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.

13 Comments

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  • Mark Bayly 1 month ago

    Canadian real estate is fine ?? You must live on Trudeau’s planet.

    • GTA Landlord 1 month ago

      Very clearly sarcasm since the author has literally explained the problem many, many times. He explained the issue in Parliament and at the CMHC about bubble-nomics. I don’t think you can find a higher profile housing critic in Canada aside from Pierre.

  • Trader Jim 1 month ago

    gotta admit it’s kind of funny that the bank regulator, who was appointed by the Liberal government so isn’t biased against them, can’t even contain that he thinks this is a bubble.

    It might invite criticism when say, BMO or candidates for the CPC make criticism. Routledge is about as unbiased as you can get and he thinks it’s worse than most of us can imagine.

  • Vishal 1 month ago

    Why did have to get THIS bad before they started to look into these things though? They’re saving face for putting people in this dangerous situation.

    • Ethan Wu 1 month ago

      Surprised Stephen didn’t say what he always does — OSFI’s job is to protect the banks, not you. We need functioning banks for the country, but the country can lose 2-3% of people no problem.

  • Simon Chan 1 month ago

    Good Pete, good Pete. Now sit.

  • Views From The Bubble 1 month ago

    Just wonderful to watch what’s going on behind the scenes while Canadians don’t have a clue.

  • Doomcouver 1 month ago

    Considering 5-year fixed-rate mortgages will be above the qualifying rate of 5.25% by year’s end, the banks have good reason to be worried.

    Even 5-year variables might be above that if the BoC gets really aggressive with rate-hiking. Variable rate mortgages are up from 0.85% in December 2021 to 2.5% already.

  • Michael 1 month ago

    Stephen touched on a unique feature of mortgages in a falling market. As far as I am aware, if someone has a conventional mortgage with LTV at 80% and the price of their home falls and the LTV climbs above 80% they will most likely be asked to take out mortgage insurance in order to remain compliant, OR, provide a lump sum payment prior to renewal to bring the LTV back to 80% or less. Mortgage insurance is on a sliding scale but could easily be $25,000 – $50,000. The lump sum payment won’t be pretty either eg. a $1,000,000 home that was at 80% LTV ($800,000 mortgage), that subsequently drops 10% in value at renewal to $900,000, will now have an 89% LTV and you will then have to ante up $81,000. If anyone has a different take on how this works I am open to being re-educated.

    • Credit Guy 1 month ago

      You nailed it. The only thing to keep in mind is how frequent the bank would actually check your LTV, which isn’t often. Even on renewal they don’t need to check at the time if you’re renewing with a lender in good standing, just subjectively “shortly” after. Guessing that can be a whole year if the bank is worried and wants prices to firm once again.

  • Michael 1 month ago

    Finally someone who understands that banks will be unable to take any risks in a downturn. If your house has a conventional mortgage and falling home values brings your house above 80% LTV at renewal, your bank has the option to either ask you to insure it via CMHC for a 2.5 – 3% premium, or ask you to make a lump sum payment to reduce LTV to at/ or below 80%. If anyone knows differently let me know, but these options are in the mortgage documents.

  • Frank 1 month ago

    Alot of people dont need to worry about anything they put in place people are going to be walking away like the 70s-80s and than banks would be begging for the borrowers to make a deal so they dont loose more of what they wiil loose
    History always repeats itself

    • Michael 1 month ago

      Hey Frank, you have a good point, however, banks will only use their best efforts to keep homeowners in their homes if it is in the best interest of the banks. In a run of the mill, slight real estate downturn, you are 100% correct, and banks are happy to let their mortgage book drift as part of an understood economic moment and they will gladly work with buyers. In longer lasting, systemic downturns, the risk profile changes dramatically and the 70% of the overall bank portfolio, which is uninsured, shifts dramatically the other way as LTV moves beyond 80% quickly. Net interest margin (profit) increases so they make more money as interest rates climb, but at the same time they must re-allocate more funds for loan loss provisions as part of their risk parameters. These additional loan loss provisions impact bank profitability and in turn forces them to get much stricter on lending (to manage risk), which, in a reflexive-loop leads to tougher lending criteria, fewer qualified buyers, less real estate sales, reduced home prices, higher bank portfolio LTV, and rapidly increasing bank risk….and the loop begins again. “Credit Guy”, feel free to chime in here if I have missed anything.

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