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The housing bears have been largely in hibernation since second quarter residential sales numbers from the Canadian Real Estate Association rebounded sharply after five straight quarters of decline. But a report from Richmond Hill corporate bond manager Canso Investment Counsel has stirred the discussion back up. While most of Canso's report contains things we already know, as well as a healthy dose of fiery rhetoric, one point demands attention due to its similarity to analysis of the U.S. crisis: inflated mortgage appraisals artificially drive up prices, a dynamic that becomes dangerously unsustainable.
The point that has been made over and over is that prices in cities like Toronto and Vancouver have far outpaced both incomes and inflation. Canso estimates quite reasonably that, based on a Toronto family spending 30 per cent of Statistics Canada's average pre-tax income, that family ought to be able to afford a 25 year mortgage valued at roughly $600,000. The average price in Toronto is currently $900,000. Is this a huge problem? The debate rages on, and I will not attempt to end it here.
That said, Canso's reference to allegations that the CMHC's automated mortgage appraisal system, EMILI, has allowed lenders to artificially inflate the appraised value of a home, are well worth revisiting.
"EMILI uses an "algorithm" which looks at the address, and particularly the postal code, and metrics of the house to be insured. The key variables are the square footage of the house and the prior sale prices for the geographic area of the house. It is our understanding from real estate professionals and bankers that there has been extensive "gaming" of this system and excessive prices generated by this system. If a higher price is required for CMHC insurance coverage, the square footage, which is input by the lender and supplied by the mortgage broker, can be increased as required."
Again, nothing new here – the alleged gaming of EMILI was investigated by the Globe last December. At the time, CMHC reps defended the system, pointing out built-in safeguards and citing Canada's low default rate since the system was introduced in 1996. But if they're wrong about the risks, we could be in for a dose of what our southern neighbour recently suffered. A new article by law professor and former bank regulator William K. Black shows that inflated mortgage appraisals contributed enormously to the U.S. housing crisis – arguably as much as the no-document "liar loans" and the like, which Canadians fervently insist could never happen here – and we should be well afraid of them.
Mr. Black cites a report observing that between 2000 and 2007 members of the appraiser industry presented Washington officials with a petition signed by 11,000 appraisers alleging that "lenders were pressuring appraisers to place artificially high prices on properties…. 'blacklisting honest appraisers' and instead assigning business only to appraisers who would hit the desired price targets." The petition went nowhere. The Globe article and Canso's report contain allegations of depressingly similar practices in Canada, yet there is no equivalent petition here, which, given our notoriously poor protection for whistleblowers and the like, is perhaps not surprising.
Mr. Black explains that "the industry used "low" [loan to value] and [debt to income] ratios as its compensating factors for doubly fraudulent loans." For example, a lender might defend a mortgage issued on a $900,000 home by insisting on a large downpayment, such as 50 per cent down ($450,000). In Canada, lenders and CMHC alike point to high loan to value ratios as proof that their mortgages are safe. However if the value of the home in our example drops by 30 per cent to $630,000, the odds of the person breaking their mortgage dramatically increase, no matter what the downpayment was. And if $630,000 houses are being appraised with any frequency at prices that are grossly inflated above long-term values, we can expect a significant number of those mortgages to go bad – even in Canada, where lenders can still pursue a borrower even if they walk away from their home.
The housing bust so far hasn't materialized, but the era of easy credit is beginning to ebb, thanks to federal mortgage regulations and rising rates. The other shoe has yet to drop, and if it lands on property valuations with a resounding thud, we can't say we weren't warned.