Crash Course

Governments looking to avoid a real estate collapse are cracking down on easy mortgages. But with low interest rates, will the new rules do anything other than penalize brokers and lenders?
Crash Course

HILLIARD MACBETH KNOWS market doomsayers like him are often taken for fools — at least, that is, until their prognostications about bursting bubbles prove painfully true. By then, of course, it’s too late to avoid a market crash that can punch gaping holes through an economy, destroy businesses and rip apart people’s lives. MacBeth is the author of a book that would alarm any current or aspiring Canadian homeowner — or for that matter, any executive working for a mortgage lender.

Published in 2015, Hilliard’s book is entitled When the Bubble Bursts: Surviving the Canadian Real Estate Crash. In it, he argues that Canada’s housing bubble — which has expanded far beyond the scorching markets of Vancouver and Toronto — is about ready to pop. Residential real estate is way overvalued. Canadians are carrying unprecedented levels of household debt. All it would take, he argues, is a slight uptick in interest rates — just a percentage point or two — and a large number of homeowners could be pushed over a default cliff.

It’s a scenario that the feds are taking seriously, if the recent tightening of mortgage rules is any indication. In the years leading up to the financial crisis in the US, the federal government had actually been trying to stimulate demand for housing. Then Canadians, protected by a regulatory firewall, watched from afar in 2007 as the US housing market crashed, taking out such banking titans as Lehman Bros. and Merrill Lynch. Since then, the government here has attempted to engineer a “soft landing” in housing with gradual policy reversals that have had little effect in the wake of historically low interest rates.

In October 2016, lawmakers ratcheted up their interventionist efforts with a restrictive mortgage “stress test.” This measure now requires all homebuyers with less than a 20-per-cent down payment to have enough income, after all household debt and expenses are taken into account, to qualify for the same mortgage at the Bank of Canada’s five-year posted rate — 4.64 per cent at the time of writing.

That measure and others unleashed a flood of criticism from a variety of disparate stakeholders. First-time homebuyers, mortgage brokers and alternative lenders all cried foul simultaneously, arguing that the government, in trying to cool the housing market, would be favouring big banks over smaller specialty mortgage lenders, while putting a dent in the brokerage industry and disqualifying thousands of Canadians from home ownership.

However, prominent economists and money managers like MacBeth say the federal government is doing exactly what it needs to be doing. In his view, a perfect storm of factors — low interest rates, laissez faire policies, foreign buyers and alternative mortgage lenders — have set the Canadian housing market up for a big fall. He says it’s already underway in Alberta, Saskatchewan and Newfoundland and will inevitably spread. If it looks anything like the subprime debacle in the United States, the crash would unfold steadily over a span of four year or so.

“The bubble will burst, and it will be a hard landing, which means a greater than 20-per-cent decline in house prices,” says MacBeth. In fact, he says, Canadian prices could decline from current levels by 40, even 50 per cent by 2020. “This means some financial institutions will get into trouble. [The Canada Mortgage and Housing Corp.] will lose billions, and there will be a recession.”

Indeed, CMHC itself has suggested that an abrupt increase in interest rates — as little as 1 per cent — could cause housing prices to dip 30 per cent and increase unemployment to as high as 11.3 per cent. In forecasting the housing market’s future, and its impact on both lenders and borrowers, MacBeth says, “the proper stance for everyone is to prepare themselves for this. And to try to find a way to survive without too much damage.”


This past decade, the federal government — first under Stephen Harper, now under Justin Trudeau — has made six rounds of changes to tighten mortgage eligibility rules. The latest, announced by Finance Minister Bill Morneau on October 3, have all been in effect since the end of November.

Apart from the aforementioned stress test, the new mortgage rules affect how the state-owned CMHC and two private mortgage insurers, Genworth MI Canada Inc. and Canada Guaranty Mortgage Insurance Co., will insure future Canadian mortgages. They will curb the ability of lenders to make loans to some Canadians who would have qualified for mortgages.

For instance, to qualify for mortgage insurance under the new rules, a borrower’s gross debt service ratio (mortgage payments, taxes and heating costs as a percentage of income) must be no more than 39 per cent. A borrower’s total debt service ratio (the carrying costs of the home and all other debt payments as a percentage of income) must be less than 44 per cent.

The maximum amortization period for an insured mortgage has been slashed from 40 years to 25. And government-backed mortgage insurance is available only on properties that have been purchased below $1 million. Moreover, to discourage a spate of foreign buying, a property must be owner-occupied to qualify for mortgage insurance. It could all leave credit-poor new homebuyers in a pickle.


The federal government, in conjunction with CMHC, is also considering regulatory changes that are less visible to consumers, but critically important to lenders and the mortgage brokers serving them. New rules have been issued by Canada’s banking watchdog, the Office of the Superintendent of Financial Institutions (OSFI). They require lenders to hold increased levels of capital in order to share more risk when it comes to mortgage insurance. That’s a risk currently borne by taxpayers through the mortgage insurance programs guaranteed by the federal government. These changes will make it more expensive for financial institutions to lend money against housing.

It also, needless to say, makes life difficult for mortgage brokers. Samantha Gale, Executive Director of the Canadian Mortgage Brokers Association (CMBA), is clearly troubled by many of the changes. A lawyer by training who previously worked in regulation with the Financial Institutions Commission in British Columbia, Gale says the market-chilling tactics of various governments will have a profound impact on more than 4,000 members of the CMBA. “These rules are a broad brushstroke. … It was a mistake to launch such broad, sweeping changes without consultation.”

The Vancouver market, says Gale, was already slowing down, even before British Columbia decided, on August 2, to impose its 15-per-cent foreign buyers’ tax on residential property transfers in Vancouver. (That move, incidentally, triggered a class action lawsuit by foreign buyers, claiming that BC has no jurisdiction to impose it, that the tax is discriminatory, and that it breaks a host of free-trade agreements.)

“At the end of the day, the market always takes care of itself. We knew it wouldn’t keep going at that rate,” says Gale. Mortgage brokers, she contends, were instrumental in putting downward pressure on mortgage interest rates and making housing more affordable for Canadians. “That’s healthy. But some of these mortgage rules are going to impact that competition.”

In October, Gale fired off a letter on behalf of the CMBA to Bill Morneau and to former economics professor Jean-Yves Duclos, now Minister of Families, Children and Social Development. In her letter, Gale cites a report by Cameron Muir, Chief Economist for the British Columbia Real Estate Association. The new rules, the report states, especially the new stress test, will “cause the sharpest drop in the purchasing power of low-equity homebuyers in years. At a time when housing affordability is a critical issue, deliberately chopping millennials’ purchasing power by as much as 20 per cent will only exacerbate a well-known problem.”

If the federal government is worried about a US-style housing crisis, Gale wants to remind us that Canada is not the US. While the US housing market crashed from 2007 to 2009, the Canadian market merely slowed. While dozens of financial institutions failed in the US and other countries, none did in Canada, where stricter financial regulation has already done much to prevent risky mortgages. Here in Canada, housing prices during the financial crisis only dipped for about eight months, then began recovering. “That was an example, I think, of the market taking care of itself. … And when you interfere with the market, it never turns out well.”


Lawyers are typically loath to speculate on things like housing market crashes. John Jason, a former partner with Norton Rose Fulbright Canada LLP in Toronto practising in financial regulation, can’t be tempted, though prior to joining Norton Rose he had insider big bank experience as Senior Vice-President, Deputy General Counsel and Chief Compliance Officer at BMO Financial Group. The big banks, he agrees, will likely benefit from rules changes announced so far.

 “They will certainly drive a bunch of borrowers out of the market,” says Jason. Those will primarily be first-time buyers or those riskier borrowers with lower credit scores, who no longer qualify for mortgages under the new rules. The changes could also drive out some competition for the big banks, as Jason explains, because it’s “the small lenders who have a predominant share of that [riskier] market.” Those alternative lenders — especially “monoline” lenders that don’t use deposits to backstop their lending — could wind up with far less of the mortgage business.

But if the big banks are encouraged by the recent mortgage crackdown, they’re not about to admit it. No general counsel for Bank of Montreal, CIBC, RBC, TD, National Bank or Scotiabank agreed to speak with Lexpert on the subject. Even smaller lenders are keeping tight-lipped, with Equitable Bank, Home Trust Co., MCAP and a number of other monolines declining interviews. Echoing the sentiment of many others lenders, Hilda Wong, Vice-President and General Counsel at First National Financial, says her organization simply wasn’t expecting the new federal rules. “I don’t think the industry was. We ourselves have to digest the changes.”

One problem alternative lenders will face is how to the find the capital necessary to fund mortgages in this new regulatory environment. Unbeknownst to most Canadians, insured mortgages are often quickly bundled into portfolios, which are then securitized and sold off, mainly to institutional investors such as pension funds, other banks, trust companies, credit unions and major investment firms.

“These [mortgage] originators are really in it for service fees and an originator fee,” explains Michael Feldman, a Toronto partner with Torys LLP who has long experience in residential and commercial mortgage securitization. (Originator fees are tacked on to the principal and range from about 25 to 100 basis points on a mortgage, depending on its size and term.)

Monolines can’t securitize without mortgage insurance, which provide the triple-A ratings that most investors require before they’re willing to buy. That insurance protecting lenders against defaults comes from three sources: CMHC and two private insurers, Genworth MI Canada Inc. and Canada Guaranty Mortgage Insurance Co.

All insured mortgages are backed by the Canadian government, and thus taxpayers: 100 per cent for CMHC-insured loans if the Crown corporation fails to cover defaults with its own reserves. The other two private insurers are subject to a 10-per-cent deductible. That means lenders carry little to no risk for the insured mortgage loans they give homebuyers. Nor do the investors who buy them.

However, on October 21, the Department of Finance launched an industry consultation process on the best way to “modestly” distribute some risk of loan losses to lenders and away from taxpayers. The consultations will wrap up on February 28. OSFI, in addition, issued a new advisory on January 1, 2017, updating its Minimum Capital Test guidelines for federally regulated mortgage insurers, including the CMHC. The regulator says it intends to force federally regulated banks, credit unions and trust companies to put more capital aside to ensure they “can absorb severe but plausible losses.”

“The interesting thing about the consultations is there are a few different public-policy objectives that you are faced with,” says Mark McElheran, a partner at Stikeman Elliott LLP in Toronto practising in corporate finance, including private and public securitizations.

“On the one hand they’re trying to encourage lenders to take some of the government’s exposure to the housing market. But by the same token you may ultimately reduce competition in the market because there are only so many institutions that can actually shoulder some of that risk. The big banks might be able to do that and might be quite happy about that. If they are compensated for it, they will take more of that risk in whatever form it is.”

Selling off mortgages to raise capital is a far less urgent matter for banks than it is for monoline lenders. Banks have their depositors to fund future loans. The monoline and other lenders lacking depositors can’t afford to retain capital on their books in order to cover the risks of any uninsured mortgages they might be stuck holding. So they rarely underwrite uninsured mortgages.

Says Feldman, with the government planning to force more risk onto lenders, the better capitalized a mortgage lender is, the better it can absorb that additional risk: “That leads you to say the bigger banks are capitalized more sufficiently to absorb the extra risk.” Not so, though, for smaller financial institutions such as credit unions and trusts, who may feel they have insufficient capital to do that.

For his part, Stikeman’s McElheran says he’s seen indications that the big banks are somewhat more receptive to taking on more of the risk. “To a certain degree it would be in their interest to take on more of the risk if their competitors aren’t able to,” he says. “And if they take on more of the risk, they are going to charge more. And that is where you are going to see pressure on [interest] rates.”


All this regulatory activity by the federal government shows that, unlike US regulators before the subprime crisis, Canadian authorities are carefully watching the housing sector and sensing that a significant crash that could hammer our economy and financial system is far from implausible.

Maybe someone in the finance department read the worrying paper that Craig Alexander, now Senior Vice-President and Chief Economist at the Conference Board of Canada, co-wrote in 2015 when he was Vice-president, Economic Analysis at the C.D. Howe Institute. In that paper, entitled “Mortgaged to the Hilt: Risk from the Distribution of Household Debt,” Alexander and economist Paul Jacobson found a “significant minority of Canadians” have taken on a “high degree of financial risk” through primary mortgages.

Their analysis determined the percent of Canadian homeowners with a mortgage-to-disposable-income ratio in excess of 500 per cent climbed from three per cent in 1999 to 11 per cent in 2012. “That is far from the majority of Canadians, but it does represent half a million households,” they wrote. By and large, few Canadians default on mortgages, even in difficult times. But those Alexander wrote about are the wobbliest of the many dominos in the housing market. If interest rates inch up a percentage point or two, or if job losses spread beyond what we’ve seen in Alberta, those home owners could trigger a cascade of mortgage defaults and a housing price freefall of 40 per cent or more.

In October, the CMHC — for the first time in the Crown corporation’s 68-year history — issued a “red” alert for our national housing market. “High levels of indebtedness coupled with elevated house prices are often followed by economic contractions,” Evan Siddall, CMHC’s CEO, warned in a Globe and Mail article published October 17, the same day that new federal mortgage rules came into effect. “The conditions we now observe in Canada concern us.”

So, says Alexander, the real question now for the Canadian government when it comes to our overvalued housing market is how to address the imbalance: “The metaphor I like to use is, imagine you are driving down the highway and all of a sudden the road has become very icy. So now there is risk. The one thing you don’t do is slam on the brakes, because that is likely to cause the very accident you are worried about happening. So the government of Canada has been taking an incremental pace in terms of tightening policy.

“So what do you do in that risk-filled environment when you are driving on icy roads? Well, stop pushing on the accelerator, and maybe you just gently tap the brakes. In a sense, that’s what the government has been doing.” And in Alexander’s backseat driver view, even if mortgage brokers and alternative lenders have to feel a bit of pain in the short term, it’s still well worth it to avoid the kind of pain Canadians would suffer in a real estate crash.

Anthony Davis is a freelance business and investigative writer based in Calgary.