The big banks and the government are wringing their hands over what to do about ballooning consumer debt levels, a problem they both agree could have potentially disastrous repercussions down the road.

The banks which made most of the loans argue that they've already done what they can to curb credit growth and it's now up to Ottawa to step in.

For his part, Jim Flaherty, the Finance Minister, insists that it was the banks that got themselves into this mess and it's up to them to fix it.

And as the two sides bicker consumers just keep on borrowing, oblivious to the consequences.

But there's an obvious solution, according to Colin Kilgour, a partner at the Kilgour Advisory Group, a boutique financial consultancy in Toronto.

The reason consumers are borrowing so much is that the government has been encouraging them, just as it's also been encouraging the banks to lend. It's called CMHC insurance and the way it works is that Ottawa guarantees virtually all of the risky home loans made by the banks.

The program was originally conceived as a way for low-income Canadians to get mortgages and buy homes.

That's a good thing but it also provides a key benefit to the lenders since it removes risk of default. In effect, CMHC insured home loans are as safe as government bonds and that's allowed the banks to treat them as such.

"What's happened is it's become the major source of bank financing in Canada," said Mr. Kilgour. "At a time when you've got basically a stagnant economy you have free-flowing liquidity to residential credit."

Simply put, loans that would otherwise be regarded as less than top quality are transformed into triple A gold, courtesy of the tax payer.

"If the government wanted to slow down the growth in consumer debt, a hugely effective policy move would be to reduce the cap on the level of mortgages that CMHC is allowed to insure," said Mr. Kilgour.

Consumer debt levels shot up across North America as central banks chopped interest rates, first in response to the dot com collapse and later after the financial crisis.

The situation came to a head in the U.S. starting in 2007 with the subprime mortgage crisis, sparking a massive consumer deleveraging process that is still going on. But Canada never had a mortgage crisis so consumers on this side of the border continued to spend and their debt levels are now at the same place they were in the U.S. immediately prior to the meltdown.

According to Mr. Kilgour, it would be wrong to force the CMHC to shoulder all the responsibility for the situation because it performed a vital function during the crisis, enabling banks to access liquidity at a time when their international peers could not.

Thanks to the government guarantee, Canadian lenders were able to securitize billions of dollars of mortgages and swap them for cash.

In connection with the crisis, Ottawa vastly expanded the program, allowing the banks to insure and sell more than $100-billion of home loans.

But as financial markets returned to normal the level, government support declined only slightly.

For the first time the amount of outstanding mortgage backed securities passed the $300-billion mark earlier this year, more than double the amount at the start of 2007.

2010 issuance is expected to reach $100-billion, the third highest level in history.

The banks love it because it's risk free business, and investors love it for the same reason.

The problem is that it's encouraging banks to lend at a time when they need to put their foot on the brake.

According to Mr. Kilgour, what needs to happen is for the CMHC to reduce the amount of insurance it provides.

Without that, "there’s no motivation for the banks to tighten up on lending – since they know that by the time the stuff hits the fan, much of their risk will be off the table," said Mr. Kilgour.

jgreenwood@nationalpost.com