On July 6, 2017, the Office of the Superintendent of Financial Institutions (OSFI) released draft changes (Draft Amendments) to Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures (Guideline B-20) for public consultation. Guideline B-20, originally implemented beginning in June 2012 (please see our prior legal update “OSFI Guideline B-20: Residential Mortgage Underwriting Practices and Procedures”), sets out the expectations of OSFI for prudent residential mortgage loan underwriting, and is applicable to all federally-regulated financial institutions (FRFIs) in Canada that are engaged in residential mortgage underwriting and/or the acquisition of residential loan assets. The five fundamental principles for sound mortgage underwriting originally set out in Guideline B-20 remain, but OSFI is seeking in the Draft Amendments to clarify and strengthen expectations in a number of specific areas, including:
Requiring FRFIs to revisit their Residential Mortgage Underwriting Policy (RMUP)
As originally set out in Guideline B-20, the RMUP remains the foundation of a FRFI’s articulated limits regarding the level of risk that the FRFI is willing to accept with respect to residential mortgages, but the Draft Amendments introduce an expectation that FRFIs should revisit their 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.
Requiring a qualifying stress test for all uninsured mortgages
Guideline B-20 sets out OSFI’s expectations with respect to FRFIs’ stress testing of debt serviceability by residential mortgage loan borrowers. The Draft Amendments introduce a requirement that FRFIs stress test all uninsured residential mortgage loans to ensure borrowers could afford their loans even if interest rates were two percentage points higher than the contractual mortgage rate being offered. This level of stress testing is more rigorous than that currently set out in Guideline B-20 with respect to uninsured mortgages, and could reduce the size of uninsured mortgages loans that many borrowers would qualify to receive.
Requiring that Loan-to-Value (LTV) measurements remain dynamic and adjust for local market conditions where they are used as a risk control, such as for qualifying borrowers
Guideline B-20 sets out OSFI’s expectations with respect to the determination of LTV ratios by FRFIs with respect to residential mortgage loans. The Draft Amendments state that robust LTV ratio frameworks can serve to mitigate the valuation risk of mortgage loans and call for more dynamic and rigorous frameworks for determining LTV ratios for residential mortgage loans. A key element in determining LTV ratios is the underlying property appraisal, and the Draft Amendments set out OSFI’s expectation that FRFI’s should maintain and implement a framework for critically reviewing and, where appropriate, effectively challenging the assumptions and methodologies underlying valuations and property appraisals, which can help address the uncertainty about the reliability of property appraisals in an environment of rapid house price increases. Furthermore, the Draft Amendments include the following new expectations regarding LTV ratio frameworks:
- FRFIs should have in place a robust process for regularly monitoring, reviewing and updating their LTV ratio frameworks
- In markets that have experienced rapid house price increases, FRFIs should use more conservative approaches to estimating the property value for LTV calculations and not assume that prices will remain stable or continue to rise
- A FRFI’s LTV limit structure for underwriting loans should reflect the risk attributes of different types of mortgage loans and be consistent with its RMUP
- FRFIs should 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 residential mortgage loans (i.e., loans that have higher-risk attributes or deficiencies relative to other conventional mortgage loans) and home equity lines of credit (HELOCs), including calculating the LTV and pricing the loan or HELOC
- For HELOCs and non-conforming residential mortgage loans, OSFI also expects FRFIs to adjust maximum LTV limits downwards in the presence of materially higher risk in a loan application (i.e., in general, the greater the extent of risk, the lower the maximum LTV limit on the HELOC or non-conforming residential mortgage loan)
- The maximum LTV ratio of 65% set out in Guideline B-20 for non-conforming residential mortgage loans should not be used as a demarcation point below which sound underwriting practices and borrower due diligence do not apply
Expressly prohibiting co-lending arrangements that are designed, or appear to be designed, to circumvent regulatory requirements
OSFI Guideline B-20 stated that a FRFI should not structure a mortgage or a combination of a mortgage and other lending products in a form that circumvents the maximum LTV ratio a FRFI establishes in its RMUP. The Draft Amendments recast this expectation with reference to co-lending arrangements, such that a FRFI 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 the FRFI establishes in its RMUP, or any requirements established by law. This would effectively preclude a FRFI from entering an arrangement with an unregulated mortgage lender for the purpose of offering a loan or HELOC that (taken as a whole) would exceed the LTV ratio limits set out in Guideline B-20.
Additional requirements with respect to income verification
Verification of a borrower’s income is a critical element in residential mortgage underwriting, and the Draft Amendments introduce additional rigour around this component of mortgage underwriting, including expectations that FRFIs:
- Should maintain adequate mechanisms for the detection, prevention and reporting of all forms of fraud or misrepresentation (e.g., falsified income documents) in the mortgage underwriting process. For insured mortgage loan applications, FRFIs are expected to report suspected or confirmed fraud or misrepresentation to the relevant mortgage insurer
- Should conduct thorough due diligence on borrowers relying on income from sources outside of Canada. 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
- Should exercise rigorous due diligence in underwriting loans that are materially dependent on income derived from the property to repay the loan (e.g., rental income derived from an investment property)
In the face of persistently low interest rates, record levels of household indebtedness and rapid increases in housing prices in certain areas of Canada, the Draft Amendments are the latest means by which regulators in Canada have attempted to protect against the significant loan losses that could ensue if economic conditions deteriorate. The Draft Amendments were published prior to the recently announced increase on the Bank of Canada overnight lending rate, which increase is one of the other recent measures governmental authorities have introduced to cool the housing markets in Canada. Interested stakeholders have until August 17, 2017 to provide feedback through written submissions and OSFI has indicated that, following a review of the submissions, it will finalize the guideline and set an effective date for later in 2017.