Stephen S Poloz: Risk sharing, flexibility and the future of
mortgages
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Credit Union
Association and Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 6 May 2019.
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Introduction
When people think about the Bank of Canada, the first thing that comes to mind is usually
interest rates. But we do have other responsibilities, including issuing safe and secure bank
notes-such as the new $10 note, which features Viola Desmond and Winnipeg's spectacular
Canadian Museum for Human Rights, and which was just named the best new bank note in the
world for 2018.
Another of our core responsibilities is ensuring that Canadians can conduct their affairs in a safe
and efficient financial system. As one of the pillars of that system, Canada's credit unions share
in this responsibility. By safe, we mean a system that is resilient to risks, and where those risks
are shared in a desirable way. By efficient, we generally mean competitive, and credit unions
bring an important competitive edge to Canada's financial marketplace.
The forces of competition drive pricing for financial services, but they also drive consumer choice
in financial services. More choice means more flexibility and a greater ability to adjust when
conditions change. This concept of flexibility is very important to the functioning of our economy,
and therefore important to us at the Bank of Canada.
The most important financial decision most Canadians make is the decision to purchase a home
and to take out a mortgage in order to do so. After you sign on the dotted line, circumstances can
change, posing risks for borrowers, for lenders and for the financial system as a whole. Financial
flexibility and optimal risk sharing can help people adapt to changes in their circumstances and
help the overall economy adjust to shocks. Recent changes to our mortgage system have
brought these issues to the fore in public debate.
In my time with you today, I want to talk about how Canada's housing markets have been
adjusting to economic forces and recent administrative changes. I will then speculate on how our
mortgage market could evolve to offer more choice for Canadians, more flexibility for the
economy and less risk overall.
Recent developments in housing
We do not have a single housing market in Canada; rather, we have several regional markets.
Each has certain national forces in common-such as changes to mortgage lending guidelines
and past increases in interest rates-but each also has unique local influences on supply and
demand, including provincial and municipal housing policies.
For the past four years we have been following three different housing stories here in Canada. In
Alberta and Saskatchewan, we have seen a significant slowdown in housing coupled with falling
prices, as the economy works through adjustments to lower oil prices. In sharp contrast, we saw
housing booms in Toronto and Vancouver, both of which were experiencing strong population
and employment growth and supply constraints on new housing. Low interest rates were of
course supporting strong housing demand. Rising house prices fuelled even stronger demand,
as first-time homebuyers feared missing out. Foreign buyers were attracted to both markets,
adding more fuel. All this helped create extrapolative expectations that prices would keep rising
rapidly, a situation that was clearly not sustainable. The third housing story-taking place
everywhere else-attracted little attention because it basically looked normal, driven by solid
employment growth and historically low interest rates.
Since early 2016, policy-makers in Ontario and British Columbia have implemented a series of
provincial and municipal policies to discourage foreign buying and speculative activity.
Policymakers at the federal level-including the Office of the Superintendent of Financial Institutions
(OSFI)-expanded the use of interest rate stress tests on mortgages in both 2016 and 2018.
And, with the economy growing strongly, the Bank of Canada began raising interest rates to keep
inflation on target. In the wake of all these developments, housing resale activity has fallen
sharply in Vancouver and Toronto.
Last month, the Bank published staff research that attempts to untangle the factors behind the
huge run-up and subsequent drop in housing activity. It is important to do this because we need
to understand well the sensitivity of the economy to higher interest rates. We believe that
sensitivity has gone up because of the debt loads people are carrying.
Our research shows that the big rise and fall in housing resale activity in British Columbia and
Ontario can mostly be explained by shifts in house price expectations. When house prices are
rising rapidly, people tend to extrapolate that experience and buy houses early to avoid further
price increases, or to profit from them if they are speculators. In other words, markets become
frothy. However, when those price expectations are revised down, demand for houses can cool
suddenly. And this is what has happened. The trigger could be anything, including new taxes on
foreign buyers, stricter mortgage guidelines, rising interest rates, or simply that rising prices
create an affordability roadblock for more and more people.
What we take from this is that it is not higher interest rates and changes to mortgage lending
guidelines that have had the greatest effect on housing demand. Rather, it is their interaction with
froth that matters most. How much a housing market adjusts depends on how much froth there
is. Supporting this conclusion is the fact that many other markets across the country look quite
healthy. Resale activity has been solid in places as diverse as Halifax, Moncton, Montréal,
Ottawa and, more recently, right here in Winnipeg. This is what we would expect in an economy
that is growing, with a rising population and strong labour market, and when interest rates remain
very low by historical standards.
Meanwhile, housing markets continue to struggle in Alberta and, to a lesser extent,
Saskatchewan. The primary cause appears to be the ongoing process of adjustment to the
2014-15 oil price shock, as well as the renewed weakness we saw late last year. Before 2014,
people and businesses were making long-range plans based on continued high oil prices. A lot
has changed since then. Most importantly, US oil production has expanded dramatically, causing
many to revise downward their long-term expectations for world oil prices. Companies have
reduced their investment budgets and worked to reduce their costs. Ultimately, the adjustments
are seen in areas that have real consequences for people, such as layoffs, lower wages and
lower house prices.
I do not mean to suggest that the new mortgage guidelines have had no effect on housing
markets, for they certainly have. The purpose of these changes was to increase the resilience of
our financial system in the face of an extremely high debt load. The stress test is designed to
ensure that new borrowers can still handle their mortgage payments even if their circumstances
change, such as a decline in income or a modest increase in interest rates.
Evidence suggests that the new guidelines have been working as designed. The quality of new
loans continues to improve, and fewer mortgages are going to highly indebted buyers. From the
house buyer's perspective, the guidelines look like a cut in purchasing power. But many are
adapting by buying less expensive housing or delaying their purchase until they have built up
more savings. To the extent that the new guidelines have helped stop the speculative rises in
house prices in Vancouver and Toronto, they presumably have also worked to help keep houses
from becoming even less affordable.
We conclude from all this that the fundamentals of the Canadian housing market remain solid,
and growth will resume once the effects of reduced expectations for house price inflation and the
new mortgage guidelines have been absorbed. Bank staff have also been monitoring the impact
of the new mortgage guidelines and higher interest rates on cash flow as households renew their
loans. From our initial look at individual loan-level data in 2019, we see that mortgage payments
did not rise for most borrowers who recently renewed a five-year, fixed-rate mortgage. Despite
increases in our policy interest rate, bond yields and mortgage rates have declined this year
along with global interest rates.
The Bank will present its complete analysis of housing and other issues in our next Financial
System Review, which will be out in a couple of weeks. We will also post information on our
Financial System Hub-a section of our website featuring the latest analysis of key financial
issues.
Toward a more flexible mortgage market
Given how different the various regional housing markets can be, it is worth looking to see
whether Canada's mortgage market could become more flexible, giving people more choices
and increasing the economy's ability to adjust.
Canadian homeowners and financial institutions have been well-served by our mortgage market.
But it is still important to think about ways to innovate and make a good system better so that
borrowers and lenders can make choices that better suit their circumstances.
Of course, there have been innovations in Canada's mortgage market over the years. Mortgage
brokers have appeared on the scene. Financial institutions are doing more business online and
reducing the time between application and approval. And mortgages combined with home equity
lines of credit, or HELOCs, have become popular. These give Canadians ready access to the
equity they have built in their homes, helping people make major purchases and smooth their
consumption over time.
Still, there has been significantly less innovation in terms of the actual mortgage product itself.
We could look at ways to develop a more flexible mortgage market that gives more choice to
customers, lenders and investors, while making the market safer and more efficient.
Diversify mortgage durations
One basic idea would be to encourage more diversity in mortgage durations. It is true that most
financial institutions offer fixed-rate mortgages longer than five years. But 45 per cent of all
mortgage loans have a fixed interest rate and a five-year term. In comparison, just 2 per cent of
all mortgages issued last year were fixed-rate loans with a term longer than five years.
There are historical reasons why the five-year fixed-rate mortgage has been so dominant in
Canada. These include legislation from the 1800s that gives borrowers the right to prepay loans
after five years without penalty. This provision means that lenders will charge more for longer
loans to guard against the risk of a loan being paid back early. And the trend toward five-year
loans was reinforced by the Canada Mortgage Bond (CMB) program, which mainly provides
fiveyear funding for financial institutions.
Still, there are compelling reasons why it would be helpful to make more use of longer-duration
mortgages. From the consumer point of view, a longer term means they face the risk of having to
renew at higher interest rates less often-the longer the term, the fewer renewals take place over
the life of the mortgage. Of course, a longer-term mortgage will carry a higher interest rate, but
some homebuyers may be willing to pay more to lower their risk. And a longer-term mortgage
might not be much more expensive in the long run depending on the details of the loan and the
prepayment penalties that apply. At a minimum, we could do more to make people aware of the
longer-term options that are available-many people I talk to do not know that longer-term
mortgages exist.
As a policy-maker, I see how longer-term mortgages can contribute to a safer financial system
and more stable economy. Simple math tells you that of all those five-year mortgages, roughly 20
per cent will be renewed every year. That is a lot of households. If all the mortgages were 10-year
loans, only 10 per cent of these homeowners would renew every year.
Another point with longer-term mortgages is that more equity is built up by the homeowner
between renewals. This equity position gives the borrower more options at renewal. Therefore,
the longer the original mortgage term, the less relevant a mortgage interest rate stress test
becomes. In other words, longer-term mortgages shift the risks shared by the lender, the
borrower and the system as a whole. All of these dimensions are worth further study.
Develop a private market for mortgage-backed securities
One obstacle to financial institutions offering longer-term mortgages relates to their funding
costs. The textbook example of funding is a bank that takes in deposits from customers and
turns them into mortgages and other loans. The reality is more complicated. Many institutions
seek out wholesale deposits in addition to their regular retail consumer deposits. The biggest
banks also get funding by issuing bonds. And, since 1987, Canadian institutions have had the
ability to issue government-supported mortgage-backed securities (MBS).
A mortgage-backed security lets institutions package mortgages they have made and sell them
to other investors. The investors receive the income from the mortgage payments. The proceeds
of the sale become funding that the original institution can use to write more mortgages, or for
other purposes. This process is basically invisible to homeowners-they keep making mortgage
payments as before.
Current rules say that only insured mortgages can be used in government-supported MBS. Since
2001, the Canada Housing Trust-which was set up by Canada Mortgage and Housing
Corporation (CMHC)-has been buying insured mortgages from institutions to use in the Canada
Mortgage Bonds that I mentioned a moment ago. CMBs have been highly successful-more
than $230 billion worth of CMBs are outstanding, equal to about 15 per cent of total mortgage
debt.
With CMBs and other forms of government support for mortgage financing, the cost for funding
insured mortgages is quite low. This has lowered mortgage rates for consumers. However,
funding for uninsured mortgages, particularly at smaller banks and mortgage finance companies,
is comparatively expensive. It is true that since 2007, Canadian institutions have been able to
fund uninsured mortgages by issuing covered bonds. But it can be difficult for smaller institutions
to do so because they do not have the same economies of scale as the big banks. What is
more, OSFI has capped the percentage of covered bonds that any single institution can have
among its assets.
So, it could be helpful for both lenders and borrowers for Canada to develop a private market for
mortgage-backed securities. This could be a more flexible source of longer-term funding for
uninsured mortgages, particularly those issued by smaller banks, credit unions and
mortgagefinance companies. This is an increasingly important point because the market share for
uninsured mortgages is increasing, and they cannot be used in CMBs.
Further, CMBs are mostly issued as five-year bonds, matching the dominant five-year mortgage
term. If we develop more diversity in mortgage duration, lenders will want different types of
funding to help match that. Private MBS could help in this regard.
Finally, private MBS could become another option for investors. Such investors include large
institutions like pension funds and insurance companies that need long-term assets to match
their liabilities. They also include mutual funds and, perhaps, regular individuals looking for a
fixed-income investment that pays more than a regular guaranteed investment certificate.
There is some momentum in Canada toward developing a private MBS market. However, for
these securities to be successful investments, they must be designed carefully. After all, many
people remember that mortgage-backed securities were at the heart of the sub-prime debacle
that preceded the global financial crisis over a decade ago.
A private MBS market in Canada would need to be transparent to give investors more confidence
about the quality of mortgages they are investing in. This would allow investors to accept a lower
yield, reducing the price difference with regular CMBs. One way to ensure transparency is to
develop a public database of mortgages used in securitization. Ideally, this database would
include general characteristics about the borrower, property and loan, and data on how the loan
has performed over time. An anonymized database would also preserve the privacy of the
mortgage holder.
It is worth pointing out that other jurisdictions, including the European Union, the United Kingdom
and Australia, already have this type of arrangement in place or are working toward it. We hope
that all financial institutions in Canada, from the Big Six banks to the smallest credit union, will
co-operate here. After all, such a database could benefit all institutions, not just those that might
issue MBS. If institutions can use the information to show how solid their mortgages are, they
could lower their funding costs, no matter how they obtain their funding.
New mortgage designs?
The last idea I want to discuss is the design of the mortgage itself. In its most recent budget, the
federal government announced the creation of a shared equity mortgage, to be administered by
CMHC. The final details will be put in place later this year. This proposal is intended mainly to
address housing affordability for first-time homebuyers by giving them an interest-free loan to add
to their down payment. The plan will also promote increased housing supply.
Another interesting aspect of the plan is that it should help improve the resilience of the financial
system and improve the economy's ability to adjust to shocks. Although there are many possible
variants, this type of mortgage has been analyzed in some depth by two US economists, Atif
Mian and Amir Sufi.
Basically, the idea is a rewrite of how the risks around a mortgage are shared between borrower
and lender. Because the mortgage is shared, like equity in a company, the risks are shared. Of
course, a shared equity mortgage does not make risk go away. The important point is that
lenders are better placed than borrowers to carry risk because they can diversify risks across
many borrowers. Borrowers are willing to pay to reduce risk, either through a higher interest rate
or through sharing their capital gains or losses with their lender. In Canada's case, with our
strong standards for mortgage underwriting, the net result of such a reallocation of risk would
likely be a safer financial system.
Of course, there are many other possible variations on mortgage design, so many that it makes
me wonder why so little has happened in our mortgage market in my lifetime. I hope that some of
the innovative spirit that credit unions have shown in the past will be applied to the mortgage
market in the future. After all, one of the founding principles of credit unions is the concept of risk
sharing.
Conclusion
It is time for me to conclude.
The Bank of Canada's mandate is to encourage a safe and efficient financial system-one that
evolves to foster resilience, promote flexibility and allow people to make choices that are right for
them.
Housing and mortgages are the heart of our system. The Bank of Canada is continuing to watch
closely how housing markets are adjusting to the combination of recent provincial and municipal
housing policy changes, the revised guidelines for mortgage lending and past increases in
interest rates. Some previously frothy markets are still adjusting to a significant shift in price
expectations, while other markets appear to be operating in a manner consistent with market
fundamentals. As markets stabilize in Toronto and Vancouver, the Canadian housing sector
should return to growth overall later this year.
The regional nature of our housing market highlights that all of us should be looking at ways to
improve the safety and efficiency of our mortgage market. More choice for borrowers and more
ways for lenders to diversify risks are desirable. To be clear, the system is not broken-it has
served Canadians and financial institutions well. But we should not stop looking for
improvements. And I invite all of you to join this effort.
I would like to thank Ron Morrow, Jason Allen, Brian Peterson, Adi Mordel and Nigel Stephens for
their help in preparing this speech.