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OSFI Annual Risk Outlook

OSFI says mortgage payment shock poses a key risk to Canada’s financial system

Canada’s banking regulator says high borrowing costs and a wave of expected renewals in the coming 18 months pose key risks to Canada’s financial system.

With 76% of outstanding mortgages expected to come up for renewal by the end of 2026, OSFI says homeowners face the risk of payment shock, particularly those who took out mortgages between 2020 and 2022 when interest rates were at historic lows.

“Households that are more heavily leveraged and have mortgages with variable rates but fixed payments will feel this shock more acutely,” OSFI said in its Annual Risk Outlook for 2024-25. “We expect payment increases to lead to a higher incidence of residential mortgage loans falling into arrears or defaults.”

OSFI notes that financial institutions could face higher credit losses in the event of a weakened residential real estate market. It added that mortgages that have already experienced payment increases, such as adjustable-rate mortgages, are already showing higher rates of default.

In response to this risk, OSFI said its previously announced loan-to-income limits for lenders’ uninsured mortgage portfolios will help “prevent a buildup of highly leveraged borrowers.”

In March, OSFI confirmed that federally regulated banks will have to limit the number of mortgages that exceed 4.5 times the borrower’s annual income, or in other words those with a loan-to-income (LTI) ratio of 450%.

“We do not expect these limits to be binding under the current interest rate environment,” OSFI noted, adding that these institution-specific loan-to-income limits are “supervisory actions” and that no additional details could be disclosed.

Additionally, OSFI said its decision in December to leave the minimum qualifying rate for uninsured mortgages unchanged at the greater of the mortgage contract rate plus 2% or 5.25% will “help ensure borrowers can still make payments if they experience negative financial shocks…”

Fixed-payment variable-rate mortgages still a concern

OSFI also once again singled out variable-rate mortgages with fixed payments as a “specific concern.”

These mortgage products, which are offered by most big banks except for Scotiabank and National Bank, keep monthly payments fixed even as interest rates fluctuate. When rates rise, as they have over the past two years, less of the monthly payment goes towards principal repayment and a greater portion ends up going towards interest costs.

These mortgage products currently make up about 15% of outstanding residential mortgages in Canada.

“If mortgage rates remain elevated, the financial commitment required by borrowers to return to their contractual amortization (for example, lump-sum payment, mortgage payment increase) may put financial strain on many of those households,” OSFI said.

This isn’t the first time OSFI has voiced its concerns about fixed-payment variable-rate mortgages. Last fall, OSFI head Peter Routledge told a Senate standing committee that the regulator views such mortgages as a “dangerous product” that put certain borrowers at increased risk of default.

While he said OSFI’s role is not to “impose a judgment on product design,” Routledge did say OSFI believes “the system would be healthier with less of that product.”

Other risks facing Canada’s financial system

OSFI’s Annual Risk Outlook also addressed other risks facing the financial system. Those include:

  • Wholesale credit risk

OSFI says wholesale credit risk, which includes commercial real estate (CRE) lending as well as corporate and commercial debt, “remains a significant exposure for institutions.”

The regulator noted that higher interest rates, inflation and lower demand “have put CRE markets under pressure” and that it expects these challenges to extend into 2024 and 2025.

  • Funding and liquidity risks

OSFI notes that liquidity risks “are a persistent concern” and can arise if depositor behaviour shifts dramatically.

“Funding and liquidity risk remains linked to credit risk as deteriorating conditions can negatively impact securitization markets,” it said. “This can trigger increased liquidity risk for institutions that rely on securitization as a key source of funding.”

In response, OSFI said it plans to broaden and intensify its assessment of liquidity risk.