CCPA misses the boat: Huge jump in low ratio insurance during GFC hints at REAL bailout

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1 Good Morning, CMHC cheap, bulk portfolio insurance provided a mechanism that allowed banks to roll risky low ratio loans to Canadian taxpayers. Knowing the risky loan securitization "eject" button was always available bank lending guidelines eased significantly over the past few years. As such, house prices went vertical. However, in the past few months the credit easing cycle came to an abrupt halt. This has largely gone unrecognized by analysts and investors as of now, however, mortgage brokers on the street tell a story of 'overnight' credit tightening with applications being increasingly rejected by big banks, forcing borrowers to credit unions and alternative lenders. Detailed in this note is what we believe is an explicit bank "bailout" during the GFC that strengthened bank balance sheets and enabled them to dodge the crisis while still providing significant liquidity through rapid securitization to the mortgage market. In addition, we see the jump in bulk portfolio insurance in late 2011, which involved insuring a disproportionate volume of low ratio mortgages originated in BC (Vancouver) and Ontario (Toronto), as a confirmation that banks are getting nervous about the prospects of a major correction in these areas. With CMHC holding $567B in insurance in force against a $600B parliamentary cap, and with political scrutiny of CMHC practices currently high and rising, that party is now over. Banks no longer have the capacity to easily shore up their balance sheets by transferring risk to the Canadian taxpayer. As such, lending has tightened significantly most notably at the mortgage broker level. When the next shock to the system hits, the CMHC wrapper for any and all loans simply won't be there. In addition, I strongly suspect that this practice will increase public scrutiny of CMHC once it is widely understood by Canadians. It raises political risks to the banks via increased scrutiny of CMHC. All tolled, as of this point, this is a credit tightening and negative earnings story. That's until house prices respond negatively and credit deteriorates and then it becomes a loss story. Mark Hanson The Secret Canadian Bank Bailout Ben Rabidoux CCPA misses the boat: Huge jump in low ratio insurance during GFC hints at REAL bailout The Canadian Centre for Policy Alternatives (CCPA) made quite a stir two weeks ago when they released a report detailing a secret Canadian bank bailout. The report focused on three programs used to support Canadian banks during the GFC- primarily the $69B Insured Mortgage Purchase Program (IMPP) initiated by the Canadian government as a liquidity measure. While the report was quick to label the IMPP a bailout, the reality is that this presented a zero net increase in taxpayer liabilities as these mortgages were already insured by CMHC. The 2011 CMHC annual report reveals what appears to be a true bank bailout that I expect will rightfully infuriate Canadian taxpayers once they

2 understand the implications. As can be seen below, CMHC bulk portfolio insurance for low ratio mortgages ballooned in 2008 and 2009 during the GFC and then again in late Bulk portfolio insurance is purchased by the banks themselves and used to insure low ratio mortgages (less than 80% LTV) which are not required to be insured at origination. Before discussing the implications, let s first get a sense of the magnitude of the jump in low ratio mortgages in these three years. CMHC has been in the mortgage insurance business since In 57 years leading up to 2012, CMHC had accrued $567B in insurance in force, $243B of which was low ratio insurance purchased by the banks themselves. Fully 54% of all low ratio mortgage insurance was purchased in these three years alone, while that total increase in low ratio mortgage insurance amounted to 23% of all insurance in force held by CMHC. This is truly a staggering jump. The REAL bailout: The story told in this data is that during the financial crisis when it was suddenly plausible for home values to fall sharply and the banks to take large hits on their uninsured mortgages, CMHC allowed Canadian banks to transfer the risk on over $90B of previously uninsured mortgages from their balance sheets on to Canadian taxpayers. This had effects: 1) It was an additional liquidity measure as these mortgages became securitization-ready 2) At this time banks were not using IFRS accounting, so mortgages that were insured and subsequently securitized would no longer show up on balance sheet. It was a simple ploy to strengthen Canadian bank balance sheets by offloading risk to the Canadian taxpayers. 3) As risk was easily offloaded by the banks lending guidelines continually eased eerily similar to what occurred in the US with higher risk loans.

3 Additionally, the Insured Mortgage Purchase Program, as the name implies, purchased insured mortgages. But what is not explicitly stated is whether these mortgages were insured at origination or later via bulk portfolio insurance and then purchased. Therefore the claim that the IMPP resulted in no net increase in taxpayer liability may not be accurate, and I suspect it isn t. It strikes me as extremely likely that a significant portion of the mortgages that were insured in 2008 and 2009 would have been purchased under this program. Is the surge in bulk portfolio insurance in late 2011 a recognition on the part of banks that certain markets are in trouble? CMHC has indicated that it received an unexpectedly large request for bulk portfolio in late While part of this increased demand has likely been in response to implementation of IFRS accounting, what is striking is that a disproportionate amount of low ratio mortgages were originated in the areas currently on highest bubble watch ; BC and Ontario. It s noteworthy that in 2011, every bank has warned of price corrections centered in Vancouver and the Toronto condo market while simultaneously offloading the risk on a disproportionate amount of low ratio mortgages originated in those areas onto taxpayers. Has this made bank balance sheets less risky? While at first blush it would appear that this is nothing but a positive for the Canadian banks as the riskiest low-ratio loans have been dumped on taxpayers, I would offer two considerations on that front:

4 1) The balance sheets of Canadian banks contain more leverage and risk than most realize. Shown below is what the collective balance sheet of top 8 Canadian banks would look like if aggregated. Note that those loan segments circled in a solid line are those we deem high risk while those in a dashed line are those that we believe are lower risk but still contain more risk than currently being priced in. For instance, we have insured mortgages dotted as lower risk. However, based on the complete lack of due-diligence in mortgage finance this cohort likely has greater rep and warranty risk than US banks with the GSE s. Also note that this aggregate balance sheet masks significantly different risk profiles within individual banks. We track the origination risks of each Canadian and make that data available to clients. We d be happy to elaborate more on this and which banks have the most risk on a client call. 2) I d suggest that current CMHC practices, once widely understood by taxpayers, will lead to significantly increased scrutiny. Criticism of CMHC s insurance program is currently high and rising with the Finance Minister going so far as to recently acknowledge that a public mortgage insurance program may at some point be phased out entirely. The bottom line is that the credit tightening we ve seen lately has been

5 the direct result of rising criticism of CMHC practices, both among regulators and the general public. Without plentiful insurance to turn residential mortgages into risk free assets, the banks simply cannot maintain their current profitability and ROE, while the credit lifeblood currently sustaining our market will dry up. It s also worth noting that when real estate prices once again soften, the capacity to support the banks in this manner simply will not be there absent the government taking a drastic about-face and increasing the insurance cap. But with Canadians increasingly critical of CMHC practices, this seems increasingly unlikely. On that note, we know that editors at some of Canada s most respected news agencies are in process of covering these very topics in-depth nearterm. The public and corporate attention, reaction, and discussion to the extreme moral hazard in the Canadian housing and mortgage markets and tax payer risk associated with such will be interest to watch and analyze as it unfolds. Best Regards, Ben Rabidoux Ben@MHanson.com Mark Hanson Mark@MHanson.com *Data for this report provided by M Hanson Advisors unless where otherwise noted DISCLAIMER: This message and attachments are for the sole use of the addressee and are privileged, confidential and exempt from disclosure. If you are not the addressee, copying, dissemination, or distribution of this communication is strictly prohibited. You must delete the e mail and destroy any copies. In publishing research, Hanson Advisors and MAHA, Inc (the

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