Concerned about rising home prices and record household debt levels, Canada’s banking watchdog is cracking down, openly asking financial institutions to do more thorough checks on borrowers and vowing to keep an eagle eye on lending practices.
In a rare open letter, the Office of the Superintendent of Financial Institutions, which oversees underwriting practices for federally regulated lenders, promised to provide extra scrutiny to a few key areas of lending: income verification, risky or non-traditional loans, debt service ratios and appraisals.
Starting now, OSFI will “place an even greater emphasis on confirming that financial institutions conduct prudent mortgage underwriting and that their internal controls and risk management practices are sound and take into account market developments,” the regulator wrote in a letter addressed to the lenders under its watch.
The following is a summary of the changes OSFI wants lenders to make:
Income verification: Work harder to prove a borrower’s income and employment.
Non-conforming loans: Scrutinize loans given to riskier borrowers, particularly those with low credit scores.
Debt service ratios: Make sure borrowers can meet their mortgage payments if interest rates rise.
Appraisals: Put in more leg work when assessing home values for mortgage approvals.
OSFI regularly holds meetings with Canadian financial institutions and asks them to submit their risk models and assumptions for review. However, any discussions or reprimands are usually kept private. It is extremely rare for the regulator to be so open about its concerns.
The new, vocal stance seems to stem from elevated worries about the housing market. “With Canadian household debt levels at all-time highs, persistently low interest rates, and rapid house price increases in some areas, the prudential risks and vulnerabilities for financial institutions have increased,” OSFI wrote.
The timing is likely no coincidence. The announcement comes the same week that the Toronto Real Estate Board said prices for detached and semi-detached homes rose about 20 per cent in June from a year earlier, while the benchmark price for single-family detached homes in Vancouver hit a new record. OSFI is worried because the spikes, combined with soaring total debt levels, “could generate significant loan losses if economic conditions deteriorate.”
OSFI head Jeremy Rudin did not say which lenders he is most worried about. Some, he said in an interview, are in good shape because they “seem to have been quite pro-active and are already quite alive to some of the issues we’ve raised in the letter.”
But others concern him, which prompted the public message. “We want them to stay ahead of the problem.”
Mr. Rudin also noted that OSFI assesses the entire financial system, which includes federal mortgage insurer Canada Mortgage and Housing Corp. Lenders sometimes say they aren’t so worried about a possible correction because mortgage insurance will cover their losses. CMHC, however, falls under the regulator’s watch, and must therefore be concerned about any downturn.
OSFI is targeting income verification because it “is aware of incidents where financial institutions have encountered misrepresentation of income and/or employment,” according to its letter. Last year, alternative mortgage lender Home Capital Group Inc. suspended nearly four dozen brokers on allegations their files contained falsified income documents. An investigation is ongoing, but early work found evidence of borrowers who had salaried jobs but falsely inflated their incomes to qualify for lower interest rates than they would have otherwise been paying.
On this front, the watchdog raised concerns with one group in particular. “Borrowers relying on income from sources outside of Canada pose a particular challenge for income verification and lenders should conduct thorough borrower due diligence in this regard. Income that cannot be verified by reliable well-documented sources should be treated cautiously when assessing the ability of a borrower to service debt obligations,” OSFI wrote.
Non-conforming loans and debt service ratios
The regulator is also concerned about so-called “non-conforming” loans, or those made to borrowers with attributes such as low credit scores or high debt burdens. OSFI is worried that underwriting practices for these loans “are often not as strong as those for conforming mortgages, especially in regard to income verification.”
Multiple times in its letter, OSFI flagged concerns about the low interest rate environment, suggesting it is worried about a distorted market. The worry, it seems, is that some borrowers won’t be able to make their mortgage payments if rates ever rise.
“Relying on the prevailing posted five-year mortgage rate to test a borrower’s ability to service its obligations in a rising interest rate environment does not represent a sufficiently conservative stress test,” OSFI wrote. The regulator is especially concerned about properties purchased for investment purposes and about owners who rely, at least in part, on income from the property to make debt repayments.
Home appraisal quality is also on its radar. “Rapid house price increases create more uncertainty about the reliability of property appraisals,” OSFI wrote. “Lenders and mortgage insurers should have processes in place that challenge property valuation appraisals and, in particular, the assumptions made, or concerns raised, about the appraised property.”
It is possible the concern stems from the way in which appraisals are conducted. Sometimes, property values are determined by simply assessing what other properties in the neighbourhood have recently sold for – rather than determining a fundamental value.
OSFI’s crackdown comes just weeks after federal Finance Minister Bill Morneau promised to take a “deep dive” into the information concerning the housing sector and also set up a working group to study the market. The group will be made up of representatives of the federal, Ontario and British Columbia governments and the cities of Vancouver and Toronto – the two big markets that are struggling with the turmoil of dramatic housing booms and soaring prices.
Ottawa has tried to cool the market multiple times, but its changes have had little effect. Since 2008, for instance, the federal government has introduced several rounds of tweaks to rules for mortgage insurance. The most recent changes took effect in February, doubling the minimum down payment on the portion of a home priced between $500,000 and $1-million to 10 per cent. Yet prices in both markets have continued to soar.
In December, OSFI proposed changes that would require lenders to devote more capital, or add more of a loss-absorbing cushion, to mortgages whenever house prices spike. It also floated the possibility of forcing lenders to allocate extra capital to mortgages where the house price is very high relative to the borrower’s income. On Wednesday, the regulator confirmed it is pushing ahead with these plans.