Canada's Housing Bubble

canadianmortgagetrends.com

CMHC is the biggest mortgage default insurer in Canada, and one of Canada’s biggest companies in general.

The federal government mandates that CMHC create policies to support Canada’s housing market. Yet, with home prices getting lofty, these very policies have been under the media microscope.

Most journalists analyze the default insurance market with the best of intentions. Due to a lack of publicly available facts, however, it’s become more common for the media to mischaracterize certain policies.  Recent stories from the National Post and the Globe made industry claims that left readers with a variety of unanswered questions. It therefore seemed logical (to us) to contact CMHC directly, pose these questions, and clarify from the source.

The primary goal was to learn about what happens behind the scenes of mortgage insurance, and share what we learned.  In the end, the information that follows gave us a much better sense for how insurer policies impact Canada’s housing market.

Along the way, we were fortunate enough to speak with Pierre Serré.  Pierre is CMHC's Vice-President of Insurance Products and Business Development.  Below you’ll find the interview we did with Pierre, sprinkled with “side notes” (the stuff in italics) that we collected throughout our research.

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CMT: Pierre, I want to thank you for taking a few moments to be with us. To begin with, can you tell us what percentage of mortgages are currently insured in Canada?

Pierre: At the end of 2008, the percentage of insured mortgages outstanding, compared to residential mortgage credit outstanding, was estimated at 68%.

Noteworthy: A large percentage of insured mortgages are under 80% loan-to-value.  That’s because many lenders use CMHC “portfolio insurance” (which provides the same default insurance coverage as for high ratio mortgages) to lower capital requirements and/or as a prerequisite to securitizing their mortgages

CMT: Securitization was key to non-bank lender survival in 2009, so let’s touch on that for a moment. If Canada didn’t have the Canada Mortgage Bond and Insured Mortgage Purchase programs, what impact might there have been on Canadian home prices, interest rates, and lender viability during the credit crisis?

Pierre: In 2008, Canada’s housing finance system was rated by the International Monetary Fund as one of the healthiest and most stable, while many other nations continue to face severe liquidity and credit issues. CMHC’s securitization and mortgage loan insurance products contributed to the strength and stability of this system.

The Insured Mortgage Purchase Program was created through Canada’s Economic Action Plan. The IMPP has helped Canadian financial institutions raise longer-term funds and make them available to consumers, homebuyers and businesses in Canada.

Noteable: In addition to Pierre’s comments, we found the quotes below. It’s common belief in our industry that Canada’s housing and lending markets would have incurred more severe losses, had it not been for CMHC-backed liquidity. In the fall of 2008 some banks would not even lend to each other. Many lenders had nowhere left to go for lending capital but the CMB market. Government-sponsored liquidity calmed market fears and prevented a panic reaction that could have thrown Canadian real estate into a tailspin.

A few quotes we found from industry notables:

• "CMHC provided Canada with some much needed financial stability since late 2007 when the worldwide credit markets seized up. Other than Canada bonds, NHA-MBS and the Canada Housing Bond were really the only instruments trading. Ottawa also authorized CMHC in 2008 to purchase insured mortgages thereby providing much needed liquidity to the Canadian banking system.”
  -- James Clayton (past President of ResMor Trust Company and past General Manager of Bridgewater Bank), in a letter to the National Post (October 22, 2009).

• "Our confidence in the integrity of Canada Mortgage Bonds and the securitization structures that underlie those bonds allow us to be a strong supporter of these programs.”
  -- Ricardo Pascoe, Executive Vice-President, Financial Markets, National Bank Financial Group, in a letter to The Hill Times (October 27, 2009).

• "…During the past several years, the Canada Mortgage Bond (bonds backed by CMHC insured mortgages and guaranteed by the Government of Canada) was one of the few financial instruments that provided liquidity to mortgage lenders and financial institutions in Canada, ensuring the continuing availability of affordable mortgage lending to Canadians throughout the financial crisis.”
  -- Stephen Smith, Chairman and President, First National Financial LP, in a letter to the National Post (October 22, 2009)

CMT: There’s been a lot of press about Canadian homeowners not having enough skin in the game.  What percentage of mortgagors put down only 5%, and how has this percentage changed in the past two years?

Pierre: While the recent CAAMP survey did not ask that question, they did find that among Canadian home owners who have mortgages on their homes, most have considerable amounts of equity. Their statistics show that only 9% of them have equity positions of less than 10%.

Through our 2009 Mortgage Consumer Survey, we have found that 73% of first-time purchasers used their own resources for a down payment including 50% who mainly used their own savings and 23% who mainly took advantage of their RRSP savings.

In addition, 75% of purchasers have a goal to be mortgage free sooner than their original amortization and 20% of recent purchasers report having made a lump sum payment to their mortgage. These results indicate that Canadians are astute mortgage consumers and manage their mortgages prudently.

CMT: How long has 5% financing been around in Canada?

Pierre: CMHC began offering mortgage loan insurance of up to 95% loan-to-value in 1992 under the First Home Loan Insurance Program. It was targeted and, in fact, only available to first time home buyers. In 1998, it became available to all Canadians.

CMT: Statistically, how much riskier is a mortgage with a 5% down payment than a 15% down payment?

Pierre: That’s difficult to say because mortgage risk is defined by a multitude of factors including borrower credit worthiness, the property, the market and the loan characteristics including LTV. It’s difficult to assess one element in isolation.

Side Note: At first blush, we weren’t fond of this answer. We wanted cold hard numbers. But after pondering it more, it started to make sense.  If you think about it, which is more risky?  A 95% LTV mortgagor with a 720 Beacon, or a 90% LTV mortgagor with a 650 Beacon?  A borrower’s ability and willingness to pay is the primary consideration of most lenders when assessing risk. That’s why, in high-ratio financing, the borrower’s debt profile and repayment track record usually carry more weight than their equity.

CMT: If 95% financing is more risky, then why do lenders charge the same interest rates on 95% and 85% insured financing?

Pierre: The default risk to lenders is the same whether the LTV is 85% or 95%--because of mortgage insurance.

You will notice, mortgage insurance premiums do increase with higher LTVs.

Of Note: The cost of risk is factored into mortgage insurance premiums. For example, given a $200,000 mortgage at 95% loan-to-value, you’d pay $5,500 in default insurance. If you put down 5% more, you’d pay $1,500 less—because the risk is less.

Incidentally, the market probably wouldn’t support higher interest rates on 95% LTVs than for 90% LTVs. The whole industry would likely have to impose the premiums in unison for it to catch on.

CMT: Pierre, there’s a belief in certain media circles that CMHC is completely independent.  What third parties oversee and regulate CMHC to ensure CMHC is insuring strong mortgages and not taking undue risk?

Pierre: CMHC is subject to stringent government oversight, including annual independent financial audits, special examinations every five years and periodic reporting requirements to Parliament in accordance with the Financial Administration Act (FAA). Ernst & Young LLP and Auditor General of Canada jointly audit CMHC accounts.

CMHC maintains capital reserves and premium reserves for future losses in accordance with guidelines set out by the Office of the Superintendent of Financial Institutions (OSFI), Canada’s mortgage insurance regulator. In fact, CMHC maintains capital reserves that are twice the minimum required by OSFI.

In addition, CMHC is governed by a Board of Directors and currently reports to Parliament through the Minister of Human Resources and Skills Development, the Honourable Diane Finley.

Incidentally: Unlike private insurers, CMHC is not regulated by OSFI. That’s because CMHC is incorporated under the CMHC Act and not the Insurance Act.

CMT: The press has honed in on the fact that the Finance Department increased the amount of mortgages CMHC can insure by 33%. Does this increase the risk to taxpayers in any significant way?

Pierre: CMHC manages its mortgage insurance business at no cost to Canadian taxpayers, through sound business practices that ensure commercial viability without having to rely on the Government of Canada for support, even in less favourable economic times. CMHC ensures it has sufficient reserves and is well capitalized in the event of claims arising from adverse economic conditions.

CMHC maintains capital reserves in accordance with OSFI’s risk-based capital adequacy framework. It also maintains premium reserves for future losses, also in accordance with OSFI guidelines.

We have been using a sophisticated electronic platform (emili) to underwrite mortgage insurance applications for more than a decade. CMHC continually monitors and adjusts its risk assessment models.

CMHC follows the OSFI guidelines in setting its capital and other insurance reserves. As set out in our 2008 annual report, CMHC is holding twice the minimum capital level recommended by OSFI. Such a level of capital reserves provides for unexpected and very severe adverse economic situations.

And while CMHC is able to insure up to $600 billion in mortgages, it currently has some $480 billion in insured mortgages.

Our Thoughts: Mortgage planners know CMHC’s penchant for risk management full well. From November 2008 to April 2009, when a shaky real estate market and unemployment were making headlines, insurers tightened up on approval and property valuation criteria—in some cases significantly. This killed a lot of deals (some of them good deals…we speak from experience), but we respect CMHC for erring on the side of prudence and maintaining overall faith in the system.

There’s also another thing that keeps taxpayers safe: recourse.

U.S. taxpayers were forced to prop up Freddie Mac and Fannie Mae after the American securitization market crumbled and homeowners turned in their keys by the hundreds of thousands. In Canada, it’s far more difficult to stop making payments and walk away.  In most cases, you’re on the hook if you default.  This lender recourse is a strong incentive for Canadians to pay their mortgages as agreed.

CMT: A layperson might ask: What incentive do lenders have to carefully underwrite before lending insured money? Why can’t they simply rely on CMHC’s guarantee if a borrower defaults?

Pierre: CMHC, as well as Canadian financial institutions, apply stringent requirements at all levels of down payments to ensure borrowers are able to manage their debts prudently within the minimum requirements for insured loans. Insurance premiums are built on this premise.

As a condition of CMHC Mortgage Insurance, Approved Lenders are expected to apply prudent lending practices, and responsibly administer loans for all CMHC-insured loans. All Approved Lenders have an obligation to manage borrower default situations and to exhaust all viable options and tools to cause the borrower to remedy the default.

Side Note: There are additional reasons why lenders are motivated to lend wisely:

1. In most cases, lenders must still service the loan, despite it being insured. Collecting on arrears can be expensive.

2. CMHC has a comprehensive quality assurance programs that looks at the lender’s overall performance and requires action where performance is poor.

3. Lenders contractually agree to ensure that all data provided to CMHC for mortgage insurance underwriting is accurate and properly verified.

4. If a mortgage defaults, the lender loses all chances to cross-sell that customer other products as well as any previously cross-sold products. (Cross-selling can be more profitable than the mortgage itself.)

5. Lenders can be shut out of the CMHC-backed securitization market if defaults are too high (We heard elsewhere that the maximum allowable default ratio is ~1%, but that’s not a confirmed number.).

6. In most cases, a lender has to make good if a securitized loan goes bad.

CMT: Some critics argue that lenders can simply sell off insured mortgages into the CMB program to eliminate their risk. They claim that the taxpayer then assumes the lender’s risk. True?

Pierre: The default risk is managed through mortgage insurance (either CMHC or an Approved Private Mortgage Insurer). This happens before any mortgages are sold into the CMB program. Therefore, there is no incremental mortgage default risk when insured mortgages are sold into the program, or even when sold into the IMPP.

Once the mortgage is funded, the lender often retains the servicing aspect. So while securitization may take the mortgage off balance sheet in return for more money to lend out, the mortgages remains the responsibility of the lender; an added incentive to ensure prudent and reasonable underwriting.

Side Note: The majority of securitized mortgages continue to be serviced by the lender.

CMT: Canadian Banks are some of the most profitable in the world. Why do they need CMHC insurance, the CMB program, and the IMPP?

Pierre: Mortgage insurance, for the most part, is required by law for LTVs greater than 80%. Mortgage insurance also helps lenders manage default risk as well as capital requirements.

The benefits of CMB and IMPP relate to the liquidity requirements of lenders rather than their profitability…in other words, they relate to securing more mortgage funding dollars.

CMT: It’s been asserted in the media that only 5-10% of properties are physically inspected by CMHC, with the remainder valued using automated models. Is this a concern? How well does CMHC’s emili valuation system actually perform at identifying overvalued properties?

Pierre: emili is not a valuation system but rather a sophisticated automated mortgage insurance system, designed to provide an effective risk assessment of mortgage applications submitted for insurance. It uses a number of statistical risking models which, when combined, synthesise the mortgage insurance risk associated with the borrower, market and property. It allows CMHC and lenders to triage applications from a default risk management perspective, flagging riskier applications for additional assessment and possible mitigation, including appraisals by accredited appraisers where appropriate.

In addition to appraisals, CMHC considers other information at its disposal to assess the risk relating to property value. In some cases this may mean that CMHC insures a property based on a lending value lower than an appraiser’s opinion of value, particularly where the appraisal comparables are related to dated transactions.

Advancements such as emili have resulted in faster mortgage approvals for consumers, improved decision quality, early fraud detection, and greater efficiency in the mortgage lending process.

We have over 13 years of experience in approving mortgage loans, through the emili system, which is the largest, most up to date database of properties in Canada.  It facilitates the approval of applications for mortgage loan insurance for a larger variety of property types located in all regions of Canada.

Observation: If the risk score is higher than CMHC’s model tolerance, mitigating actions are undertaken, which may include ordering an appraisal. Per above, insurers can be very conservative with their lending values. Overly conservative values have been a common broker complaint at the insurer panels we’ve attended. So, from our viewpoint, one cannot say CMHC is being lax on valuations.

CMT: Can you tell us, what were default rates in past periods of large rate increases (like 1980-81 or 88-89)?

Pierre: According to the Canadian Bankers Association, the highest rate of mortgage arrears—which is, greater than 90 days--occurred in 1982 and in 1983. The rates were 0.96% and 1.02% respectively, compared to today’s rate of 0.43%.

CMT: Mortgage arrears are currently around 0.4% in Canada—exceptionally low, especially for a recession. I assume CMHC’s risk analysts have calculated what would happen in a worst-case scenario of mass defaults?

Pierre: CMHC internal analysis supports CMHC being able to cope with a variety of economic scenarios, including some rather severe ones.

Notable: OSFI requires insurers to do scenario analysis constantly to gauge their exposure to massive foreclosures.  While we don’t know the variables that go into insurer stress testing analysis, one would have to imagine they model default rates that are at least 10 times what they are today.

Moreover, CMHC, for example, has a large unearned premium reserve for insurance policies that are still active – these reserves are also based on OSFI guidance.

CMT: Assuming the worst case came to pass, is CMHC capitalized enough—at 2x OSFI guidelines--to insulate taxpayers?

Pierre: The overall performance of the economy is the main determinant of future claims patterns. Changes in unemployment rates and in mortgage interest rates are more significant variables affecting the incidence of claims, as they impact a borrower’s ability to continue making their mortgage payments. Recent data from the Canadian Bankers Association show a slight increase in the overall rate of mortgages in arrears, but it remains at a low level and similar to the level experienced in 2001.

CMHC maintains capital reserves in accordance with OSFI’s risk-based capital adequacy framework. CMHC also maintains premium reserves for future losses, also in accordance with OSFI guidelines. CMHC has been using a sophisticated electronic platform to underwrite its mortgage insurance applications for more than a decade. CMHC continually monitors and adjusts its risk assessment models.

CMHC follows the OSFI guidelines in setting its capital and other insurance reserves. As set out in our 2008 annual report, CMHC is holding twice the minimum capital level recommended by OSFI. Such a level of capital reserves provides for unexpected and very severe adverse economic situations.