It's difficult to imagine our banks begging the feds to make it tougher for them to lend money to clients. But this is precisely what Canada's Big Five banks did when they petitioned Ottawa to impose stricter mortgage-lending standards.
The petition came as we learned that the average price of existing homes in Canada had been on a tear, rising 19 per cent in the past year and leading many observers to believe an asset bubble was forming in the Canadian housing market.
The current rules allow Canadians to take out a mortgage to buy a home with little money down - as low as 5 per cent of the property's value - and to spread their payments over a long amortization period (as much as 35 years). The banks' main concern was that, under these rules, families of lesser means were being lured into the home-ownership game by the artificially low interest rates maintained by the Bank of Canada to keep the economy going.
In the current interest-rate environment, the Big Five argued, it might be easy to take out a variable-rate mortgage to buy a house. But when rates go up, as they inevitably will, many families entering the market today when rates are low won't be able to afford their mortgages, and we will end up with a real-estate market crisis of our own making.
If raising lending standards made so much sense, why wouldn't the Big Five raise them on their own instead of asking Ottawa to beef up the rules? The reason is simple.
The Big Five, as it turns out, aren't the only game in town. A unilateral move on their part, as beneficial as it might have been for the system, might have backfired by allowing their more venturesome competitors to fill the void and gain market share at the Big Five's expense.
One wonders why other players in the mortgage-lending market might not share the same risk concerns as the Big Five. There's a simple answer to that question, too.
In Canada, more risky mortgages (those with a down payment of less than 20 per cent) are insured by the Canada Mortgage and Housing Corp., whose chief mandate is to "promote" home ownership. As long as CMHC is willing to "insure" the mortgages, there's no stopping less picky lenders from lending. Essentially, CMHC provides a back door through which low-quality mortgages can creep into the system. And if something goes wrong and CMHC can't absorb the losses, who will have to foot the bill? You guessed it: We will.
As long as CMHC is configured this way, the system remains vulnerable to the games the few are willing to play at the expense of the many. This explains why the Big Five insisted Ottawa handcuff the entire industry with tougher rules.
How did Ottawa respond? In typical fashion, Finance Minister Jim Flaherty agreed to meet the Big Five partway. Effective April 16, borrowers applying for a variable mortgage will have to qualify for a three- to five-year fixed-term mortgage rate. The minimum down payment for an investment property will increase from 5 per cent to 20 per cent. And the ceiling for home-equity loans will be reduced from 95 per cent to 90 per cent of the home's market value.
These are all positive changes that will reduce the leverage in the system and make it safer, but Ottawa could have gone further. Reducing the maximum amortization period from 35 years to 30 would have been a smart move, and raising the minimum down payment from 5 per cent to 10 per cent would have made a great deal of sense.
So why didn't Ottawa go all the way? Probably because it feared that cooling down the real-estate market might undermine the fragile state of the economy. The real problem, though, is that Canadians are already overly committed financially, so they need all the "help" they can get from Ottawa. According to Statistics Canada, consumer credit and mortgage liabilities have risen from 77 per cent in 1990 to 132 per cent of our collective personal disposable income. Debt is addictive; we have to reduce it to weather the storm ahead.
Two threats loom.
First, although we've enjoyed a pretty good run in the housing market over the past 30 years or so, there's no guarantee home-ownership will pay off as handsomely for the next generation entering the market today. Recent experience in the U.S. and Europe, especially Ireland, tells us the forces of gravity are as potent in the residential real-estate market as they are in the physical world: House prices do go down. Increasing the minimum down payment or reducing the maximum amortization period on a mortgage would go a long way toward mitigating the risks.
Second, when central banks start tightening monetary policy to mop up excess liquidity and stave off inflationary expectations and when capital markets start pushing back against massive government deficit funding and corporate debt rollovers, interest rates will have nowhere to go but up. So we can bet that mortgage servicing costs will also go up.
The best way to prepare is to pay our debt, not go further into it. In these uncertain times, leverage is out and deleveraging is in. We might just need an extra nudge from Ottawa to set us on the right course.
Louis Gagnon is a finance professor at Queen's School of Business and a former senior manager in risk management at the Royal Bank of Canada.