Canadian real estate has a new risk factor catching the attention of regulators — CLPs. Combined Mortgage-HELOC Loan Plans (CLPs), better known as readvanceable mortgages, are fueling higher home prices. That was the take from OSFI, the country’s bank regulator. CLPs are rarely mentioned by regulators, but they’ve come up in several speeches since last year. As interest rates rise, CLPs can provide an elevated risk for lenders (and borrowers). The industry is now discussing if further regulations are needed, with consultation potentially beginning this year.
Combined Mortgage-HELOC Loan Plans (CLPs) aka Readvanceable Mortgages
Readvanceable mortgages are mortgages combined with a home equity line of credit (HELOC). You pay your mortgage as usual, just like any other fixed rate mortgage. Lenders often only require the interest paid on the HELOC portion, though. The big selling point here is that every mortgage payment increases your available HELOC credit. After paying, a portion of the funds are available to be borrowed soon after.
Debt products aren’t good or bad, but the circumstances in which they’re used are important. One positive is borrowers can tap home equity very quickly. This can minimize the burden of negative economic shock, which is good. If you can tap home equity at any bank machine, you might not need to set aside so much cash for an emergency. That’s great with inflation this high.
Readvanceable mortgages are also a key part of the Smith Maneuver, a popular financial planning strategy. It involves using the product to convert mortgage interest into a deduction. Rich people have been using it since before I was born, and they’ll probably be using it long after.
CLPs Become Riskier As Canadian Homes Have Exaggerated Values
The problem with debt products is leverage works both ways. While home prices were rising, it was easy for some owners to spend their new $80,000/month in equity. Spending unrealized profits can be not so fun if they disappear due to falling prices.
Canadian real estate’s fast growth has lenders looking carefully at risk. For example, the Chief Risk Officer at BMO told the bank’s shareholders that recent gains may “exaggerate” value. The collateral value of the home might not be reliable (worth as much as people think it is now). Consequently, they’ve had to up manual verification to determine if borrowers will pay, even if prices fall.
These exaggerated values can mean a readvanceable mortgage has less than expected equity. If the home’s value falls below a key threshold, the borrower might need to find some money very quickly. This can present a risk for lenders, which they generally dislike. Remember, OSFI’s job is to protect the banks and financial system, not you directly.
CLPs Are Inflating Canadian Real Estate Prices
OSFI has flat out mentioned this next one, which is CLPs might be hiding distress. One of the benefits above is being able to tap their home equity if they’re unable to pay their bills. Tapping this facility for payments on a second home or to sustain life can artificially inflate values.
“Non-traditional housing backed lending products like Combined Mortgage-HELOC Loan Plans (“CLPs”), which can have re-advanceable structures embedded within them, may be simultaneously fueling and helping Canadians afford rising home valuations,” explained OSFI Superintendent Peter Routeledge back in November.
If not used prudently, these products both increase borrower vulnerability and prices. It might be Canada’s very own subprime-type of mortgage innovation, that could go very wrong. That would only happen if regulators ignore the risk though, which they very much aren’t.
OSFI Is “Monitoring,” But May Further Regulate CLP Leverage
OSFI has the tendency to go from “monitoring” to “prudential regulation” within a few months. The Superintendent explained in January, “We will ensure that lenders that offer Combined Mortgage-HELOC Loan Products (“CLPs”) risk-weight that exposure to reflect tail risk for a loan that dynamically re-advances credit to mortgagors of up to 80% of their homes’ current value.”
A tail risk is one with catastrophic impact that is unlikely to happen, but can occur in a rare circumstance. Things like global war, an inflation shock, or Toronto condo prices dropping 1%. You know? Things people think will never happen in our lifetime.
OSFI slipped regulations into the last Guideline B-20 update, better known as the stress test. A CLP can technically have a combined loan to value (LTV) of 80%, meaning borrowers can have 20% equity in their home. The Guideline now advises lenders to maintain an authorized LTV of 65% or less, for the combined sum of the mortgage and HELOC debt.
The next Guideline B-20 update is likely to open industry consultation on CLPs. Federal employees familiar with the issue have said preliminary discussions have already begun. Though with the number of times the OSFI regulator has suddenly mentioned them, it wasn’t hard to see.
Update March 11, 2022: OSFI has notified us that the dollar volume of CLP-style mortgages grew 25% from Sept 2019 to Sept 2021.