The Canadian government continues to be concerned with the escalation in house prices in Canada, particularly in Toronto and Vancouver. While the government will not say that it considers these markets to be overvalued, clearly, there is concern that the extended period of low interest rates has caused homeowners to be overextended. On December 11th, in simultaneous announcements, the Minister of Finance and the Office of the Superintendent of Financial Institutions (OSFI) took steps to address these concerns.
Background to mortgage regulation
Prior to the 1960s, Canadian banks were largely prohibited from offering residential mortgages on the theory that the long term nature of these assets was not a good match for a bank’s primary funding source; short term deposits. However, a government policy of promoting home ownership, and pressure to open up new sources of funding for borrowers, eventually lead to an elimination of this restriction. Lingering concerns about the funding mismatch led the government of the time to imposed a restriction on the amount that a bank could lend against the appraised value of a property. Originally set at 60%, the excess value of the property over the amount of a loan provided ample cushion to guard against the perceived risk of allowing the banks to offer these mortgages.
Given that many borrowers, particularly first time borrowers, did not have enough cash to provide the 40% down payment, an exception was made that permitted banks to exceed the cap if the mortgage was insured against default. The Canada Mortgage and Housing Corporation (CMHC), a government agency that had been established to promote home ownership, was given the authority to insure the mortgages, essentially, eliminating the risk of default on these “high-ratio mortgages”.
This regime remains in place to this day. Eventually, the loan to value ratio was increased to 80% allowing the banks greater scope to make uninsured mortgages. Further, the government provided guarantees to certain private mortgage insurers broadening the availability of insurance for high-ratio mortgages.
Addressing the high levels of debt
On December 11th, the Minister announced that the regime would be tweaked. Going forward, CMHC and the other government–backed insurers are being required to change their underwriting standards effective February 15, 2016 so that only borrowers that make a down payment of 10% or more on the portion of the purchase price of the property between $500,000 and $1 million would be eligible for insurance. Under current underwriting standards, on properties up to $1 million, the required down payment is just 5%. The down payment required for the first $500,000 of purchase price will remain at 5%. Also not changing is the down payment requirement for homes priced at $1 million or more. It remains at 20%.
Under the new rules, anyone purchasing a home valued at $1 million or more will have to make a 20% down payment, purchasers of homes valued at less than $500,000 may borrow up to 95% of the purchase price if the loan is insured, and purchasers of homes valued between $500,000 and $1 million can borrow up to 95% of the first $500,000 but only 90% of the portion above $500,000.
This change will likely have a greater impact on the Toronto and Vancouver markets where the average sale price for homes currently exceeds $500,000. It might also have more of an impact on first time buyers in these markets as they do not have the ability to use the equity that they have built up in their current homes to cover the down payment on the new one.
OSFI looks to increase capital charges
On the same day as the Minister’s announcement, OSFI announced that it intends to update the rules it applies for determining the amount of capital that banks and private mortgage insurers must hold in respect of residential mortgage loans or the insurance that they provide for such loans.
While OSFI indicated that it intends to consult with the banks and mortgage insurers, and with the public more generally, before finalizing the changes, an indication of the direction of the new rules was provided. For banks that have been authorized to use internal models to calculate their required capital, OSFI is proposing to add a risk-sensitive floor for one of the model inputs (losses in the event of default) that will be tied to increases in local property prices and/or to house prices that are high relative to borrower incomes.
OSFI indicated that the rules for mortgage insurers will be adjusted so that they will be required to keep more capital for the insurance that they provide at times when house prices are high relative to borrower incomes.
The new rules will only be brought into force in 2017. However, given the strong indication of the direction that OSFI is heading, the banks and insurers might look to adjusting their lending and insurance policies sooner rather than later, particularly if the new capital requirements end up applying retroactively to existing mortgage portfolios. While it is not possible to say what these adjustments might be, it is possible that they will want to consider either re-pricing their products or reducing their exposure to certain types of mortgages.