A wise and studious reader of this blog brought this article to my attention the day after I read it online.
Where banks once sent human appraisers to assess a home’s value and determine whether to provide a mortgage for it, the banking industry – encouraged by the federal government’s own Canadian Mortgage and Housing Corporation (CMHC) – had largely converted to a faster and cheaper system of automated underwriting, using computerized models to determine how much money to safely lend.The models weren’t perfect, but they were close enough. And what did it matter? House prices always seemed to be going up in Canada anyway.Insuring against the accuracy of those automated systems seemed like a safe bet, but First American got burned. “In 2009 and 2010, we started to see a slight up-tick in the Canadian default rate. And that is where we started to see deficiencies,” Mr. Gilmore told analysts on the call.CMHC’s automated underwriting program – called Emili – had been stamping its approval on millions of mortgages as safe. But in Emili-approved cases where the banks were forced to foreclose, the homes turned out to be worth much less than believed. First American had to pay the banks $45-million. The company stopped offering the policy immediately. “We’ve taken the situation, obviously, very seriously,” Mr. Gilmore said.As the housing market in Canada begins to cool and the federal government talks of a soft landing for home prices, rather than a hard crash, attention is turning to the factors that fed record borrowing and contributed to overheated sales and price increases – and the risks that now lie within the financial system. Rock-bottom interest rates propelled Canadian real estate to undreamt-of heights, and Ottawa’s decision to loosen mortgage rules added to the froth, as marginal buyers flooded into the market.That much is amply documented. But an investigation by The Globe and Mail has uncovered a hidden risk in Canada’s housing markets: The rise of automated lending approvals, which has created a rapid-fire system that has financial regulators worried about the foundations that underpin Canada’s housing market. There are worries that the true worth of Canadians’ homes could be lower than what computerized methods spit out. There are also worries that unscrupulous human appraisers can manipulate home values.
And CMHC officials say the system is designed to catch manipulation. “If lenders submit multiple purchase prices, this will raise a red flag in the system,” a spokeswoman said in an e-mail.
However, several banking industry insiders, speaking on condition of anonymity, told The Globe that commissioned staff within their ranks have been found gaming Emili in order to boost their bonuses.
The OSFI documents show that one industry official warned the regulator that Emili distorts the market by sending the wrong signal on housing values to homeowners.
“Buyers feel reassured with respect to the value of their investments because it was validated by a Crown corporation, while the CMHC does not appraise the real value of the purchased property. Instead it appraises the risk associated with the debtor,” the industry member said.
Although automated systems save time, there is also cost to consumers. Since CMHC charges premiums for insuring loans against default, larger mortgages approved by the system mean bigger premiums.
“The time saved comes with a high price tag for the consumer,” an industry member argues in the documents. “If the property is overvalued, the insurance premium will be based on the overvaluation and multiplied by 25 years of mortgage payments.”
“The resulting sum may be considerable. Thus, the CMHC, a Crown corporation, cuts corners by not demanding professional appraisals and generates higher revenues by basing its premiums on overvalued figures.”
In the past decade, CMHC has made more than $17-billion for the federal government, including income taxes.
My view:
Long time readers know well my view of the Canadian housing market and its vulnerability to a significant correction.
What readers may not realize is the striking similarity to the US housing bubble that burst in 2007.
The amount of debt compared to household income that Canadians have is now actually greater than the amount Americans carried at the peak of their debt bubble.
It seems incredible that executives and regulators refused to learn from the American experience and clamp down on the excess leverage that was apparent 7 years ago.
Indeed, denial that it could happen here runs very deep.
Instead, CMHC, this Canadian version of Freddie Mac and Fannie Mae, decided to extend amortization periods from 25 years to 35 years, and lower down-payments to 5%.
Now, 5 years after the American bubble began to burst, we see the first significant signs of cooling of Canadian housing prices.
The amount of time taken for reality to begin to set in has certainly surprised your intrepid blogger.
My expectations were for a substantial downturn starting 2 years ago.
Now, it appears the proverbial housing chickens are coming home to roost.
A relatively recent report from the Royal Bank of Canada indicates that a 10% drop in home prices translates to a 15% drop in household net worth.
If the house price drop is contained to RBC's conservative measure, a significant spill over of debt deflation will enter the real economy as credit tightens, equity extraction from lines of credit secured by house mortgages will become more restricted.
My own estimate, based on income levels compared to home prices suggests at least a 25% drop. The corresponding decline in net worth for the average household then becomes at least 35%.
Regardless of the exact figures, the degree of decline in home prices will be significant and the impact on the real economy should be substantial and debt deflationary.
For the under 40 generation that has not seen firsthand the impact of a housing decline, and have been convinced that real estate values always rise, and a home is a store of value, the experience will be memorable to put it mildly.
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