Guideline B-20: Residential Mortgage Underwriting Practices and Procedures (the Guideline) sets out the expectations of the Office of the Superintendent of Financial Institutions Canada (OSFI) for prudent residential mortgage underwriting, and is applicable to all federally-regulated financial institutions (FRFIs) that are engaged in residential mortgage underwriting and/or the acquisition of residential mortgage loan assets in Canada. The Guideline does not apply retroactively to residential mortgages already in place. OSFI’s expectation is that the FRFIs are to be in full compliance with the Guideline by the end of the 2012 fiscal year and OSFI has indicated that, where possible, FRFIs should comply with the principles and expectations set out in the Guideline as of June 21, 2012.
The Guideline covers any loan to an individual that is secured by a residential property (i.e., one to four unit dwellings), home equity lines of credit (HELOCs), home equity loans and other such products that use residential property as security.
The Guideline sets out five fundamental principles for sound residential mortgage underwriting, each of which is discussed below.
FRFIs that are engaged in residential mortgage underwriting and/or the acquisition of residential mortgage loan assets should have a comprehensive Residential Mortgage Underwriting Policy (RMUP). Residential mortgage practices and procedures of FRFIs should comply with their established RMUP.
The Guideline speaks to board and senior management oversight of residential mortgage practices and procedures. A Board-approved Risk Appetite Framework (the requirements of which will be set out in a revised version of OSFI guideline Corporate Governance Guideline yet to be published) should establish limits regarding the level of risk that the FRFI is willing to accept with respect to residential mortgages, and this should form the basis for the RMUP. The RMUP, which is the responsibility of senior management, should align with the FRFI’s enterprise-wide strategy and, in turn, be linked to the enterprise risk management framework. It should reflect the size, nature and complexity of a FRFI’s residential mortgage business.
OSFI expects the board of the FRFI to review and discuss the RMUP or any changes thereto and to understand the decisions, plans and policies being undertaken by senior management with respect to residential mortgage underwriting and/or the acquisition of residential mortgage loan assets, and their potential impact on the FRFI. The board should probe, question and seek assurances from senior management that these are consistent with the board’s own decisions and board-approved business and risk strategy for the FRFI, and that the corresponding internal controls are sound and are being implemented in an effective manner. As a practical matter, the board should be in a position to demonstrate to OSFI that it has fulfilled such expectations and should document communications in a way that would allow it to do so.
FRFIs, typically through their risk management oversight function, should have adequate processes in place to independently and objectively identify, assess, analyze, monitor, control and mitigate risks with respect to residential mortgages and to ensure that risk management policies are being adhered to (and provide assurances to the board and senior management) and to provide reporting on exceptions and the effectiveness of models.
A senior officer of a FRFI should make an annual declaration to the board confirming that the FRFI’s residential mortgage underwriting and acquisition practices and associated risk management practices and procedures meet, except as otherwise disclosed in the declaration and reported to the board and OSFI, the standards set out in the Guideline.
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.
The Guideline provides that FRFIs should ensure that they make a reasonable enquiry into the background, credit history, and borrowing behaviour of a prospective residential mortgage loan borrower as a means to establish an assessment of the borrower’s reliability to repay a mortgage loan. To this end, FRFIs should maintain complete documentation of the information that led to a mortgage approval, including a description of the purpose of the loan, employment status and verification of income, debt service ratio calculations, LTV ratio, property valuation and appraisal documentation, credit bureau reports and any other credit enquiries, documentation verifying the source of the down payment, purchase and sale agreements and other collateral supporting documents, an explanation of any mitigating criteria or other elements for higher credit risk factors, a clearly stated rationale for the decision (including exceptions), and a record from the mortgage insurer validating approval to insure the mortgage where there may be an exception to the mortgage insurer’s underwriting policies. A credit score alone should not be relied upon to assess borrower qualification.
Such documentation should be obtained at the origination of the mortgage and for any subsequent refinancing of the mortgage and the borrower analysis should be updated periodically (not just at renewal).
FRFIs should adequately assess the borrower’s capacity to service his/her debt obligations on a timely basis.
As a means to assessing a borrower’s ability to service his or her debt obligations, the Guideline provides that FRFIs should make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income (including employment status and income history) and also undertake sufficient credit due diligence on any guarantor or co-signor. FRFIs should establish debt serviceability metrics, set prudent measures for debt serviceability (which should be set out in the RMUP) and calculate each borrower’s debt serviceability ratios for the purposes of assessing affordability.
FRFIs should have a stated maximum amortization period for all residential mortgages that are underwritten. OSFI expects that the average amortization period for mortgages underwritten be less than the FRFI’s stated maximum, as set out in its RMUP. The Guideline does not require FRFIs to have specified amortization requirements in place for all outstanding HELOC balances. HELOCs with a loan-to-value rate of 65% or less do not need to be amortized.
FRFIs should have sound collateral management and appraisal processes for the underlying mortgage properties.
The Guideline provides that FRFIs should have clear and transparent valuation policies and procedures with respect to appraisal of underlying properties. Examples cited are on-site inspections, third party appraisals and/or automated valuation tools, but the Guideline makes it clear that FRFIs should not rely exclusively on any one on these and should instead take a more comprehensive and prudent approach to property valuation.
Loan to value (LTV) ratios are commonly used for measuring credit risk and OSFI acknowledges the correlation between LTV ratios and credit risk. The Guideline specifies that FRFIs should adhere to an appropriate maximum LTV ratio (for various types of mortgage transactions), which may be determined by law or based on current and expected market conditions and other risk factors.
By law, residential mortgages underwritten for the purpose of purchasing, renovating or improving a property must be insured if their LTV ratios are greater than 80 %. Also, OSFI expects FRFIs to impose a maximum LTV ratio less than or equal to 65 % for non-conforming residential mortgages.
In the case of HELOCs, OSFI expects FRFIs to limit the non-amortizing HELOC component of a residential mortgage to a maximum authorized LTV ratio of less than or equal to 65 %.
OSFI expects that the average LTV ratio for all conforming and non-conforming residential mortgages and HELOCs to be less than the FRFI’s stated maximums, as articulated in its RMUP, and reflect a reasonable distribution of LTV ratios across the portfolio.
FRFIs should have effective credit and counterparty risk management practices and procedures that support residential mortgage and underwriting and loan asset portfolio management, including, as appropriate, mortgage insurance.
To mitigate risk, FRFIs may obtain mortgage insurance from CMHC and private mortgage insurance providers and OSFI indicates that the use of either is appropriate, provided that a FRFI conduct periodic due diligence on the mortgage insurer commensurate with its level of exposure to that insurer. OSFI has indicated that the Guideline does not apply to mortgage insurers, although a separate draft guideline addressing mortgage insurers is expected to be forthcoming.
FRFIs that acquire residential mortgage loans that have been originated by a third party should ensure that the underwriting standards of that third party are consistent with the FRFI’s RMUP and compliant with the Guideline.
The Guideline sets out the general principle that FRFIs should publicly disclose sufficient information related to their residential mortgage portfolios for market participants to be able to conduct an adequate evaluation of the soundness and condition of FRFI’s residential mortgage operations.
Recommended public disclosures related to residential mortgages should include, but are not limited to (i) the amount and percentage of the total residential mortgage loans and HELOCs that are insured versus uninsured, (ii) the percentage of residential mortgages that fall within various amortization period ranges significant for the FRFI, (iii) the average LTV ratio for the newly originated and acquired uninsured residential mortgages and HELOCs at the end of each period and (iv) a discussion on the potential impact on residential mortgage loans and HELOCs in the event of an economic downturn. Such disclosure should be published quarterly in a format and location that will support public availability and understandability.
A FRFI will be required to maintain and provide to OSFI, upon request, its RMUP and associated management reports. Moreover, a FRFI should promptly inform OSFI if it becomes aware of any mortgage underwriting issues that could materially impact its financial condition.
Where a FRFI fails to adequately account and control for the risks of underwriting or acquisition of residential mortgages, OSFI can take, or require the FRFI to take, corrective measures, including heightened supervisory activity and/or an adjustment of the FRFI’s capital requirements or authorized asset-to-capital multiple, commensurate with the risks being undertaken by the FRFI.