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Canadian Institute of Mortgage Brokers and Lenders Submission in Response to Finance Canada's 2006 Review of Financial Sector Legislation:

June 3, 2005

Mr. Gerry Salembier
Director, Financial Institutions Division
Financial Sector Policy Branch
Department of Finance
L'Esplanade Laurier
20th Floor, East Tower
140 O'Connor Street
Ottawa, Canada
K1A 0G5

Dear Mr. Salembier:

We are writing on behalf of the members of the Canadian Institute of Mortgage Brokers and Lenders (CIMBL) in response to an invitation to comment from the Department of Finance contained in Annex 6 of the February 2005 Federal Budget.

We have attached CIMBL's comments on the issue of the current regulatory requirement that mortgage loans from financial institutions must be insured when the mortgage loan is for an amount exceeding 75% of the value of the property.

CIMBL believes that it is important for the government to note that Canada has had a long history of promoting home ownership, and mortgage insurance has played a significant role in allowing higher risk borrowers to get access to low interest rate mortgages. In 1992, just 20% of the dollar value of mortgage loans from chartered banks was insured. By 2004 this had risen to 47%, reflecting the increased willingness of borrowers to incur, and lenders to finance higher leverage through insured high LTV mortgages.

CIMBL recommends that policy makers working on the mortgage insurance issue in Annex 6 be very careful before changes are made to a system that has provided Canadians with a high level of home ownership while maintaining a strong financial system. Mortgage insurance is an integral part of the housing market and removing the requirement for mortgage insurance may have unintended adverse consequences such as higher costs for low and moderate income Canadians. The onus is on policy makers to ensure that any policy changes lead to net positive outcomes and continued financial stability.

We appreciate this opportunity to provide you with our comments. We would be pleased to supply you with any additional background information which you might require on this matter.

CIMBL has no objection to Finance posting this submission on the Finance Canada Web site. If you wish to contact us, our preference is that be in English and French via email.

Sincerely,

finance - image

Michael Ellenzweig, AMP
Executive Director
director@cimbl.ca
416-385-2333 ext 26

finance - image

Mark Webb
Senior Director Professional Affairs, CIMBL
mwebb@cimbl.ca
416-385-2333 ext 27

Comments From The Canadian Institute Of Mortgage Brokers And Lenders With Respect To Removing The Statutory Restriction On Residential Mortgages Exceeding 75% Of The Value Of The Property.

Background

As part of its annual budget, delivered in February 2005, the Government of Canada, through the Department of Finance began a process to review Canadian financial institutions and the Canadian financial service sector. Sunset clauses in the Bank Act, Insurance Companies Act, Trust and Loan Companies Act, and Co-operative Credit Associations Act provide for an automatic five (5) year review of the parent legislation. The Government states "this is a practice that sets Canada apart from virtually every other country in the world providing an important advantage to Canadian financial institutions relative to their foreign competitors".

In Annex 6 to the Budget 2005 - Budget Plan, the Government indicates that the requirement to have insurance in every case in which a mortgage exceeds 75% of the value of the property may have increased the cost of home ownership for some Canadians. Annex 6 then goes on to state that "The government is seeking views on providing more flexibility to residential mortgage lenders and home buyers by removing the statutory restriction on residential mortgages exceeding 75% of the value of the property".

This Paper is the response from the Canadian Institute of Mortgage Brokers and Lenders to the request for comments on the matter of mortgage insurance.

Who We Are

The Canadian Institute of Mortgage Brokers and Lenders (CIMBL) is a national organization representing Canada's mortgage industry. With over 7,200 mortgage professionals, its membership is drawn from every province and from all industry sectors, including mortgage brokers, mortgage lenders, and mortgage insurers. Its members include the major banks and lending institutions, both mortgage insurers, and all of the major mortgage brokers. In total, CIMBL has more than 700 corporate members. This diversified membership enables CIMBL to bring together key players from all sectors with the aim of enhancing professionalism in Canada's mortgage industry through the enforcement of a Code of Ethics, development of Best Practices, promotion of harmonized educational standards, distribution of informative mortgage publications and improved public profile. CIMBL is the largest member-based mortgage industry organization in Canada.

Issues Impacting the Policy of Requiring Mortgage Insurance on High LTV Mortgages

We have attempted to identify some key issues that should be carefully considered before any changes are made to the current policy of requiring mortgage insurance on high loan-to-value mortgages.

1. Mortgage Market and Mortgage Insurance

Mortgage originations have enjoyed successive record years, growing from $90 billion in 2000 to over $130 billion in 2004. This growth has been fueled by low interest rates, strong housing affordability and continued housing appreciation. Mortgage insurance has played an integral part in this expansion with the proportion of insured mortgages rising from 20% in 1992 to approximately 47% in 2004.

As noted by the Bank of Canada in the Financial System Review (June 2004), "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." Mortgage insurance covers the risk of mortgage default associated with high loan-to-value mortgages, thereby making homeownership available sooner to first-time homebuyers.

As evidenced by increased rate discounting, the level of competition in the mortgage industry has increased dramatically over the past 10 years. Mortgage originators possess the skills and knowledge to analyze the various products offered by the competing financial institutions in order to find the consumer the best product at the lowest price to suit their needs.

Mortgage insurance has been key to increasing and sustaining competition by leveling the playing field for smaller lenders. Small lenders are able to use mortgage insurance to mitigate the risks associated with high loan-to-value lending and are therefore able to compete effectively. Also, mortgage insurance provides the necessary credit enhancement to provide access to secondary market funding through securitization or whole loan sales to pension funds or other financial institutions.

There are two segments in the Canadian mortgage market – conforming loans and non-conforming loans. Conforming loans for prime borrowers represents 90 to 95 percent of the market and is served by traditional lenders such as banks, credit unions, caisse populaires and other mortgage lenders. Conforming loans qualify for mortgage insurance.

The non-conforming segment is between 5 and 10 percent of annual mortgage originations. Often referred to as sub-prime lending, non-conforming loans are typically funded by non-regulated, often foreign, financial institutions or by private investors. In some circumstances, a federally regulated financial institution may provide a first mortgage for up to 75% of the property value with a private individual providing a second mortgage at a much higher interest rate.

Since mortgage insurance is currently not available on sub-prime loans, regulated financial institutions cannot directly compete in the market for mortgages that exceed 75% loan to value ratio. In recent years, there have been several new entrants in the sub-prime market which have increased the choice available for borrowers. Careful consideration must be given to the consequences on the larger conforming loan market of change to the requirement for mortgage insurance on high loan-to-value mortgages.

2. Pooling versus Social Equity

Like all forms of insurance, there is the pooling of risks with mortgage insurance. The current insurance model pools risk by placing all borrowers in a pool based on the loan to value ratio. On the surface, it may appear that some individuals who, based on the strength of their own individual credit worthiness, may not require insurance on high loan to value mortgages, except for the fact that it is mandated by regulation. The potential savings for these lower risk borrowers will be reduced if:

  • Risk premiums are added to compensate for the increased volatility of an individual lender's smaller, less diverse pool of borrowers.
  • Market pricing inefficiencies result in lenders increasing their margins over and above that necessary to cover the inherent risk of low risk borrowers.

This pooling means that the mortgage insurance premiums reflect the blended risk in the pool, so the lower risk borrowers pay a higher premium than they would under individual risk based pricing and the higher risk borrowers pay a lower premium than they would under individual risk based pricing. If mortgage insurance were not required, it is possible that lenders might not require lower risk borrowers to purchase mortgage insurance, which would provide a cost saving to these borrowers. From a public policy perspective, it is interesting to estimate the proportion of Canadians who would pay less and who would pay more under individual risk based pricing.  Data from Clayton Research Associates indicates that only about 40% of the high LTV borrowers would benefit from lower premiums under risk based pricing while the remaining 60%, would have to pay higher premiums.   The borrowers who would have to pay higher premiums would generally be those borrowers least able to pay the higher premium.

Pooling has allowed the mortgage insurers to expand their underwriting guidelines to include more borrowers - for example, borrowers with marginal credit profiles, self-employed borrowers with limited income verification, and borrowers with borrowed down payments or cashback equity. Pooling is also good for communities whose general property values are perceived to be at a higher risk by financial institutions, e.g. small towns and northern communities. Pooling also facilitates the underwriting of less traditional forms of housing like manufactured homes.

This results in a pool that contains borrowers with a wide range of credit scores from urban and rural areas coast to coast. This pooling helps to keep rates down for those individuals whose mortgages are considered to be riskier, and allows broader access to inexpensive mortgage financing. The ready access to mortgage financing promotes home ownership among the middle and working class and allows individuals within those classes to take advantage of appreciating property values, thereby improving their net worth.

Lower risk borrowers may benefit if lenders were allowed to self-insure. Lenders would be free to segment the market by credit quality and price the risk of each segment accordingly. Although this system of risk based pricing may result in savings for lower risk borrowers, it is important to note that high loan-to-value mortgages have a higher inherent risk than mortgages with 25 percent or more equity. Lenders are still likely to incur a loss if a high loan-to-value mortgage with a lower risk borrower defaults as a result of job loss, temporary illness or marital break-up. These risks are random and not predictable based on the borrower quality. As a result, lower risk borrowers (approximately one-third of all borrowers) will likely pay fees and a higher interest rate.

If the benefit from the broad pooling of risk provided by the insurers were removed, there is the potential that fewer Canadians would be able to become homeowners. Removing the low risk borrowers and properties from the pool will result in higher mortgage insurance premiums for moderate and higher risk borrowers (approximately, two thirds of all borrowers, according to research data from Clayton Research) as well as those who live in small towns and rural areas or those who wish to purchase less traditional types of housing. This would have a negative impact on the economy if the effect of the narrower access to mortgage funding led to a decrease in activity in the housing sector that was not counterbalanced by the potential increase in expenditures from those who would benefit financially if the insurance requirement were removed.

3. Leaving the Mortgage Insurance Decision to Market Forces versus Protecting Deposits

Lenders currently manage their own credit risk on a wide range of products without being subject to specific legislative rules like the 75% loan to value (LTV) standard for mortgage insurance. This competition allows the most efficient organizations to offer the best prices to the largest number of people and make the most profit for their shareholders. It can be argued that lending institutions should be left to manage their mortgage business the same way they manage credit cards, car loans, commercial loans and other types of loans where they are free to assess credit risks and price the loans to correspond to the risks. If the market functions properly, the result should be that a borrower would only be required to get insurance when the risk warrants, and the interest rate should reflect the risks of the borrower and the property. This should yield the lowest overall costs for consumers.

In order for a competitive market to yield its benefits, mortgage lenders would have to be able to properly assess credit risk and require mortgage insurance where warranted and price correctly to account for the risk of the borrower and property. In order to do this, mortgage lenders would need a geographically dispersed national portfolio, access to performance data on high loan-to-value loans, and sophisticated risk management systems. Today, not all lenders have these capabilities. It is true that the larger lenders have considerable experience in risk assessment across a broad range of financial products and they have the ability to put in place risk assessment tools for mortgages, but it is not certain that the quality of their assessments will be as advanced as those of CMHC and Genworth. The two insurers have the advantage of many years of specialized experience in assessing mortgage loan default risk, and have experienced multiple real estate cycles. As a result, they have access to sizable long term data on mortgage defaults. If larger lenders were concerned that they might not be able to match the expertise of the current mortgage insurers, a natural response would be for them to charge additional fees or increase interest rates in order to compensate for the additional risk.  This would have the effect of decreasing any potential savings that might accrue to the lower risk borrowers.  This, coupled with the increased costs that high risk borrowers would face in a competitive market could result in net higher overall costs to the borrowing public.

As the size of the lender decreases, the ability of the lender to match the expertise of the current insurers will probably decrease because they will not be able to invest as much in risk assessment tools, and their loss experience will be based on a smaller sample size that is less geographically diversified. This would require smaller lenders to charge higher rates, or purchase insurance to compensate for the higher risk, which would decrease their ability to compete with lenders which are capable of self insuring.  If the benefits of broad pooling of risks were not available to smaller lenders, consumers could be faced with higher mortgage costs and reduced competition for mortgages, making it more difficult to access mortgage financing. Therefore, the removal of the requirement to insure high loan-to-value loans may change the competitive dynamics in the mortgage industry and diminish consumer choice.

Mortgages are an important product for lenders and they constitute a significant proportion of the banks' assets. If left to the market, it is possible that some lenders, in attempts to gain a competitive advantage, might be overly aggressive in removing their requirements for mortgage insurance. This could result in a domino effect if other lenders followed suit in order to remain competitive. If this occurred, the financial system would be left at a higher risk unless the regulators increased their oversight of the quality of the lenders' mortgage portfolios.

The availability of mortgage insurance for loans beyond 75% of the property value allows for the public policy good of promoting home ownership as broadly as possible, while at the same time promoting the safety and soundness of financial institutions.

4. Risk versus Premium Levels

As a result of favorable economic climate, both insurers have reported large profits. This raises the question as to whether high LTV borrowers are being forced to purchase mortgage insurance at a price that is higher than needed to cover a very low level of default risk.

Critics of the amount of mortgage insurance premiums must keep in mind that the premiums recognize the long duration of the risk exposure of the insurers. Economies are cyclical, so mortgage insurers must create financial reserves in prosperous times, to fund payouts when the economies weaken and mortgage defaults rise dramatically. The current economy and housing market is strong, with low interest rates and rising property values but economic conditions can change in unpredictable ways. If interest rates spike up and the economy slows, some individuals will not be able to carry their mortgages and defaults will rise.

Canada has experienced periods when mortgage defaults rose and mortgage insurers made substantial payouts. For example, between 1995 and 2000, CMHC had net claims of over $2 billion dollars. Between 1979 and 1981 they had net claims of $1.4 billion. Accumulating mortgage insurance surpluses during times when the economy is strong and defaults are low allows the insurers to provide payouts during periods when defaults rise, without the need to raise premiums during the downturns.

The insurance cost to borrowers is modest. Mortgage insurers have reduced premiums by 30% in the last two years in response to the favorable economic environment. A borrower who puts down 20% and has a mortgage of $200,000 pays a premium of 1%, or $2,000. Adding this premium to the mortgage (assume 25 year amortization, 5 year fixed at 5%) would increase the monthly payment by $11.63/month, or $139.56 per year. The highest premium is 2.75% for those with 5% down. On a $200,000 mortgage, the premium would be $5,500 and would increase the monthly mortgage payment by $31.99/month. These increases in monthly payment to cover the insurance are very modest amounts, particularly if the insurance makes it possible for a borrower to own a home.

It should also be noted that both insurers run loss mitigation programs to help borrowers keep their homes when they are faced with a financial setback, which furthers the policy goal of encouraging home ownership.

Conclusion

Canada has had a long history of promoting home ownership, and mortgage insurance has played a significant role in allowing higher risk borrowers to get access to low interest rate mortgages. In 1992, just 20% of the dollar value of mortgage loans from chartered banks was insured. By 2004 this had risen to 47%, reflecting the increased willingness of borrowers to incur, and lenders to finance higher leverage through insured high LTV mortgages.

CIMBL recommends that policy makers working on the mortgage insurance issue in Annex 6 be very careful before changes are made to a system that has provided Canadians with a high level of home ownership while maintaining a strong financial system. Mortgage insurance is an integral part of the housing market and removing the requirement for mortgage insurance may have unintended adverse consequences such as higher costs for low and moderate income Canadians. The onus is on policy makers to ensure that any policy changes lead to net positive outcomes and continued financial stability.

CIMBL appreciates this opportunity to provide you with our comments. We would be pleased to participate in any further discussions that you might wish to have on this issue.