More stringent rules on mortgage borrowing could be on the horizon for Canadian homebuyers. The Canadian banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has issued a call for comments on proposed new regulations. This intended to limit banks’ use of leverage and lessen their exposure to risk. Risk instruments like the stress test have proven their worth. Now they’re looking to fill any holes that have opened up because of this.
Possible Income-Based Loan Limits for Canadian Mortgage Borrowers
There may soon be limits placed on how much money an individual or family can borrow in relation to their income, known as loan-to-income (LTI) or debt-to-income (DTI) ratios. The level of household debt as a percentage of disposable income is expressed as the LTI ratio. A loan-to-income (LTI) ratio of 200% indicates that the borrower has taken on debt equal to twice their annual salary. Borrowers are termed overleveraged or heavily indebted when their LTI ratio for their mortgage is 450% (4.5x income). If a borrower’s balance drops below this critical point, they are at risk of a financial crisis.
There are currently no limits placed on the total amount of loans at this tier. OSFI research indicates that the Q3 2022 will witness over one-third of all new mortgages issued to borrowers who are already in financial distress. However, since the beginning of the epidemic, highly leveraged borrowers have become a larger portion of the market, despite the fact that their share has dropped from 40% to 20%.
OSFI is considering a change in this by implementing a “high LTI threshold” of 4.5x for mortgages. This wouldn’t get rid of them because there are buyers out there. These buyers have high incomes and good credit histories for whom lenders consider them lower risk. The proportion of these mortgages that the lenders can be capped at 25%. It’s better than the pre-crisis average of 23.8 percent. However, it still implies 8.7 percent of recent loans wouldn’t have been as large as they were in the most recent reported quarter.
The predicted result is a lessening of leverage, which should make the system more resilient to shocks. In addition, it would reduce leverage, so limiting the market’s overall capacity. Given the rise of highly leveraged speculators who are outbidding end consumers, this is likely a positive development. New Zealand just instituted a similar policy, and it’s having a major effect. While not quite as significant as increased interest rates.
Debt Service Coverage Regulations Aim to Curb the Plight of Overleveraged Mortgage Borrowers
The OSFI is also thinking about imposing debt service coverage requirements, which would cap financial commitments at a specific percentage of income. In the case of insured mortgages, federally supervised lenders already deal with these.
Gross debt service ratios are used to make sure that mortgage payments for insured borrowers do not exceed 39% of monthly gross income (GDS). Using a debt service ratio, total monthly debt obligations (including mortgage payments, car payments, and student loan payments) cannot exceed 44% of income (DSR).
“Beyond those requirements, B-20 does not articulate limits on GDS and TDS for uninsured mortgages and generally permits FRFIs to establish debt serviceability metrics under their RMUPs that facilitate an accurate assessment of a borrower’s capacity to service the loan,” according to the industry consultation documents.
To put it another way, neither GDS nor TDS impose any restrictions on federally chartered lenders in regard to uninsured mortgages. Risk management strategies should include a prohibition on irrational lending practices. There is, however, no universally applicable rule or policy that applies to all federal loan providers.
OSFI is mulling over a policy shift that would see comparable regulations applied to lenders. It could be targeted at the borrower specifically or implemented across the board for all of the lenders. To that end, they advocate for capping amortisation periods at reasonable levels. The end goal is ostensibly another limit on leverage in case a borrower circumvents the others, albeit this one might not have as much of an effect.
Consumer loans in Canada, such as auto loans, could be subject to a revised stress test
The traditional “mortgage stress test” has been updated to include interest rate affordability testing. The amount of leverage a mortgage borrower can use is currently limited by a minimum qualifying rate (MQR). People tried to fit themselves into the one-size-fits-all approach, but ended up switching to variable-rate mortgages in search of a better interest rate. Many borrowers with variable rates are now paying interest rates higher than the stress test rate, so that strategy didn’t work out so well.
To mitigate this threat, OSFI is considering implementing multiple MQRs depending on the specifics of each product’s risk profile. Consider the fact that a mortgage with an adjustable interest rate has proven to be riskier than a mortgage with a fixed rate. The qualifying rate would be lower for longer fixed terms since there is less potential for payment shocks.
It would be fascinating if the regulator also considered testing for consumer debt payments. They imply that it may be necessary to explicitly emphasise the necessity of comparing the stress test rate to the TDS ratio, which is not currently done.
Conclusion
Soon, a stress test could be implemented for retail loans. Non-mortgage retail financing could be subjected to a stress test, according to the obliquely phrased consideration. Retail lending that is not secured by a mortgage, such as car loans, has been on the rise as record highs are approached. This isn’t such a bad plan.
Despite common misconceptions, OSFI’s input time isn’t for mere consideration. They are answers to problems that they may not have fully explained to the general audience. There is more of a “why shouldn’t we do this?” tone to the discussions. There seems to be no reasonable explanation for the sudden rise in the prevalence of excessive leverage in the property market.
Further underwriting policy is also anticipated to be updated. The government agency in charge of regulating financial institutions keeps bringing up combined-loan plans (CLPs), pointing out how these plans cause people to constantly carry debt and make them more susceptible to economic shock. They foresaw the need for it in the event of a sharp decline in property prices or widespread job loss, and the former is already a reality.