Flaherty Threatens Tighter Lending Standards

Jim-Flaherty Finance Minister, Jim Flaherty, told CTV yesterday that the federal government would “take some action” and tighten mortgage guidelines if borrowers (or real estate prices) become irrational.

Flaherty said:  "The likely action we will take is to increase the size of the down payment from 5% to a higher figure, and probably once again, reduce the amortization period – so bring it down from a maximum of 35 years to something less."

Flaherty’s statements come amid ascending home prices, a threat of rate hikes in 2010, and lots of “bubble”-talk in the press.

His worry, of course, is that homeowners are taking on too much debt and won’t be able to handle:

A)  The higher payments that come with rising interest rates; and/or,

B)  Losses from falling home prices

If Flaherty changes lending guidelines, the impact on Canadian housing could be significant and immediate. 

On the plus-side, Flaherty would be keeping a certain number of Canadians out of trouble.  That’s a good thing because overinflated real estate markets usually end badly…and people can be financially ruined when they buy into them with little equity.

On the other hand, the dosage of Flaherty’s medicine must be carefully measured. He first needs to understand how many home buyers are actually at risk (see Rising Rates & Mortgage Arrears). He then has to determine what action is needed to save them from themselves. 

If rates jump in 2010 as many expect, this in itself will brake the housing market without any government intervention. Low rates are fuelling home prices more than any other factor.

Economists also have another worry.  Canada’s real estate market is like a giant airliner. Turning the rudder too quickly can rip the tail right off.  If 90% LTVs and 30-year amortizations are imposed in knee-jerk fashion, it would eliminate significant demand from the market.  Home values could drop shortly thereafter, and no one knows how much.  Canadians who rely on their home equity could be hurt (perhaps more than if the government did nothing) and hundreds of thousands of young buyers (mostly well qualified young buyers) would be shut out of home ownership.

That’s not to say tightening mortgage standards is necessarily a bad idea. If home prices and debt ratios continue climbing, it may be quite appropriate. The issue is, which tool does one use to remove the “cancer”: a chainsaw or a scalpel. 

Many would argue there are more surgical alternatives than what Flaherty proposes.  Instead of dropping an A-bomb on the whole market, Flaherty could instead make precision strikes where the threats are high. The finance department could require that lenders:

  • Not extend 95% financing to borrowers with debt service ratios over the standard 40%.
  • Increase minimum credit score requirements for 95% financing. (e.g.  From the current 600, to 650 or 680)
  • Tighten down payment guidelines in locations with overinflated home prices–using the Finance Department’s definition of “overinflated”, or some other objective measure.  (It’s important to remember that most local Canadian real estate markets are not materially overvalued.)
  • Impose small but reasonable minimum net worth requirements on 5/35 mortgages (those with only 5% down and 35-year amz).

These things, singularly or in combination, could address the problem of overleveraged home buyers while encouraging a softer landing for house prices. 

More importantly, a targeted solution would avoid penalizing the majority of well-qualified and responsible Canadians, for whom 35-year amortizations and 5% down payments are sometimes reasonable choices.

  1. Merry Christmas Rob and co!
    In a nutshell didn’t these guys loosen the rules before? In the long term this will be better for everyone. The cheap money reminds me of what happen in the US. My concern is no so much rates going up, as if we had a new wave of job losses. If you have no job it is hard to pay for a mortgage at any cost.

  2. While it may more sense to be more selective in choosing potentially at risk borrowers, I cannot see differing guidelines based on locations judged by potentially inaccurate “overinflation” measures ever being considered equitable.
    Also, would 7.5/35 mortgages really be all that bad? I’m thinking it could work. OTOH, a sudden change to 10/30 would be too harsh a change all at once.

  3. If he is hinting at it, it could happen. Public officials generally think they know best and not want to listen to what the marketplace thinks.
    If they went 10/30, owch. I would expect to see a huge drop in the first time buyers, and the rich richer yet again.
    It’s pretty hard for some to pay huge rents and save for a DP.

  4. Happy Holidays everyone,
    I think a more constructive solution would be to start including other debts in the lenders TDS guidelines, and create a budget for our clients. We should be including other monthly obligations such as gas, car insurance, phone bills, etc… Also, I’m not sure why we only use half of the condo fees in qualifying, especially when these fees are always increasing.
    The other idea would be to qualify people based on their net income. How can use people’s gross income to qualify for a mortgage, when they actually pay for the mortgage with after tax dollars?
    I think some of these measures would be much more practical and limit how much people would be able to afford, rather than reducing down payments. Even with larger down payments, people still loose jobs and cannot afford the mortgage. If the home gos power of sale, chance are most of the equity gets eaten by lawyers anyway.

  5. I don’t understand … we survived here for decades with 25% downpayments and 25-year mortgages.
    Now that we’re considering going back from 5% downpayments to 10%, and from 30-year mortgages to 25-year, why would it suddenly be such a catastrophe?
    It’s a very responsible way to cool the unsustainable growth in the housing sector, and I say this even as a homeowner who has value at stake here.

  6. Dan said it best. It’s easy money that has made things unaffordable. There’s not many people left to hurt anyway since homeownership is at 70% levels. We’ve got an oversupply of housing as well with the boomers to downsize shortly. Keeping things inflated does not help people own homes, it just helps banks victimize new buyers. Do you really ‘get into’ homeownership when the bank owns 95% of your house? A landlord owns 100%, so what’s the difference?

  7. As they say, once you’ve rung a bell, you can’t unring it.
    Since 5/35 is already commonplace, it would make sense that any retreat from that should be done prudently. We can’t just turn back the clock to 1965 and expect everything to be hunky dory.

  8. Agree with Eug.
    There is absolutely nothing wrong with 5/35 mortgages in the hands of the right borrowers.
    It’s like driving down the 401. Cutting the speed limit from 100km/h to 80km/h would save lives, but at what cost?
    Responsible drivers deserve to go a little faster even though you get the occasional yahoo doing 140km/h.
    Similarly, responsible borrowers deserve to become homeowners sooner—-if they want to and they can handle it.

  9. It’s good to see so many people here with sane, reasonable opinions here. (Unlike the bear blogs I sometimes read.)
    I agree with the prevailing sentiment. It was easy to turn up the taps and let credit flow… it will be much harder to turn that tap off again.
    That being said, dropping an A-bomb like 10/30 may not be such a bad thing. First-time buyers may be priced out for a while, but eventually prices will correct to a sustainable level. The only ones who get hurt are richer folks who have investment properties (so I would have to disagree with k’s comment that the rich would get richer).
    The only downside is consumer confidence — if home prices start dropping, confidence may plummet along with it and cause a huge price swing the other way.
    But then again, the nature of the market is cyclical, so Flaherty might as well let it happen. The BoC has already prevented the cycle from taking its natural course by artificially keeping rates so low for so long… the longer we delay the inevitable, the harder we’ll feel the eventual effects.

  10. if this was to become legislated I would list my house just prior to this taking effect, hoping there would be a run on 5/35 with buyers sitting on the fence about buying.
    I foresee a small spike, then a decline in house prices, at which point I would re-enter the market.
    I would only do if it is a move that puts $$ in my bank.

  11. It likely wouldn’t be worth it to sell and rebuy, given the hassle, commissions and taxes.
    Timing the market rarely works well anyway, unless you just happen to be lucky.
    For example, one year ago, who would have thought prices would be where they are today?

  12. I can’t see any stats specifically on the percentage of 5%/35-yr mortgages, but I’ve read some related stats that indicate the average down payment is definitely under 10%:
    1) “By mid-2007, average equity as a share of home value was down to 6% — from 48% in 2003.”
    2) A graph of average equity of home buyers can be found here:
    Unfortunately, these only show data to 2007… I would think that this particular stat (equity of home buyer) couldn’t have gotten better from 2007-2009.

  13. When I saw Flaherty yesterday I got a sick feeling. Like K says, I really don’t think he listens to anyone but the media and polls. This type of policymaking is totally political when it shouldn’t be.
    1/5 of our economy is at stake if Flaherty gets it wrong. I agree that steps should be taken if things get worse but tread carefully. Selective action will be way less damaging to the overall market while still accomplishing the goal.

  14. I disagree with some of what Flaherty has said, but not making a change isn’t necessarily the safe choice. Sometimes there’s more risk in doing nothing.
    I think a good alternative would be to raise the credit raiting needed on 35 year mortgages, instead of banning them entirely. If someone has good credit, why not give them more control over their payments?

  15. I’m really hoping this change does go through and it does go from 5/35 to 10/30. The combination of 5/35 and low rates is madness, at least it is in Vancouver. I know two friends that have recently ran out to buy ‘investment’ condos that they are now trying to rent out for less than their monthly costs. They just want to flip them when prices go up another 20% in a year or 2. That would make their 1 bedroom <600sqft condo's in the suburbs worth $350K. Sick.

  16. Whatever Finance’s move (or lack thereof) turns out to be, I’m hopeful that it will be based on solid quantitative evidence (i.e. relevant metrics).
    There is too much reliance, IMO, on personal anecdote in this debate. We have to remember that the housing market is huge, comprised of millions upon millions of households. In other words, the number of individuals with unhealthy debt service ratios within your immediate social circle is likely not very representative of the aggregate market.
    In the same way, the experience in Toronto/Vancouver is not necessarily the same as in Ottawa or Fredericton, let alone Smith’s Falls or Humboldt.
    Al R

  17. Can’t imagine paying for 35 years. The effect has been to drive up purchase prices under a more “affordable” 420 payment schedule. This has been a benefit to existing owners but I’m less certain about new home buyers. I’m curious about modeling what prices would have looked like under the old scheme with TDS restrictions limiting appreciation. Lenders may be thrilled but I’d be happy with at least a partial rollback.

  18. FYI – I noticed (after doing a bit more digging) that those average equity stats are not accurate… CMHC has put out this silly chart in 2008:
    If you go to page 5, you can read the assumptions that went into that chart:
    “To calculate the accumulation of equity due to making monthly mortgage payments, we assume a 5 percent down payment, a 25-year amortization, and that the home was purchased at the average MLS price in the month of purchase”
    So, these ’statistics’ aren’t stats at all, and were completely made up based on a representative example. The bar graph is completely misleading, since it is supposed to show how much equity a random 5% homebuyer would have gained — and it is not intended as some kind of chart showing a downward trend in downpayment amounts.
    So, chalk that stat up to 1 useless CMHC report and 1 misinformed blogger.
    (FYI – in case any of you read greaterfool.ca, I also noted this error over there)
    Regardless, I guarantee that 5%/35-years is a large percentage of new mortgages — especially with first-time buyers.

  19. Mark – I did check the stats, hence my 2nd post explaining the fake data from CMHC.
    9% of Canadians with < 10% equity seems misleading if that includes those without mortgages and those who have already re-financed. I'd be curious to know: A) Percentage of new mortgages (not re-financing) from 2006-2009 that are 35-40 year amortizations. B) Percentage of new mortgages from 2006-2009 that have 10% or less down payment (90%+ LTV). I still think that both A and B would be 50% or higher.

  20. I’m not sure why people think 10/30 will kill the market. In 2008 they removed 0/40 and it certainly didn’t kill the market.
    Interest rate hikes will punish the market more than anything:
    $300K 35-year @ 4% = $1381 per month
    $300K 30-year @ 4% = $1490 per month
    $300K 35-year @ 5% = $1575 per month
    So a 1% rate increase costs more than 5 years of extra payments.
    In any case, I doubt Flaherty will go for 10/30. Of course, I thought he wouldn’t go after income trusts as well. :-)

  21. @ValueMoney
    100% financing still exists. Only high-ratio 40yr amortizations disappeared.
    First-time homebuyers set entry level prices, which influence all prices above them. Therefore prices would have to fall if 10% D/Ps caused far fewer 1st-timers to buy.

  22. @Jonathan
    Thanks for the note.
    I still don’t see what the fuss is about. We moved from 0/40 to 5/35 (or a conditional 0/35) and this didn’t kill the market. So I’m not convinced a move to 10/30 (perhaps a conditional 0/30) will change the current momentum.
    In my example above its an extra $109 a month. If borrowers are living this close to the edge, then it seems like a pretty fragile market and we should be applauding the finance minister for recognizing the issue. If its not this fragile, then what’s there to worry about with this minor regulatory change?

  23. Happy Holidays!
    I spoke with 10 of my Realtors and 9 out of 10 strongly agreed that jump from 5 to 10% d/p will significantly (negatively) impact their business.
    I don’t see monthly payment as an issue – D/P IS A HUGE ISSUE, especially among ethnic communities, new immigrants and young professionals.

  24. @Ben
    Did you ask the realtors if this is the case, then why didn’t it slow the market when they moved from 0/40 to 5/35?
    Again, I’d have to ask if these borrowers are so tight on their cash supply, then should they be participating in the market? I think the finance minister’s rhetoric echos my sentiments.
    BTW, it seems the realtor shouldn’t worry too much. As Jonathan was alluding to, banks still offer 100% financing:
    e.g. http://www.cibc.com/ca/mortgages/flexible-downpayment-mortg.html
    If you look around you’ll find its not the only 100% financing deal around. Now this is disturbing. The banks aren’t dumb, so this suggests to me they’re moving these risky mortgages off their balance sheet via securitization.

  25. Thanks for the comment Kevin. You’re right, the banks can only move 95% of the mortgage off their balance sheet. So they take 5% of the risk. Unfortunately, this doesn’t make me feel any better.
    95% risk to tax payers via the government via the CMHC is not my idea of appropriate governance over this market.

  26. ValueMonkey I have been watching your comments and your numerical statements are consistently innacurate.
    It is not 95% risk to the taxpayer.
    If you want a rough mathematical approximation of the risk, it equals
    [The default rate] X [.95] X [mortgage principal] – [The insurer reserves allocated to that mortgage]

  27. Thanks Pete. Good thing I don’t make my money as a mortgage broker. :-)
    You’re correct about my hyperbole on actual risk, but you’re missing the point. If we follow your formula, the bank’s portion of the risk is only 5% of the default rate. The insurer (and taxpayer down the line) assumes the remainder. So the banks are taking very little risk in this big game of leverage assuming their not keeping the mortgages on their balance sheets. And from what I’ve read, this is exactly what’s going on. Please feel free to correct me if you have evidence to show the banks are using deposits rather than securitization to fund their current mortgages.
    Now hopefully we don’t see a cascade of mortgage defaults that stress tests the insurers. That’s why I’m in favour of Flaherty’s measures to curtail an asset bubble in this sector before a stress test is certain.
    … your numerical statements are consistently innacurate.
    Its inaccurate, not “innacurate”. :-)

  28. ValueMonkey there was a story here a few weeks ago on CMHC. It invalidated the misconception that lenders do not assume risk when they lend against insured mortgages. You should take some time and read it.
    Risk is an insurer’s business. CMHC gets paid handsomely for the controlled risk that it assumes. These profits flow through directly to taxpayers.
    It seems to me that you are merely taking what you read in newspapers and trying to use it here to argue against Canada’s lending system. Yet, you obviously (to me anyway) have little knowledge of how that system actually works.
    As an example, banks fund the majority of mortgages from their balance sheets. That is common knowledge in the industry. Someone who is arguing against the lending establishment should really know that.

  29. Thanks for the comments Pete.
    …there was a story here a few weeks ago on CMHC.
    Could you provide the link?
    It invalidated the misconception that lenders do not assume risk when they lend against insured mortgages.
    I agree in part. Banks assume risk when they lend based on their deposits. However, I don’t think banks are on the hook when they securitize the mortgage. Correct me if I’m wrong, but I’m asking for evidence, not your conjecture.
    It seems to me that you are merely taking what you read in newspapers and trying to use it here to argue against Canada’s lending system.
    You’ve taken a red herring and sprinkled on a touch of ad hominem. I’m not sure how you conclude I’m arguing against Canada’s lending system. This is simply not the case. I’ve argued to support the finance minister’s position for 10/30. If I’m against our lending system, then you should conclude Flaherty is as well.
    Its true I discuss what I’ve read. Here’s an interesting article by Jonathan at the America Canada blog:
    Based on data taken from CMHC he shows securitization accounts for over 90% of all growth in total Canadian mortgage credit since 2007. Its true that most existing mortgages are backed by deposits. However, based on the current rate of securitization growth this won’t be the case within a year or so.

  30. Look up the CMHC story in the archives. It was a few weeks ago.
    Canadian Mortgage Trends explains that lenders do not relinquish responsibility just because they securitize a mortgage.
    Remember that securitization rose in the last few years because markets seized and it was the cheapest form of funding. Now that the credit crisis has ended, balance sheet lending will increase again.
    Securitization itself is in no way bad. It is securitization of unknown assets that is bad. This is what happened in the United States. Lenders there were securitizing bad assets like NINJA mortgages. That does not happen in Canada.
    To equate the securitization systems in Canada and United States is as “innacurate” as the spelling of this word.

  31. Pete – you are confusing insuring vs. securitizing. The banks have no risk because the mortgages are 100% insured by CMHC.
    The fact that CMHC then goes and securitizes those mortgages is not the point.

  32. T.O. the lingering argument actually seems to be that lenders have “no risk” when they insure and/or securitize a mortgage.
    That is not true. They are still “on the hook” in many ways.
    What matters is that Canadian lenders generally have great incentives not to issue bad mortgages. That is a fact and it should not be distorted by all this talk that is anti-CMHC, anti-securitization, anti-this and anti-that.

  33. My understanding was that the CMHC insurance only applies to the 20% “downpayment” on the mortgage, and any loss into the 80% remaining is the bank’s liability.
    Can somewhat factually correct me (with a link if possible) if I am wrong?

  34. CMHC insurance covers all losses for principal and accrued interest in the event of default. I don’t have a link. Sorry.

  35. Thanks for the comments Pete.
    I read the CMHC story (at least I think its the one you wanted me to read). Interesting, but it still shows CMHC shoulders the mortgages on their balance sheet, not the lenders. There are measures to keep them honest, but CMHC (and the taxpayer) is still holding the ball.
    Securitization itself is in no way bad. It is securitization of unknown assets that is bad.
    This sounds like a contradiction. How can securitization in no way be bad and yet be bad under a certain context?
    Again, let’s frame the discussion. We’re talking about 10/30. I’m not arguing against securitization or CMHC. I’m saying that 10/30 is a valid tactic in a market where cheap credit is leading to an asset bubble. Securitization is one enabler of this cheap credit. I’ll go one further and say that without securitization, tactics like 10/30 would be unnecessary.

  36. CMHC is an insurer and, like most insurers, they are well paid for taking risk. That doesn’t mean lenders themselves have no risk. Nor does it mean Canadian lenders have an incentive to fund risky mortgages. It’s just not the way the system works.
    About securitization. It is a simple concept Valuemonkey. Let me simplify things for you. It’s like saying driving a car is not bad, unless you’re drunk.
    The act of securitizing by itself is not harmful. All kinds of assets are securitized (like mortgages, car loans, credit cards). Problems occur only when BAD assets are securitized.
    Lastly, this has been repeated several times. Yes, 10/30 is “a” tactic, but it is not the BEST tactic. The best tactic is one that discourages bad practices without eliminating options for responsible borrowers.

  37. Thanks for the comments Pete.
    CMHC is an insurer and, like most insurers, they are well paid for taking risk.
    Yes, but unlike most insurers they’re backed by the government and taxpayer. And who said actuary models improve because you’re well paid? If this was the case, then our neighbours to the south wouldn’t be in their current mess.
    Nor does it mean Canadian lenders have an incentive to fund risky mortgages.
    Its the liquidity created through removal of mortgages from the lenders’ balance sheets that leads to a systemic risk. Loose credit is fueling an asset bubble. Its certainly not real estate valuations or job creation.
    The act of securitizing by itself is not harmful.
    True, but its the enormous growth of securitization that’s problematic. Securitization accounts for 90% of mortgages since 2007 and its one of the credit liquidity factors that is leading us towards an asset bubble. Even with the low interest rates, if lenders couldn’t securitize, then lending standards would have tightened up and 10/30 wouldn’t be a topic for discussion.
    Yes, 10/30 is “a” tactic, but it is not the BEST tactic. The best tactic is one that discourages bad practices without eliminating options for responsible borrowers.
    I think the best tactic is the one that diffuses the asset bubble. If the finance minister wants to add on other factors like DSR maximums and credit score minimums, then all the better.
    If a few borrowers are taken out of the market, then they’ll have to work at saving an extra 5% (which the banks may lend them anyways). After a few years they’ll be able to enter the market. If they can’t manage to save the extra 5%, then its a bad time to be entering the market.

  38. We’ve done a fair share of 95% financing over the years. Maybe a handful of our customers could not afford their payments if rates went up. For those who cannot, we always suggest they postpone their purchases until they are more stable.
    On the other hand, I tend to agree that any new rules should not force strong borrowers out of the market. There are lots of young families that haven’t saved for a 10% down payment. Yet they have 700 Beacons and stable professional employment. Why should they be told they cannot buy simply because some people claim real estate is overvalued? That makes little sense.
    Raise Beacon requirements or set the TDS ceiling at 40%, but don’t impose down payment and amortization rules across the board just to have a quick fix.

  39. Why should they be told they cannot buy simply because some people claim real estate is overvalued?
    Because one of those people is the finance minister and he’s concerned about an asset bubble that affects all Canadian, not just a few young couples. If they have good credit ratings and stable professions, then they’ll get there. What’s the rush?
    BTW, when the finance minister killed 0/40 he also establish consistent minimum credit scores, so its possible if he moves on this, new approval standards will be established at the same time.

  40. The finance minister is one person and one opinion. Just because he says something doesn’t make other analysts wrong.
    The government meddles in enough affairs. It is wrong for them to tell good qualified borrowers that they have to wait to buy a home.

  41. I think we can safely say the finance minister is informed by many people. For starters, there’s the entire Department of Finance.
    Did you protest with their meddling when they allowed 0/40? Did you protest their meddling when they created IMPP?

  42. Hi, great post! Let me quote my fav part:
    Many would argue there are more surgical alternatives than what Flaherty proposes. Instead of dropping an A-bomb on the whole market, Flaherty could instead make precision strikes where the threats are high.

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