Following Ottawa’s landscape-changing insurance rules last fall, the Department of Finance has raised little concern about the prime uninsured mortgage market, at least publicly.
Nor should it—at least with respect to the uninsured market overall. By and large, uninsured borrowers are:
- in a safe equity position
- financed without direct government backing, unlike default insured borrowers
- underwritten reasonably conservatively—as measured by international standards and regulator-accepted performance metrics (not even the biggest risk-sharing cheerleaders could convincingly argue that banks pose a moral hazard on uninsured loans)
But OSFI isn’t content with that. Despite:
- there being insufficient time to properly assess the last insurance regulations (So much for the parliamentary hearing and their report recommending a moratorium on new mortgage regulations…what a fricken dog and pony show that was.)
- the Minister of Finance (to whom OSFI effectively reports) reportedly being far less concerned with the uninsured market, and
- key housing markets rolling over…
…OSFI seems ready to swing yet another giant hammer: the uninsured stress test.
Now, to be fair, OSFI’s job is to protect the solvency of the institutions it regulates. So it’s looking at stats like this and flipping out:
- Uninsured mortgages are growing 14% y/y (Src: BMO)
- About half of Big 6 Bank mortgages are now uninsured (Src: BMO)
- Roughly 80% of new big bank lending in the richly valued Toronto and Vancouver markets is low-ratio mortgage lending (Src: BoC)
- About half of new mortgage originations are clustered near the conventional LTV limit of 80% (Src: BoC)
- More than half of low-ratio mortgages now have 30-year amortizations
- By volume, the share of uninsured mortgages with loan-to-income ratios above 450% (the government’s preferred warning threshold) is up from 19% to 27% in two years (Src: BoC)
So based on recent data, OSFI has a right to be concerned. It’s what the regulator has proposed to do about it that’ll be fiercely debated.
Take its new uninsured stress test for example. Like so many other OSFI measures, it assumes a meaningful number of lenders and borrowers lack the self-preservation instinct. That, they argue, justifies putting tighter handcuffs on all parties.
If B-20 3.0 (as drafted) becomes “law” of the land, more and overleveraged borrowers will be shot down by banks. No question about it. And that’s a good thing, in and of itself.
Unfortunately, (and here we go again) the majority of other borrowers who present virtually no risk to the banking system would see their maximum theoretical mortgage amounts slashed and/or their interest costs rise.
The Likely Effects
With 4 in 5 mortgages being conventional, OSFI’s B-20 trequel is a massive change. By year-end, there are 10 outcomes that Canadians should expect if this iteration of B-20 goes through:
- Slashed Buying Power — The majority of homebuyers put down 20% or more. The bulk of those are uninsured mortgage customers. OSFI’s stress test, as proposed, would slash buying power for prime buyers by roughly 18%—assuming they chose a bank mortgage and 25-year amortization. (This last point is a huge question mark. Will OSFI require uninsured borrowers to qualify at a 25-year maximum amortization?? If not, it defeats some of their purpose as a 30-year am. levers you more and gets you ~7%+ more buying power.) For non-prime borrowers, qualifying rates would immediately rocket into the 6% to 7% range—unheard of territory for most young buyers. NBF says dual income Ontario borrowers with 30-year amortizations could suddenly find their gross debt service ratios (on paper) soaring some 700 bps.
- Home Price Haircut — Equity is the #1 safety net keeping bank mortgage books safe. Less buying power means less demand at the same price. OSFI’s much tighter credit policies could conspire with other factors (e.g., rate hikes and debt loads) to kill a portion of demand and jeopardize equity for 70% of the Canadians who own. That soft landing we all hope for could harden up, tout suite. On the other hand (I sound like an economist), home prices have weathered regulation well in the past. Buyers…remarkably…find a way to adapt, such that a crash is sharply less probable than a correction.
- Heightened Borrower Risk — OSFI’s draft proposes the same stress test (200 bps above the contract rate) for all terms. This has to be a mistake, no? Any broker fresh out of broker school could tell you that higher-GDS borrowers will gravitate to shorter terms in order to qualify. That’s the exact opposite of the regulator’s goal today. A typical borrower choosing the lowest variable rate today, for example, might qualify for roughly $16,000 more (and this number is skewed lower due to an abnormally flat yield curve) than someone getting a “safer” 5-year fixed. And they’d qualify for $50,000 bigger mortgage than a 10-year fixed borrower. Do regulators really want higher indebted borrowers in shorter / variable-rate terms?
- Fewer Debt Ratio Exceptions — Banks routinely provide debt ratio exceptions if the borrower’s overall risk profile warrants it. Say goodbye to these on higher LTV deals in markets with high valuations.
- The Non-Prime Shuffle — OSFI’s proposal does not rid the system of lower quality borrowers. It simply:
- pushes them down the credit ladder into the welcoming arms of high-cost less-regulated subprime lenders
- reinforces “Freedom 75” as Canadians’ new life goal (the coming retirement crisis just got accelerated five years)
- heightens overall economic risk.
If you’re a regulator who thinks borrowers won’t buy or refinance because of tighter regulations, then Rob Halford has this to say to you…
- Second Mortgage Boom — Lenders providing second mortgages will see a renaissance, for three reasons:
- FIs would no longer be able to facilitate second mortgages (in addition to their first mortgage) if the combined mortgages exceed 80% LTV, but brokers will still be able to
- To the extent these rules lower LTVs at federally regulated lenders, brokers will increasingly use secondary charges
- If we’re in a rising rate and/or tougher qualifying environment, borrowers will use seconds to protect the rate on their first mortgage and/or keep from having to refinance their first.
- Field Day for Credit Unions — Many credit unions can still go up to 80% LTV on HELOCs and offer 35-year amortizations. So you better believe that some will continue letting borrowers qualify at the contract rate, barring a provincial regulatory agreement with the feds. Some of those low-ratio applicants that can no longer get the mortgage they desire at their bank will then find their way to CUs. It’s hard to imagine how OSFI’s “gift” doesn’t benefit CU market share.
- LTVs Drop & Rates Rise in Big Cities — Big cities are where most of the jobs are, so naturally people want to live close to them. But lenders could now be forced to cut conventional LTVs and/or raise rates in places like Toronto, Vancouver, Hamilton and so on.
- OSFI Becomes a Target — We can already hear the chorus: OSFI’s measures are “too much, too late.” If OSFI’s measures do burst the housing balloon and smash people’s net worth into little bits, they will wear this badge of dishonour for years to come (unless, of course, you’ve been waiting for this opportunity to buy).
- Bank Challengers Applaud — DoF policy has crushed refi volumes at bank competitors. At mortgage finance companies (MFCs), refis are down at least 40-60% year-over-year, depending on which lender you talk to. The CEO of Canada’s biggest MFC concedes he’s been at a “disadvantage” to banks in the conventional mortgage market. He says OSFI’s proposal “is appropriate to put all lenders on a level playing field.” The questions now become:
- Is it really a level playing field? (Per above, it’s certainly less slanted than before but it ain’t flat. An MFC that securitizes, for example, may be stuck with a 25-year amortization while banks can sell 30-year amortizations at the same rate till the cows come home.)
- how prime lender earnings will fare if qualification gets harder and home prices go south (careful what you wish for, they say!).
A Department of Finance spokesperson said it’s premature to comment on whether the insured stress test (which is based on the Bank of Canada’s 5-year posted rate) will be homogenized with OSFI’s new 200-basis-point test. Frankly, I’m wondering if they scrap both qualifying rates and come up with one “improved” standard, like 200 bps above the lender’s posted 3-year fixed rate (remember when lenders used to routinely use the 3-year rate for qualification?). Whatever the case, once B-20 is finalized the DoF will be taking a hard look at this issue, he said.
Here’s more of the new wording that OSFI inserted into this revised version of B-20 (here’s the old one for reference):
- “FRFIs should maintain adequate mechanisms for the detection, prevention and reporting of all forms of fraud or misrepresentation (e.g., falsified income documents) in the mortgage underwriting process. For insured mortgage loan applications, FRFIs are expected to report suspected or confirmed fraud or misrepresentation to the relevant mortgage insurer.”
- “FRFIs should demonstrate rigour in the verification of a borrower’s income…”
- “For borrowers who are self-employed, FRFIs should also be guided by the sound principles listed above. In particular, FRFIs should obtain proof of income (e.g., Notice of Assessment and T1 General) and relevant business documentation.”
- OSFI added the “T1 General” requirement and is now explicitly equating self-employed income validation procedures with non-self-employee procedures.
- “Lenders should also exercise rigorous due diligence in underwriting loans that are materially dependent on income derived from the property to repay the loan (e.g., rental income derived from an investment property).”
- “Borrowers relying on income from sources outside of Canada pose a particular challenge for income verification, and lenders should conduct thorough due diligence in this regard.”
- “FRFIs should undertake a more comprehensive and prudent approach to collateral valuation for higher-risk transactions. Such transactions include, for example…loans for illiquid properties, and loans in markets that have experienced rapid property price increases, which generate more uncertainty about the accuracy and stability of property valuations.”
- “A FRFI should not arrange (or appear to arrange) with another lender, a mortgage or combination of a mortgage and other lending products (secured by the same property), in any form that circumvents the maximum LTV ratio or other limits it establishes in its RMUP, or any requirements established by law, i.e., no co-lending.”
- “FRFIs should make rigorous efforts to determine if [the down payment] is sourced from the borrower’s own resources or savings.” (“Rigorous efforts” replaces the prior wording, “reasonable efforts.”)
- “Where non-traditional sources of down payment (e.g., borrowed funds) are being used, further consideration should be given to establishing greater risk mitigation.”
- “In markets that have experienced rapid house price increases, FRFIs should use more conservative approaches to estimating the property value for LTV calculations and not assume that prices will remain stable or continue to rise.”
- “This [65% LTV] threshold [for non-conforming mortgages] should not be used as a demarcation point below which sound underwriting practices and borrower due diligence do not apply.”
- “OSFI expects FRFIs to take a critical view of the sustainability of housing market prices and appropriately adjust the property value when making an underwriting decision on non-conforming loans, including calculating the LTV and pricing the loan. OSFI also expects FRFIs to adjust maximum LTV limits downwards in the presence of multiple higher-risk attributes or deficiencies in a loan application (i.e., in general, the greater the extent of higher-risk factors or deficiencies, the lower the maximum LTV on a non-conforming loan).”
- “FRFIs should review the authorized amount of a HELOC where any material decline in the value of the underlying property has occurred or the borrower’s financial condition has changed materially. This expectation also applies where a HELOC is structured as part of a consolidated or linked mortgage loan product.”
- “OSFI expects FRFIs to take a critical view of the sustainability of housing market prices and appropriately adjust the property value when making an underwriting decision on a HELOC, including calculating the LTV and pricing the HELOC. For HELOCs, OSFI also expects FRFIs to adjust maximum LTV limits downwards in the presence of materially higher risk in a loan application (i.e., in general, the greater the extent of risk, the lower the maximum LTV limit on the HELOC).”
- “FRFIs that acquire residential mortgage loans that have been originated by a third party should…consider the risks associated with other functions that may be performed by the third party in respect of acquired loans (e.g., servicing).”
Rob, I really enjoy reading your articles, thanks for the info in plain Engish.
what a houses of cards built on a foundation of fraud and delusion.
Great post. Great down-to-earth analysis.
Owning a home will be more difficult for most first time home buyers. High end price may drop, low end price is likely to increase.
As always terrific analysis from Rob. There are two interesting things to draw from all this:
1) The DOF and OSFI exist in righteous terror of the expansion of mortgage debt in Canada and they are willing to do whatever it takes to wrestle it down to Earth, naturally a lot of what they do is misguided and mistaken but after all they are apparatchiks so there was never any hope of brilliant strategy.
2) Consumers, lenders, mortgage brokers and all others that have a stake in the mortgage industry in Canada with the sole exception of the Big 6 Banks have ZERO influence on government mortgage policy.. If we were honest with ourselves the evidence is simply irrefutable. The Feds are good for Selfies and pointless testimony in front of toothless committees but at the pinnacle of decision making the government lives in it’s own echo chamber.
Does anyone which CU specifically in Ontario is still allowing the items listed in #7 above?
Quote: “Field Day for Credit Unions — Many credit unions can still go up to 80% LTV on HELOCs and offer 35-year amortizations. So you better believe that some will continue letting borrowers qualify at the contract rate, barring a provincial regulatory agreement with the feds.”