– The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies through research that is nonpartisan, evidence-based and subject to definitive expert review.
CANADA – Ottawa should reject a “blunt” option it is considering to address the build-up of risky mortgages in the housing sector, according to the latest C.D. Howe report.
In “Mortgage Insurance Deductibles: An Idea Whose Time Hasn’t Come“, authors Thorsten V. Koeppl and James C. MacGee, two leading thinkers on financial stability issues, definitively reject Ottawa’s proposal to spread more risk to mortgage lenders from insurers as ineffective and recommend a better approach.
The rise in housing prices and the number of home-owners with high debt-to-income ratios suggests an ongoing build-up of risk in Canadian housing markets, note the authors. In response, the Department of Finance has proposed a deductible on lenders for insured mortgage losses, which would shift a significant amount of potential losses back to mortgage lenders from the insurers.
The deductible is intended to address moral-hazard concerns, whereby lenders have an incentive to extend credit to high-risk borrowers if they can shift all of the default risk to mortgage insurers.
In analyzing the proposal, Koeppl and MacGee conclude “the deductible is a blunt and ineffective tool to address these concerns.”
The report finds that the quantitative impact of a deductible on the lending rate for risky borrowers would be very small, and that a deductible would not be effective in discouraging lending to risky borrowers.
A better solution, they say, is to combine a change in the pricing regime for mortgage insurance with further refinement of the regulation of the mortgage insurance system. They recommend risk-based pricing for mortgages.
“Charging the lender an insurance premium that takes into account risks associated with idiosyncratic characteristics of the borrower would directly address moral-hazard concerns,” states MacGee.
This shift to risk-based pricing should be complemented with a continued refinement of regulations for mortgage insurance underwriting to limit further build-up of risks in the housing sector.
The risk-based pricing approach has several benefits over the proposed deductible:
- It would tackle the flat-fee mortgage insurance system’s moral-hazard problem by giving lenders an incentive to offer interest rates that reflect borrowers’ default risk;
- It could encourage competition in the marketplace; and
- It is less likely to encourage borrowers to migrate to lenders outside the mortgage system.
The report concludes that, “The most direct approach to reducing risk-taking by mortgage lenders would be through the strengthening of minimum lending standards and the adoption of risk-based pricing of mortgage insurance premiums.”
