Canada’s bank regulator is getting its ducks in a row after a routine audit to assess financial system risk. The Office of the Superintendent of Financial Institutions (OSFI) published its first Annual Risk Outlook last week. The report covers systemic risks to the system, including a home price crash. Amongst the issues uncovered was mortgage income verification and over-leveraged borrowers. OSFI plans to address the risks in the next few weeks, likely meaning tighter lending.
Canada’s Bank Regulator Questions Mortgages, False Incomes Is “Common”
Mortgage loan underwriting risks are common, according to the agency. For those unaware, underwriting is the process to ensure a quality loan. This includes income verification, checking assets and debt, and property details. Bad underwriting is a disaster waiting to happen during risk periods.
“Recent supervisory reviews identified several common issues around underwriting, specifically income verification in areas that have been raised as being problematic in the past including business for self, rentals, exceptions to income sustainability as well as collateral management.” read the report.
In other words, incomes may have been inflated to obtain more leverage. It was a dry way of wording it, but this is a big problem whether it persists or if there’s a crackdown. If it was really common, this would see investors (the largest segment of borrowers) dry up fast.
Extending Prudential Regulation To Other Products
Non-traditional mortgage products are becoming very common and may require further regulation. Reverse mortgages, shared equity, and combined loan plans (CLPs) are becoming popular. The regulator cites the popularity of these formerly niche products as an area that needs stronger rules. B-20 Guidelines, which ensure quality underwriting, may be extended to other areas soon.
CLPs may be a bigger issue than the public knows, considering the frequency mentioned. These combine a mortgage and a home equity line of credit (HELOC) into one product. By doing this, borrowers see their HELOC credit limit rise with each payment. OSFI has previously cited CLPs as a valuation risk, believing it hides distress.
Mortgage Stress Test Rate May Rise This Winter
The mortgage stress test is another issue OSFI cites as a concern these days. Uninsured mortgages are “stress tested” with a minimum qualifying rate (MQR). The MQR is currently 5.25% or the contract rate plus 2 points, whichever is higher. That is, a borrower needs to qualify for a mortgage at the higher of the two regardless of what they’ll pay.
As the overnight rate is forecast to climb nearly 2 points in a year, the MQR may need a revision. The next planned MQR announcement date is on December 15, 2022 — about seven months from now.
Remember, risk takes care of itself while prices are rising. A homeowner is unlikely to default in a market where they can sell a home within days of an emergency. Additional equity also makes it easier to cover distress, like with CLP mortgages. Only when the bid dries up do real valuations become apparent, in a non-stimulus market. That can be considerably lower than right now.