Further to Blakes Bulletin - Update on Federal Consumer Protection (March 2012) in which we reported on new guidance (the Guidance) from the Financial Consumer Agency of Canada (FCAC) and the new Code of Conduct for Federally Regulated Financial Institutions (the Code), both of which relate to improved disclosure of mortgage prepayment charges, on March 19, 2012, the Office of the Superintendant of Financial Institutions Canada (OSFI) released Draft Guideline B-20 - Residential Mortgage Underwriting Practices and Procedures (the Draft Guideline). Whereas the Guidance and the Code aim to protect consumers by ensuring access to adequate information to make informed financial decisions, the Draft Guideline seeks to protect federally regulated financial institutions (FRFIs) from the increased credit risk associated with defaulted residential mortgages by strengthening residential mortgage underwriting practices. It also requires increased public disclosure in respect of residential mortgage underwriting practices and portfolios to enable market participants to better evaluate the soundness and conditions of FRFIs residential mortgage operations.
If the Draft Guideline is finalized in the current form, FRFI residential mortgage lenders and acquirors and residential mortgage default insurers will have to review and revise their own mortgage underwriting practices and procedures and those of the sellers from which they purchase residential mortgage loans, as well as those of any relevant service providers, in order to ensure compliance. This may require changes to mortgage origination, sale and service agreements, as well as closer supervision of the practices and procedures of sellers and service providers.
The Draft Guideline and the related press release and OSFI letter do not give any indication as to whether there will be any time allowed for implementation prior to the Draft Guideline becoming effective.
Comments on the Draft Guideline must be provided to OSFI by May 1, 2012.
Summary of the Draft Guideline
The Draft Guideline is applicable to all FRFIs that are engaged in residential mortgage underwriting, the purchase of residential mortgage loan assets, and the issuance of mortgage default insurance, in Canada and internationally. A residential mortgage is defined for this purpose to include "any loan to an individual that is secured by residential property (i.e., one to four dwelling units)." Home equity lines of credit (HELOCs), equity loans and other such products that use residential property as security are also covered.
The Draft Guideline sets out five fundamental principles for prudent residential mortgage underwriting. These principles are summarized below. The Draft Guideline is to be read alongside the Principles for Sound Residential Mortgage Underwriting, first published in November 2011 by the Financial Stability Board (the Board) for consultation and to be published in final form in the coming weeks.
In addition to the five fundamental principles for sound residential mortgage underwriting, the Draft Guideline includes publication requirements with respect to residential mortgage underwriting practices and portfolios.
When an FRFI fails to comply with the Draft Guideline, OSFI can take, or require the FRFI to take, corrective measures on a case-by-case basis. Corrective actions within the authority of OSFI include heightened supervision, discretionary power to adjust the FRFI's capital requirements, and implementation of an asset-to-capital multiple or target-solvency ratio.
Principle 1: FRFIs that are engaged in residential mortgage lending, purchasing and/or insurance should have a comprehensive, Board-approved Residential Mortgage Underwriting Policy (RMUP). Residential mortgage practices and procedures of FRFIs should comply with their established RMUP.
The RMUP should be based on risk limits set in the Board-approved Risk Appetite Framework, a framework expected to be summarized in the upcoming revised OSFI Corporate Governance Guideline. The RMUP should reflect the size, nature and complexity of the FRFI's residential mortgage business, and detail, at a minimum, the FRFI's business approach to its residential mortgage business; its risk management practices; acceptable underwriting, purchasing and insurance standards; the identification process of and limitations to any underwriting exceptions; the use and applicability of residential mortgage models; and the roles, responsibilities and accountability of those charged with overseeing, implementing, monitoring and updating the RMUP. In order to ensure ongoing operational compliance with the RMUP, FRFIs are encouraged to develop effective internal controls as well as monitoring and reporting systems and procedures.
The Draft Guideline also provides more detailed requirements with respect to the following areas: board and senior management oversight; internal controls, monitoring and reporting; and mortgage underwriting declarations (an annual declaration of compliance with the Guideline – where we would have expected a declaration of compliance with the RMUP, which is the Board-approved policy). Finally, the Draft Guideline calls for deviations from the Guideline (again, not the RMUP) to be documented and disclosed in full to the Board and OSFI.
Principle 2: FRFIs should perform reasonable due diligence to record and assess the borrower's identity, background and demonstrated willingness to service his/her debt obligations on a timely basis.
The Draft Guideline specifically provides that a credit score should not be the sole indicator of a potential borrower's ability to service debt obligations on a timely basis. FRFIs must undertake and document, in detail, due diligence that supports the conclusion that the borrower can service and repay the loan in accordance with its terms. This information should be updated at appropriate intervals, including each subsequent renewal or refinancing of the mortgage. OSFI also reminds FRFIs to subject mortgage loans to the requirements of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act and its applicable regulations, paying particular attention to customer identification and record-keeping requirements and the customer risk assessment required under this legislation.
Principle 3: FRFIs should adequately assess the borrower's capacity to service his/her debt obligations on a timely basis without causing him/her undue hardship and/or overindebtedness.
The third principle focuses on the adequate assessment of a borrower's capacity to service his/her debt obligations without causing undue hardship or over-indebtedness. OSFI recommends that FRFIs make reasonable inquiries to verify a borrower's income, including the verification of the borrower's employment status and income history. Where a borrower obtains a mortgage supported by a co-signor or guarantor, the FRFI should also undertake sufficient due diligence to verify the co-signor/guarantor's income and credit rating, as well as the co-signor/guarantor's understanding of his/her legal responsibilities under the borrower's mortgage.
FRFIs should establish and implement conservative debt serviceability metrics to assess affordability for each borrower, and the Draft Guideline outlines some other assessment criteria to be considered. The Draft Guideline provides that FRFIs should have a stated maximum amortization period for all residential mortgages, including HELOCs. The requirement that all HELOCs have amortization requirements for all outstanding balances may not meet the intention of the customer who wants an available revolving line of credit.
Publication requirements in respect of debt serviceability metrics and amortization periods are outlined in Part III of the Draft Guideline.
Principle 4: FRFIs should have sound collateral management and appraisal processes for the underlying mortgage properties.
FRFIs should have clear and transparent valuation policies and procedures regarding collateral management and appraisals with respect to underlying mortgage properties. The appraisal process should take into account the liquidity of the property and may include such methods as on-site inspection, third-party appraiser and automated valuation tools. One commonly used tool supported by OSFI is the loan-to-value (LTV) ratio, although the Draft Guideline is clear that it should not be used as the sole determining factor.
The Draft Guideline reflects OSFI's concern with HELOCs. The guidance provided in respect of Principle 4 indicates that FRFIs should treat HELOCs in the same manner as non-conforming residential mortgages, conducting the necessary due diligence to ensure that the borrower is able to fully repay the loan over time.
Principle 5: FRFIs should have effective credit and counterparty risk management practices and procedures that support residential mortgage underwriting and asset portfolio management, including, as appropriate, mortgage insurance.
FRFIs should have risk mitigation strategies and procedures that support their residential mortgage underwriting. While mortgage default insurance is often secured as a risk mitigation strategy, OSFI states that it should not be used as a substitute for adequate due diligence. Mortgage insurance may be obtained from the Canadian Mortgage and Housing Corporation or private mortgage insurance providers. FRFIs should periodically evaluate their mortgage insurance counterparty to monitor the credit risk associated with mortgage insurance.
Valuation models are often used by FRFIs to evaluate their residential mortgage underwriting and/or purchasing decisions. These models should have an independent validation process along with a rigorous stress-testing regime that considers all plausible scenarios that may impact their residential mortgage portfolio. Additionally, OSFI expects FRFIs to exercise heightened prudence when evaluating mortgage asset or mortgage insurance portfolios that constitute greater credit or insurance risk by way of greater Board oversight, increased reporting or monitoring requirements, stronger internal control, and increased capital levels.
OSFI suggests that the Draft Guideline be read in conjunction with other OSFI guidance including the upcoming revised Corporate Governance Guideline, Guideline B-1 (Prudent Person Approach), Guideline B-2 (Large Exposure Limits), Guideline B-8 (Deterring and Detecting Money Laundering and Terrorist Financing), Capital Adequacy Requirements Guideline and the Minimum Capital Test Guideline.
Draft Guideline B-20 includes publication requirements with respect to residential mortgage underwriting practices and portfolios of FRFIs. Public disclosure should include, but is not limited to, the publication of the information FRFIs are required to collect under the Guideline. This information should be provided to the public in a manner that is widely available and easy to understand. As noted above, the purpose of these publication requirements is to enable market participants to better evaluate the soundness and condition of FRFIs residential mortgage operations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.