On December 11, 2015, the Canadian Department of Finance, the Office of the Superintendent of Financial Institutions (OSFI) and the Canada Mortgage Housing Corporation (CMHC) announced forthcoming changes to existing federal rules for government-backed mortgage insurance, capital requirements for residential mortgages, and increases in guarantee fees for CMHC-sponsored securitization programs, respectively.
Increasing Regulation of the Canadian Residential Mortgage Market
Banks and other federally regulated financial institutions (FRFIs) have been subject to a loan-to-value restriction for certain types of residential mortgage loans for many years. Prior to 2008 the only change made to residential lending business rules was the 2007 increase of the maximum permitted loan to value ratio for non-insured mortgages from 75 per cent to 80 per cent.
However, in recent years, the federal government has increased the regulation of Canadian residential mortgage lending by FRFIs in response to evolving risks in the marketplace, including:
- ?Since 2008, the federal government has implemented several changes to the rules for government-backed insured mortgages, insured through CMHC and private sector mortgage insurers, including shorter amortization periods, lower maximum borrowing amounts during refinancing, limits on maximum gross debt service and total debt service ratios, and increases to the minimum down payment required by homebuyers.
- In June 2011, the Protection of Residential Mortgage or Hypothecary Insurance Act (PRMHIA) received royal assent and came into force in January 2013. The stated purpose of the PRMHIA regime is to support stability of the housing finance market in Canada by authorizing the Minister of Finance to provide protection in respect of certain mortgage insurance contracts issued by private mortgage insurers and to mitigate the risks arising from the provision of that protection. OSFI oversees private mortgage insurers’ compliance with the PRMHIA regime.
- In June 2012, OSFI’s Guideline B-20 “Residential Mortgage Underwriting Practices and Procedures” (Guideline B-20) came into effect, following which consequential amendments were made, effective November 2014. Guideline B-20 sets out the regulator’s expectations for prudent residential mortgage underwriting and includes the requirement that FRFIs maintain adequate regulatory capital levels to properly reflect the risks being undertaken through the underwriting and/or acquisition of residential mortgages. Furthermore, Guideline B-20 emphasises the importance of FRFIs maintaining sound administrative practices and conducting thorough assessments of a prospective borrower’s income and repayment capacity.
- In November 2014, OSFI released a companion guideline applicable to OSFI-regulated mortgage insurers, Guideline B-21 “Residential Mortgage Insurance Underwriting Practices and Procedures” (Guideline B-21), with an effective implementation date of June 2015. Guideline B-21 articulates OSFI’s expectations regarding sound residential mortgage insurance underwriting and emphasises the importance of insurers reviewing lenders’ underwriting practices and monitoring lender compliance with the terms of insurance contracts.
- CMHC’s securitization guarantee programs enable approved financial institutions to pool eligible mortgages and convert them into marketable securities, creating an additional source of funds for mortgage lending. As compensation for the guarantee, issuers of securitized mortgages pay CMHC guarantee fees. In December 2014, CMHC announced an increase in guarantee fees, effective April 2015, payable by issuers in its National Housing Act Mortgage-Backed Securities (NHA MBS) program.
INCREASING REGULATION TO COMBAT INCREASING RISK
The Bank of Canada publishes a Financial System Review (FSR) biannually, which summarizes the opinion of the Bank of Canada’s Governing Council on the main vulnerabilities and risks to the stability of the Canadian financial system. In its 2014 and 2015 FSRs, the Bank of Canada identified two key housing market vulnerabilities that it continues to monitor: (i) elevated levels of household indebtedness, and (ii) imbalances in the housing market created as a result of increasing resale activity and higher house prices. Furthermore, in its December 2015 FSR, the Bank of Canada identified the risk that FRFIs may overextend mortgage credit and underinvest in other productive assets because of how cost-effectively they can securitize mortgages under CMHC’s securitization programs. This overextension could lead to more leveraged households and elevated house prices.
Mindful of these concerns identified by the Bank of Canada, and in conjunction with the existing regulatory framework, the new rules discussed below reflect the current focus of the federal government to ensure that the housing finance market can withstand a severe housing downturn. Collectively, these changes are reflective of the graduated approach taken by the federal government to promote a more resilient housing financing system and to encourage long-term stability in the housing market. The new rules aim to accomplish this by adjusting the risk FRFIs take on in their lending and insuring activities, by requiring them to have greater capital reserves to absorb more severe losses, and by encouraging sound risk management practices to combat fraudulent mortgage practices.
Minimum Down Payment
The general rule under the Bank Act (Canada) and Trust and Loan Companies Act is that FRFIs cannot make residential mortgage loans where the loan-to-value ratio exceeds 80 per cent, unless the loan is insured by CMHC or an OSFI-approved private mortgage insurer. Both CMHC, which is governed by the National Housing Act, and OSFI-approved private insurers, which are governed by the PRMHIA, are permitted under those statutes to insure loans (i) with loan-to-value ratios up to 95 per cent, and (ii) on properties valued at less than C$1-million. Therefore, for a FRFI to make a mortgage on a residential property valued at over C$1-million, the borrower must make a 20 per cent down payment.
The Department of Finance announced that effective February 15, 2016, the minimum down payment for new insured mortgages will increase from five per cent to 10 per cent for the portion of the house price above C$500,000. The five per cent minimum down payment required for properties up to C$500,000, and the 20 per cent minimum down payment required for properties valued at greater than C$1-million remain unchanged. The Department of Finance has stated that existing residential mortgages will not be impacted by the new changes. This implies that renewals of those mortgages should not be affected either.
Capital Requirements for Residential Mortgages
OSFI announced that it is planning to update the regulatory capital requirements for loans (residential mortgages and home equity lines of credit) secured by residential real estate properties. The anticipated changes will impact the regulatory capital requirements for those deposit-taking institutions using internal models, such as for mortgage default risk, where OSFI is proposing that a risk-sensitive floor will be implemented, which will be tied to increases in local property prices and/or house prices that are higher relative to borrower incomes. Also, OSFI is to introduce updates to the standardized capital requirements for Canada’s private mortgage insurers whereby OSFI will require that regulated private mortgage insurers hold more capital when house prices are high relative to borrower incomes. Furthermore, OSFI is also considering additional criteria for recognizing the capital benefits of mortgage insurance in light of concerns relating to fraudulent mortgage applications. OSFI will consult with FRFIs and other stakeholders before making any changes, beginning with a directed consultation early in 2016 and followed by broader public consultation later in 2016. OSFI expects the new rules will be in place no later than 2017.
Further to the 2015 fee increase, CMHC announced new changes to the guarantee fees it charges issuers of securitized mortgages for its NHA MBS securitization program. Effective July 1, 2016, CMHC is increasing the upper tier NHA MBS guarantee fees. In addition, CMHC is raising the threshold beyond which the upper tier fees will apply from C$6-billion to C$7.5-billion.