The Office of the Superintendent of Financial Institutions (OSFI) is Canada’s primary financial regulator. On Monday it released new proposed regulations outlining the steps banks must follow when issuing mortgages. As described at HuffingtonPost.ca, these pearls of wisdom include:
- Check the background and credit history of prospective mortgage borrowers
- Verify the borrower’s income
- Maintain “sound” documentation of loans
- Confirm the creditworthiness of co-signers/loan guarantors
- Assess the adequacy of a borrowers’ income
Thank you for the painfully obvious insights. I have two observations:
- If lenders already follow these practices: why are scarce taxpayer dollars wasted to craft superfluous regulations?
- If lenders do not always follow these practices: why aren’t they afraid of the consequences (e.g. losses, insolvency) of bad loans?
Why are scarce taxpayer dollars wasted to craft superfluous regulations?
Regulations are expensive. They require armies of salaried bureaucrats to create and enforce them. Regulations also pile up. For example, as of 2010 the Federal Register of US regulations was 83,500 pages long and counting.
Yet many large corporations embrace these intrusions into their businesses. Says Marcia Moffat, head of home equity financing at RBC, of the new mortgage rules:
There’s always opportunity to tie things up in a bow, and perhaps that’s where this goes.
It is difficult and expensive to comply with regulations. The task often requires entire divisions exclusively devoted to maintaining regulatory compliance. Large institutions are able to afford this overhead. New start-ups are not. Regulations, then, often serve to restrict entry into the market and stifle competition. This is good news for banks, who can then pass on these costs to customers. This is bad news for consumers.
Why aren’t lenders afraid of the consequences of bad loans?
In Canada, high-ratio mortgages (consisting of a down-payment less than 20%) are guaranteed by taxpayer money through the Canada Mortgage and Housing Corporation (CMHC). From the CMHC website:
For some accounts, despite the efforts of the lender, the borrower, and the support of CMHC’s default management team, it may not be possible to prevent default. In this case, if CMHC approved the original loan(…) CMHC will pay 100 per cent of eligible claims and costs.
There you have it. We have a system designed to privatize profits and dump losses on the taxpayer. This scenario creates moral hazard. Stated differently, the promise of a government bailout leads lenders to engage in increasingly risky behaviour. Alas, fortunately for us, the OSFI has anticipated the problems to which this may lead:
In its guidance Monday, OSFI told banks that “mortgage insurance should not be a substitute for sound underwriting practices.”
Nice try. To use an analogy from pharmacy practice, if you have a patient selling his OxyContin on the street, you don’t solve the problem by strictly enforcing the days interval between refills; you solve it by discontinuing the prescription.
Similarly, you don’t solve the problem of subprime loans by regulating mortgage lending practices. You solve it by ending taxpayer-funded mortgage “insurance”. Let lenders face the negative consequences of making bad loans.
There is a precedent for this. In January 2011, the risk associated with default on home equity lines of credit was shifted from taxpayer to private lender. The outcome:
That rule change shifted the risk of home equity lines from taxpayers to banks, and it succeeded in encouraging more prudent lending.
Now that’s a breath of fresh air.