Emerging Prudential Risks in Housing

Remarks by Superintendent Peter Routledge to the Chartered Financial Analyst (CFA) Society Vancouver, Vancouver (Virtual), British Columbia

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Thank you for the kind introduction, and thank you to the Vancouver Chapter of the CFA for allowing me to speak at your Keynote Luncheon this afternoon.

I am here to speak to you today about housing. But before I begin talking about modern-day mortgages, I’d first like acknowledge that the territory where I’m physically located today to deliver these remarks, is home to the Anishnabeg and Algonquin First Nations Peoples. They have lived and worked in this region for millennia, and this land is unceded by those peoples. For a time, I lived, worked and studied in the Metro Vancouver area, which I recognize as the traditional lands of the Coast Salish peoples, the Squamish, Sto-lo and Tsleiel-Waututh and Musqueam First Nations.

I believe that it is important for all Canadians, wherever they are located, to work toward reconciliation with Canada’s Indigenous Peoples. In that spirit, I encourage all Canadians to read the Final Report of the Truth and Reconciliation Commission of Canada, and for you to consider the land where you live and work, and acknowledge its history, and ongoing stewardship, wherever you might be.

Introduction

My family lives in North Vancouver, BC. and I have been worried about them and about all my fellow British Columbians over the last week as Canadians in that province dealt with the ravages of extreme rainfall and flooding. I know they are resilient and that many emergency workers are doing more than their part to re-open transportation lines in BC. We thank them for their effort.

Climate events, such as this one, remind us of the imperative of quantifying and adapting to climate risk; a permanent and intensifying risk in our operating environment.

As I’ve noted several times since becoming Superintendent, now is a particularly consequential time for OSFI. The organization is known for having a good track record of prudent financial regulation, and Canada’s financial system has fared extraordinarily well through several bouts of financial volatility, including the past 18 months that we have come to know as the COVID-19 pandemic.

In addition to the present pandemic related challenges we also find the Canadian financial system facing uncertainties. Two important challenges that I’ll be tackling in coming years include the urgent necessity of the financial industry to finance a reduction of green house gas emissions and to manage and capitalize on the risks posed by the digitalization of financial services.

Our mandate and approach is about focussing on the risks in the financial landscape and setting out and supervising expectations for federally regulated financial institutions. Indeed, prudential supervision is about protecting the real economy for the benefit of Canadians.

In the view of my colleagues and myself, a volatile economic environment requires transformative change at OSFI for it to remain an effective and proactive regulator and supervisor. I made a public announcement saying just that at the Global Risk Institute on September 29, when I outlined the fierce urgency required to anticipate more frequent bouts of volatility in financial markets.

I, and my leadership team, followed up on these public commitments by releasing OSFI’s Transformation Blueprint to our colleagues that will guide our transformative effort over the next several years. Briefly put, we are challenging our assumptions about risk.

Today, I will speak to one of the risks often attributed to OSFI - home ownership.

Many Canadians pursue home ownership as part of their Canadian dream. Therefore, housing affordability is an issue of great public interest, particularly for those seeking to buy their first home. This can be seen by the attention this issue received during recent federal and provincial elections.

This level of attention leads an analyst or, more precisely, a bank supervisor to examine risk in Canadian residential mortgage credit. And as the head of the agency charged with contributing to public confidence in the Canadian financial system via the supervision of lenders, among other institutions, we constantly ask ourselves, “What are the avenues to lessen that risk?”

Although the word “exuberant” characterizes the housing markets in many Canadian cities & towns since the fall of 2020, we at OSFI believe residential mortgage credit risk has risen only modestly. There remains a risk that residential mortgage credit conditions could deteriorate, but fortunately OSFI has leveraged several prudential tools to increase the margin of safety in that market. In this endeavour, our federal and provincial financial safety-net peers have contributed mightily. Nevertheless, we consider the current imbalance between housing demand and supply to be a material prudential risk, and all actors in the Canadian housing system must take actions if we are to lessen the risk.

I will make four arguments to support this point of view:

1. Prudential risk in residential housing finance has risen modestly and warrants OSFI’s continued vigilance.
2. OSFI has employed several tools to enhance our vigilance over residential mortgage credit risk and reduce systemic fragility.
3. The greatest prudential risk in Canada’s financial system is the supply / demand imbalance in housing.
4. Intergovernmental efforts are required to address the housing demand and supply mismatch in Canada.

Prudential risk in residential housing finance has risen modestly and warrants OSFI’s continued vigilance

Since the onset of the pandemic house prices have risen 24% nationally.^{Footnote 1} Residential resales are at record highs and inventories are at record lows.^{Footnote 2} Through it all, residential mortgage credit growth, at 10% annually, is the fastest it has been since 2008.^{Footnote 3}

In fact, the Bank of Canada has developed a “House Price Exuberance Indicator” or HPEI, which is basically a model used to detect overvaluation of house prices in cities across Canada. This model indicates that the vulnerability associated with imbalances in the housing market has increased, but unevenly across the country.

Despite this exuberance and rising mortgage credit levels, Canadians are dedicating less income to debt service payments such as mortgage payments, automobile loans, and credit card payments.^{Footnote 4} On the other hand, there is also evidence that variable rate mortgages are more popular than they have ever been, accounting for 51% of new residential mortgages in recent months.^{Footnote 5} As variable mortgage rates are lower than fixed mortgage rates, new home buyers may be accepting the elevated interest rate risk that comes with variable rate mortgages in order to become home owners.

Combined mortgage-HELOCs and debt

Non-traditional housing backed lending products like Combined Mortgage-HELOC Loan Plans (“CLPs”), which can have re-advanceable structures embedded within them, may be simultaneously fueling and helping Canadians afford rising home valuations. CLPs are an area of focus for OSFI as they represent a significant portion of uninsured Canadian household mortgage debt. With this product, Canadian mortgagors can readvance to themselves principal paydown in the form of a HELOC – basically they can flexibly borrow against their homes, sometimes up to 80% of their homes’ current value. These can be great products for people to consolidate debt at lower interest rates and to manage cashflow challenges, however they can also create vulnerabilities.

The use of HELOCs and non-traditional housing backed products can lead to greater and more persistent outstanding principal balances, increasing risk of loss to lenders. Further, it can be easier for borrowers to manage financial distress by drawing on their lines of credit to make mortgage payments. This makes it challenging for lenders, markets and regulators to adequately assess credit risk exposures in a timely manner during periods of stress.  

When OSFI sees products growing rapidly, it is our job to understand why and assess what risks that growth may present to institutions and the economy. Further, as product structures evolve, there is a potential that such products become non-compliant with our underwriting expectations. We have asked lenders to closely review the risks arising from their own combined loans and HELOC-mortgage structures.

We have also clarified the expectations in B-20 for these types of re-advanceable products and are currently working with industry participants to ensure compliance with those expectations, including heightened focus on HELOC account management programs. If we see that risks are growing faster than controls, we take action as required, and can revisit our underwriting expectations contained in guideline B-20.

From these insights and data, one can infer the following about residential mortgage credit in Canada:

• Demand for Canadian housing remains quite strong and that demand is fueling very significant price increases and debt accumulation.
• Canadians are managing the higher debt loads quite handily in the present interest rate environment, and have ample cushion for rising interest rates.
• But in this environment, Canadian household credit risk is growing marginally more fragile and we at OSFI must remain vigilant.

OSFI has employed several tools to enhance our vigilance over residential mortgage credit risk and reduce systemic fragility

We have written and refined our guideline for residential mortgage underwriting which requires lenders to maintain responsible underwriting of residential mortgages, such as:

• ensuring they test borrowers for adverse conditions,
• verifying a borrower’s employment status and income history,
• placing more scrutiny on property valuations,
• establishing dynamic loan-to-value limits that reflect the risk of specific properties and markets, and
• updating these limits and practices as housing markets and the economic environment evolve.

We continuously refine and improve the capital requirements lenders must hold against residential mortgage credit risk. This includes the forthcoming domestic implementation of the Basel III capital standards in 2023. The package of reforms we proposed in our spring 2021 consultation,^{Footnote 6} advances a more resilient and proportional bank regulatory regime in Canada that protects depositors, maintains market confidence and promotes continued financial stability, especially during times of stress.

The results of our consultation and the final guidelines will be released in the coming weeks and they include reforms to requirements for residential lending exposures to address potential fragility and protect the financial system and taxpayers from severe financial stress, however, they are not our only actions.

Earlier this year we instituted an additional margin of safety into the system – by requiring lenders to confirm borrowers would be able to continue repaying their mortgage loans if faced with a sudden change to their circumstances (such as, income loss, increased interest rates, additional expenses, etc.) This margin of safety is also known as the minimum qualifying rate (MQR) for uninsured mortgages, or the mortgage stress test.

We established a straight forward measure for applying the MQR. The minimum qualifying rate for uninsured mortgages - that is, residential mortgages with a down payment of 20 percent or more- will be the greater of the mortgage contract rate plus 2 percent or 5.25 percent. Note, we also promised to review the MQR annually. We will announce the results of our review in the coming weeks, well before the Spring housing market – so stay tuned.

Today, this means that Canadian mortgagors will have to qualify at a mortgage rate of 5.25%, a figure well above the current average of contracted mortgage rates. This makes the system safer in a number of ways. First, it attenuates some of the exuberance (not all, I grant you) that would otherwise drive house prices even higher than they have risen in the past year. Second, it ensures households are better able to withstand a shock of lost employment or higher interest rates. And third, it leans against the tendency of some homebuyers to over-extend themselves in taking on debt.

Our more transparent approach recognizes that housing is fundamental to the well-being of individuals, institutions, and the Canadian economy. There are countless elements that influence personal decisions and policy actions. Often these interact with each other to create new uncertainties. House price volatility, driven by the combined forces of new supply-chain challenges and inflation rates that we haven’t seen in decades, are beginning to shape the near and long-term risks that Canada and Canadians will need to face.

Some observers have reasonably and responsibly pointed out that the strain of the MQR falls unevenly on new home buyers; that is fair - it adds to the already high burden of large down payments required by high home prices. But sacrificing this margin of safety is not the optimal solution. Particularly when there are near term and long-term risks to consider when looking at Canada’s mortgage market.  

The greatest long-term prudential risk in Canada’s financial system is the supply / demand imbalance in housing

It is very difficult to measure supply and demand imbalances – in spite of much research that has gone into it – nevertheless, empirical evidence is sound enough to indicate that in Canada housing supply has not kept up with housing demand in recent years.

Data from Statistics Canada^{Footnote 7} and the CMHC^{Footnote 8} indicate that, between 2017 and 2019, new household formations totaled 797k cumulatively, meanwhile CMHC data indicates housing completions totaled 578k; a difference of 219k. Now in 2020, we experienced some COVID-related relief with an estimated 27k new household formations, compared to housing completions of 199k but the longer-term trend remains, and we suspect 2021 will look something like 2017-2019.

Recent Bank of Canada research suggests the supply/demand imbalance is specific to a few Canadian cities with low measured housing supply elasticities^{Footnote 9} - Canada’s three hottest housing markets: Vancouver, Toronto, and Montreal. These low elasticities suggest that prices rise more rapidly in these cities as demand increases. Anecdotal evidence tends to support this inference.

Recently, economists at the Bank of Nova Scotia pointed out that Canada has the lowest number of housing units per 1,000 residents of any G7 country. Moreover, they estimate that an additional 100,000 housing units would have been necessary to keep the ratio of units to population stable. This estimate is in the same neighborhood as the gap between household formation and housing completions over the past four years.

A sustained, multi-year imbalance between housing demand and supply intensifies risks to Canada’s housing market and to Canada’s system of housing finance. The imbalance tends to drive price increases to ever higher levels relative to income; this in turn induces more Canadians to resort to more leverage when buying a home. Such an imbalance certainly does not contribute to housing affordability for younger generations who, understandably, see that part of the Canadian dream as further away than prior generations did.

A note on housing and immigration

Canada has long had very strong immigration relative to our G7 peers and it is certainly true that immigration into Canada drives higher levels of household formation and therefore robust housing demand; and I think it important to stop a minute and consider a few salient facts about Canadian immigration and our housing market.

Our neighbors to the south often claim to be that shining city on the hill. Despite my admiration for the United States, I think that honorific applies just as well to Canada, if not more so.

Put yourself in the shoes of a young or mid-career profession from the developing world – what would you see when you looked at Canada.

• A country with legally guaranteed and protected human rights and property rights.
• A country founded upon the rule of law.
• A country where citizens have access to good education and good health care.
• A country that is tremendously diverse and welcoming of immigrants where, perhaps, several friends or family members now live very attractive lifestyles.

You would do well to ask yourself if there is a more preferable place on the planet to raise a family, or to pursue your personal or professional ambitions. And I think if you did, you would not find a better alternative than Canada.

National Bank has put some interesting numbers around Canadian immigration last year.^{Footnote 10} They point out Canada’s population has been among the fastest-growing of the OECD countries for years now.

Immigration to Canada stands out not only for its volume but for its composition. OECD data show that about 60% of the annual inflow of permanent residents are “economic” immigrants – applicants selected for “their ability to become economically established in Canada.” That’s four times the percentage for U.S. immigration.

Of Canada’s foreign-born population of working age (15 to 64), almost 70% have a post-secondary education, by far the largest proportion in the OECD and almost 30 percentage points higher than the proportion for the U.S.

No fewer than 30% of the 25- to 44-year-old immigrants arriving in Canada in the previous five years were homeowners. Among those who arrived between five and 10 years previously, 53% were homeowners, only 6 points less than the percentage for Canadian-born.

The people who come to Canada to raise their families and pursue their ambitions are amongst the world’s best and brightest; because of that they contribute mightily to our country from the get-go; and they need places to live alongside those of us whose parents or ancestors once counted as new Canadians, and alongside our compatriots of indigenous descent.

A robust housing market in Canada, though not risk-free, is a sign of the underlying strength of the Canadian economy and the Canadian dream.

Intergovernmental efforts are required to address the housing demand and supply mismatch in Canada

OSFI is not the only agency interested in a vibrant but stable mortgage and housing market in Canada. This interest is shared by buyers, sellers, builders, communities, cities and provinces. Sharing interests is not the same as agreeing on all matters. The role that OSFI plays is one that fulfils our perspective and mandate for safe institutions and a stable financial system.

The importance of the housing and mortgage market to all involved means that more people need to be engaged in deeper discussions to find more workable enhancements to Canada’s housing market and finance system. Federal government initiatives over the past have done much to address exuberant demand, but those tools will not be as effective in the current environment.

Demographic changes and the need for immigration to grow our economy put further pressures on how and where house prices shift. Through it all, the stock of housing supply is not growing as fast as household formation.

Although, this is a complicated economic and policy making environment, the urgency for bringing housing supply up to the level of housing demand is an imperative for long-term financial stability in Canada. Provincial and local governments will have to play a greater role in addressing the housing supply / demand mismatch in their regions.

There have been a number of actions taken at various levels of government over the past few years, including non-occupant taxes, consideration of transit and zoning changes and other projects to increase access to affordable housing. While there have been some successes in specific regions that address specific issues, these targeted efforts can have a limited impact and can be slow to deliver lasting results.

Let’s have all levels of government and the private sector work together to sustain Canadian housing as a cornerstone of strength for our country. To that end, we see a welcome advancement in the federal government’s commitment to increasing housing supply and the decision to create a new cabinet position focused on Canadian housing.

There are ways that we can work together toward better outcomes and OSFI is eager to engage in the conversations that will contribute to confidence in the Canadian financial system. We see these issues as needing more discussions, not fewer, and more information, not less.

But until then I am happy to have a conversation with you all today.

I look forward to your questions.