Defending the Blue Line: Financial Stability and CMHC

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

Marché de l’habitation, Grand Montréal du futur : à quoi ressemblera la carte immobilière?

Palais des congrès de Montréal
1001 Place Jean-Paul-Riopelle
Montréal, Québec

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My name is Evan and I’m a Toronto Maple Leafs fan.

That’s an ill-advised way to start a speech in Montreal but forgive me: I was born this way. The first step in a 12-step program is admitting you have a problem. And we are true fans in Toronto — in the sense of being fanatical: faithful to our team in the face of all evidence to the contrary.

More than being a Leaf fan, however, I am a hockey fan. I therefore have a grudging respect for the Habs. As fans of the game, we rarely notice some of the best displays of hockey skills: a giveaway prevented, a timely back-check, a breakaway avoided by a defenceman who simply stayed in position. The unsung heroes of sport are the defensively disciplined stalwarts we rarely see on the scoresheet.

Give me a stay-at-home defenceman like Scott Stevens or Serge Savard over a goal-scoring, turnover machine who takes risks with his first passes. It never made sense to me to pay more for goal production than for goal prevention: they win games at the same rate. Every coach knows that the best systems are built on the foundation of a strong defence. It’s a cliché that “Offence wins games but defence wins championships.”

I want to associate us, CMHC, with the unsung heroes today. When it comes to Canada’s financial stability, we play defence at CMHC. If we get it right, you never notice us.

Macroprudential Policy: The Neutral Zone Trap

Hockey fans will remember the ubiquity of the mind-numbing defensive system known as the neutral-zone trap. With origins in the 1920s- and 1930s-era Toronto Maple Leafs (sorry, it’s true), the innovation was adopted by Scotty Bowman’s Canadiens in the 1970s and, more recently, by Jacques Lemaire’s New Jersey Devils in the mid-1990s.

We run a kind of neutral zone trap in financial stability and housing finance. While the NHL has since made several rule changes to neutralize the trap system, our trap is here to stay.

Our system is founded on two federal programs we run. First, the federal government requires homebuyers with less than a 20 per cent down payment to purchase mortgage insurance, either from CMHC or a private insurer. That insurance is backed by the Government of Canada. By shielding lenders from losses on the riskiest borrowers, we make it easier for Canadians, primarily first-time homebuyers, to purchase a home. Lenders don’t charge higher rates for these loans.

We also gather mortgages into pools to create securities that investors want to own. This process of “securitization” ensures that funding for mortgage lending is available in good times and in bad.

The underlying mortgage insurance eliminates the risk of loss on the mortgages: the “credit risk,” if you will. However, investors also worry about the potential failure of the lending institution, since insolvency processes might hold up their payments. So we apply a “timely payment” guarantee on these securities to assure that investors will receive their payments. Again, this guarantee is backed by the Government of Canada.

We also ring-fence the system by requiring that any low ratio mortgage that is portfolio insured must be securitized or the purchased insurance will be cancelled. In other words, portfolio-insured mortgages must be used only to fund new mortgage lending. Furthermore, government-backed insured mortgages – whether high or low ratio – can only be securitized using CMHC’s mortgage-backed securities programs.

Plays of the Day

Picking up on the hockey analogy, I will note two examples where CMHC’s quiet defensive play fortified our system. The first, during the recent global financial crisis, is the example of the Insured Mortgage Purchase Program, when CMHC stood ready to provide up to $130 billion of liquidity support to mortgage lenders by purchasing insured mortgages.

That solution was pulled together over a frantic weekend in 2008. We were able to act quickly because CMHC did not have to undertake fundamental policy shifts or require significant new authorities – they were already in place. A solid presence in peacetime allows for more effective responsiveness – and better policy – in times of crisis.

Unlike people in many other countries, Canadians never had to worry about the ability to buy or sell a home on a given day. CMHC helped keep our mortgage and housing markets operating. Crucially, Canadians were able to renew their mortgages during a global credit crisis. Like an effective but unnoticed defenceman, you never knew we were there.

Similarly, our key role earlier this year in evaluating the Government’s options regarding Home Capital are under-appreciated.

Who remembers New Century Financial? It was the second largest subprime lender in the U.S. in 2007. Its collapse was the first step that led to the financial crisis. People worry a lot about “larger” institutions, as they should. However, crises are frequently triggered via smaller institutions, rarely via those judged to be “systemically important.”

Earlier this year, people were justifiably concerned that Home Capital’s circumstances could destabilize the Canadian system.

Conventional stabilizers like deposit insurance proved ineffective as, almost overnight, Home Capital’s CDIC-insured high-interest saving account deposits dropped 42 per cent.¹

Investors smelled blood in the water and targeted Equitable Group, Canada Western Bank and others.

The Department of Finance gathered officials from the Bank of Canada, the Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance Corporation, and ourselves to evaluate our options in responding to a range of possible events. Those intense days saw very close collaboration among all of us. The Minister of Finance reassured markets that we were monitoring the situation, as we were, actively and continuously.

Our goal at the time was twofold: first, to contain unsubstantiated contagion that could destabilize the housing finance system by investors targeting institutions beyond Home Capital; and second, to avoid interfering unnecessarily with market discipline. The junction of those two objectives is hard to see clearly in a crisis, and we had some vigorous debates.

At its core, our debate centered around the risk of contagion – the possibility that concern about the state of Home Capital’s financial affairs would spread to engulf other financial institutions. We did not feel a responsibility to bail out Home Capital. We did not, however, want the punishing effects of a loss of investor confidence in an untenable business model to extend to credit-worthy and solvent lenders.

In the end, private actors found a resolution. Under the captaincy of the Department of Finance, all of the federal players gathered and worked together as a team, standing ready to manage the situation. And CMHC played our role, at the blue line, on that team.

Contagion: The Risk Accelerator

Experts on financial stability toiled in relative obscurity before 2008. Co-operation among super powers, globalization and the Great Post-War Expansion had thinking people talking about the “end of history.”² Monetary policy ignored stability risks and was increasingly focused on inflation targeting.

In some ways the backwater of central banking, financial stability nevertheless remained a crucial question for some dedicated souls. Chief among them was Ben Bernanke, a student of the Great Depression, who steered the U.S. through the global financial crisis as Chair of the Federal Reserve.

Kristin Forbes of the Massachusetts Institute of Technology, one of the foremost experts on financial contagion, asserts that sound, long-term economic and financial policy is the most reliable method of overcoming contagion. She draws an interesting comparison: “… just as lifestyle changes can reduce the risks of many diseases in the future, policymakers concerned about contagion in the future can adopt structural reforms to reduce (although not completely remove) contagion risks in the long term.”³

In 2014, Dong Beom Choi of the Federal Reserve Bank of New York analyzed models of financial spillover among financial institutions with differing fragilities. Against traditional thinking, Choi argues that in times of contagion, the strongest players – not the weaker – should be supported. He argues that panic does not set in until the strongest institutions in the contagion chain begin to ponder market exit, which then prompts weaker players to exit, leading to the self-fulfilling prophecy of failure.⁴ Our concern this past April was exactly that: that a small institution’s failings could engulf others.

Researchers at the Washington-based Office of Financial Research have developed a contagion index based on connectivity, leverage and size. “A bank with a high contagion index poses a systemic risk in the sense that it is more susceptible to failure (due to high leverage), its failure has large consequences (due to its size), and its failure has a potentially large impact on the rest of the financial system (due to its high financial connectivity).”⁵ By the time contagion captures larger institutions, however, it may be too late.

Financial instruments, including mortgage-backed securities, were primary risk-transmission vehicles during the financial crisis.⁶ We need to ensure that our programs do not help propagate contagion from small to large lenders.

Financial stability had come to the forefront of monetary policy by the time I joined the Bank of Canada in 2010, and has been the focus of my public service career. Our work at the Bank was influential in creating bail-in regimes here at home and among the world’s largest banks, on central clearing of wholesale funding vehicles and on the regulation of derivatives.⁷

In 2014, I left the world of monetary policy for the everyday work of housing finance. It looks different but it’s essentially the same thing. Housing is implicated in financial stability via the linkages among mortgages, banking and economic prosperity. Of the 46 systemic banking crises for which house price data are available, more than two thirds were preceded by boom-bust patterns in house prices.⁸

Toward “Parity” in Macroprudential Policy

Back to hockey: today’s NHL is marked by parity. The so-called Salary Cap Era has generated six different Stanley Cup winners in the last 10 years. Alas, Montreal, the days of the empire are passed. Mercifully, so are the days when Leaf management would blow millions of dollars and draft picks on the fool’s errand of chasing a playoff spot. Teams must now be built carefully.

Extending the hockey analogy to our housing finance system, we need to make sure that all teams play by similar rules and that the temptation to take short cuts doesn’t compromise the integrity of the game. Otherwise, our ability to contain failures will be difficult.

Good defence emerges from a strong system and constant analysis of how the game is developing. In the words of former Hab Chris Chelios, “It takes brains. It's not like a forward, where you can get away with scoring and not play defense. On defense you have to be thinking.” At CMHC, we are always thinking, along with our cousins in the “Federal Family.”

We have taken meaningful steps to reduce the risk of insured mortgages, raising the bar of qualification. This has led to a shift away from insured to uninsured mortgages. Nationally, we estimate that insured mortgages accounted for 32 per cent of all housing transactions in 2016. This figure was about 16 per cent in Toronto and 12 per cent in Vancouver, and the trend is continuing to move downwards into 2017.

Uninsured mortgages are not subject to the same stringent rules as insured mortgages and the Bank of Canada has been very vocal about the growing risks in this segment of the market, including higher loan-to-income ratios and a high number of 30-year amortizations. OSFI has taken steps to reduce risks in the uninsured space, but these measures apply only to federally-regulated financial institutions.

We are concerned about increasing levels of riskier mortgage activity by non-federally-regulated financial institutions. Our timely payment guarantee exposes CMHC to the failure of any participant in our securitization programs. Moreover, as I’ve stated, we have a responsibility to isolate sound, solvent institutions from the contagion that can erupt when a lender fails.

Accordingly, as a responsible risk manager, CMHC will be seeking data from securitization program participants on their uninsured conventional mortgage lending. We are aware that OFSI’s B-20 Guidelines do not apply to lenders they do not regulate. While we would hope provincial regulators would act accordingly, we cannot compel them to in respecting their jurisdiction. We need to know what risk we are exposed to, so we will be asking all Approved Issuers to report this information to us.

This information request will allow us to determine if changes are needed to our Approved Issuer Framework to manage contagion and CMHC’s guarantee risk. The data we gather will help us better understand our role and inform future policy decisions.

“Sandbox” changes to Support Economic Growth

The Government of Canada has taken several measures to ensure that housing activity is not compromising the growth of our economy. For the moment, no further measures are contemplated but we actively monitor market developments.

And to those who questioned the wisdom of the October 2016 measures initiated by the Minister of Finance, I should confirm that events have played out as we hoped. We expected a 25 to 30 per cent decline in our volumes. Since the effective date, we are down 25 per cent.

I should add that, easy as it is to criticize, being complacent and not acting would have had a greater long run economic cost, in our assessment.

Post-announcement house price trends suggest the impact was more than just cosmetic – again, as we had hoped. We have also seen a reduction in high loan-to-income ratio mortgages, another intended consequence given the very legitimate concerns of the Bank of Canada and others, including CMHC, about record levels of household debt in Canada.

Affordability, Social Inclusion and Housing Demand Policies

I will conclude with some observations about the value of coherent housing and macroprudential policy. Housing finance policy appears to some as a wrestling match between affordability and financial stability. This perceived tension emerges from a myopic demand-side lens. It is also a trap.

Tempting as it is to offer subsidies and low-cost financing to homebuyers, the resulting increased demand will increase prices unless supply is unconstrained. And supply is always subject to constraint. We know supply is especially unresponsive in markets like Vancouver and Toronto, where it is most needed to help working families live within their means. We will be releasing our study on the causes of escalating house prices in the new year with further insight on these questions.

Many factors are at play: geography, planning requirements, land banking, availability of financing, and so on. Land prices are increasing, encouraging builders to build denser housing structures, and we need to encourage this trend by ensuring that government processes are efficient.

And let’s not forget that some of Canada’s cities are simply world class and are dealing with world-class housing demand issues. Recent 2016 census data suggest that people are increasing their propensity to rent versus buy, a sensible adjustment in cities with more expensive ownership costs. Demand is already well-supported by economic growth, immigration, low interest rates and government programs.⁹

At the federal level, tax measures such as the capital gains tax exemption on principal residences, the GST rebate on new home purchases, and the first-time home buyers’ tax credit provide substantial support towards homeownership.

Other programs further stoke demand. At the provincial and municipal levels, various borrower assistance programs make it possible for homebuyers to purchase a home without a down payment, or worse, with negative equity.

The U.S. government promoted homeownership heavily through government-sponsored entities Fannie Mae and Freddie Mac. House prices skyrocketed, and we know how badly that ended. Ill-considered demand-side housing programs meant to increase the rate of homeownership helped cause a global financial crisis.¹⁰ We best practice caution given the state of our housing markets.

Homeownership in Canada would seem to have peaked at around 69 per cent and have declined a little in response to high house prices and increased interest rates. An increased propensity to rent is observed in Toronto and Vancouver, a natural response to high house prices but one that increases rental demand and crowds out poorer Canadians.

Where people want us to provide financial support to help people buy homes, therefore, at the margin it might better support affordability to restrict unhealthy demand via macroprudential limits and devote more of our financial resources to stimulating supply.

The federal government will soon announce the first National Housing Strategy in Canadian history. I am proud of the role CMHC has played in balancing various interests to fashion a balanced plan that will focus on those most in need. The Strategy will include a healthy supply of stimulus, more targeted at rental housing. Rent or own, it’s still a home.

We have also taken the opportunity at CMHC to re-examine our own policies to ensure that we are promoting the goals of the National Housing Strategy in our commercial operations. As a result of this review, are looking at ways to qualify for mortgage insurance borrowers whose income is more challenging to verify, such as the self-employed.

We have also reviewed the socio-economic characteristics of mortgage insurance incentives to determine if we are promoting social inclusion or reinforcing bias. Our work is not yet complete and the results are mixed. While immigrants and people with disabilities seem not to be disadvantaged, we know that Indigenous people and visible minorities have lower rates of homeownership. Married people and men also appear to benefit more frequently from mortgage insurance.

I should add that, last month, we funded and co-sponsored with Status of Women Canada a Pan-Canadian Symposium on Women and Housing. And we have subjected the National Housing Strategy to a Gender-Based Analysis Plus review.

In closing my remarks about hockey and housing, I now have two great wishes. First, I hope that every Canadian has the housing she needs – and can afford.

Second, I want the Leafs to win the Cup. Just once more. Go Leafs Go!

Thank you.

¹ Data compiled from Home Capital Group Inc. news releases providing updates on liquidity and deposits.

² Francis Fukuyama, 1989. “The End of History?” The National Interest, Summer 1989.

³ Kristin Forbes, 2012. “The Big “C”: Identifying Contagion,” National Bureau of Economic Research (NBER) Working Paper Series, Working Paper 18465, October 2012.

⁴ Dong Beom Choi, 2014. “Heterogeneity and Stability: Bolster the Strong, Not the Weak,” Oxford University Press (on behalf of The Society for Financial Studies). 4 April 2014.

⁵ Paul Glasserman and H. Peyton Young, 2015. “Contagion in Financial Networks,” Office of Financial Research Working Paper, 15-21, 20 October 2015.

⁶ Ben S. Bernanke, 2010. The Squam Lake Report: Fixing the Financial System, (speech toThe Squam Lake Conference, New York, New York, 16 June 2010).

⁷ Budget 2013 committed the Government of Canada to implement a bail-in regime to ensure that, in the unlikely event that a systemically important bank depletes its capital, the bank can be recapitalized and returned to viability through the very rapid conversion of certain bank liabilities into regulatory capital. Amendments to the Bank Act and Canada Deposit Insurance Corporation Act in 2016 established the bail-in legislative framework, which will be implemented through regulations published in the Canada Gazette earlier this year.

The Bank of Canada also convened a group of banks and investment dealers to work with the Canadian Derivatives Clearing Corporation in creating a central clearing function for repurchase agreements (“repos”). Repos are used extensively for wholesale funding by financial institutions. A central clearing counterparty distributes the risk of the failure of one institution across all members.

Refer to: Multilateral Instruments 91-101 Derivatives: Product Determination and 96-101 Trade Repositories and Derivatives Data Reporting. Sources: OTC Derivatives Working Group, 2010. Reform of Over-the-Counter (OTC) Derivatives Markets in Canada: Discussion Paper from the Canadian OTC Derivatives Working Group, 26 October 2010; Eric Belli-Bivar (DLA Piper LLP), 2012. “The regulation of derivatives in Canada – background and new developments,” Lexology, 21 December 2012; and Canadian Securities Administrators, 2016. “Canadian Securities Regulators amend derivatives reporting rules,” 30 June 2016.

⁸ Christopher Crowe, Giovanni Dell'Ariccia, Deniz Igan and Paul Rabanal, 2011. “How to Deal with Real Estate Booms: Lessons from Country Experiences,” IMF Working Paper, April 2011.

⁹ Bob Dugan, CMHC Chief Economist, 2017. “Why the foreign buyers tax isn’t making Vancouver more affordable,” Maclean’s Magazine, 17 August 2017.

¹⁰ Gretchen Morgenson and Joshua Rosner, 2012. Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time, St. Martin's Press, 2012.