Canadian homebuyers may soon face tougher mortgage regulations. The Office of the Superintendent of Financial Institutions (OSFI), Canada’s banking regulator, is seeking feedback on a series of new rules to reduce leverage and mitigate risk. Now that risk tools like the stress test have proven why they’re important, they’re looking to close any gaps that may have appeared. Here’s what they’re looking at.
Canadian mortgage borrowers may see a limit on their loan-to-income ratio
Households may soon face loan-to-income (LTI) and debt-to-income constraints that limit overall leverage. The LTI ratio is the measure of household debt as a share of income. For example, an LTI ratio of 200% means that the borrower has an outstanding loan that is 2 times their income. When a mortgage has an LTI ratio of 450% (4.5x income), the borrower is considered over-indebted or highly indebted. Exceeding this threshold means that the borrower is vulnerable to a shock.
There are currently no limits on the amount of loans that can be made at this level. An OSFI analysis shows that nearly 1 in 3 mortgage loans in the third quarter of 2022 were to over-indebted borrowers. It is down from 40%, but since the start of the pandemic, highly leveraged borrowers have become a larger part of the market.
OSFI is considering changing this by adopting a “high LTI threshold” of 4.5x for mortgages. That wouldn’t eliminate those borrowers, as lenders see less risk for certain buyers with high incomes and solid credit. Instead, it will limit the share of these mortgages to 25% of lenders. That’s higher than the pre-pandemic average of 23.8% of new mortgage loans, but still means the 8.7% of recent loans would not be as large as in the last reported quarter.
The prior impact would be to reduce leverage, improve shock absorption capacity. This would also reduce leverage, reducing the maximum the market can take. This is probably a good thing, as heavily indebted speculators have become a significant part of the market, outstripping end users.
New Zealand recently implemented a similar measure that has had a significant impact. Although it is not as big as higher interest rates.
Reducing over-indebted mortgage borrowers with debt service coverage rules
OSFI is also considering debt service coverage limits, which would limit liabilities to a share of income. Federally regulated lenders already handle them to some extent, at least when it comes to insured mortgages.
Insured borrowers are tested to ensure their housing payments do not exceed 39% of their gross debt service (GDS) income. Housing payments and all other debt, such as car and student loans, are limited to 44% of income using the debt service ratio (DSR).
“In addition to these requirements, B-20 does not articulate GDS and TDS limits for uninsured mortgages and generally allows FRFIs to establish debt service metrics within their RMUPs that facilitate an accurate assessment of a borrower’s capacity to service the loan,” reads the consultation in the industry documents.
More bluntly, federal lenders are not officially restricted from GDS or TDS for uninsured mortgages. They are expected to have a plan to reduce risk, which means not making stupid loans. However, there is no standard for federal lenders or anything written in stone.
OSFI is considering changing that by potentially applying similar rules to lenders. It can be applied specifically to the borrower or applied across the lender’s portfolio. They would also like to limit excessive depreciation terms to help achieve this. After all, the stated objective is one more limit on leverage in case a borrower runs away from the others, though not necessarily an additional impact.
Canadians may see a revamped stress test, and it could apply to consumer loans like auto
The Interest Rate Affordability Stress Test is a reworking of the “mortgage stress test” you are familiar with. Currently, mortgage borrowers must be tested against a minimum qualified rate (MQR), which determines how much leverage they can have. However, this one-size-fits-all method has caused people to turn to variable rate mortgages to qualify for a lower rate. This has not worked out so well, as many variable rate borrowers now have interest rates that exceed the stress test rate.
OSFI is considering eliminating this risk by applying different MQRs based on the risk characteristics of the product. For example, an adjustable rate mortgage has just shown higher risk than its fixed rate alternatives. Because longer fixed terms have less risk of payment shocks, they would have a lower qualifying rate.
The regulator is also considering testing consumer debt payments, which would be interesting. Currently only testing the stress test rate against the TDS ratio is expected, but they suggest it may need to be explicitly stated.
Retail lending may also soon find itself under a stress test. The vaguely worded recital mentions the potential to stress test non-mortgage retail lending. Non-mortgage retail lending will include things like auto loans, which have been on the rise recently as prices approach astronomical levels. Not a terrible idea.
OSFI’s feedback period is often dismissed as a mere consideration, but it’s not just spitting ideas. These are solutions to problems that they may not have fully communicated to the public. Consultations are more like – why not do this? It’s hard to explain why after excessive leverage began to dominate housing.
We are also expected to receive an update on the further signing policy. The regulator has repeatedly discussed combined loan plans (CLP), explaining that households are continuously carrying debt and increasing the risk of vulnerability during an economic shock. They warned that this would have to happen in the event of a sharp fall in house prices or job losses, and the former of those two has arrived.
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