You may have heard the story recently the government of Canada is buying $75 billion in insured mortgages.
In a way that seems strange. After all if the mortgages are insured then what's the worry? It's hard to make sense of what's happening here.
I have a theory on it. The problem is the insurance. Not that they are insured, but the quality of the insurance itself is dubious.
It is a fact that many mortgages in Canada are insured by AIG. You may have heard of AIG, that's the large American insurance company that is insolvent and was nationalized by the US government.
The reason AIG is insolvent [i.e. unable to pay claims] is largely because of financial insurance. That would include mortgage default insurance, bond insurance, CDO insurance, credit default swaps. AIG miscalculated the risks and when these financial objects went bad at an unexpected rate [including an ongoing tidal wave of mortgage foreclosures] then AIG did not have enough reserves set aside to pay out the claims.
So here in Canada any lender holding an AIG insured mortgage is in trouble because they can't count on the insurance being any good when some percentage of the mortgages default. And mortgage defaults in Canada will be increasing steadily for the next while.
If the insurance is no good then the owner of the loan is facing raw exposure to the loss on the defaults. That would force the lenders to reduce the value of those assets if they have unreliable default insurance protection. Such an asset loss could well leave the lenders insolvent or forced to raise capital in an unfavorable market.
I think it works something like this. Suppose I loan Andy $3000 unsecured. In return Andy agrees to pay me $100 a month for 3 years. So far so good. Then as a precaution I purchase insurance on this loan from AIG for say $200. The insurance is good for the remaining unpaid principal up to $3000.
So I can rest easy knowing that the loan is worth at least $3000 on my books because even if Andy defaults AIG will cover me up to $3000.
Now suppose with recent events I'm no longer confident AIG is good for the money if Andy defaults. This is really bad for me. Now I have to worry about Andy defaulting because I will lose the full outstanding amount of payments owed. I have to reduce the book value of the loan to Andy because it is not worth minimum $3000 any more since if Andy defaults I now have to eat the loss, not AIG.
It could cause other problems. Suppose I have made two other such loans. And I used the loans as collateral on a $9000 line of credit for myself [since the loans with the insurance were worth a minimum of $3000 each]. Now I can be in even more trouble if my line of credit holder sees his collateral is impaired he could cut off or call the LOC; and he has to reduce the value of his asset which is now no longer fully secured. So any other debts using these assets as collateral are now also impaired and would need to be written down.
So instead the government of Canada is absorbing the mortages with questionable insurance, and unfortunately quietly eating the losses when the defaults occur. It's too bad really. The truth is the mortgages the government is buying are basically subprime [although it is taboo to use that word in Canada]. AIG or whoever if they had done due diligence would not have insured them. Of course without the insurance the mortgages would not have been approved by the lenders due to the risks.
I suspect a lot of these mortgages are no money down mortgages, 40 year mortgages, mortages where people have refinanced credit card and other consumer debts onto the mortgage [perhaps multiple times], mortgages given to people with questionable credit history.
How bad will the losses be to the taxpayers of Canada on this $75 billion portfolio? That's a good question. 10%, 20%, 50%? Since the door is now open for a deficit the government may just allocate for a large loss (like 35%) on these mortgages this year and pile it onto the deficit we're going to have anyway.