On July 6, 2017, the Office of the Superintendent of Financial Institutions (OSFI) issued a revised version of Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures (Draft Guideline) for comment. This Draft Guideline comes after OSFI issued a letter to the industry, on July 7, 2016, highlighting its concerns with residential mortgage underwriting practices and the adequacy of risk management controls implemented by residential mortgage originators. The letter indicated that OSFI would be reviewing Guideline B-20 to ensure it is aligned with prudent industry practice and Canadian housing market realities. The Draft Guideline is the product of OSFI’s review.
The basic framework of Guideline B-20 has not changed: the five fundamental principles for sound residential mortgage underwriting remain. However, OSFI has tightened and clarified its expectations, as well as introduced new expectations.
These changes address OSFI’s concerns regarding Canada’s residential mortgage market: possible housing bubbles in Vancouver and Toronto, the likelihood of rising interest rates and their potential negative effects on households with high residential mortgage debt, and governance controls.
Below we look at some of the new measures proposed by OSFI in the Draft Guideline to address these concerns.
RISK MANAGEMENT AND INTERNAL CONTROLS
OSFI expects mortgage originators and their insurers to demonstrate an understanding of mortgage portfolio risk and appropriately manage that risk. Accordingly, federally regulated financial institutions (FRFIs) who engage in residential mortgage lending are now expected to verify that their residential mortgage operations are well supported by prudent underwriting practices and have sound risk management and internal controls that are commensurate with these operations. FRFIs should also revisit their Residential Mortgage Underwriting Policy (RMUP) on a regular basis to ensure that there is strong alignment between their risk appetite statement and their actual mortgage underwriting, acquisition and risk management policies and practices.
STRESS TESTS FOR UNINSURED MORTGAGE LOANS
Last fall, the Government of Canada announced tighter mortgage insurance rules to require all insured homeowners to qualify for mortgage insurance at an interest rate that is deemed to be the greater of their contractual mortgage rate and the Bank of Canada’s conventional five-year fixed posted rate, which is currently 4.64 per cent. By applying the higher rate to calculate the borrower’s “Gross Debt Service”, which cannot exceed 39 per cent, and “Total Debt Service”, which cannot exceed 44 per cent, FRFIs are in effect now “stress testing” the borrower’s ability to service his or her mortgage debt even if interest rates rise. These existing requirements for insured residential mortgage loans are already reflected in the mortgage insurers’ requirements regarding debt serviceability, and the Draft Guideline stipulates that FRFIs should meet those requirements.
Under the Draft Guideline, the requirement for tighter stress tests now extends to uninsured mortgage loans, but in some respects goes even further than the requirements for insured mortgage loans. For uninsured mortgage loans, OSFI expects FRFIs to take into account current and future conditions when considering qualifying rates and make appropriate judgements and, at a minimum, ensure that uninsured borrowers can withstand a rate hike of at least two per cent above the contract rate. However, the subjective aspects of OSFI’s expectation means that lenders should evaluate the specific risks associated with each loan application and apply commensurate stress testing measures; relying on the two per cent minimum will not be sufficient in all cases.
The practical implication of this requirement for stress testing is that borrowers may no longer qualify for the size of mortgages that they originally anticipated.
OFSI has articulated concerns with overvaluation in certain Canadian housing markets, such as Greater Vancouver and Toronto, and certain proposals in the Draft Guideline are intended to ensure that risks associated with a potential fall in these or other housing markets are appropriately monitored and mitigated. Accordingly, the Draft Guideline contemplates more rigorous standards for determining the loan-to-value (LTV) ratio for a residential mortgage loan. In particular, each FRFI should:
- Maintain and implement a framework for critically reviewing and, where appropriate, effectively challenging the assumptions and methodologies underlying valuations and property appraisals
- In markets that have experienced rapid house price increases, use more conservative approaches to estimating the property value for LTV calculations and not assume that prices will remain stable or continue to rise
- Ensure that its LTV limit structure reflects the risk attributes of different types of mortgage loans and is consistent with its RMUP
- Have a robust process for regularly monitoring, reviewing and updating the LTV ratio framework
- Update the property analysis periodically (not only at renewal) in order to effectively evaluate credit risk
OSFI expects FRFIs to take a critical view of the sustainability of housing market prices and appropriately adjust the property value when making an underwriting decision on non-conforming loans and on home equity lines of credits (HELOCs), including calculating the LTV and pricing the loan. OSFI also expects FRFIs to adjust maximum LTV limits downwards in the presence of multiple higher-risk attributes or deficiencies in a loan application. For HELOCs, this means that the maximum authorized amount on the HELOC may need to be downwards adjusted if there is a material decline in the value of the underlying property. This may affect the marketability of HELOCs, especially if property values begin to drop.
OTHER CHANGES TO THE CREDIT DECISION AND UNDERWRITING PROCESS
In a few instances, OSFI’s expectations regarding the underwriting process have been heightened from “sufficient” or “reasonable” to “rigorous”. For example, the existing Guideline B-20 requires “reasonable steps” to obtain income verification, whereas the Draft Guideline requires that FRFIs use “rigorous efforts” to verify income.
FRFIs will now need to require proof of property insurance and, in the case of insured mortgage loans, obtain a record from the mortgage insurer validating its commitment to insure the mortgage. The insurer’s record is required for all insured mortgage loans, whereas previously, a record of the insurer’s approval was only required where there may be an exception to the insurer’s underwriting policies.
The Draft Guideline expands on the requirement to describe the purpose of the loan. A new section under Principle 2, titled “Purpose of Mortgage Loan” has been added. Per this new section, OSFI expects FRFIs to ascertain and document the purpose of the prospective loan, including the intended use of the loan, type of purchase or refinancing. OSFI considers that the purpose of the loan is a key consideration in assessing credit risk. For example, a property that relies on rental income to service the loan will require the lender to understand the rental market and factor any associated risks into its credit decision and underwriting processes.
MAINTAINING UNDERWRITING STANDARDS FOR FOREIGN BUYERS
Concerns with foreign ownership have been well documented in the media. As a prudential regulator, OSFI’s focus is on ensuring that lenders exercise the same rigorous underwriting and credit decision standards for foreign as well as domestic buyers. To that end, the Draft Guideline emphasizes that where borrowers are relying on income from sources outside of Canada, lenders must conduct thorough diligence. The result may be that fewer foreign buyers will qualify for a residential mortgage and this may have a cooling effect on the markets.
A new section on misrepresentation has been added, which stipulates that FRFIs should maintain adequate mechanisms for the detection, prevention and reporting of fraud and misrepresentation, such as falsified income documents. FRFIs are expected to report suspected or confirmed fraud or misrepresentation to the mortgage insurer where the mortgage loan application is for an insured mortgage.
FRFIs cannot lend more than 80 per cent against the value of a mortgaged property without obtaining mortgage insurance. OSFI also expects FRFIs to impose a maximum LTV ratio less than or equal to 65 per cent for nonconforming residential mortgages, which may include non-income qualifying loans, loans to those with low credit scores and mortgages on illiquid properties.
Under the Draft Guideline, FRFIs should not arrange or appear to arrange with another lender a mortgage or combination of a mortgage and other lending products secured by the same property in any form that circumvents the maximum LTV ratio or other limits it establishes in its RMUP. Accordingly, FRFIs will be precluded from entering into arrangements with unregulated mortgage lenders, including mortgage investment corporations (MICs), to offer mortgage loans that exceed the prescribed limits.
APPLICATION TO ALL RESIDENTIAL MORTGAGES
OSFI has clarified that a “residential mortgage” includes any loan to a borrower that is secured by residential property, as opposed to a loan to an individual that is secured by residential property, as currently provided under Guideline B-20. This change resolves any uncertainty as to whether Guideline B-20 applied to a residential mortgage loan made to a corporation or other entity.
FRFIs that acquire residential mortgage loans from third-party originators must consider the risks associated with the functions that may be performed by the third party in respect of those acquired loans, including servicing functions. A FRFI will want to ensure that it has adequately assessed counterparty risk when acquiring residential mortgage loans, whether for its own book, as a mortgage aggregator, or for inclusion in a bank-sponsored conduit.
FRFIs that engage in residential mortgage lending or the acquisition of residential mortgage loans will need to anticipate changes to their governance and underwriting processes, and begin looking now at what operational changes will need to be implemented once the Draft Guideline is finalized. Particular attention should be paid to the more rigorous standards that will be expected by OSFI.
Under the existing Guideline B-20, FRFIs that acquire residential mortgage loans 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 existing Guideline B-20. This requirement continues to apply under the Draft Guideline, so non-FRFI mortgage lenders who sell their mortgages to FRFIs will also need to update their processes to ensure that they are able to sell mortgages to FRFIs.
The industry has until August 17, 2017 to provide comments on the Draft Guideline. Comments can be emailed to [email protected]. OSFI will publish a non-attributed summary of the comments they receive, along with OSFI’s responses, on its website when the final version of Guideline B-20 is released. OSFI expects to release the final guideline in fall 2017 and expects it to come into effect shortly afterward. OSFI also expects to make consequential changes to Guideline B-21 – Residential Mortgage Insurance Underwriting Practices and Procedures shortly after the final version of Guideline B-20 comes into effect.