Canada’s Bank Regulator Is Preparing Mortgage Lenders For Real Estate Price Declines

Canadian real estate is probably fine, but the bank regulator just wants your lender to be extra safe. Earlier today, the Office of the Superintendent of Financial Institutions (OSFI) sent an advisory on real estate secured lending (RESL). OSFI, who oversees federally-regulated financial institutions (FRFIs), clarified expectations for risky mortgages. Lenders have been asked to pay extra attention to the loan size in relation to home values. This comes after the OSFI head warned a housing crash is possible, which would leave borrowers with less equity. Less equity means more leverage, and higher risk for mortgage lenders.

Loan-To-Values and Guideline B-20

Today you’ll need to know two key terms to understand the impact, with the first being loan-to-value (LTV). The LTV is the size of the loan represented as a percent of the value of the asset used to secure the loan, in today’s case, a home. Higher LTVs mean more debt is outstanding relative to the asset value. Lower LTVs mean less debt in relation to the debt outstanding. Pretty straightforward so far, right? 

For example, let’s say you bought a home with a 20% downpayment and financed the remaining 80%. The LTV of your mortgage would be 80%. If you paid off more principal or home prices rise, the LTV would fall. If home prices fall faster than repayment, the LTV rises as equity disappears. If the LTV rises above 100%, it means the borrower is negative equity and the loan is underwater. 

OSFI Guideline B-20 is the other term we need today. This is a set of guidelines for FRFIs, a.k.a. banks and federal mortgage companies. It’s known for introducing the “stress test,” which qualifies borrowers at higher rates. However, it also lays out risk expectations for Canada’s federally regulated lenders. Sometimes those regulations are a little abstract, so they have to specify what they mean. Today they did that for combined loan plans, shared equity mortgages, and reverse mortgages. 

Combined Loan Plan (CLP) Are Limited At 65% of The Home’s Value

Combined loan plans (CLPs) are a combination of mortgage and home equity line of credit (HELOC). CLPs, often called readvanceable mortgages, turn every principal payment into HELOC credit. No need to reapply or have the value of the home re-assessed, you can just borrow the principal you just paid. The more of the mortgage paid off, the more HELOC credit is available.

These are great conceptually, but do have a few problems. It’s obviously a win to have borrowers able to access credit instantly in an emergency. However, like all credit it’s prone to abuse and can become a way to never reduce your debt load. Persistent debt loads that never shrink present a “heightened risk for lenders,” warned OSFI.

OSFI further explained, the persistent debt can amplify risks, and clarify the leverage required. Currently a conventional mortgage can have a maximum LTV of 80%. Today’s note explains to lenders that CLPs can only have a maximum LTV of 65%, though. Any remaining loan up to 80% can’t be readvanceable and must be amortizing. In other words, you don’t have to do an equity take out to borrow the full 80% of the home. However, anything borrowed above an LTV of 65% needs a clear date on when it will be repaid. No revolving debt.

It might not be a big change, but in the event that price falls, it’s unlikely CLPs would have less than the 80% maximum LTV.

Lenders Participating In Shared Equity Programs Must Have First Lien

Canada is entering a new era of mortgage lending with shared equity programs. These are loans where an equity investor provides some of the downpayment to “help” buyers. An example is the Government of Canada’s First-Time Home Buyer Incentive (FTHBI). These programs are promoted as improving affordability, but economists argue they raise prices. That’s another point for another day.

OSFI notified FRFIs that they can finance shared equity mortgages but need to be first lien. That means lenders get first dibs on equity in the event of default, not the investors. Even if the investor is the taxpayer, in some cases. It’s also worth noting that earlier this month, the CMHC changed the FTHBI to limit losses to 8% per year. Some partner, eh?

Canada’s Reverse Mortgage Lender Has Been Asked To Pay Strict Attention To LTVs

Reverse mortgages are also getting the attention of regulators these days. Reverse mortgages allow a senior homeowner to borrow equity from their home as a lump sum or regular payments. The loan is secured against the home’s equity, sort of like a HELOC but with one huge difference — repayment.

Repayment is generally only due upon death, default, or sale of the property. Homeowners can continue to not make payments as long as the account conditions are met. It’s worth mentioning that interest costs are much higher than most HELOCs we’ve seen. It’s understandable, since they have no clue when they’re being repaid, so a premium is in order.

While they don’t have to pay, interest continues to accumulate in the background. No payments and higher interest. Can you see the problem? People without a repayment plan can be left with less equity than expected when selling.

OSFI rarely mentions reverse mortgages, most likely because the risk had been small. With home prices rising far in excess of low rates, there was likely little concern. Now that borrowing costs are rising and home prices might drop, they want lenders to be prudent about a max LTV of 65%. It’s my understanding reverse mortgages rarely originate that high. They might just be getting ahead of any issues.

A point worth emphasizing is how fast a borrower’s equity would disappear at these rates. Say a senior borrowed 65% to, I don’t know, help their grandkid with a downpayment and some living expenses. At the 7.35% a 5-year fixed goes for, it would only take 6 years for interest accumulation to wipe out the remaining equity. That’s assuming prices stay the same — faster if prices fall and slower if home prices rise.

Clarifications Comes After Regulator Warned That Canadian Real Estate Is A “Speculative Mania”

The clarification comes at an interesting time — right after the real estate boom and in the middle of a tightening cycle. The head of OSFI also recently said Canada’s real estate is a “speculative mania,” and expects home prices to fall. Separately, he warned of CLP dangers. Focusing on LTVs puts lenders on notice that they should be prudent in the tightening cycle. In the event home prices drop, LTVs can rise sharply. This can leave homeowners with little-to-no equity that may exceed the legal limit of 80% LTV for uninsured mortgages. 

OSFI isn’t the only organization that’s mentioned problematic LTV ratios. Last year, BMO’s chief risk officer told investors that home equity might be “exaggerated.” This makes the LTVs unreliable, since the loan is compared to the exaggerated value. The bank consequently began focusing on a borrower’s ability to service the loan. On paper, loans seem to be secure but it’s based on exaggerated values. BMO’s shift required more manual verification of borrowers. 

The risk measure clarifications might sound ominous, but helps reduce negative outcomes. This also can prevent real estate prices from capitulating, minimizing declines. It’s only when lenders and borrowers are caught off guard that a correction turns into a bloodbath.

When corrections go smoothly, even big ones, most people don’t notice. If you’re an end-user, you would most likely ride out any downturn. It’s short-term investors that need liquidity that get caught either way.