In recent months, the Minister of Finance, the Hon. Jim Flaherty, and Bank of Canada Governor Mark Carney have expressed concern about the high level of Canadian household debt, which has risen significantly in a prolonged low interest rate environment.
To combat the risk of Canadian consumer indebtedness “evolving into problems for the financial sector”, on March 19, 2012 the Office of the Superintendent of Financial Institutions (Canada) (OSFI) released for comment draft Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures (the Guideline). This Guideline addressing OSFI’s expectations for federally regulated financial institutions (FRFIs) when – in Canada or internationally – they engage in residential mortgage underwriting, the purchase of residential mortgage loan assets and the issuance of mortgage default insurance. OSFI has requested comments on the Guideline by May 1, 2012. Residential mortgage underwriting is a focus not only in Canada, but internationally; the Financial Stability Board, which Mr. Carney heads, will soon publish in final form Principles for Sound Residential Mortgage Underwriting.
For the purposes of the Guideline, a residential mortgage includes any loan to an individual that is secured by residential property (i.e., one to four unit dwellings). It would also include home equity lines of credit (HELOCs), equity loans and other products that use residential property as security. Consistent with OSFI’s principles-based approach to supervision, the Guideline articulates five principles for sound residential mortgage underwriting:
Principle 1: FRFIs that are engaged in residential mortgage lending, purchasing and/or insurance should have a comprehensive, Board-approved Residential Mortgage Underwriting Policy (the “RMUP”). Residential mortgage practices and procedures of FRFIs should comply with their established Policy.
A Board-approved Risk Appetite Framework should establish limits for the level of residential mortgage risk that the FRFI is willing to accept, which limits will form the basis for the RMUP. The RMUP should align with the FRFI’s enterprise-wide strategy and enterprise risk management framework. The Board of an FRFI should review and approve any necessary changes to the RMUP at least annually. The RMUP should include details on:
- significant elements of the FRFI’s business approach to residential mortgage underwriting, purchasing and/or insurance;
- risk management practices and processes with respect to residential mortgage loans;
- acceptable underwriting, purchasing and insurance standards, criteria and limits for all residential mortgage products and portfolios;
- limits on any exceptions, including portfolio sub-limits on higher-risk residential mortgage business;
- the use and applicability of residential mortgage models; and
- accountability and processes for ensuring that the RMUP is updated, as needed.
In addition to developing the RMUP, FRFIs should develop effective control, monitoring and reporting systems to ensure operational compliance with the RMUP. A senior officer should make an annual declaration to the Board confirming that the risk management practices and procedures meet the standards set out in the Guideline, or disclosing (to the Board and OSFI) how deviations from the RMUP will be corrected or mitigated.
Principle 2: FRFIs should perform reasonable due diligence to record and assess the borrower’s identity, background and demonstrated willingness to service his/her debt obligations on a timely basis.
FRFIs should make reasonable inquiries into the background, credit history and borrowing behaviour of a prospective residential mortgage loan borrower to assess the borrower’s reliability to repay the loan. FRFIs should not rely solely on a credit score. Moreover, FRFIs should maintain complete documentation of information which led to a mortgage approval (for origination and renewal or refinancing), including documentation with respect to the description of the purpose of the loan (the FRFI should be satisfied that there are no reasonable grounds to suspect that the mortgage loan is being used for illicit purposes), employment status and verification of income of the borrower, loan to value (LTV) and debt service ratio calculations, an explanation of any mitigating elements for higher credit risk factors as well as a clearly stated rationale for the credit decision.
Principle 3: FRFIs should adequately assess the borrower’s capacity to service his/her debt obligations on a timely basis without causing him/her undue hardship and/or over-indebtedness.
A borrower’s income should be a key factor in assessing the capacity of the borrower to repay the mortgage loan. Accordingly, reasonable inquiries and steps should be taken to verify a borrower’s income by substantiating such facts as the employment status and income history of the borrower (and of any guarantor or co-signor supporting a mortgage). To assess affordability, FRFIs should establish debt serviceability metrics.
In addition, to determine a borrower’s capacity to service his or her debt obligations, the amortization period should also be considered as it affects the required debt service for the borrower, the speed of repayment and the growth of equity in the underlying property. In this respect, FRFIs should have a stated maximum amortization period for all residential mortgages, including HELOCs.
Principle 4: FRFIs should have sound collateral management and appraisal processes for the underlying mortgage properties.
For realization purposes, FRFIs must establish sound collateral practices and procedures in the form of clear and transparent valuation policies. Proper and thorough assessments of the underlying property and its appraised value should be conducted. The Guideline sets out a number of approaches to property valuation. FRFIs should have a thorough understanding of collateral enforceability issues for all jurisdictions with action plans in place in case of borrower default. In addition, FRFIs should adhere to appropriate maximum LTV ratios for different types of mortgages when evaluating the amount of collateral value that can be used to support a loan.
Principle 5: FRFIs should have effective credit and counterparty risk management practices and procedures that support residential mortgage underwriting and asset portfolio management, including, as appropriate, mortgage insurance.
Mortgage default insurance is often used by FRFIs as a risk mitigation strategy. FRFIs should conduct due diligence on mortgage insurers by giving consideration to, among other things, the claims payment record of the insurer, balance sheet strength, reinsurance arrangements, and funding sources including the level of and access by the insurer to capital.
Further, should FRFIs acquire residential mortgage loans originating from a third party, the FRFI should conduct proper due diligence on the underwriting standards of the third party to ensure that they are consistent with the RMUP of the FRFI and OSFI’s Guideline.
Initial and ongoing independent validation of underwriting models is necessary. The results of stress-testing of the impact of unlikely but plausible scenarios on residential mortgage portfolios should be considered in model validation and in the FRFI’s ICAAP process.
Higher risk assets or insurance portfolios require heightened prudence. Assets or insurance with greater risk should be reflected in the FRFI’s risk-based rating systems or through risk-sensitive capital increases.
FRFI’s should publicly disclose information related to their mortgage portfolios, broken out provincially in Canada and for foreign operations, to allow market participants to evaluate the soundness and condition of their residential mortgage operations. Quarterly public disclosures should include:
- the amount and percentage, as well as a geographic breakdown of the total residential mortgage loans and HELOCs that are insured versus uninsured;
- the percentage of total residential mortgages and HELOCs that fall within various amortization period ranges significant for the FRFI;
- the average LTV ratio for the total newly originated and acquired uninsured residential mortgages and HELOCs at the end of each period;
- a description of the primary credit quality indicators used to assess and monitor credit quality for residential mortgage loans and
- HELOCs; and
- a discussion on the potential impact on mortgage loans and HELOCs of an economic downturn.
This Guideline places clear responsibility on the Boards of FRFIs to oversee – with significant granularity – the mortgage underwriting risk management processes of their institutions. FRFIs will have to exercise heightened prudence with higher-risk mortgage asset or insurance portfolios and take appropriate measures to mitigate those risks. FRFIs will be expected to disclose information about their mortgage lending operations domestically and internationally, information that their foreign competitors may not be required to disclose in the same foreign markets.