In the first half of this year, as the subprime mortgage crisis was exploding in the United States, a contagion of U.S.-style lending practices quietly crossed the border and infected Canada's previously prudent mortgage regime.
New mortgage borrowers signed up for an estimated $56-billion of risky 40-year mortgages, more than half of the total new mortgages approved by banks, trust companies and other lenders during that time, according to banking and insurance sources. Those sources estimated that 10 per cent of the mortgages, worth about $10-billion, were taken out with no money down.
The mushrooming of a Canadian version of subprime mortgages has gone largely unnoticed. The Conservative government finally banned the practice last summer, after repeated warnings from frustrated senior officials and bankers that the country's financial system was being exposed to far too much risk as the housing market weakened.
Just yesterday, Finance Minister Jim Flaherty repeated the mantra that the government acted early to get rid of risky mortgages. What he and Prime Minister Stephen Harper do not explain, however, is that the expansion of zero-down, 40-year mortgages began with measures contained in the first Conservative budget in May of 2006.
At the time, Mr. Flaherty announced that the government was opening up the market to more private insurers.
"These changes will result in greater choice and innovation in the market for mortgage insurance, benefiting consumers and promoting home ownership," Mr. Flaherty said.
The new rules encouraged the entry of U.S. players such as American International Group - the world's largest insurance company - and Triad Guarantee Inc. of Winston-Salem, N.C. Former Triad chief executive officer Mark Tonnesen, who spearheaded his company's aborted push into Canada, said the proliferation of high-risk mortgages could have been mitigated if Ottawa had been more watchful.
"There was a lack of regulation around the expansion of increased risk," he said.
Virtually unavailable in Canada two years ago, high-risk mortgages proliferated in 2007 and early 2008 and must now be shouldered by thousands of consumers at a time when the economy is sinking quickly and real-estate prices are swooning. Long-term mortgages - designed to help newcomers get into the housing market sooner - are the most expensive in terms of interest costs, and least flexible when mortgage-holders cannot meet their payments and need extensions.
The Bank of Canada this week warned that the perilous economy could lead to a doubling of so-called "vulnerable households" - those unable to meet their debts - and perhaps cost thousands of Canadians their homes. The central bank, which is always cautious with its words, said in a report that there is the potential for "a substantial increase in default rates on household debt."
The federal government waited until June of this year to slam the regulatory door on 40-year mortgages. In October, as the global financial crisis erupted, Mr. Harper lauded his government for its "early" response to the mortgage dangers.
"In the U.S., they are still responding to the fallout of the subprime mortgage mess. In Canada, we acted early over the past year," Mr. Harper said in a speech to the Empire Club in Toronto.
He didn't say that, not only did his own government open the sheltered Canadian mortgage market to U.S. insurers, but it also doubled to $200-billion the pool of federal money it would commit to guarantee their business. The foreigners unleashed what one U.S. insurance executive described as a fierce "dogfight for market share" that prompted rivals, including the giant federal agency Canada Mortgage and Housing Corporation, to aggressively push such risky U.S.-style lending.
An investigation by The Globe and Mail found:
AIG's Greensboro, N.C., mortgage subsidiary launched a quiet lobbying campaign in 2004 with senior U.S. executives and a former CMHC official to push open the doors to Canada's mortgage insurance market, where some of the world's highest insurance rates are charged. Two years later, on May 1, 2006, AIG's mortgage insurance division registered with the lobbying commissioner's office. It was the day before the federal budget revealed new players would be allowed into Canada.
Banking and insurance officials were so concerned about the alarming rush to 40-year mortgages at the beginning of 2008 that one bank executive warned the Bank of Canada's chief financial stability officer, Mark Zelmer, in a meeting that "the government has got to put an end to this."
Critics, including former Bank of Canada governor David Dodge, say the lax mortgage policies only further stoked soaring house prices. As for mortgage insurance premiums, industry officials say rates remain virtually unchanged and could potentially rise as troubled U.S. players begin to retreat from Canada.
The story of how the U.S. housing crisis spread to Canada is a tale of carefully orchestrated U.S. corporate lobbying, failed public-policy promises and government inaction to numerous private and public warnings about reckless mortgage practices.
Few of these consequences appear to have been anticipated by either the government or the financial institutions pushing high-risk mortgages on the public.
"Quite honestly I was surprised [the 40-year mortgage]was seized upon so eagerly by the Canadian banks and borrowers," said a U.S. insurance executive who asked not to be named. "You hear all the usual excuses: 'It's a cash-flow management tool, people will pay off their mortgage ahead of time.' But in reality it just becomes a mechanism for borrowing more than you probably should have."
A FOOT IN THE DOOR
How did the staid world of mortgage insurance become the cradle of so much financial risk in the Canadian housing sector? It started almost by accident.
For nearly 40 years after CMHC was founded in 1954, the business of mortgage insurance was about as exciting as an actuarial table. The agency was set up by the federal government as a kind of financial cushion to encourage the country's conservative financial institutions to open their vaults and lend more money to homeowners.
If a home buyer couldn't pony up a 25-per-cent down payment on a house purchase, CMHC shouldered the risk of default by insuring the mortgage and charging the buyer an insurance premium. Backing CMHC's insurance policies was a 100-per-cent federal guarantee. In bad years, Ottawa piped money into CMHC; in good years, the agency added to the federal treasury by paying taxes.
The smooth working system hit a pothole in late 1988 when Canada's only other mortgage insurer at the time, Toronto-based MICC, was nearly wiped out by new international bank capital rules.
The rules threatened to shutter MICC because they effectively made it cheaper for banks to use CMHC's government-guaranteed mortgage insurance.
Faced with the imminent collapse of Canada's only private-sector mortgage insurer, the then Conservative government went to a place that few other industrialized countries have gone by agreeing to guarantee the policies of a non-government mortgage insurer. According to people involved in the crisis, Ottawa "hesitantly" agreed to "taking on an enormous liability" of guaranteeing 90 per cent of MICC's insurance policies.
The government's worst fears about a massive liability materialized in 1995, when MICC's risky insurance bets in the construction sector threatened to torpedo the company. As Ottawa wrestled with the grim prospect of losing the insurer for millions of dollars in mortgages, the world's largest non-bank financial company came knocking with a rescue proposal.
The company was General Electric. The U.S. conglomerate was offering to take over MICC's mortgage insurance portfolio provided Ottawa met one condition: It would bless GE's planned new Canadian mortgage insurance subsidiary with a federal guarantee.
"It was a bit of a slam dunk," recalls one former Ottawa official. "GE was one of the strongest companies in the world."
Ottawa agreed to GE's offer, thereby shifting the federal government's 90-per- cent guarantee from a small Canadian mortgage insurer to a unit of a global giant with aggressive Canadian ambitions. GE's mortgage subsidiary, later spun off and renamed Genworth Mortgage Insurance Co., rapidly carved out a major presence in Canada, capturing about 30 per cent of the market and reporting $205-million of profits in 2005.
Other U.S. insurers took notice.
THE DOOR WIDENS
The days of a CMHC-Genworth duopoly were numbered. In the fall of 2005, a tiny paragraph buried in a 280-page federal government estimate of expenditures signalled a new era of competition in the industry.
The Finance Department's provision was considered so insignificant at the time that many staffers of the minister, Liberal MP Ralph Goodale, didn't recall it when contacted by The Globe. A current spokesman for the Saskatchewan MP insisted that the provision was not designed to open the market to riskier products.
Another federal official who declined to be identified said the wording of the provision was eased because Genworth's name had changed and the government wanted to leave room for additional switches.
Despite these explanations, executives and advisers to a number of U.S. insurers and Canadian players said the paragraph was widely interpreted as a signal that Ottawa was opening the country's mortgage insurance sector to outside competitors.
Intended or not, the shift followed years of mobilizing by U.S. insurance companies, all hungry for a piece of what is regarded as one of the most lucrative and the second-largest mortgage insurance market in the world.
At the forefront of this movement was mammoth AIG, now in near ruins as a result of its role in the U.S. subprime crisis.
U.S. competitors had envied premium rates on Canadian mortgage insurance policies for years. With only two players competing in the space, Triad's Mr. Tonnesen said CMHC and Genworth were so profitable that they were "basically printing money."
Eyeing the rich northern market, representatives from at least three U.S. insurers made regular trips to Ottawa for meetings with the Finance Department and Office of the Superintendent of Financial Institutions, the insurance regulator. But AIG created a strategic advantage by hiring Bill Mulvihill, a Canadian mortgage expert who had spent years as the chief financial officer at CMHC. Mr. Mulvihill, who is still a director of AIG's Canadian operation, declined to comment.
"The difference that Bill Mulvihill made was that he was able to connect into the policy folks with OSFI and at Finance and convince them that we were for real," said a former AIG executive who asked not to be identified.
Following in AIG's footsteps were U.S. insurers such as PMI Group Inc., Triad and the Milwaukee-based Mortgage Guaranty Insurance Company.
Ultimately, Parliament did not vote on the Finance Department's proposal, thanks to the 2006 federal election and the Conservatives' rise to office.
But the U.S. insurers' efforts weren't for naught; the new Harper government quickly embraced the idea of them coming north.
On May 2, 2006, in his first budget, Mr. Flaherty announced that not only would Ottawa guarantee the business of U.S. insurers, it was doubling the guarantee to $200-billion.
Twenty-four hours before Mr. Flaherty's announcement, AIG's mortgage subsidiary first registered with Canada's lobbyist commissioner, according to a federal registry. At the time, companies who spent more than 20 per cent of their time lobbying the government for changes in policy were required, by law, to register. It is not known how much time AIG spent promoting its cause to the government.
In a statement, AIG's Canadian chief executive officer, Andy Charles, said the company began a "preliminary investigation" of Canadian opportunities years ago. He said the company "did not engage in discussions with elected officials until we became aware that our market entry was being debated." Until that point, he said, the companies' "interactions were with the Department of Finance and Office of the Superintendent of Financial Institutions."
The lobbyist AIG hired was John Capobianco, a former aide to various MPPs in the Ontario government of Mike Harris and a defeated candidate for the federal Tories in the 2006 election.
Mr. Capobianco said in an interview he wasn't familiar with any of AIG's negotiations with the federal government before he was retained in May. He was brought aboard to promote AIG's argument that more competition was good for consumers and massage the proposed policy through the finance committees of the House of Commons and Senate.
By the time he was hired, Mr. Capobianco said, "the rubber was on the road."
Lenders step through
Although new U.S. insurers didn't generate any press coverage or public concern from the opposition parties, there was at least one lawmaker who had misgivings.
Garth Turner, the former financial journalist turned politician who has bounced between the Conservative and Liberal parties, urged the finance committee to hold a day of hearings on the new U.S. insurers. He was a Conservative MP at the time, but was wary of his party's proposal.
"We had a fairly stable market at a time when the American market was already starting to go to hell," Mr. Turner said in an interview. "I was quite concerned that mucking around with our mortgage fundamentals would have the potential for chaos."
During a day of hearings, executives from the new U.S. insurers all pledged to make home ownership more affordable for people on the cusp of being approved by a traditional lender. AIG's new Canadian mortgage insurance chief, Mr. Charles, promised to service the neediest - immigrants, the self-employed and those with blemishes on their credit scores - who were mostly ignored by CMHC and Genworth.
Peter Vukanovich, Genworth's Canadian chief, fought to protect his profitable turf during the hearings and warned the government that it hadn't conducted any studies about the threat of disruption posed by new competitors.
Shortly after the hearing, Mr. Turner said he was approached by Mr. Flaherty's parliamentary secretary, Diane Ablonczy, in the House of Commons.
"She came to my desk where I was computing away on my laptop," Mr. Turner said, recalling that she told him to "get onside."
In the end, no one raised a single question about the prospect of 40-year or zero-down mortgages. The bill sailed through the committee - including a vote of support from Mr. Turner.
"At the end of the day I sadly acquiesced," he said, adding that he regrets voting the way he did. "At the time it was politically difficult."
(He has since written and published a book, The Greater Fool, predicting a Canadian real-estate market crash similar to the one in the United States.)
The provision later passed through the Senate committee, but not without one ominous exchange.
Senator Terry Stratton, a Conservative, had a prophetic inquiry about the potential that AIG might engage "higher risk" mortgage insurance practices, "thereby increasing the potential for forfeiture, which would place an additional burden on the federal government."
Mr. Charles, AIG's top executive in Canada, waved off the concerns. "In terms of exposure to the government, the practical likelihood of AIG, an organization with $800-billion in assets, ever coming to the government for anything as it relates to a claim is not nil, but it is as close to nil as it possibly could be."
Two years later, Washington has had to pump $150-billion into AIG after its business was shattered by reckless financial gambles.
A STEP TOO FAR
In February, 2006, as AIG was still trying to establish itself in Canada, CMHC moved to protect its coveted spot and announced a pilot project to insure 30-year mortgages.
For the industry, it was a declaration of war.
Two weeks later, Genworth announced it would do the Crown corporation one better, saying it would insure 35-year mortgages. CMHC matched that with its own 35-year product and raised the stakes by announcing it would insure interest-only loans that effectively required no down payment.
The aggressive new mortgage products alarmed Mr. Dodge, the Bank of Canada governor, who scolded the president of CMHC, Karen Kinsley, in a letter for "very unhelpful" mortgages that he said would inflate prices and ultimately make homes less affordable.
In October, Genworth struck again, announcing Canada's first 40-year mortgage insurance policy. AIG and CMHC later added their own 40-year insurance products.
Industry officials repeatedly said in interviews that they were shocked at the frenzied escalation of risk. "It was fast and furious," said one AIG executive.
Mr. Vukanovich, the head of Genworth, declined repeated interview requests. In a statement, Genworth said it introduced 40-year mortgage insurance policies "as a continuation of global lending practices and trends at that time." The company added the policies were "prudently underwritten and not used to bring unqualified borrowers into the housing market."
In an interview yesterday, CMHC vice-president Pierre Serré repeatedly pointed to the behaviour of his competitors when asked about the agency's riskier products, explaining that CMHC's rivals were the first to introduce the 40-year products.
Asked if he thought that the new U.S. insurers pushed CMHC into riskier policies, Mr. Serré paused. "It' s a tough one for me to answer. In retrospect you can look at all the individual things happening and you can link them together, but it's a hard one to tell.
"We think we've done a prudent job of introducing these products and managing these products," he added, declining to explain how many 40-year and zero-down mortgages the public agency now has on its books. Unlike in the United States, such figures are not made publicly available in Canada.
Two-and-a-half years after Ottawa launched its mortgage insurance initiative, the promise of increased competition has all but died. Three of the entrants, PMI, Triad and Mortgage Guaranty Insurance Co., have retreated. Genworth and AIG are still operating, but, as financial woes mount for their U.S. parents, their future in Canada remains uncertain. Industry sources said most banks have become so cautious in the wake of global financial crisis that they have sharply reduced their use of private insurance in Canada.
The retreat by international insurers means that CMHC's dominant grip on the mortgage insurance market is expanding again, possibly beyond the 70-per-cent market share it enjoyed prior to the arrival of the bigger U.S. competitors.
An adviser to one of the U.S. insurers, who declined to be identified, summed it up this way: "It's a failed experiment."
Prudent mortgage-lending rules have been allowed to slip in Canada in recent years, letting home buyers run much deeper in debt and putting lenders at greater risk.
Household debt is nearly 140% of a year's salary
Residential mortgage credit, outstanding balances of major private institutional lenders, for each August ($ billions)
SOURCES: STATISTICS CANADA, IPSOS REID, AND BANK OF CANADA CALCULATIONS
HOW MUCH INTEREST YOU PAY
Amount you're borrowing after putting down the new minimum 5-per-cent down payment: $250,000
25-year amortization period on an accelerated bi-weekly payment of $$763. Total interest paid: $171,755
40-year amortization* period on an accelerated bi-weekly payment of $639. Total interest paid: $269,915
* To be eliminated
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