Home prices have doubled over the last decade, propelled by low rates and easy mortgage terms. But as the U.S. experience proved, soaring property values can come with an ugly downside. Starting with this story, The Globe and Mail examines the foundation of Canada's historic real-estate boom in a series.
When Dennis Gilmore gathered financial analysts and investors on a conference call last summer, the head of California-based First American Financial Corp. had some troubling news. It was what he referred to bluntly as “the situation” up in Canada.
The Los Angeles-area insurance company was losing tens of millions of dollars due to hidden problems in the Canadian housing market, and there were no assurances that the bleeding was going to stop.
Few Canadians may have heard of First American Financial – but several of Canada’s biggest banks knew the firm well.
As home prices soared over the past decade, the banks quietly turned to First American Financial to buy protection against mounting risk in the housing market.
It was an odd relationship. Based in a suburban industrial park, First American was a long way from the financial towers of Toronto or New York.
But the company was willing to offer the banks a particular kind of insurance that many other companies weren’t.
It allowed the financial institutions to protect themselves against the risk posed by a new form of lending that had dramatically altered the way homes are bought in Canada.
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.
Those distortions matter less in a strong economy and a rising market, in which price appreciation covers up any errors. But the days of steady gains in real estate are gone: Almost all major metropolitan markets have plateaued, and in some, such as Vancouver, housing prices are falling at a worrying pace. And in an environment of declining prices, the inflation resulting from automated lending poses a risk not just to individual homeowners – who could see the value of their equity severely eroded or even erased – but to the entire banking system, which now has to contend with the possibility that their mortgage loans are backed by homes that aren’t worth what they thought.