining household's financial stability and, potentially, the sustainability of homeownership. [Return]
12. Even with mandatory insurance requirement lender may try to find ways to self insure. In the recent historic low rate environment US lenders have been able to offer mortgage packages to top quality borrowers who would otherwise require mortgage insurance. The borrower makes a 10% down payment, takes a first mortgage for 80%, and takes a second mortgage of 10% of the value of the loan. The tax deductibility of mortgage interest payments makes this mortgages package to appear to be a better deal than a conventional mortgage with a 20% down payment, a first mortgage of 80% of the loan value and mortgage insurance. On closer examination we see that the risks the homeowner is taking is significantly different. The second mortgage is typically an interest-only loan. If rates rise the borrower could face substantially greater interest expense. The borrower is also more highly levered. The impact for mortgage insurers is that they are adversely selected.
This adverse selection is also present in the funding side of the US market. The narrow charter for the FHA has allowed the two largest GSEs to expand the scope of their lending activity and take away a key borrower segment from the FHA. Consequently, the overall risk of the FHA portfolio has risen. [Return]
13. There is no reliable source of subprime performance data in Canada. The only publicly available data covers 90 day delinquency rates for Xceed and GMAC. The data are summarized as follows: Canadian Big 5 Banks,.27%; Xceed (Jan.2005),.74%; GMAC Securitization (Oct. 2004),.53% Average FICO of 695 (primarily Alt A loans). [Return]
14. This study also shows that pricing from prime to subprime will not be gradual. There will be significant difference in the mortgage offered to a marginally prime borrower and a marginally subprime borrower. The size of the affected group facing this cliff effect in pricing will grow as market segmentation grows. If, however, there is mandatory mortgage insurance then the degree of market segmentation is lessened as the mandatory mortgage insurance allows for a pooled equilibrium that can include most of the applicants that would otherwise be rejected as this approach allows for greater economies of scale and scope. In Canada a benefit of mandatory mortgage insurance has been a crowding out of the subprime market. [Return]
Dr. Susan Wachter is Richard B. Worley Professor of Financial Management and Professor of Real Estate and Finance at The Wharton School at the University of Pennsylvania. Dr. Wachter served as Assistant Secretary for Policy Development and Research at HUD, a President appointed and Senate confirmed position, from 1998 to 2001, and was senior advisor responsible for national housing and urban policy. The Chairperson of the Wharton Real Estate Department from 1996 to 1998, Dr. Wachter is the author of over 100 publications. Dr. Wachter served as President of the American Real Estate and Urban Economics Association and coeditor of Real Estate Economics, the leading academic real estate journal. Dr. Wachter currently serves on multiple editorial boards, and is the Founder and Director of the Wharton Geospatial Initiative and the Founder and Co-Director of the Penn Institute for Urban Research.
In 2005, Dr. Wachter received the George Bloom Award for Lifetime Achievement from the American Real Estate and Urban Economics Association. Also in 2005, Dr. Wachter was appointed as the Inaugural Holder of Visiting Chair, The Celia Moh Professorial Chair, at Singapore Management University. Current research focus is on mortgage systems and housing markets. Recent published research includes:
"Does the Current System for Resolving Failed Banks Offer a Model for the Resolution of Failed GSEs?" Journal of Financial Stability, 2005.
"Subprime Lending: Neighborhood Patterns over Time." co-authors Jonathan Hershaff and Karl Russo. Promises & Pitfalls - Federal Reserve System's Fourth Communitv Affairs Research Conference. 2005.
"Neighborhood Patterns of Subprime Lending: Evidence from Disparate Cities," co-authors Paul Calem and Jonathan E. Hershaff, Housing Policy Debate. Volume 15 Issue 3, 2005.
"Bank Lending and Real Estate in Asia: Market Optimism and Asset Bubbles," co-authors Winston Koh et al., Journal of Asian Economics, Vol. 15 Issue 6, November-December, 2004.
In 2004 and 2005, Dr. Wachter presented invited testimony to the Senate Banking Committee of the US Congress on US mortgage markets. This and related work was also featured in keynote addresses at both international and national conferences, including programs convened by the US Federal Reserve System in Washington, DC, New York, Atlanta, and Chicago. Dr. Wachter is frequently cited in media worldwide.