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Canada Mortgage and Housing Corp. (CMHC), the government agency that insures residential mortgages for buyers with less than a 20-per-cent down payment, is a dramatically different animal than it was just a few years ago.

Changes in mortgage insurance rules and a significant reduction in their bulk insurance program (used widely by Canadian lenders to insure conventional loans for the purpose of securitization) have led to CMHC's total insurance in force declining from a peak of $570-billion in 2012 to $546-billion in its latest quarter. This is a far cry from CMHC's 11.6-per-cent compound annual growth rate in insurance in force going back to 1990.

Meanwhile, CMHC has recently abandoned some of its more questionable programs, including offering insurance on construction loans to condo developers. I wrote about this program in an op-ed in early 2014:

These changes should be welcome news to taxpayers, who ultimately bear the risk of default on these mortgages should a housing correction render CMHC insolvent. And as an aside, taxpayers also indirectly backstop the "private" mortgage insurers such as Genworth Canada and Canada Guaranty, as in the event of their insolvency the government has agreed to pay future claims on their insurance policies at 90 cents on the dollar. In the last major housing downturn in the 1990s, this scenario played out when Mortgage Insurance Co. of Canada (MICC) was rendered insolvent. Collectively, these private insurers have a total insurance cap of $350-billion.

Yet in spite of these welcome changes, mortgage insurance still creates some odd distortions and, arguably, a big case of moral hazard.

This was driven home this week when I hosted clients in Montreal for a day of meetings with realtors and mortgage brokers where it was learned, among other things, that lenders were tightening guidelines on condo purchases in the city.

This is an entirely rational thing for a lender to do in response to a condo market that has seen MLS inventory rise 44 per cent and sales decline 30 per cent since 2012, consequently leading to the largest ever yearly decline in Montreal's Teranet House Price Index in February. Clearly, there is more risk in that market and any prudent lender would want to limit their exposure to this risk.

But here's the catch: The tightening has only applied to uninsured mortgages where buyers put more than 20 per cent down. A year ago, such buyers could purchase with the minimum 20 per cent down, but today, some lenders want 25 per cent down to protect from softening prices.

Note that banks have not changed lending standards on insured mortgages. And why would they? After all, it's not the lenders themselves who bear the risk on an insured mortgage.

Picture this scenario: A young couple have diligently saved a 20-per-cent down payment on a condo they'd like to purchase in Montreal. They walk into a bank branch and ask for a mortgage, only to be told that they would have to put 25 per cent down since their mortgage wouldn't qualify for insurance and the lender is not comfortable with the risk involved. But if that same couple opted to put just 5 per cent down, which would qualify them for mortgage insurance, they could be approved with no problems and could even qualify for a 5-per-cent cash-back mortgage to boot. Perverse? Absolutely. Moral hazard? Arguably.

Consumers understand that if they make a claim on an insurance policy, they will need to pay a deductible. This is a practice implemented by the insurance industry to discourage risky behaviour and force people to have a bit of "skin in the game." Yet in the mortgage insurance world in Canada, lenders do not pay deductibles on claims made when a mortgage goes delinquent.

The solution here is pretty simple in theory (though I recognize the complications it raises for non-balance-sheet lenders such as monolines): If lenders were forced to pay a small deductible on claims, such that they were in first loss position, they would naturally have to apply the same risk management practices on insured loans as they do on their uninsured mortgages. This would go a long way in aligning the best interests of the lenders with those of the taxpayers who ultimately backstop those guarantees.

Ben Rabidoux is president of North Cove Advisors, a market research firm covering Canadian housing, macro and credit trends for institutional investors.

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