http://www.theglobeandmail.com/report-on-business/economy/housing/shaky-foundations-how-ottawas-computers-get-canadian-home-prices-wrong/article6673774/?page=all
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.
Cheaper, faster
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 – 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,” Mr. Somerville of UBC said.
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 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,” said
Tsur Somerville, an associate business professor at the University of
British Columbia who specializes in real estate. 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.”
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