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Canadian lessons from Fannie & Freddie

The CMHC controls roughly 70% of the mortgage insurance market covering approximately $519-billion worth of assets

Jesse Kline
April 14, 2011

The Canadian housing market is booming, and some economists fear it could come crashing down. There were warning signs for years about the pending housing crisis in the United States, but they all went unheeded. Canadians now have the chance to start discussing how to prevent a similar situation from occurring north of the border, yet politicians from all parties seem intent on turning a blind eye.

The only mention of housing in the Conservative and Liberal policy platforms is to say how much the parties have spent, or will spend, to support housing. Yet, the collapse of a government-encouraged housing bubble could endanger the country’s precarious financial situation.

Three years after the global financial crisis started, due in large part to troubles in the U.S. housing market, the American government is just now beginning to address the issue of Fannie Mae and Freddie Mac, the government-sponsored enterprises that helped fuel the housing crisis.

By purchasing and insuring risky mortgages, backed by an implicit guarantee from the federal government, Fannie and Freddie created perverse incentives for mortgage originators to give out bad loans. A new study by Anthony Randazzo at the Reason Foundation found that these guarantees always underprice risk, drive mortgage investment into unsafe markets, and inflate housing prices by distorting the allocation of capital — all of which eventually created a U.S. housing bubble that burst in the lead-up to the 2008 financial crisis.

When the bubble burst, the mortgage giants were taken over by the federal government, and have since been suckling on the taxpayer’s teat to the tune of $154 billion and counting. As a result, even the Obama administration has come out in favour of reducing the government’s role in the housing industry.

A similar situation in Canada would put a significant strain on the treasury, because the Canadian government explicitly guarantees a significant portion of outstanding mortgages through the Canada Mortgage and Housing Corporation (CMHC), the crown corporation that insures and securitizes mortgages.

Since the Bank of Canada has been keeping the interest rate artificially low — below what it would be sitting at if the rate were determined by market forces, instead of government bureaucrats — the housing market is on fire and household debt levels are skyrocketing. Finance Minister Jim Flaherty introduced new mortgage regulations that took effect on March 18, which limit the number of mortgage products available to consumers, in order to discourage household borrowing. But the new rules won’t help prevent a housing collapse similar to what happened in the United States.

The Canadian mortgage industry is different than its U.S. counterpart in some key respects. For instance, we have no large-scale sub-prime market similar to that which crashed U.S. housing. Overall, however, Canadian household debt levels are now higher than they are in the United States; and many economists are worried that if house prices continue to rise faster than household income, prices could start falling sharply.

House prices dipped slightly during the recession, but have since rebounded to record high levels. The average price of a Canadian home has doubled since 1999, according to the Canadian Real Estate Association. A similar situation occurred in the United States, where the well-respected Case-Shiller home price index increased 70% between 1999 and 2006.

Since then, the value of American homes has fallen 37%. And according to a recent report from Capital Economics, the Canadian market could face a similar decline of up to 25% in the next few years.

If the market does collapse, Canadian taxpayers potentially could be worse off than their American counterparts because risk is highly concentrated with the Canadian government. The CMHC controls roughly 70% of the mortgage insurance market, covering approximately $519-billion worth of assets.

It guarantees 100% of the loans, and the government of Canada is fully liable for any losses it incurs. (In fact, the government has been forced to bail out the CMHC twice.) On top of this, the government also guarantees 90% of the value of mortgages insured by private companies.

Capital Economics warns that a sharp decline in the housing market could plunge the economy back into recession and result in approximately $10-billion in losses at the CMHC.

Instead of limiting the types of mortgages that consumers have available to them, the government should privatize the CMHC and allow the banks and insurance companies to decide what types of loans they want to give out and how much risk they are willing to take on.

Doing so would not only spread the risk throughout the financial system and protect taxpayers, it would also reduce the likelihood of Canada experiencing a U.S.-style housing crisis.

The guarantees provided by the government give banks an incentive to issue risky loans. A recent survey conducted by the Bank of Montreal found that 18% of Canadians would have trouble meeting their obligations if their mortgage payments increased. In other words, a significant number of people could end up walking away from their mortgages if house prices declined and their rates increased, which is precisely what happened in the United States.

So while the Americans are forced to clean up the mess caused by government intervention in the marketplace after the fact, Canadians have a chance to make substantial reforms before a similar situation develops in their country.



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