Why Housing Matters to Canada’s Financial Stability: Insights on Housing Market Risks and CMHC’s Financial Stability Role

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

C.D. Howe Institute Roundtable Luncheon

421 7 Avenue Southwest, Suite 4000
Calgary, Alberta

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Thank you Bill, and a special thanks to the C.D. Howe Institute. C.D. Howe is of course well known as one of Canada’s foremost economic think tanks.

I want to speak today about how Canada’s housing finance system contributes to our overall financial stability — not only when economic times are good, but more importantly when they are bad.

The Institute is no stranger to the debate about the merits of Canada’s housing finance system. Its economists and analysts have offered some pointed views in recent years.

I can’t say we’ve always agreed but I deeply respect your contributions to the housing finance debate, even if we don’t always agree. An open and public exchange of opinions is key to good policy development, particularly in an area as fundamental to Canada’s economic well-being as housing and financial stability.

It wasn’t that long ago that the Institute was calling for CMHC to be privatized, arguing that we had outlived our mandate.¹ You may recall that this view was shared by Finance Minister Flaherty at the time, famously declaring that we had grown “too grand.” The core argument was not that there was a problem with what we were doing — just that it should be done by others.

This is always a fair question. The privatization benchmark is a good one for public institutions. Like any company, we need to know what’s special about us – why we need to exist. Public institutions that are not offering something unique and important become extinct.

On other occasions, C.D. Howe has criticized CMHC for not being forthcoming enough about our stress testing regime. And it has also suggested that Canada needs to develop a private residential mortgage-backed securities market that operates without CMHC guarantees.

Last July, the C.D. Howe Institute published a provocative, thoughtful commentary recommending that Canada replace the existing government backstop for mortgage loan insurance with a segregated, self-financing backstop fund.²

This report acknowledged CMHC’s stabilizing role during a housing crisis by filling in for private insurers who might curtail their activities. The authors also tipped their hats to our role as a standard-setter in mortgage loan insurance.

In a sense, the paper is an endorsement of the current macro-prudential regime in housing finance that includes a meaningful public-sector presence. Indeed, the commentary characterizes the recommendations as merely strengthening the existing regime, rather than overhauling it.

To me, the paper implies that privatizing a properly circumscribed CMHC would result in a weakening of the Canadian financial system.

That thinking might have satisfied the authors, both Ontario economists. But I sense that some of you may need more convincing of the need for CMHC, given the “small government” ethos of both C.D. Howe and Albertans in general.

So I’d like to engage this afternoon in a broader discussion of CMHC’s evolving role as a stabilizing presence in Canada’s economy. Even through that narrow lens, I will respectfully argue that Canada is better off with a focused CMHC than without.

Let me begin with the premise that as a Crown corporation, CMHC needs to be purposeful about where we can help, and where we should leave the market alone to adjust. We also need to avoid activities that exacerbate problems, adding to financial instability or compounding affordability problems by stoking demand.

In 2014, we undertook a major review of our mortgage loan insurance business and made some important changes, reflecting our belief that CMHC’s role is to help qualified borrowers meet their housing needs, rather than wants.

We discontinued some products, including mortgage loan insurance for second homes and for condominium construction, and increased insurance premiums.

Late last year, the Minister of Finance, OSFI and CMHC collaborated on a three-part initiative to further constrain house purchase enthusiasm. In addition to product price increases by CMHC and some proposed new capital rules from OSFI, we have doubled the minimum down payment from 5 to 10 per cent on the portion of homes valued above $500,000.

These changes align CMHC with our core objectives: to contribute to the stability of the housing market and financial system, while also facilitating access to housing.

CMHC’s share of the mortgage loan insurance market has also declined markedly, from approximately 85 per cent in 2009 to about 50 per cent in 2015. We believe that our current market presence – which is around 50 per cent of the mortgage loan insurance market — is close to the minimum necessary to satisfy our mandate.

We are quite conscious of the critical mass needed to fulfill our role: we need to be big enough that we can scale-up our operations quickly should another financial crisis force our competitors to retreat from the market, as they did in 2008.

When that happened, CMHC was there to fill the void, so that qualified borrowers could continue to get mortgage financing to buy homes. The strength of the housing sector was a key factor that enabled Canada to weather the economic downturn better than most other economies.

Just as we can’t be “too grand,” so too can we not be “too modest.”

The point being that, as a Crown corporation with a public policy mandate, CMHC needs to be present in the market through all economic cycles. This is a fundamental way in which we contribute to Canada’s financial stability.

In fact, our role now in Alberta is to support continuous access for Albertans to the housing market, even if private insurers choose to pull back.

CMHC’s securitization programs are also an essential component of Canada’s housing finance system, as they facilitate the supply of reliable funding for mortgage lending, which is a challenge in many jurisdictions.

CMHC guarantees timely payment of interest and principal to investors in National Housing Act Mortgage-Backed Securities and Canada Mortgage Bonds. This guarantee is backed by the Government of Canada.

Imagine a scenario where a bank in a liquidity crisis could not fund its mortgage business. New home sales would dry up. Worse, people looking to renew their mortgages could not, forcing them to sell in what could become a procyclical vicious cycle of collapsing house prices and hardship.

Some – including the C.D. Howe Institute – have suggested that lenders have become too dependent on CMHC’s securitization programs as a source of funding, concerned in part because it creates yet more risk for taxpayers. That’s a fair query as well.

Since the financial crisis we have focused our attention on promoting funding alternatives for banks and other lenders without adding risk for taxpayers. The CMHC-administered Canadian Covered Bonds program, for example, was created to help lenders further diversify their sources of funding without government backing.

The government has taken other steps to encourage alternative sources of funding. For example, the annual limit on new securitization guarantees is an important oversight mechanism to manage housing market risks and the Government’s exposure to the housing sector.

Moreover, we have worked with the Government to increase the guarantee fees that CMHC charges to issuers on National Housing Act Mortgage-Backed Securities and Canada Mortgage Bonds.

The second round of fee increases will take effect on July 1. The objective is to encourage the development of private market funding alternatives by narrowing the funding cost difference between government sponsored and private funding sources.

One of the strengths of the Canadian housing finance system is that CMHC is available as policy tool. We can be a “shock absorber” in times of economic crisis, somewhat like the deposit insurance that protects Canadians in the case of a bank failure. Let me give you an example.

When the global liquidity crisis took hold in late 2008, the Government of Canada introduced a temporary measure called the Insured Mortgage Purchase Program, or IMPP.

Through this initiative, CMHC purchased and securitized almost $70 billion in insured mortgages from Canadian financial institutions, giving them access to longer-term funds for lending to consumers, homebuyers and businesses.

Thanks in large part to our existing infrastructure and expertise, CMHC was able to ramp up this program quickly and efficiently. As a result, Canada generally avoided the credit crunch and liquidity problems that destabilized other economies during a time of severe economic stress. The scenario I painted earlier did not transpire, and we were within days of that very possibility.

In our position of industry leadership, we are also able to set high underwriting and risk management standards for other insurers and lenders to follow.

As a Crown corporation with a mandate to help backstop the stability of the financial system, it is imperative that CMHC be a best-in-class risk manager. We have made significant investments in technology and personnel to enhance our stress testing processes and capabilities to reach this objective.

A failure of imagination is all that prevents us from coming to terms with the risk we carry. Our primary bedrock scenario, which is used to set the capital levels for our mortgage loan insurance business, plays out the impact of a 30 per cent decline in house prices and a five per cent increase in unemployment.

We estimated last year that such an event would result in our cumulative net income going from a $7.5 billion profit to a $2.8 billion loss over the five-year planning horizon.

These are very severe impacts, and I’m not at all predicting this outcome, but it is worth noting that our capital position is quite strong. Our ending capital ratios would be well above our minimum capital target of 100 per cent MCT, equivalent to OSFI-mandated minimum levels for our private competitors.

There are two additional implications to underscore here:

• First, these losses are fully borne by us, with no losses on insured loans taken by the banks and lenders that originated the loans.
• And second, since the Government’s fiscal position has benefitted from our historic profits – $15 billion over the past decade — it would also have to absorb our losses in a stressed scenario such as we have contemplated … but would still be in a long-term positive position with CMHC as a Crown corporation.

Unlike many media commentators, we don’t think Canadian housing markets are headed the way of the U.S. markets eight years ago. But what if they do? CMHC needs to be prepared. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

In addition to our bedrock scenario, therefore, as part of our 2015 stress testing program we also modeled three additional cases developed via our internal scenario planning exercise, a first for us at CMHC. These cases explored our exposure to a five-year period of global economic deflation, an earthquake in Vancouver, and an oil price shock involving sustained US $35 per barrel oil prices.

Noteworthy in the Alberta of today, the “low oil” case costs us over $7 billion in lost profits, but we still remain above 370 per cent of our minimum capital requirement at all times.

Each case stresses our business differently. However, none of them depletes our capital below our 100 per cent minimum capital level, the point at which we would need to stop underwriting new business, barring recapitalization.

The bottom line: it would take a very severe housing downturn and a big jump in national unemployment rates, both persisting for a number of years, to start eroding our capital in a significant manner.

Making stress testing results public is not a common practice for Canadian financial institutions, but we believe that increased transparency and information dissemination is a key component of risk diffusion.

This is part of our overall drive to lead through information and insight and answers some old challenges by the Institute. With some “back of the envelope” stress tests being published, including by C.D. Howe,³ we thought we needed to contribute publicly to the debate about the tail risks we insure.

We will continue to publish our stress tests annually.

We are also looking to continue to manage risk efficiently to achieve our policy objectives. As I have said on previous occasions, this could involve increased risk-sharing with lenders and a further focus of government guaranteed mortgage loan insurance on tail risks alone.

As the Government of Canada’s advisor on housing policy, we offer a uniquely informed perspective on this and other housing finance matters. We are working with our colleagues at the Department of Finance, the Bank of Canada and OSFI to explore ways to distribute risks more effectively across the financial system while maintaining Government support for housing finance.

The financial crisis of 2008-2009 was a wake-up call — a stark reminder that we are not immune to economic events that happen outside our borders, that regulators must be vigilant and that housing markets that seem distinct can be linked via invisible “risk transmissions,” like financial instruments.

Some commentators like to equate us with our U.S. cousins, the infamous Fannie and Freddie, who made the U.S. crisis far worse than it needed to be.

Unlike these companies, however, we are publicly owned, our executives aren’t paid to make us larger or more profitable, we do not hold substantial inventories of mortgages and we benefit from intensive regulatory oversight. We do not insure sub-prime or non-recourse loans.

Simply put, we may be cousins but we were far better conceived.

We did not need to bail out banks in Canada, as was done in the U.S. at the cost of hundreds of billions of dollars, but it would be a mistake to be smug about that. We don’t necessarily know what the next crisis will bring.

I have a chart on a wall of my office that reminds me of how frequent financial crises have been throughout history. When people say our system is fine or that “this time is different,” don’t believe them.⁴

And keep in mind that historically there have been 43 bank failures in Canada – mostly in the 1980s and 1990s. The good news is that no depositors have lost money since the Canada Deposit Insurance Corporation was created in 1967. In Maple Bank, CMHC is now working through a bank failure for the first time in over 20 years.

In the wake of the great financial crisis, the Financial Stability Board was established with a mandate to promote stability in the international financial system. One of its solutions is a “bail-in” plan, which forces debt holders to carry more of the burden of a bank failure.⁵

Less reliance on taxpayers’ dollars to bail-out failed banks forces higher scrutiny by creditors of the financial institution’s business practices.

And what of homeowners? Housing being inextricably linked via mortgages to banks and the financial system, the potential need for government to step in during a tail event in the absence of mortgage insurance cannot be overlooked.

In Canada, CMHC collects premiums for assuming exactly that risk — to the tune of $15 billion in profits over the last decade. Residential real estate being the largest store of wealth, financial stability is served by our mortgage loan insurance regime. This is the premise behind the Bank Act mortgage insurance requirement that lies at the foundation of our regime.

Bank of Canada Deputy Governor Lawrence Schembri addressed the issue of household debt in a speech to the Guelph Chamber of Commerce last month.⁶ He noted that an economic shock, such as a widespread increase in unemployment, could force some vulnerable homeowners to sell their homes or eventually default on their mortgages.

This could accelerate a decline in house prices across Canada. While the consequences for Canadian lenders and mortgage insurers would be large, Mr. Schembri noted that results from stress tests show that there are sufficient buffers in the financial system to withstand such a scenario.

I should add that the Deputy Governor noted that the probability of such a scenario remains low.

Although residential mortgage arrears rates remain low and credit scores are strong, household debt remains a vulnerability that would amplify an economic shock, in part because consumers would be more restricted in spending to support a recovery.⁷

Indeed, the high level of household debt, at 165 per cent of disposable income, worries us. This might be less about CMHC risk — Canadians consistently make their mortgage payments – and much more about reduced economic growth if consumers cut spending to save their homes.

As I mentioned at the outset, the recent C.D. Howe paper on mortgage insurance as a macro-prudential tool acknowledges CMHC’s core role in contributing to financial stability. In a sense, this is perhaps a validation of our vision statement: to be “at the heart of a world-leading housing system.”

While the paper supports a continued role for CMHC, it advocates that the current system be replaced with a segregated self-financing backstop fund that has the capacity to borrow, with a government guarantee, against future premium revenue.

The principle is interesting but not without its drawbacks. Put simply, such an approach would divert funds that could otherwise be used to reduce government debt.

I still favour our current system, where CMHC pays both a guarantee fee and contributes its profit to the government’s consolidated accounts, thus compensating government for potential exposure to a tail event.

Shifting away from a small government premise, CMHC’s mandate is not just about promoting financial stability — we are also charged with the important task of facilitating access to housing.

About 80 per cent of Canadians are able to meet their housing needs in the market – either by renting or purchasing a home — thanks in part to our housing finance programs.

For the 20 per cent of Canadian households whose needs are not met in the market, CMHC provides a federal investment of approximately $2 billion a year in housing assistance.

Last year, more than 500,000 households received some form of federal support to ensure they could afford their homes. We’re talking about the most vulnerable sectors of our population here: low-income families and seniors, people with disabilities, Indigenous people and victims of family violence.

Of course, it’s about more than putting a roof over their heads. When we help low-income households access the housing they need, we are helping to build a foundation for broader social and economic success for these families.

Research has shown that housing stability is strongly correlated with improved health, education and justice system outcomes. Transitional housing support is a classic economic “externality” that many economists see as comprising the proper role of a central government.

For many households, social housing is a temporary bridge to a better, more self-reliant future. Analysis based on Statistics Canada survey data showed that about half of Canadians who lived in social housing returned to market housing.⁸

As you may know, the federal government has committed to re-establishing its leadership role in affordable housing and making significant new investments in social infrastructure, which we expect to learn more about in next week’s budget.

These investments, which are expected to prioritize funding for affordable housing, could be targeted to help low-income households, First Nations communities and others in housing need.

Importantly, housing investments would also create needed short-term economic stimulus, which many are calling for.

As a public institution, with the “sacred trust” of managing public resources, CMHC is held to a high standard of performance. As I said, if Canadians don’t hold public institutions in high regard, we may lose the right to exist.

Our goal is to be an “academy organization,” with learning and innovation at the centre of what we do.

At CMHC, we are determined to be a high-performing organization: accountable, transparent, efficient and, crucially, innovative. We need to experiment and lead in order to serve the housing needs of tomorrow.

Canadians deserve a national housing agency to admire and be proud of — the high-performing organization CMHC aims to be. This is our goal.

Of bankers, Mark Twain said they “lend you an umbrella when the sun is shining, but want it back the minute it begins to rain.” Don’t let the sunshine of today’s stable markets blind you. CMHC is part of the Canadian secret. We will be here when it rains.

Thank you again for the opportunity to be here and to present the case for a strong, focused CMHC at the heart of Canada’s housing system. I hope to see many of you again in October, at CMHC’s Housing Finance Symposium in Ottawa.

¹ Finn Poschmann, “Private sector should take on CMHC’s role,” Globe & Mail, January 3, 2013.

² Thorsten V. Koeppl & James MacGee, “Mortgage Insurance as a Macroprudential Tool: Dealing with the Risk of a Housing Market Crash in Canada,” C.D. Howe Institute, Commentary No. 430, July 2015.

³ Craig Alexander & Paul Jacobson, “Mortgaged to the Hilt: Risks From The Distribution of Household Mortgage Debt,” C.D. Howe Institute, Commentary No. 441, December 2015.

⁴ Carmen M. Reinhart & Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.

⁵ Mark Carney, “Financial Reforms — Achieving and Sustaining Resilience for All,” Chair’s letter to the G20, Financial Stability Board, November 9, 2015.

⁶ Lawrence Schembri, “Connecting the Dots: Elevated Household Debt and the Risk to Financial Stability,” Bank of Canada, February 24, 2016.

⁷ Atif Mian & Amir Sufi, House of Debt: How They (And You) Caused the Great Recession and How We Can Prevent It from Happening Again, University of Chicago Press, 2014.

⁸ Based on the longitudinal data for 2006 to 2010 from Statistics Canada’s Survey of Labour and Income Dynamics, about 635,410 of the 1,156,230 individuals that reported living in social housing at least one year returned to market housing during that period.