The moral hazard machinery

Here is a hypothetical situation: let’s say you work at an office and one of your co-workers, Gary, wants to borrow $10,000.00 from you with an attractive interest rate and will make payments back to you over a period of 2 years. You think he might earn $45,000/year but you are not 100% sure. You have no other information other than he seems to be a good guy. Would you lend Gary $10,000.00?

Probably not. The risk would be too great as you lack key information about Gary’s ability to pay back the loan, you don’t know his credit history and you don’t know what the heck he’s going to do with the money.

Let’s change this hypothetical.  Assume everything else remains the same except that Gary’s boss, Melony, promised you that if Gary failed to pay back the loan, she will step in and pay you the full amount and any outstanding interest. Assume Melony is good for the money and her promise is legally binding. If Gary fails to pay, all you do is fill out some paperwork and abracadabra your money is there. You wouldn’t even have to pay anything for Melony’s promise, Gary would pay her small amount of money for this safety net which protects you.  Would you now lend Gary $10,000.00?

Why on earth would you not lend Gary the money? There is a legally binding contract in place that in the event Gary doesn’t make his payments, Melony will come in and make them. Your risk has been reduced to almost zero. You no longer need to thoroughly examine Gary’s credit, income and ability to pay back the loan.

Would this hypothetical ever happen in real life? To be frank, the whole thing sounds ridiculous.  It is absurd that Melony would promise to pay back a loan for a small fee which is only a fraction of the actual loan amount.  What if Melony made a dozen of promises like this and they all went sour in quick succession? Would she even have the money to pay back all the lenders at once?  

To the shock of many, the above hypothetical happens thousands of times a day involving obscene amounts of money.  Welcome to the bizarre and crazy world of mortgage insurance.

The CMHC

Melony is known as the Canadian Mortgage and Housing Corporation (CMHC). The CMHC is a federal government Crown corporation created in 1945 under the National Housing Act. Its original purpose was to help returning war veterans by reducing the cost of mortgage loans. Later, the CHMC got into the business of building social housing.  In 1986, coincidentally the same year when prices took off in the Toronto, the CMHC introduced the Mortgage Backed Securities (MBS) and dove head first into insuring mortgage loans for everyday people.

So what is mortgage insurance? A borrower will pay for an insurance policy that benefits the lender in the event that the borrower cannot make the mortgage payments.  According to the CMHC website: “[b]y protecting lenders against borrower default, CMHC Mortgage Loan Insurance creates an opportunity for Canadians to realize their dreams of homeownership.”  

The idea seems nice and lofty on paper. Everyone should own a home just like everyone should be a parent (sarcasm). Lenders are too poor to lend out money to needy home buyers unless there is a guarantee they could get their money back if something went wrong.  Wait, what?

Why would a bank that makes billions of dollars, in profit, every 90 days need an insurance policy? Banks make mega bucks, yet they require a tax payer bail out if something goes wrong? When was the last time you had insurance policy on money you lent to a friend, relative, or even a business?

The moral hazard

A moral hazard can easily be described as a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.

Using the example at the beginning of this blog post, if you were to make the loan to Gary you would want to verify his income, ensure he could pay back the loan and also figure out what he wanted to do with money. It’s to reduce the chances of you making a loan that won’t be repaid.

Using the second example, if Melony would cover you if something went wrong, do you really need to make the same inquiries? Likely not. There is a legally binding contract in place that if the loan was not repaid Melony would come to the rescue and make all remaining payments to you. Sure, you’ll do a cursory check of Gary, but you likely won’t do much more than that. You won’t call his human resources department to verify his income, you won’t ask him to produce his recent bank statements, you won’t check his tax returns, and you won’t check his credit score. It just doesn’t make sense, it costs money and time, and why bother if your risk is already reduced to almost zero.

Lenders, hence, have been making risky loans knowing full well that in the event of a default, they are off the hook. If this insurance policy did not exist, I can assure you that many of loans made in the last 10 years would have never been approved or the interest rate would have been much higher to reflect the true risk.  

Perhaps the CMHC should change its name to “The Canadian Moral Hazard Corporation”.

Can I still acquire a property using no money down and have the mortgage insured?

I sure hope not because that would mean that there are people out there who have insured mortgages while putting none of their own money down. If the borrower defaulted for whatever reason and the property was sold off for less than the mortgage, you, me and your dog are on the hook for the difference.  Let’s see what the CMHC says about this:

“Normally, the minimum down payment comes from your own resources. However, a gift of a down payment from an immediate relative is acceptable for dwellings of 1 to 4 units. For eligible borrowers, additional sources of down payment, such as lender incentives and borrowed funds, are also permitted. Check with your lender for qualifying criteria and availability.”  

Uh oh!

Borrowed funds are permitted? Yes, the rumours are true. You can still buy a home with no money down and have it insured by the Canadian tax payer. You might as well put the down payment on those condos using a credit card so you can collect the travel points and score a nice Caribbean vacation. 

What about non-insured mortgages? I don’t know about you, but if anyone had the chutzpah to lend 100% of the purchase price, all the power to him or her! All joking aside, I thought Canada was highly regulated and we did not follow the same path as our friends down south with 100% financing since it created a disaster of biblical proportions, right? 

Does the CMHC require an appraisal on the property before the insurance policy is issued?

In a world without mortgage insurance, a property appraisal is almost always required by lenders before any mortgage is approved.  A property appraisal is simply an evaluation of the market value of a property.  A lender typically would want to ensure that any mortgage is not in excess of the value because if it was and the loan were to go bad, the lender would not be able to recoup its money.

Appraisals, although imperfect, provide some base line of confidence before huge sums of money are transferred.

Unfortunately, I was unable to figure out one way or another if CMHC requires a property appraisal before a CMHC insurance policy was issued.  Therefore, I went to a local bank and set up an appointment with a "mortgage specialist". Thankfully this meeting was with the bank manager as the employee I was supposed to meet with called in sick that day.  We can, then, have high confidence in the information this bank manager conveyed to me.

This bank manager was very clear that no property appraisal was required if the property was purchased "in or around the listing price."  As you might imagine, I was quite perplexed by this answer as listing price has nothing to do with what the property is truly worth.  I followed up with "even if the same house across the street sold for $400k less just three months earlier, as long as I pay close to what the seller listed it, there is no problem?" The answer was a firm "yes, no appraisal needed".

Well that's comforting; we provide mortgage insurance on homes with no appraisals.

But if a lender had no insurance, an appraisal would be 100% mandatory.  Moral hazard on steroids.

What happens to all these insured mortgages?

Most people believe that their lending institution holds onto to their mortgage. It certainly isn’t a crazy idea, you pay your mortgage monthly to the lending institution that issued it, right? Hold that thought.

Let’s talk food.

Burrito theory

Burritos are delicious and you will likely find me in a burrito shop at least twice a week chowing down on such a fine delicacy. Burritos can be made in thousands of different combinations and some places have more than one guacamole option. Although the shell of burrito looks the same, the insides can be very different from one burrito to another.

Let’s say you are at a burrito place on a very busy day.  You place your order and have to wait 15 minutes as everything seems to be in chaos.  You finally make it to the front counter and there are 10 wrapped burritos sitting there with no markings on the label, would you be able to tell which one was yours? Likely not unless you open them up and take a bite, but even then you may not get all the ingredients in the first bite. You would have to literally open up the burrito to see what's inside.

This is how mortgage pooling works - a whole bunch of mortgages are put together in a “mortgage pool” similar to putting in a whole bunch of ingredients and sauces into a burrito.  No one knows exactly what went into these pools. Do the borrowers all have good credit? Bad credit? No credit? What is their income situation? Who provided the down payment? Was the down payment borrowed? No one knows and the paper trail may be prohibitively expensive to figure it out, if it even exists at all. They are all mystery burritos and no one knows if they have been tainted with a something toxic.

After these mortgages are pooled together (burritos are packaged up), they are then sold off to investors as Mortgage Backed Securities and given a AAA credit rating as they are backed by the CMHC which is backed by Le Gouvernement du Canada (you, me and your dog). 

Mortgages that are not insured are also pooled together in a similar fashion and sold as "covered bonds" to investors overseas who likely have little idea what they are investing in. Here is a link of one of the Big Banks doing this very thing in case you are skeptical of what’s written in this blog. [Skepticism is always welcome at this blog!]

When you pay your mortgage, you are really paying your money to hundreds or thousands of investors all over the world.

Let's recap as I'm sure I lost of a few of you at this point: mortgages are pooled together just like a whole a bunch of different ingredients would go into a burrito. The pools are then diced up into Mortgage Backed Securities and sold off to the highest bidder. No one really knows what kind of borrowers go into each of these mortgage pools and the investors who buy these securities have little idea as well. All Mortgage Backed Securities are backstopped by the Government of Canada, except for uninsured mortgages.

At this point, you're likely thinking to yourself "this sounds quite familiar to the premise in the movie The Big Short."  Our system shares many similarities with our friends down south.  We may use different words to label them and we may put out fancier brochures to sell them, but if it looks like a duck, walks like a duck, acts a like a duck and quacks like a duck, it's a bloody duck!
 
Does the CMHC check up on the lenders to ensure they are following all the rules when processing mortgage applications?

One of the most fundamental questions is whether the CMHC conducts any audits of lenders who utilize mortgage insurance. You know, to make sure lenders are legitimately inquiring about people’s incomes, debts and ability to re-pay the mortgage so we are not on the hook if the loans go bad.

According to the CMHC’s recent 286-page circular on securitization, there does not appear to be any audit mechanism whereby the CMHC would scrutinize loan applications. All verifications are left with the lending institution, the same people who could care less if the borrower defaulted or not.  I contacted the CMHC on your behalf two months ago, before I started this blog, and I have not received a response to this very question.  I would imagine the answer would not add any confidence.

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They say the road to financial hell is paved with good intentions – it was unfortunately insured by all Canadian tax payers instead of the uber-rich lenders who made the loans.

As you can see, moral hazards are firmly built into our mortgage finance system. The system itself encourages risky lending because there are no consequences for the results of a bad loan. Lenders can lend to whomever and get paid regardless.

What could possibly go wrong in a system that encourages risky lending while protecting those lenders who fail to do any meaningful due diligence?  Has this happened before in other countries? Take a wild guess what the expected consequences are.