The Risk Sharing Role of Financial Intermediaries: Housing and Beyond

Speaking Notes for Evan Siddall, President and Chief Executive Officer, Canada Mortgage and Housing Corporation

Global Risk Institute Conference
Saint James Club
Montréal, Québec

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I’m going to talk today about how we manage housing risk in Canada to promote financial stability. The economic crisis taught the world some harsh lessons about risk management, and many economies have yet to pay the bill from the experience.

Canada weathered the 2008 financial crisis well compared to many other economies but we always need to be thinking about the future – the next economic storm – to ensure that our housing finance system is adaptable and resilient.

Today’s discussion is timely for CMHC: we are re-examining our role in the Canadian housing and financial markets and looking to be part of an even more resilient system.

I will start my remarks by asserting a foundational premise: one of theraisons d’êtreof government involvement in housing finance systems is that government inherently assumes the tail risk. As much as we never want to use taxpayer money to bail out banks, governments consistently want to help home owners in the event of a generalized housing crisis.

As a Crown corporation — Canada’s national housing agency — CMHC therefore contributes to the stability of the financial system by providing mortgage loan insurance to lenders and by guaranteeing the timely payment of principal and interest on NHA MBS and CMB.

There is significant risk involved in both of these businesses. By backing CMHC, the Government of Canada has explicitly assumed the associated tail risks.

In return, Government makes the rules and is compensated for taking on the risk — to the tune of $18 billion in profits from CMHC alone over the past decade.

As a government entity, we need to have a different approach to risk management. Implicitly, we are in the bail-out avoidance business. Lenders pay us a premium to back them up if things go wrong.

So we have an explicit responsibility to manage tail risk and survive, since insolvency is a less obvious option for us.

Lots of work has been done on how corporations can better manage commercial risks, but in my view, too little attention has been paid to government’s management of tail risk.

We can’t assume away disaster scenarios, which the private sector implicitly can do through buying insurance, filing for bankruptcy protection or receiving overt bail-outs.

CMHC has an imperative to advise government on potential improvements to our housing system. This responsibility is central to the mission of CMHC, to our role as a risk manager and consistent with our vision of a world-leading housing system for Canada.

Some $550 billion of that risk sits on CMHC’s shoulders via our mortgage loan insurance business, and over $160 billion more is indirectly assumed by the government via its 90 per cent backing of mortgage loan insurance issued by our private sector competitors, Genworth and Canada Guaranty.

The B20 and B21 guidelines, both of which CMHC supports and embraces, have helped alleviate some of the implicit moral hazard in our mortgage insurance scheme.

Our task is to define a strategy for CMHC that preserves our buffering role in a crisis, while not assuming so large a market presence that we distort pricing to consumers.

Earlier this year, we measured our mortgage loan insurance programs against the yard stick of attending to Canadians’ housing needs — as opposed to wants, desires well-served by the private sector.

As a result of these and other changes, our insurance-in-force has begun to decline.

In our role as an adviser to government, we are evaluating a range of ideas on future improvements to our housing finance system, including risk-sharing with lenders to further confront moral hazard, future sandbox changes if housing markets are to become less stable, and increased capital requirements. I will return to capital shortly.

Economist Hyman Minsky warned of the risks of sowing the seeds of the next crises in advancing solutions to the last. He was talking about how stabilizers can reduce our perceptiveness of risk.

The analogy is imperfect but I cite it so that those of you in the banking business do not continue to rush to judgment that we are unaware of the consequences of our actions.

CMHC’s responsibility is to contribute to a durable financial stability, not to jeopardize it. We are committed to this outcome, and to consultations with the private sector as we consider new ideas.

As a risk manager, let me tell you why we aren’t overly worried about a housing bubble at this point in time, based on what we know. This “based on what we know” is an important caveat, and I’ll come back to that in a minute.

CMHC has the greatest collection of housing experts, expertise and information in Canada. We have developed a tool that is rooted in economic literature and has been tested vigorously. We call it the Housing Price Analysis and Assessment framework, or HPAA, and it enables us to assess multiple lines of evidence that we believe, again based on past experience, could point to a housing bubble.

The multiple line of evidence approach is more robust than the use of simple, popular two-variable charts, which consistently over-simplify complex market dynamics.

The HPAA examines a number of risk factors of problematic house price conditions, namely:

(1) overheating of demand in the housing market;
(2) acceleration in house prices;
(3) overvaluation in house prices; and
(4) over-building in the housing market. 

As such, it represents a useful tool for analyzing Canada’s housing market because it serves as an early warning indicator of potentially problematic conditions.

Current HPAA results show that, despite some overvaluation, there are no immediate problematic housing market conditions at the national level.

So, overvaluation is currently present in the Canadian housing market. There is, in fact, nothing abnormal about that. Most of the time, markets are over- or under-valued; they are almost never at fair value.

Our educated opinion is that growth in house prices in Canada will moderate. If we are wrong, and price growth remains strong or accelerates, we may need to look to macro-prudential counter-weights to avoid excesses. As I said, we are currently evaluating them.

I want to note that while the HPAA is a sophisticated framework, it is built using conventional econometric forecasting techniques and behavioural data that are based on the assumption that the world of the future will unfold like the world of the past.

While past experience is important and we should learn from history, we must also remember that you shouldn’t drive a car looking in the rear-view mirror. There’s no question that a multi-variable analysis is better than simpler approaches, but we also acknowledge that even the HPAA cannot capture market conditions that may unfold differently.

The future isn’t clear. As the scholar and statistician Nassim Nicholas Taleb has said: “The world we live in is vastly different from the world we think we live in.”

So while the conventional view is for a soft landing of the Canadian housing market based on what we know, it’s my job to worry much more about what we don’t know.

The well-documented elevated levels of Canadian consumer indebtedness point to heightened economic vulnerability. So economic surprises worry me even more.

I mentioned my fear about what we don’t know ...

One potentially effective way to convert an “unknown unknown,” what Taleb called a Black Swan event, into a “known unknown” – in other words, an identifiable risk that can potentially be managed – is to recruit others to share in the cause of finding it.

This imperative is even more important for a manager of tail risks: Black Swans predominate in the long tail.

Information diffusion is a key tactic in promoting a community of risk management. And of course, information dissemination is far easier using the Internet, modern technologies and big data solutions, and CMHC needs to take full advantage of those tools.

As a manager of tail catastrophic risks, CMHC is committed to sharing information and analysis about the housing system. We recognize there are significant data and information gaps, and we are working to identify and, where appropriate, fill them.

I mentioned the HPAA as a new tool for sharing information and analysis. We will be publicizing our current HPAA assessments for specific Canadian centres over the fall and winter seasons.

Likewise, we are publishing speeches like this one on our website and circulating them on social media.

To help Canadians better understand our mortgage loan insurance activities, CMHC is also publishing a supplement to our Quarterly Financial Reports. The supplement provides meaningful information that enables greater transparency and clarity with respect to our insurance underwriting practices.

CMHC also recently unveiled the Housing Market Information Portal, a dynamic new web-based tool that gives users quick and easy access to our wealth of housing market data in one location.

We plan to add further information and functionality to the Portal. We hope it inspires housing industry academics and commentators to pursue new ideas and make better-informed decisions.

In addition, like any financial institution, we engage in stress testing of our risk portfolio. We are actively considering the merits of publishing our stress testing results to gain insights from others and better inform Canadians about CMHC.

For now, I am pleased to report that our stress testing confirms that CMHC would survive a 2008 – 2009 U.S.-type housing and financial crisis, if that were to occur in Canada. Further, our analysis suggests that we have sufficient capital to withstand a severe and prolonged economic recession.

CMHC’s Board of Directors recently reviewed our mortgage loan insurance capital targets and determined that the capital holding target should be increased from 200 per cent to 220 per cent.

The increase is as a result of enhancements made to our stress testing and capital management framework, and is consistent with prudently managing taxpayer exposure to the housing market.

In August, we published some new data on condominium ownership in Toronto and Vancouver. We believe the results released in early August, while still limited in scope to local individual investors, will help to shed some light on the profile and purchasing motivations of a segment of condominium investors in those two cities.

On top of these developments, we have established an internal “data gaps” working group. This is a broad and far reaching project that seeks to address data gaps related to housing markets, housing finance, social housing, as well as gaps related to research.

All parts of our business are participating in this initiative. We are also reaching out to stakeholders to help us identify information and data gaps. I would welcome any thoughts you might have on the subject this afternoon.

You can expect to hear more announcements from CMHC about our efforts to address the data gaps in the months ahead.

Some of you will recognize this openness as a new posture for CMHC. It is very much by design and driven by our strategy of being a best-in-class risk manager and authoritative voice on Canadian housing.

It is imperative that CMHC be a best-in-class risk manager. We have a responsibility to preserve the stability of the housing system for all Canadians.

That’s a huge responsibility, since the greatest store of personal wealth in Canada is residential real estate.

We are a different kind of risk manager: we overtly manage tail risks.

Information dissemination and the resulting crowd-sourcing of new ideas and even risk identification are central to what we do. It is a direct reflection of CMHC’s strategy to be a reliable steward of the Government’s exposure to housing tail risks.

CMHC is positioning itself to lead the practice of risk management in new directions. We shouldn’t just keep the housing system safe, but make it even safer.

In doing so, we will achieve our vision for CMHC as being “the heart of a world leading housing system.”