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.
"Everyone is getting nervous now," says Phil West, a veteran of the appraisal industry who is critical of Emili. "There is more and more potential of a downturn in the marketplace. And everyone is looking at: Where is the Achilles heel?"
Although the issue has been kept out of the public eye, documents obtained by The Globe and Mail show that concern about inaccuracy, flawed data, and risk within the system has spread to the highest echelons in Ottawa and in the banking industry. In the spring, the federal banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), acted on alerts from industry insiders and ordered banks to stop relying so heavily on automated systems when approving mortgages.
The time had come, OSFI warned, for Canadian lenders to be more rigorous.
Until the mid-1990s, borrowing money to buy a home was, by today's standards, a more tedious exercise. The bank looked at a proposed transaction to determine if the buyer could afford the payments, and typically sent an appraiser to see if the home represented sufficient collateral for the loan.
The appraiser inspected and measured the house, and took rolls of photos that were dropped off for developing. Back at the office, the appraiser sifted through books of recent sales data on similar homes in the area. The whole process took two or three days. The cost, about $200, was typically passed on to the consumer.
Because they cost time and money, such on-site appraisals were not popular with consumers and real estate agents hurrying to close a sale. "It's when the appraiser gets involved that there's a problem," Rick Sieb, a long-time appraiser in the Vancouver area, says sardonically. "We're just a big pain in the ass."
The approach to appraisals changed dramatically in 1996, when CMHC introduced its Emili system.
CMHC encourages banks to lend by insuring mortgages where the buyer has a down payment of less than 20 per cent. It charges the borrower a premium for the service, and essentially allows the banks to offload the risk of a default onto the government.
In the mid-1990s, CMHC created Emili as a computerized tool to determine quickly if a loan was safe from risk of default, based on the estimated value of the home and several other factors. Information about the house, the buyer, and average sales for the area were fed into the program, which then spit out a risk assessment. Internal lore has it that Emili was named for the daughter of a former CMHC vice-president.
The system was only used internally at first. But in 1996, Emili was offered to banks, for a fee, allowing them to also use the software on uninsured mortgages and refinancings where CMHC wasn't involved.
Touted as a ground-breaking "loan decisioning system" by CMHC, Emili would compress application approval times for the banks "from days to seconds." And since using Emili was faster and cheaper than sending out an appraiser to look at the house, CMHC said the system would "increase profits" for banks.
Not surprisingly, the lenders were anxious to buy in. "The banks asked us to use it," Pierre Serré, the chief risk officer at CMHC, said in an interview.
The invention was a hit. Though Emili isn't the only system of its kind – other mortgage insurers and data companies have their own computerized models – it is by far the one in widest use, stamping its approval on hundreds of thousands of Canadian mortgages each year.
Though CMHC is reluctant to detail exactly how the Emili system works, it's very simple from the banks' perspective. For a fee of about $50, "you ping CMHC to say I have this house on this street at this address," said David McKay, head of retail lending for Royal Bank of Canada, the country's largest bank. "You ask, is it worth $300,000? You send them a question, and they come back saying it's in the range – yes or no. They don't feed you a number back, they tell you it's in the range, or it's outside. And then you have to say, 'Okay, good enough for me. I'm going to lend against $300,000.' "
The problem with Emili
The Globe and Mail's investigation has revealed serious concerns – behind the scenes in Ottawa and within the housing and banking sectors – over whether mortgage lenders have exercised enough caution and diligence in recent years as the industry wrote record amounts of new loans, and whether the data produced by the computerized systems are flawed.
Documents obtained by The Globe through numerous Access to Information requests show that the banking regulator, OSFI, is concerned about the "relaxation of valuation policies" by the banks, as automated appraisals have come to dominate.
The documents, which include transcripts of consultations with industry insiders, show OSFI has become worried about the accuracy of the data used in automated systems, including the possibility that those systems are inflating housing prices and putting lenders at risk.
CMHC's Mr. Serré defends the Emili system, saying it takes into account municipal property tax assessments, recent sales in the area, and prior transactions involving the home, if available. The models also use data about the property being purchased, such as square footage, as well as information about the borrower, including income and debt levels.
However, the housing data fed into the Emili system are, by nature, imperfect. OSFI warns in the documents that automated models "have their drawbacks," because the data relied upon often include information provided by sellers, which can't always be trusted. "[The programs] are driven by the sellers' listings, which often inflates the value of the home," OSFI says.
And municipal tax assessment information is typically outdated, and could take years to capture falling prices, as some markets in Canada are now experiencing.
It also concerns the bank regulator as well as industry members that automated programs do not examine the particulars of a home – such as an aging foundation or lack of upkeep.
"Neighbouring or adjoining properties can and often have vastly different physical characteristics that can impact overall values," an industry member states in the documents. (The names of each party involved in OSFI consultations were blacked out before the files were provided to The Globe.)
An on-site visit to a suburban Vancouver home with Mr. Sieb illustrates the concern. As he begins walking through the house, the appraiser grows skeptical about the information the bank has been given about this home.
The listing says this house – a bungalow listed for $479,000 – was built in 1980 and is newly renovated. He notes some fresh carpet and a recently installed light switch, but the kitchen and other rooms show troubling signs of age. "This isn't a renovation," he says flatly. "You wouldn't call it that unless you were stretching what you see for the purpose of getting the value up."
Mr. Sieb checks the dates stamped on the plumbing. "This place was built in the 70s," he says, shaking his head.
This, he explains, is the sort of thing that the computers miss.
Last month, Mr. Sieb appraised a home that turned out to be several hundred feet smaller than what the paperwork on the house claimed.
"In my career," says Mr. Sieb, who has been appraising for 30 years and now runs Inter-City Appraisals of Coquitlam, B.C., "maybe five times have I had the exact same measurements as the realtor."
The OSFI documents say the age of a property is a particular area of concern. "Often, this figure is neither verified nor validated and rests upon the buyer's or seller's word," the documents say.
Nor can computer systems assess the basic quality of the property: "The physical quality of the building is not verified on site. A building's construction quality as well as its condition and specific location are other highly important factors that determine an immovable property's value."
Such flawed data skew the risk assessment on loans, and can lead to the green-lighting of bigger mortgages than should be permitted. That pattern, in turn, stokes inflation of the market.
The systemic inaccuracy creates latent risk within the lending system. The documents indicate OSFI is concerned that banks have come to rely too frequently "on one method" – computers – to evaluate homes and mortgage applications. One industry insider estimates some banks used automated systems for as much as 70 per cent of their mortgages and refinancings at the peak of the housing market.
In interviews, CMHC officials stressed that Emili uses a wide variety of data. However, officials refused to provide a specific list of where it obtains the data that feeds into Emili.
CMHC characterizes the views expressed in the documents as debate among industry members. But Mr. West, a former CMHC official, told The Globe the concerns about the accuracy of automated systems are warranted. Because the software can't see the home, it can't spot basic problems.
"One of the things that the on-site inspection does is it actually proves that the home exists in the first place. And that may sound like a very funny thing, but believe me, it would not be the first time a loan was put on a vacant piece of property," said Mr. West, who is now president of Centract Settlement, a division of real estate giant Brookfield Residential Property Services.
CMHC acknowledges that this weakness exists in the system. A spokeswoman told The Globe in an e-mail that staff are aware of "a handful of cases" in which Emili has approved a mortgage for a non-existent house.
The problem with humans
While on-site assessments would catch such obvious flaws, switching from automated systems to in-person appraisers doesn't solve all problems. Just as computers have weaknesses, so do humans.
"It's not like appraisers are flawless or perfect," said Tsur Somerville, an associate business professor at the University of British Columbia who specializes in real estate
Shopping around for a friendly appraisal is not unheard of in the industry – it can happen when mortgage brokers worry about a tough appraisal scuttling a deal or diminishing the price. In other cases, pushing up the value of the home in the appraisal allows the borrower to get a bigger loan.
"When we are dealing with mortgage brokers, we hear it a lot: 'Can I get more? Get me more,' " says Mr. Sieb, the B.C. appraiser. "We actually have a broker who will e-mail us and say, 'I need $500,000 on this, what do you think?' The appraiser might say, there's no way in hell. Then the broker just hangs up and phones the next guy until he gets the answer he likes."
Walking through the backyard of a home in the Vancouver suburbs, Mr. Sieb gives a glimpse of how an on-site appraisal can be manipulated. There are tricks of the trade that every appraiser knows.
The yard looks out over a wooded area that hides a road. How you describe that view, he says, can be worth $10,000. Evaluating the type of street the home is on – busy or quiet – and the neighbourhood's amenities is also highly subjective.
Kitchens are where most of the problems occur. "A kitchen could be a $20,000 or a $50,000 kitchen and look almost identical in a photo," Mr. Sieb says. "Age and condition, design and quality" – those are the things that afford a lot of slack in an appraisal. "Renovations are where a lot of the fraud occurs."
Just as a computer model can mistakenly upgrade or downgrade a home depending on its neighbourhood, an appraiser can inflate the value of a house by being overly optimistic in picking "comparable" houses as market benchmarks. A common criticism of appraisers is that they can be influenced. Although appraisal management firms such as Centract have sprouted up as intermediaries between banks and appraisers, financial institutions often keep lists of approved appraisers. This system of picking favourites has been made illegal in the U.S., where appraisers are not allowed to be tied to the lender in any way.
It is an open secret in Canada that brokers who bring in a lot of business to one lender can push to have certain appraisers added to those lists, one mortgage broker told The Globe and Mail on condition of anonymity.
Peter McLean, an appraiser in Peterborough who is president of the Ontario division of the Appraisal Institute of Canada, says regulations should be stepped up.
Although the industry group requires its people to complete a battery of courses, it is "increasingly concerned about the number of individuals who hold themselves out as 'appraisers' – and offer very attractive rates – who have no relevant qualifications or expertise and who are accountable to no one," Mr. McLean said.
"I've probably been asked 100 times, 'I really need this number and I'll pay you extra,' " Mr. McLean said. "Fortunately, I'm busy enough [to say no]. But if you need the business, desperate people do desperate things."
At a time when the U.S. has introduced new regulation to reform appraisal practices that are believed to have contributed to its housing crisis, Canada has yet to act. The concerns about automated appraisals, contained in the documents obtained by The Globe, are only starting to come to the surface.
Relying on any one system too heavily – whether human or computer – is what ultimately creates problems, observers say.
"We've got to change the way the appraisal industry goes about doing their job," Mr. West said. "I see this perfect storm on the horizon. You can't turn the industry on a dime."
Gaming the system
In the rush to faster and cheaper approvals over the past decade, on-site appraisals have fallen out of favour for mortgage refinancings. And this trend has created an entirely new set of concerns over accuracy.
The imprecision of automated systems becomes even more problematic when it comes to home refinancings, where homeowners can add hundreds of thousands of dollars to their mortgage.
Where the sale of a house is subject to the market – the buyer and seller must agree on a price – no such check exists for refinancings. The house may not have been on the market for years, and a computer crunching average prices for the area could end up being significantly wrong about a particular property.
Refinancings have grown rapidly in the housing boom, and now measure in the tens of billions of dollars annually. Though reliable historic data isn't available, Canadians borrowed more than $30-billion through refinancings in the last year alone, according to the Canadian Association of Accredited Mortgage Professionals.
When the Bank of Canada flagged consumer debt as the "biggest domestic risk" to the economy this year, it said the habit of consumers taking equity out of their home was at the heart of the problem, and noted that such growth appears to have occurred "in a context of underwriting standards that are less than optimal."
In tandem with low interest rates, lax appraisal standards fuelled this stunning rise in borrowing. In the case of mortgage refinancings, it was simply a matter of the banks "pinging" Emili to see if a house could support a bigger loan – say an extra $50,000, or maybe $500,000.
Royal Bank of Canada, the country's biggest lender, acknowledges this risk. "CMHC would disagree with this, but for our books I don't want to do a refinancing where someone comes in and says, 'My house is worth $700,000, it's up from $400,000 three years ago, I'd like a refinancing and I'd like to borrow $500,000 against that please,' " Mr. McKay said.
"There is no transaction to look to. The customer thinks their house has gone up in value, so how do you verify that? You have a range of values that Emili works within. You haven't sent anyone over to the house, and Emili is looking at the street number and the context of the price within [the neighbourhood], but you don't know if it's the most run-down house in the neighbourhood or the most valuable."
Since the automated system only determines if a loan is risky or not, an overzealous consumer, or an aggressive loans officer who wants to encourage a customer to borrow as much as possible, can use the system to discover the maximum threshold for a loan to be considered acceptable. This can inflate both consumer borrowing and house prices.
"It's what I've heard coined as 'gaming Emili,' " Mr. West says. "You submit a variety of different numbers until you get to the number that Emili kicks out and says: unlikely or highly unlikely" to default.
Officials at CMHC play down these concerns.
"Yes, Emili can approve an application on its own, but only after it looks at all the factors and it satisfies our predetermined parameters," Mr. Serré said. "All Emili does is rank the mortgage loan applications from low to high in terms of applications that are more likely to default. That's its purpose in life."
And CMHC officials say the system is designed to catch manipulation. "If lenders submit multiple purchase prices, this will raise a red flag in the system," a spokeswoman said in an e-mail.
However, several banking industry insiders, speaking on condition of anonymity, told The Globe that commissioned staff within their ranks have been found gaming Emili in order to boost their bonuses.
The OSFI documents show that one industry official warned the regulator that Emili distorts the market by sending the wrong signal on housing values to homeowners.
"Buyers feel reassured with respect to the value of their investments because it was validated by a Crown corporation, while the CMHC does not appraise the real value of the purchased property. Instead it appraises the risk associated with the debtor," the industry member said.
Although automated systems save time, there is also cost to consumers. Since CMHC charges premiums for insuring loans against default, larger mortgages approved by the system mean bigger premiums.
"The time saved comes with a high price tag for the consumer," an industry member argues in the documents. "If the property is overvalued, the insurance premium will be based on the overvaluation and multiplied by 25 years of mortgage payments."
"The resulting sum may be considerable. Thus, the CMHC, a Crown corporation, cuts corners by not demanding professional appraisals and generates higher revenues by basing its premiums on overvalued figures."
In the past decade, CMHC has made more than $17-billion for the federal government, including income taxes.
In an interview, CMHC officials pointed to the country's low default rate as evidence such worries are overblown. Since 1996, Emili has handled about five million mortgage applications, and defaults are running at less than 1 per cent.
However, economists and real estate experts note that this statistic tends to lag behind market reality, and the true extent of the problem will only be known after housing prices cool off.
"You can hide a lot of sins in underwriting through market appreciation," Mr. West says. "No one cares when it's good times and everyone is happy, and your only need is to put as much money out as you possibly can, as opposed to balancing risk."
For banks, sound appraisals are essential to measuring the ratio of loans to home values, critical for lenders in monitoring their own loan portfolios – which are mostly comprised of mortgages. If home values are off, then so too will be the ratios used by banks to manage risk.
As the market gets more volatile, the data used in automated systems become less reliable, since the information does not capture the most recent movements in home prices.
Automated models are "imperfect," Mr. Somerville of UBC said. Just as computers can mistakenly overestimate the value of a house, they can also underestimate a property with faulty data, making a good loan appear to be high-risk. Because of these issues, the systems must be used carefully, he says. "Cheaper and faster is not always better for the health of the financial system."
OSFI's request last March that lenders stop relying solely on automated valuations was the first hint of a problem with appraisals. The regulator ordered banks to conduct in-person appraisals or – at the very least – drive-by inspections to confirm basic details. In an interview with The Globe, OSFI superintendent Julie Dickson said the regulator grew concerned that some lenders weren't "sticking to policies" on lending, particularly "in a market with froth."
Finance Minister Jim Flaherty agreed. "Some financial institutions in Canada were accepting mortgages without proper due diligence," Mr. Flaherty said in a recent interview.
Senior executives at two of Canada's largest banks acknowledged that there is a need to shore up the country's underwriting standards, and suggested OSFI's concern over appraisals is the start of that process.
"We were obviously the core participants in a market that was showing signs of frothiness," Toronto-Dominion Bank chief executive officer Ed Clark said.
"What [regulators] really want us to do is not get sloppy here," Mr. Clark said. "And so by and large, the banks are looking to make sure that we're not sloppy. We get what they're trying to get after."
Mr. McKay at RBC agrees with his rival. In a market that is cooling off, banks need to be more certain about what's on their books. "We know exactly how much we lent," Mr. McKay said. "We better be just as sure of the value of that home we've lent against."
The most exposed
As First American Financial copes with tens of millions of dollars of losses based on its bad bet in the Canadian housing market, Mr. Sieb, the B.C. appraiser, wonders who is looking out for the homeowner.
He pulls his grey pickup truck into a cul-de-sac in Coquitlam, B.C., and points out two homes side by side. They are virtually identical – most people would have a hard time telling them apart, especially if you were running market data through a computer. But when Mr. Sieb was called by a bank to evaluate the properties in person, the results were surprising. Neither had been on the market in years. One was significantly run-down inside, the other had been extensively renovated. The two homes, similar on the outside, were valued at nearly $100,000 apart.
An automated system wouldn't have picked up the differences. A refinancing would have slipped through the software.
In a market fuelled by record borrowing and price inflation over the past decade, buyers are the ones exposed to the most risk, he figures. When prices fall, valuation problems come to the surface. "The only person hurt," he says, "is the person who pays too much."
THE PROBLEM WITH AUTOMATED APPRAISALS
Since 1996, the use of automated computer systems by banks to determine how much should be lent in a mortgage or home refinancing has flourished in Canada. For banks, these computer models were cheaper and faster than conducting a full appraisal. However, documents showing discussions between Canada's banking regulator and the financial and real estate sectors indicate there are serious concerns about the accuracy of these automated systems, and an overreliance on them by banks. This adds risk to the housing market.
The documents, marked Protected – For Internal Purposes Only, were obtained by The Globe and Mail through Access to Information during a six-month investigation into lending practices in the housing sector over the past decade. Below are excerpts, along with an explanation of what is being said.
"Automated models… have their drawback – primarily that they are driven by the sellers' listings, which often inflates the value of the home." – OSFI.
What it means: Canada's banking regulator is warning the banking sector that the computer models they use to determine how much to lend use data that are skewed toward making the home look more attractive by the sellers, which inflates prices and calls into question the accuracy of the system.
These concerns are significant, since the regulator has never discussed this problem publicly.
"FRFIs should use other valuation methods, including on-sites. This is the lender's responsibility. Property appraisal is the lender's responsibility."
What it means: The regulator is urging banks (federally regulated financial institutions, or FRFIs) to stop relying solely on computer models and databases to evaluate home values and loan risk, and to see the homes in person through on-site appraisals.