Developments in the Canadian Residential Mortgage Market

Recent Changes to Insured Mortgage Rules

On June 21, 2012, the Department of Finance and the Office of the Superintendent of Financial Institutions (OSFI) made separate announcements that are expected to affect Canadian mortgage lending practices. These changes demonstrate that the federal government is concerned about its financial exposure and the exposure of federally regulated financial institutions (FRFIs) to a possible downturn in the Canadian housing market.

The new rules from the Department of Finance will come into force on July 9, 2012. Transitional rules are provided for binding agreements of purchase and sale, financing or refinancing coupled with mortgage insurance applications made before July 9, 2012.

The Department of Finance’s announcement is the third in a series of similar announcements that it has made (the first two being in February 2010 and March 2011). The June 2012 release states that the department is instituting the following changes to government-backed insured mortgages:

  1. reducing the maximum amortization period for insured mortgages from 30 to 25 years (previously reduced from 35 to 30 years by the March 2011 release);
     
  2. lowering the maximum amount that Canadians can withdraw in refinancing an insured mortgage from 85% to 80% of the value of their homes (previously reduced from 95% to 90% by the February 2010 release and to 85% by the March 2011 release);
     
  3. setting the maximum gross debt service ratio at 39% and reducing the maximum total debt service ratio from 45% to 44% (as per the February 2010 release, these tests are to be met using the interest rate on a five-year fixed rate mortgage even if the borrower chooses a mortgage with a lower interest rate and shorter term); and
     
  4. withdrawing government insurance backing on residential mortgages on homes with a purchase price of $1 million or more.

Other rules that were implemented as a result of the prior releases that remain in effect include the following:

  1. requiring a minimum down payment of 5% for owner-occupied properties and 20% for speculative properties; and
     
  2. withdrawing government insurance backing on home equity lines of credit (HELOCs).

Earlier this year Finance Minister Jim Flaherty indicated that the federal government has no current plans to increase the statutory limit on the aggregate amount of insurance that Canada Mortgage and Housing Corporation (CMHC) could have outstanding beyond its current $600 billion limit. (This limit had been raised from $350 billion to $450 billion in March 2008 and then to $600 billion in March 2009.) From the beginning of the financial crisis in late 2007 until the end of last year, many FRFIs were relying heavily upon their ability to obtain bulk insurance from CMHC in order to manage their capital and liquidity positions and to fund their mortgage businesses through the securitization programs administered by CMHC. As at December 31, 2011, CMHC had over $567 billion worth of outstanding insurance on Canadian residential mortgages (an amount that exceeded the entire Canadian federal debt). As a result of the government’s indication that CMHC’s insurance limit would not be increased, CMHC advised its approved lenders in the first quarter of 2012 that their allocations of CMHC bulk insurance would be drastically reduced (in some cases by up to 90%). By maintaining the $600 billion cap on CMHC insurance and making the changes set out in the June 2012 release, the government is indicating an intention for CMHC to revert to its original purpose of assisting Canadians to achieve new home ownership.

The new rules announced in the June 2012 release will, over time, improve the credit quality of insured mortgages and may be viewed as prudent steps to protect the exposure of Canadian taxpayers in the event of a downturn in the housing market. 


OSFI Guideline B-20

On June 21, 2012 OSFI released its final Guideline B-20: Residential Mortgage Underwriting Practices and Procedures. A draft of Guideline B-20 was released on March 19, 2012, for comment and the final Guideline remains very close to the draft Guideline. The Guideline sets out OSFI’s expectations for prudent residential mortgage underwriting and is applicable to all FRFIs that are engaged in residential mortgage underwriting or the acquisition of residential mortgages in Canada (although certain aspects of the Guideline also extend to foreign operations). The Guideline sets out five basic principles for sound residential mortgage underwriting, each of which will be briefly described below.

Principle 1: Applicable FRFIs should have a comprehensive Residential Mortgage Underwriting Policy (RMUP) and the residential mortgage underwriting practices and procedures of FRFIs should comply with their established RMUP.

Guideline B-20 requires, among other things, the board of directors of the FRFI to take an active role in considering the RMUP (and any changes to the RMUP). The FRFI will also be expected to have effective control, monitoring and reporting systems and procedures to ensure ongoing operational compliance with its RMUP. A senior officer of the FRFI should make an annual declaration to the board of directors confirming that the FRFI’s residential mortgage underwriting and acquisition procedures and associated risk-management practices and procedures meet the standards set out in Guideline B-20; where there are exceptions, however, the senior officer should disclose the exceptions to the board of directors and to OSFI. The RMUP is also expected to cover a FRFI’s international mortgage lending and acquisition activities.

Principle 2: FRFIs should perform reasonable due diligence to record and assess each borrower’s identity, background and demonstrated willingness to service his or her debt obligations on a timely basis.

Under this principle, guidance is given as to what constitutes a reasonable enquiry into the background and credit history of the borrower, and FRFIs are instructed to maintain complete documentation of the information leading to the mortgage approval and given a list of the documents that should generally be included.

One of the most contentious issues in the draft Guideline was the suggestion that borrowers would have to requalify at the time of mortgage renewal. Many argued that this would leave many borrowers with perfect payment records unable to renew their mortgages, potentially resulting in the loss of their homes. OSFI has backed off this requirement and now simply requires that FRFIs should update their borrower analysis periodically (not necessarily at renewal). Presumably the updating requirement should be part of the RMUP.

Principle 3: FRFIs should adequately assess the borrower’s capacity to service his or her debt obligations on a timely basis.

FRFIs should achieve this assessment through income verification of the borrower and any guarantors or co-signers, analysis of debt service coverage tests (both gross debt service and total debt service ratios) and stated maximum amortization periods. OSFI indicates that at a minimum, the qualifying mortgage rate to use for purpose of the debt service coverage ratios for all variable interest rate mortgages, regardless of term, and fixed rate mortgages with terms less than five years should be the contractual mortgage rate or the five-year benchmark rate published by the Bank of Canada, whichever is greater. FRFIs may also take into consideration other factors that would not ordinarily be captured by debt service calculations, such as the borrower’s assets, other living expenses and recurring payment obligations.

Principle 4: FRFIs should have a sound collateral management and appraisal process for mortgage properties.

The Guideline indicates that FRFIs should not rely on any single method for property valuation and that they should undertake a more comprehensive approach to collateral valuation for higher-risk transactions such as loans with relatively high loan to value (LTV) ratios.

By law, FRFIs may invest only  in residential mortgages with LTV ratios greater than 80% if they are insured. In addition to this statutory restriction, the Guideline indicates that OSFI expects FRFIs to impose a maximum LTV ratio less than or equal to 65% for non-conforming residential mortgages. The definition of “non-conforming” may vary from FRFI to FRFI but, in general, the definition can include non-income qualifying loans, loans to those with low credit scores or high debt service ratios, mortgages of properties whose attributes carry elevated credit risk and loans that have clear deficiencies relative to a conforming residential mortgage.

Importantly, the Guideline requires that the LTV ratio should be recalculated upon any refinancing but not necessarily at the time of renewal (as proposed by the draft Guideline). It is important to distinguish the Guideline’s use of the terms "refinancing" and "renewal." In a refinancing, the mortgage contract is being altered or additional funds are being advanced. A renewal is simply an extension of the term of the existing mortgage with a resetting of the interest rate to current rates.

FRFIs are expected to make reasonable efforts to determine where a borrower sources his or her down payment. When part or all of the down payment is gifted to the borrower, it should be accompanied by a letter from those providing the gift confirming that they have no recourse to the borrower for repayment of the gift.

The Guideline provides special rules for HELOCs. OSFI is of the view that HELOCs present greater risks than traditional mortgages in that they are not required to amortize. The Guideline stipulates that FRFIs are expected to limit the non-amortizing HELOC component of a residential mortgage to a maximum authorized LTV ratio of 65% or less. This topic was the subject of several comments on the draft Guideline but OSFI decided to stay with the rule in the draft Guideline. However, OSFI did delete a provision from the draft Guideline that would have imposed an amortization requirement on that portion of a HELOC below a 65% LTV.

Principle 5: FRFIs should have effective credit and counterparty risk-management practices and procedures that support residential mortgage underwriting and loan asset portfolio management, including, as appropriate, mortgage insurance.

One provision of the Guideline that is sure to cause much consternation among mortgage lenders is the requirement that those FRFIs that acquire residential mortgage loans from third parties ensure that the underwriting standards of those third parties are consistent with the FRFIs’ RMUP and compliant with Guideline B-20. FRFIs should not rely solely on the representations and warranties of the third party. This requirement could affect liquidity in the secondary mortgage market. This requirement limits the ability of a FRFI to address mortgage portfolio issues through adjustments to the purchase price or the use of other mitigating measures. The result (possibly fully intended) is that the requirements of Guideline B-20 may well extend to mortgage lenders that are not FRFIs if those mortgage lenders wish to have liquidity for their mortgages in the secondary mortgage market. Non-conforming mortgages will become more illiquid than ever before.


Disclosure Requirements

The Guideline will promote greater transparency by requiring FRFIs to publicly disclose, on a quarterly basis, specified information regarding their residential mortgage portfolio, including the following:

  1. the percentage insured versus uninsured, together with a geographic breakdown for each category by province as well as from foreign operations;
     
  2. distribution by amortization period ranges in Canada as well as from foreign operations;
     
  3. average LTV ratios for newly originated and acquired uninsured residential mortgages and HELOCs, together with a geographic breakdown by province in Canada as well as from foreign operations; and
     
  4. a discussion on the potential impact of an economic downturn.

The draft Guideline had called for the disclosure of additional information that was removed from the final Guideline on the basis that FRFIs are not expected to be required to disclose information where such disclosure could cause FRFIs to be at a competitive disadvantage to mortgage lenders not bound by Guideline B-20.


Non-Compliance

If a FRFI fails to comply with Guideline B-20, OSFI can take, or require the FRFI to take, corrective measures. OSFI’s actions can include heightened supervisory activity and/or the discretionary authority to adjust the FRFI’s capital requirements or authorized asset-to-capital multiple. FRFIs will be strongly persuaded by these regulatory measures to fully comply with the Guideline.


Implementation of Guideline B-20

In its June 21, 2012, news release, OSFI indicated that the Guideline would not apply retroactively to in-force residential mortgages. OSFI’s cover letter to FRFIs indicated that full implementation of Guideline B-20 is expected by no later than fiscal year-end 2012 (October 31, 2012, for large Schedule 1 banks and December 31, 2012, for most other FRFIs), with the relevant public disclosures beginning in the first fiscal quarter of 2013.

Several implementation questions remain to be dealt with. For example, will the Guideline apply to preclude a FRFI from acquiring mortgages originated before October 31, 2012 (or December 31, 2012, as applicable) that do not comply with the Guideline? Will a borrower under an in-place HELOC with an approved credit limit above 65% LTV be able to obtain non-amortizing advances in excess of 65% LTV after October 31, 2012 (or December 31, 2012)? Will the lender under an in-force HELOC with an outstanding balance currently in excess of a 65% LTV be expected to require that excess portion to begin amortizing after October 31, 2012 (or December 31, 2012)?

We expect that OSFI will deal with these and other transitional issues on an ad hoc basis and in certain cases may be willing to provide rulings to clarify any remaining uncertainty.

 

 

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

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