## 1canea2020002 ## Source details **Canonical URL:** [1canea2020002](https://www.imf.org/-/media/files/publications/cr/2020/english/1canea2020002.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2020/english/1canea2020002.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2020/english/1canea2020002.pdf.json) --- ### Executive summary — market structure and resilience - Housing finance is broadly resilient, but pockets of vulnerabilities exist. - Mortgage finance is dominated by domestic systemically important financial institutions (D-SIFIs) and supported by the government via mortgage insurance, securitization guarantees, and other policies. - D-SIFIs have a market share of about 70 percent and focus on prime borrowers; their lending is backed by their strong balance sheets. - The smaller (uninsured) non-prime segment is largely served by smaller banks and prudentially unregulated lenders, which are comparatively less resilient and may rely on less stable, higher-cost funding such as brokered deposits or redeemable equity. - Market concerns about non-prime business models manifested in a liquidity crisis at a mid-sized deposit-taking institution in 2017. ### Mortgage lending and origination — selected statistics and features - Residential mortgage credit was Can$1.54 trillion as of December 2018, equivalent to 69 percent of GDP and 11 percent of financial system assets. - Other housing-secured retail lending by banks was around Can$250 billion. - Mortgage growth has averaged around 5.5 percent annually since end-2014 but has recently slowed to 3.1 percent. - The six D-SIBs hold over two-thirds of residential mortgages on their balance sheets (68 percent). - Provincially regulated deposit-takers such as credit unions account for 14 percent; federally regulated smaller banks 6 percent; and nonbanks 10 percent. - Mortgage Investment Companies (MICs) were assessed to have about Can$10 billion in mortgage assets as of end-2017. - Mortgage Finance Companies (MFCs) have accounted for roughly 31 percent of all insured mortgage originations since 2013 despite retaining a significantly smaller share on their balance sheets. - Most mortgages have contractual maturities of 5 years or less, with amortizations typically around 25 years; the “prime” segment is largest and most competitive; non-prime borrowers typically face shorter maturities (typically 1–2 years). - Consumer lending backed by residential property (HELOCs and other property-backed lending) is growing 6 percent year-on-year, and is about one-fifth the size of federally regulated banks’ mortgage loan portfolio. ### Mortgage insurance — structure, trends, and public backstop - Around half of all Canadian residential mortgages were insured in 2018Q2; this proportion is down from about 60 percent in 2014. - Two key product types: - Transactional (loan-level) insurance: required for mortgages with LTV ratio over 80 percent; borrower charged a single up-front premium typically funded by the bank and added to the mortgage principal. - Portfolio (bulk) insurance: lenders can bulk-insure existing mortgages with LTV ratios of 80 percent or below if they conform to underwriting standards; historically important for accessing the government-guaranteed securitization program. - Portfolio insurance volumes grew rapidly in 2015–2016 but have dropped around 75 percent since 2016 after tightened rules and higher capital requirements for insurers. - Transactional mortgage insurance volumes have remained relatively stable but have declined recently. - MFC mortgages accounted for 31 percent of all insurance volumes between 2013 and 2018Q2; smaller banks and provincially regulated lenders accounted for another 16 percent. - The market features a public-private hybrid model: Canada Mortgage and Housing Corporation (CMHC) (government-owned) competes with two private entities (Genworth Financial and Canada Guaranty) which collectively have a market share of about 35 percent of insurance-in-force. - The government guarantees private insurers’ obligations in the event of default with a 10 percent deductible for the lender. - Insurance coverage includes most costs and expenses related to work-out and foreclosure in addition to 100 percent of the lost principal and interest on mortgage exposures. - Because of government-backed risk mitigation, banks are required to hold minimal or no capital against insured mortgage exposures. ### Mortgage insurance pricing and market structure - CMHC determines insurance pricing for high-LTV mortgages using seven tiers based on the original LTV of the mortgage and the source of the down payment. - More price competition exists in the smaller portfolio insurance space, though volumes in this segment declined after tighter regulation. - Mortgage insurers do not reinsure their obligations but pay the government a guarantee fee for federal backstops: - CMHC pays 3.25 percent of total premiums. - Private insurers pay 2.25 percent of total premiums. - Insured borrowers face a risk-sensitive price component in the form of the mortgage insurance premium, which can be as high as 4 percent of the loan principal; banks commonly fund this cost on the same terms as the mortgage. ### Market pricing, risk assessment, and procyclicality - The cost of prime mortgage financing is low and little differentiated; credit risk is underpriced in some segments. - Government policies ensuring housing affordability contribute to low mortgage financing costs. - Capital charges for uninsured mortgage lending are low and do not fully reflect through-the-cycle credit risk. - Lenders have assessed credit risk as extremely low after a long period of benign macrofinancial conditions, justifying minimal capital and mostly uniform pricing. - For insured mortgages, costs faced by riskier borrowers are compressed by insurers’ practice of insuring loans that fund insurance premiums (up to 4.5 percent of principal) on the same terms as the mortgages. - Credit spreads of prime mortgage lending have narrowed in recent years, undermining the impact of macroprudential policy tightening. - Procyclical amplification channels identified: - Core lenders may constrain new lending or renewals of maturing uninsured mortgages, adding pressure on housing markets. - Sudden adoption of risk-based pricing for financially weak borrowers could amplify household debt-servicing fragility. - Rising losses and tighter funding at weaker lenders might impair credit flow to non-prime borrowers with shorter-maturity mortgages (typically, 1–2 years). ### Mortgage funding — sources, securitization, and instruments - Over four-fifths of mortgages are funded by the D-SIBs and provincially regulated institutions. - These lenders rely on large, low-cost customer deposit bases, accounting for roughly 60 and 69 percent of total assets at these respective institutions. - D-SIFIs’ strong capital and liquidity buffers support access to low cost wholesale funding at longer maturities. - Thirty one percent of all mortgages are securitized via the NHA MBS program, where CMHC provides a timely payment guarantee for securitization of insured mortgages. - Nonbanks (mostly MFCs) accounted for roughly 16 percent of the Can$485 billion in outstanding issuance as of 2018Q3, up from 10 percent in 2014; other nonbanks and credit unions accounted for another 16 percent. - Around 45 percent of NHA MBS (roughly Can$200 billion) have been sold to Canada Housing Trust (CHT); CHT packages these bonds into Canada Mortgage Bonds (CMB). - Yields: - CMB yields are typically only 20–40 basis points above equivalent Government of Canada (GoC) bond maturities. - Of NHA MBS not sold to the CMB program, funding costs are around 40–80 basis points higher than sovereign yields with similar maturity. - About 36 percent of NHA MBS were retained by banks on their balance sheets and have status as high-quality liquid assets (HQLA) Level 1 assets. - Covered bonds finance almost 10 percent of mortgages and have more than doubled since end-2013, to Can$147 billion; covered bonds are largely issued in foreign currencies to foreign investors, limited to 5.5 percent of an issuer’s assets, and restricted to uninsured mortgages. - Private (uninsured) mortgage securitization accounts for just 0.7 percent of all mortgage funding, down from around 3 percent pre-crisis. ### Funding vulnerabilities among smaller and nonbank lenders - Some smaller federally regulated lenders have elevated reliance (above 50 percent in many cases) on more expensive brokered deposits; these instruments are considered vulnerable to depositor runs even with full deposit insurance coverage. - The liquidity crisis experienced by a monoline lender in early 2017 was triggered by a pullback in brokered deposits after disclosure issues. - MICs are estimated to have only about Can$10–15 billion in assets under management and may be funded through redeemable equity supplemented with bank credit lines secured by the underlying property. - MFCs’ funding risks are primarily related to potential loss of access to the NHA MBS securitization program or other mortgage sales channels; largest MFCs maintain large, term-matched credit lines, asset-backed commercial paper programs, and access to repo liquidity. ### Key policy developments (selected measures since 2016) - February 2016 — Underwriting: Increased minimum down payments; down payments raised to 10 percent for the portion of a home price over Can$500,000 (from 5 percent). - July 2016 — Insurance: Portfolio insurance restricted; limited to use to facilitate government-backed securitization. - October 2016 — Underwriting: Stress test expanded to all insured mortgages; debt-servicing assessed at the higher of contractual rate or BOC posted five-year rate; limits on insurance eligibility of low-LTV mortgages; portfolio-insured mortgages required to meet same eligibility criteria as mortgages with an LTV above 80 percent. - January 2017 — Insurance: OSFI revised the risk-based capital framework for mortgage insurers, increasing capital requirements, particularly for portfolio-insured mortgages, and adding a capital surcharge for mortgages in areas with price-to-income ratios above historical norms. - March 2017 — Insurance: CMHC raised mortgage insurance premiums for both transactional and portfolio insurance; the two private insurers followed the pricing change. - January 2018 — Underwriting: OSFI expanded borrower stress tests for uninsured mortgages (B-20 guidelines); stress test is the higher of the BOC posted 5-year rate or 2 percentage points above the contractual rate; B-20 disallows arranging mortgages secured by same property to circumvent maximum LTV ratio. - January 2018 — Securitization: CMHC raised guarantee fees for NHA MBS from 80 to 100 basis points for annual guarantees in excess of Can$9 billion. ### Impacts of policy tightening and insurance trends - Total mortgage insurance-in-force declined to Can$743 billion as of 2018Q2, down from Can$796 billion in 2016. - The insured share of federally regulated lenders’ mortgage portfolios declined to 43 percent, from 53 percent at end-2016. - New insured lending slipped to 29 percent of all new mortgages in 2018, down from 36 percent in 2014. - For new insured mortgages originated by federally regulated lenders, the share with loan-to-income (LTI) ratios above 450 percent fell from 20 percent to 10 percent in 2017. - Use of new portfolio insurance origination dropped significantly, slowing growth in NHA MBS issuance. ### Market risks and vulnerabilities - Mortgage pricing is low and relatively little-differentiated by borrower risk factors, raising the probability of an increase in risk-based pricing during a downturn and contributing to debt accumulation among potentially weaker borrowers. - Non-prime lenders are small but less resilient, with more concentrated exposures to riskier borrowers. - The policy framework may be driving borrower migration to weaker lenders and contributing to lower mortgage pricing for higher quality borrowers. - Prime mortgage pricing (5-year new mortgage rates less 5-year GoC bond yield) has been trending lower despite rising systemic risk from elevated household indebtedness and housing market imbalances. - Risk weights and PDs: - IRB risk weights cited: about 3 and 10 percent for insured and uninsured mortgages, respectively. - 83 percent of mortgage and HELOC exposures assigned a PD of less than 0.5 percent, with an aggregate PD of 0.11 percent for that exposure segment. ### Risk underpricing, non-prime vulnerabilities, and prudential options - Risk could be underpriced for certain higher-risk prime borrower types if future mortgage defaults prove to be worse than in recent Canadian historical experience. - Cross-country evidence shows defaults and losses can concentrate in the prime segment or middle credit-score distribution. - Non-prime segment vulnerabilities: - Concentrated exposures in high-misalignment areas (e.g., Vancouver and Toronto). - Weaker funding profiles and higher funding costs precluding participation in prime lending markets. - Underwriting perimeter effects: - Tightening the underwriting perimeter can cause borrower migration to weaker institutions outside the perimeter, with higher funding costs and shorter maturities. - Over a quarter of existing borrowers must renew their mortgage every year, with an additional 13 percent facing HELOC re-pricing, increasing refinancing pressure. - Prudential adjustments suggested: - Require a floor for the average level of mortgage risk weights to better reflect through-the-cycle default risk. - Additional adjustments to credit risk modeling (e.g., stepped up correlation factors). - Risk weight increases could be offset by equivalent reductions in Pillar 2 Domestic Stability Buffer requirements (currently set at 1.75 percent of risk-weighted assets). - International comparators for IRB adjustments (selected examples and cited floors/add-ons): - Australia: Risk-weight floor 25 percent (2016). - Belgium: Risk-weight add-on 12 percent (2016). - Finland: Risk-weight floor 15 percent (2018). - Norway: Input floors 21 percent (2014). - Sweden: Risk-weight floor 25 percent (2016). - Hong Kong SAR: Risk-weight floor 25 percent (2017). - New Zealand: Input floors 28 percent (2015). ### Measures to improve risk-based pricing for insured mortgages - Potential measures include: - Limit banks' ability to subsidize the cost of mortgage insurance premiums by requiring banks to fund mortgage insurance premiums as separate loans with maximum amortizations (e.g., of five years) and interest rates closer to unsecured consumer rates. - Expand the range and detail of mortgage risk characteristics that determine insurer capital requirements, premiums, and the cost of the government guarantee; consider increasing premiums for insurance-eligible multi-unit and investor properties or withdrawing coverage for these properties entirely. - Require insurance contracts to stipulate loan-level pricing adjustments similar to models adopted by U.S. government-sponsored entities post-global financial crisis: specify minimum increases in lender interest rates relative to a base rate that accumulate based on risk factors (LTV, credit score, number of units financed, loan purpose). Based on Fannie Mae requirements, the mandated difference in interest rates offered to low and high-risk mortgages can exceed 3 percentage points. - Trade-offs: Some measures may negatively impact homeowner affordability at the margin and must be weighed against risks of increased household debt and upward pressure on home prices. ### Principles and guidelines for managing a housing market downturn - Develop a clear set of principles and guidelines that: - Protect taxpayer interests by identifying an appropriate level of exposure to housing insurance and mechanisms to keep exposure within limits; one policy option is a professionally managed government-sponsored mortgage reinsurance fund funded by existing guarantee fees. - Understand effectiveness and trade-offs of existing tools; calibrate government macroprudential and other tools based on how they would perform in a downturn to avoid too little or too much easing. - Limit moral hazard by restricting use of portfolio insurance as a crisis management tool except at punitive premiums that ensure taxpayer profits; prefer refinancing and liquidity programs over permanent credit risk transfers to the government. ### Policy recommendations (priorities and timeframes) - Improve risk-based pricing in insured mortgage lending by: - (i) tightening lending terms for mortgage insurance premiums; and - (ii) expanding use of borrower risk factors in determining capital requirements, premiums, and the government’s cost of reinsurance. - Priority: M; Timeframe: MT - Improve risk-based pricing in uninsured mortgage lending by making prudential adjustments to risk-based capital calculations to better account for Canada’s lack of a full default cycle. - Priority: M; Timeframe: MT - Develop a clear set of principles and guidelines for managing a housing market downturn that protects taxpayer interests and limits moral hazard. - Priority: L; Timeframe: NT - Authorities should limit use of portfolio insurance as a crisis management tool, except at punitive premiums that reduce moral hazard and ensure taxpayer profits. - Priority: M; Timeframe: NT *Source: EXECUTIVE SUMMARY and selected excerpts, 1canea2020002* ### EXECUTIVE SUMMARY __________________________________________________________________________ 4 ### EXECUTIVE SUMMARY ### Key findings on market structure and resilience - Housing finance is broadly resilient, but pockets of vulnerabilities exist. - Mortgage finance is dominated by domestic systemically important financial institutions (D-SIFIs) and supported by the government via mortgage insurance, securitization guarantees, and other policies. - D-SIFIs have a market share of about 70 percent and focus on prime borrowers; their lending is backed by their strong balance sheets. - The smaller (uninsured) non-prime segment is largely served by smaller banks and prudentially unregulated lenders, which are comparatively less resilient and may rely on less stable, higher-cost funding such as brokered deposits or redeemable equity. - Market concerns about non-prime business models manifested in a liquidity crisis at a mid-sized deposit-taking institution in 2017. ### Mortgage lending and origination (selected statistics and features) - Residential mortgage credit was Can$1.54 trillion as of December 2018, equivalent to 69 percent of GDP and 11 percent of financial system assets. - Other housing-secured retail lending by banks was around Can$250 billion. - Mortgage growth has averaged around 5.5 percent annually since end-2014 but has recently slowed to 3.1 percent. - The six D-SIBs hold over two-thirds of residential mortgages on their balance sheets (68 percent). - Provincially regulated deposit-takers such as credit unions account for 14 percent; federally regulated smaller banks 6 percent; and nonbanks 10 percent (shares referenced in the market-structure discussion). - Private mortgage lending outside the regulatory perimeter appears small; Mortgage Investment Companies (MICs) were assessed to have about Can$10 billion in mortgage assets as of end-2017. - Mortgage Finance Companies (MFCs) have accounted for roughly 31 percent of all insured mortgage originations since 2013 despite retaining a significantly smaller share on their balance sheets. - Most mortgages have contractual maturities of 5 years or less, with amortizations typically around 25 years; this maturity-amortization mismatch requires roll-over or “renewal” of mortgages. - The “prime” segment is the largest and most competitive; non-prime borrowers (new immigrants, self-employed, weaker credit profiles) are tended to by smaller banks and unregulated lenders, with shorter maturities (typically 1–2 years). - Consumer lending backed by residential property (HELOCs and other property-backed lending) is growing 6 percent year-on-year, and is about one-fifth the size of federally regulated banks’ mortgage loan portfolio. ### Mortgage insurance: structure, trends, and public backstop - Around half of all Canadian residential mortgages were insured in 2018Q2; this proportion is down from about 60 percent in 2014. - Two key product types: - Transactional (loan-level) insurance: required for mortgages with LTV ratio over 80 percent; borrower charged a single up-front premium typically funded by the bank and added to the mortgage principal. - Portfolio (bulk) insurance: lenders can bulk-insure existing mortgages with LTV ratios of 80 percent or below if they conform to underwriting standards; historically important for accessing the government-guaranteed securitization program. - Portfolio insurance volumes grew rapidly in 2015–2016 but have dropped around 75 percent since 2016 after tightened rules and higher capital requirements for insurers. - Transactional mortgage insurance volumes have remained relatively stable but have declined recently. - MFC mortgages accounted for 31 percent of all insurance volumes between 2013 and 2018Q2; smaller banks and provincially regulated lenders accounted for another 16 percent. - The market features a public-private hybrid model: Canada Mortgage and Housing Corporation (CMHC) (government-owned) competes with two private entities (Genworth Financial and Canada Guaranty) which collectively have a market share of about 35 percent of insurance-in-force. - The government guarantees private insurers’ obligations in the event of default with a 10 percent deductible for the lender. - Insurance coverage includes most costs and expenses related to work-out and foreclosure in addition to 100 percent of the lost principal and interest on mortgage exposures. - Because of government-backed risk mitigation, banks are required to hold minimal or no capital against insured mortgage exposures. ### Market pricing, risk assessment, and procyclicality - The cost of prime mortgage financing is low and little differentiated; credit risk is underpriced in some segments. - Government policies ensuring housing affordability contribute to low mortgage financing costs. - Capital charges for uninsured mortgage lending are low and do not fully reflect through-the-cycle credit risk. - A long period of benign macrofinancial conditions has led lenders to assess credit risk as extremely low, justifying minimal capital and mostly uniform pricing to borrowers. - For insured mortgages, costs faced by riskier borrowers are compressed by mortgage insurers’ practice of insuring loans that fund insurance premiums (up to 4.5 percent of principal) on the same terms as the mortgages; as a result, borrowing costs for riskier borrowers are near risk-free levels. - Credit spreads of prime mortgage lending have narrowed in recent years, undermining the impact of macroprudential policy tightening. - Aspects of Canada’s mortgage finance may amplify procyclical effects during severe downturns: - Core lenders’ reaction to deteriorating household debt-servicing capacity may involve constraining new lending or renewals of maturing uninsured mortgages (typically, 5-years contractual maturity and 25-years amortization period), adding pressure on housing markets. - Sudden adoption of risk-based pricing for financially weak borrowers could amplify household debt-servicing fragility. - Rising losses and tighter funding conditions at weaker lenders might impair credit flow to non-prime borrowers, who face increased refinancing pressure due to shorter-maturity mortgages (typically, 1–2 years). ### Policy recommendations (Table 1) - Improve risk-based pricing in insured mortgage lending by: - (i) tightening lending terms for mortgage insurance premiums; and - (ii) expanding use of borrower risk factors in determining capital requirements, premiums, and the government’s cost of reinsurance. - Priority: M; Timeframe: MT - Improve risk-based pricing in uninsured mortgage lending by making prudential adjustments to risk-based capital calculations to better account for Canada’s lack of a full default cycle. - Priority: M; Timeframe: MT - Develop a clear set of principles and guidelines for managing a housing market downturn that protects taxpayer interests and limits moral hazard. - Priority: L; Timeframe: NT - Authorities should limit use of portfolio insurance as a crisis management tool, except at punitive premiums that reduce moral hazard and ensure taxpayer profits. - Priority: M; Timeframe: NT *Source: EXECUTIVE SUMMARY, 1canea2020002* ### 12. CMHC and the government are dominant in determining mortgage insurance pricing. ### 12. CMHC and the government are dominant in determining mortgage insurance pricing. ### Mortgage insurance pricing and market structure - In practice, insurance pricing for high-LTV mortgages is determined by CMHC, which offers seven tiers of pricing based on the original LTV of the mortgage and the source of the down payment. - There is more price competition in the smaller portfolio insurance space, where private mortgage insurers have played a comparatively larger role, although volumes in this segment have declined due to tighter regulation. - Mortgage insurers do not reinsure their obligations but pay the government a guarantee fee for their federal backstops: - CMHC pays 3.25 percent of total premiums. - Private insurers pay 2.25 percent of total premiums. - The lockstep pricing in transactional mortgage insurance and the fixed guarantee cost offer limited input for market-based pricing of risks. - Insured borrowers face a risk-sensitive price component in the form of the mortgage insurance premium, which can be as high as 4 percent of the loan principal; banks commonly fund this cost on the same terms as the mortgage, minimizing the borrower price impact. ### Mortgage insurance as a policy tool and crisis role - Tightening eligibility for mortgage insurance has been a key prudential tool for authorities in addressing housing market vulnerabilities. - Authorities consider provision of insurance via CMHC a potential countercyclical tool in the event of an economic downturn. - During the global financial crisis, CMHC rapidly increased its use of portfolio insurance to facilitate the creation of insured mortgages eligible for government-backed securitization. Many of these securities were then purchased by the government (via CMHC) as part of the Can$69 billion Insured Mortgage Purchase Program. - Using portfolio insurance during a crisis to transfer credit risk to the government may increase moral hazard and expose the taxpayer to losses. ### C. Mortgage Funding — funding sources and mechanisms - Over four-fifths of mortgages are funded by the D-SIBs and provincially regulated institutions. - These lenders rely on large, low-cost customer deposit bases, accounting for roughly 60 and 69 percent of total assets at these respective institutions. - For the domestic systemically important financial institutions (D-SIFIs), strong capital and liquidity buffers support access to low cost wholesale funding at longer maturities. ### Government-guaranteed securitization (NHA MBS) and nonbank participation - Thirty one percent of all mortgages are securitized via the NHA MBS program, where CMHC provides a timely payment guarantee for securitization of insured mortgages. - With issuance quotas distributed equally among qualified issuers regardless of size, the program has facilitated greater participation of nonbanks in mortgage lending by providing low-cost longer-term funding with government guarantee of credit risk. - Nonbanks (mostly MFCs) accounted for roughly 16 percent of the Can$485 billion in outstanding issuance as of 2018Q3, up from 10 percent in 2014; other nonbanks and credit unions accounted for another 16 percent. ### NHA MBS, CHT/CMB, and funding costs - Around 45 percent of NHA MBS (roughly Can$200 billion) have been sold to Canada Housing Trust (CHT), a unit of CMHC. - CHT packages these bonds into Canada Mortgage Bonds (CMB), which are standard bullet payment bonds without the pre-payment risk of the NHA MBS. - Yields: - CMB yields are typically only 20–40 basis points above equivalent Government of Canada (GoC) bond maturities. - Of NHA MBS not sold to the CMB program, funding costs are around 40–80 basis points higher than sovereign yields with similar maturity. - About 36 percent of NHA MBS were retained by banks on their balance sheets and have status as high-quality liquid assets (HQLA) Level 1 assets. ### Covered bonds and other funding instruments - Covered bonds finance almost 10 percent of mortgages and have more than doubled since end-2013, to Can$147 billion. - Covered bonds are largely issued in foreign currencies to foreign investors and offer a low cost of funding. - Covered bonds are limited to 5.5 percent of an issuer’s assets and cover pools are restricted to uninsured mortgages. - Covered bond programs are only available to the D-SIFIs due to cost and complexity. ### Funding vulnerabilities among smaller and nonbank lenders - Some smaller federally regulated lenders have elevated reliance (above 50 percent in many cases) on more expensive brokered deposits; these instruments are considered vulnerable to depositor runs even with full deposit insurance coverage. - The liquidity crisis experienced by a monoline lender in early 2017 was triggered by a pullback in brokered deposits after disclosure issues. - Unregulated private lenders: - MICs are estimated to have only about Can$10–15 billion in assets under management and may be funded through redeemable equity supplemented with bank credit lines secured by the underlying property, which could be drawn down in a housing downturn. - MFCs’ funding risks: - Primarily related to potential loss of access to the NHA MBS securitization program or other mortgage sales channels. - Largest MFCs maintain large, term-matched credit lines from banks in excess of their committed exposures, asset-backed commercial paper programs, and access to repo liquidity. - Private (uninsured) mortgage securitization: - Accounts for just 0.7 percent of all mortgage funding, down from around 3 percent pre-crisis. - Early attempts to restart the RMBS market were not sufficiently profitable given market funding costs. ### Key policy developments (selected measures since 2016) - February 2016 — Underwriting: Increased minimum down payments; down payments raised to 10 percent for the portion of a home price over Can$500,000 (from 5 percent). - July 2016 — Insurance: Portfolio insurance restricted; limited to use to facilitate government-backed securitization. - October 2016 — Underwriting: Stress test expanded to all insured mortgages; debt-servicing assessed at the higher of contractual rate or BOC posted five-year rate; limits on insurance eligibility of low-LTV mortgages; portfolio-insured mortgages required to meet same eligibility criteria as mortgages with an LTV above 80 percent. - January 2017 — Insurance: OSFI revised the risk-based capital framework for mortgage insurers, increasing capital requirements, particularly for portfolio-insured mortgages, and adding a capital surcharge for mortgages in areas with price-to-income ratios above historical norms. - March 2017 — Insurance: CMHC raised mortgage insurance premiums for both transactional and portfolio insurance; the two private insurers followed the pricing change. - January 2018 — Underwriting: OSFI expanded borrower stress tests for uninsured mortgages (B-20 guidelines); stress test is the higher of the BOC posted 5-year rate or 2 percentage points above the contractual rate; B-20 disallows arranging mortgages secured by same property to circumvent maximum LTV ratio. - January 2018 — Securitization: CMHC raised guarantee fees for NHA MBS from 80 to 100 basis points for annual guarantees in excess of Can$9 billion. ### Impacts of policy tightening and insurance trends - Total mortgage insurance-in-force declined to Can$743 billion as of 2018Q2, down from Can$796 billion in 2016. - The insured share of federally regulated lenders’ mortgage portfolios declined to 43 percent, from 53 percent at end-2016. - New insured lending slipped to 29 percent of all new mortgages in 2018, down from 36 percent in 2014. - For new insured mortgages originated by federally regulated lenders, the share with loan-to-income (LTI) ratios above 450 percent fell from 20 percent to 10 percent in 2017. - Use of new portfolio insurance origination dropped significantly, slowing growth in NHA MBS issuance. ### Market risks and vulnerabilities - Institutions providing housing finance are broadly resilient, but potential vulnerabilities exist: - Mortgage pricing is low and relatively little-differentiated by borrower risk factors, raising the probability of an increase in risk-based pricing during a downturn and contributing to debt accumulation among potentially weaker borrowers. - Non-prime lenders are small but less resilient, with more concentrated exposures to riskier borrowers. - The policy framework may be driving borrower migration to weaker lenders and contributing to lower mortgage pricing for higher quality borrowers. - Prime lending segment: - Prime mortgage pricing (as measured by 5-year new mortgage rates less 5-year GoC bond yield) has been trending lower despite rising systemic risk from elevated household indebtedness and housing market imbalances, and macroprudential policy tightening. - Prime mortgage pricing has generally been too low to be sufficiently profitable for smaller lenders. - Uninsured prime mortgage rates have also been too low to profitably fund via private-label securitization. - Limited risk-based differentiation: - Insured mortgages are effectively free of credit risk for lenders and carry no pricing inputs sensitive to borrower risk profile. - Risk weights for uninsured mortgages are risk-sensitive, but most prime borrowers are assessed to be extremely low risk: 83 percent of mortgage and HELOC exposures assigned a PD of less than 0.5 percent, with an aggregate PD of 0.11 percent for that exposure segment. - Low estimated PDs for nearly all prime uninsured lending mean few risk-based capital incentives to differentiate pricing by potential risk characteristics. *Source: CANADA — INTERNATIONAL MONETARY FUND excerpt.* ### 29. This implies that risk could be underpriced for certain higher-risk prime borrower ### 29–38: Risk Pricing, Vulnerabilities, and Policy Options for Canada’s Mortgage Market ### Risk underpricing and prime borrowers - Risk could be underpriced for certain higher-risk prime borrower types if future mortgage defaults prove to be worse than in recent Canadian historical experience. - Cross-country evidence indicates housing market stress has often been driven by borrowers within the prime segment: - Ferreira and Gyourko (2015) found that in the U.S. post-global financial crisis, prime borrowers accounted for twice as many home losses (foreclosures and short sales) than subprime borrowers. - Albanesi, De Giorgi, and Nosal (2017) found the rise in defaults concentrated in the middle of the credit score distribution and that most delinquencies in this segment were from real estate investors rather than borrowers with one first mortgage. - OSFI has tightened underwriting standards for certain investor-type mortgages, and provincial recourse rules reduce the appeal of strategic default for investors, but the low estimated probability of default for these exposures may nonetheless underprice their potential risks. ### Non-prime segment vulnerabilities - The non-prime segment is small but may be vulnerable due to: - Lenders’ concentrated credit risk exposures to higher-risk mortgages, particularly in areas with large house price misalignments such as the Vancouver and Toronto areas. - Weaker funding profiles: these lenders are comparatively more reliant on less stable, higher-cost funding like brokered deposits or redeemable equity. - Market concerns manifested in a liquidity crisis at a monoline mortgage lender in 2017. - Higher funding costs largely preclude participation in prime mortgage lending markets by these smaller banks and private lenders, leading them to focus on higher interest rate lending to non-prime borrowers. ### Underwriting perimeter, pricing, and procyclicality - The lack of risk-based pricing forces authorities to rely on tightening the underwriting perimeter to curb risk, which has downsides: - May cause borrower migration from resilient prime institutions to financially weaker smaller banks and private lenders outside the regulatory perimeter. - Affected borrowers outside the prime perimeter may face significantly higher funding costs and shorter available mortgage maturities, weakening authorities’ ability to monitor vulnerabilities. - Mortgage rates fell relative to benchmark interest rates after policy tightening began in 2016, with the spread between the two reaching the lowest level in published Bank of Canada data in late 2018, suggesting further countercyclical tightening could require additional narrowing of the underwriting perimeter. - Aspects of Canada’s mortgage system may amplify procyclical tightening in a severe downturn: - Core lenders’ low-risk business models and low cost of capital might constrain appetite for new lending or renewals when household credit quality deteriorates and house prices fall. - Stress-test results show that introduction of a small risk premium to mortgage interest rates faced by higher risk borrowers with renewing mortgages would increase estimated system-wide cumulative defaults and cumulative losses by 44 and 48 percent, respectively. - Weaker lenders and short maturities outside the prime segment could compound tightening: - Over a quarter of existing borrowers must renew their mortgage every year, with an additional 13 percent facing HELOC re-pricing. - This increases the share of borrowers facing refinancing pressure when lending appetite is constrained. ### Prudential adjustments and mortgage risk weights - Increasing lender pricing of potential future risk factors in mortgage interest rates can improve resilience by: - Limiting accumulation of higher risk mortgages. - Ensuring debt-servicing capacity is stress tested at rates that incorporate additional risk premia borrowers may face in a downturn. - Reducing reliance on dynamically adjusting underwriting standards countercyclically. - Helping level the playing field between largest banks and smaller peers that use standardized risk-based capital approaches resulting in significantly higher capital requirements for mortgages. - With internal ratings-based (IRB) risk weights of about 3 and 10 percent for insured and uninsured mortgages, respectively, Canada stands out as having among the lowest overall risk weights among peer countries. - International experience and possible adjustments: - Require a floor for the average level of mortgage risk weights to better reflect through-the-cycle default risk. - Additional prudential adjustments to credit risk modeling, e.g., stepped up correlation factors for certain loan types. - Many countries tightened the Basel III IRB approach where recent default cycles are lacking (examples in other jurisdictions include floors of 15 or 25 percent and input floors for LGD and PD assumptions). - Note on calibration and capital neutrality: - Risk weight increases could be offset by equivalent reductions in Pillar 2, i.e., D-SIB Domestic Stability Buffer requirements, which are currently set at 1.75 percent of risk-weighted assets. ### Specific international examples of IRB adjustments (selected) - Australia: Risk-weight floor 25 percent (2016); APRA requires minimum average mortgage risk weighting of 25 percent for owner-occupied properties and proposed increased correlation factors for investor and interest-only mortgages. - Belgium: Risk-weight add-on 12 percent (2016): proportionate add-on of 33 percent of exposure weighted average of risk-weights; plus flat add-on of 5 percentage points. - Finland: Risk-weight floor 15 percent (2018). - Norway: Input floors 21 percent (2014): LGD assumptions must be at least 20 percent; other minimums for PD modeling. - Sweden: Risk-weight floor 25 percent (2016), converted from Pillar II to Pillar I. - Hong Kong SAR: Risk-weight floor 25 percent (2017), raised from 15 percent. - New Zealand: Input floors 28 percent (2015): stepped-up minimum LGD and correlation factor inputs based on LTV ratio and loan purpose; supervisory overlay to PD inputs. ### Measures to improve risk-based pricing for insured mortgages - Potential measures include: - Limit banks' ability to subsidize the cost of mortgage insurance premiums, increasing borrowers' upfront cost in proportion to their risk profile. For example, require banks to fund mortgage insurance premiums as separate loans with maximum amortizations (e.g., of five years) and interest rates closer to unsecured consumer rates. - Expand the range and detail of mortgage risk characteristics that determine insurer capital requirements, premiums, and the cost of the government guarantee. Consider increasing premiums for insurance-eligible multi-unit and investor properties or withdrawing coverage for these properties entirely. - Require insurance contracts to stipulate loan-level pricing adjustments similar to models adopted by U.S. government-sponsored entities post-global financial crisis: specify minimum increases in lender interest rates relative to a base rate that accumulate based on risk factors (LTV, credit score, number of units financed, loan purpose). Based on Fannie Mae requirements, the mandated difference in interest rates offered to low and high-risk mortgages can exceed 3 percentage points. - Trade-offs: Some recommendations may negatively impact homeowner affordability at the margin; these trade-offs must be weighed against the risk that current policy settings incentivize increased household debt and indirectly contribute to increasing home prices. ### Principles and guidelines for managing a housing market downturn - Given substantial taxpayer exposure to housing finance, develop a clear set of principles and guidelines to manage downturns, balancing: - Protecting taxpayer interests: - Identify an appropriate level of exposure to housing insurance and mechanisms to keep exposure within limits. - One policy option is a professionally managed government-sponsored mortgage reinsurance fund funded by existing guarantee fees. - Understanding effectiveness and trade-offs of existing tools: - Calibrate government macroprudential and other tools based on how they would perform in a downturn; avoid too little easing (ineffective) or too much easing (increases government exposure, moral hazard, limits household deleveraging). - Design countercyclical stimulus to avoid impeding necessary macrofinancial adjustments (e.g., house price corrections and household deleveraging). - Limiting moral hazard: - Limit use of portfolio insurance as a crisis management tool except at punitive premiums ensuring taxpayer profits. - Prefer refinancing and liquidity programs over permanent credit risk transfers to the government to address funding and credit transmission bottlenecks. *Source: Excerpts from IMF chapter section 29–38, as provided.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1canea2020002.pdf_