On January 12, 2023, the Office of the Superintendent of Financial Institutions (OSFI) launched a public consultation regarding changes to Guideline B-20 Residential Mortgage Underwriting Practices and Procedures that would further tighten mortgage underwriting rules and possibly related rules that apply to federally regulated lenders.
OSFI views lending risks as having significantly increased due to a combination of high interest rates, high levels of indebtedness, and the risks of an economic downturn. The consultation was telegraphed in OSFI's Annual Risk Outlook 2022-23. It reflects the Bank of Canada's latest Monetary Policy Report in October 2022, noting that inflationary pressures remain elevated, the pace of economic growth in Canada is slowing and there is potential for a sharp slowdown in the global economy in an era of combined tightening by central banks.
To mitigate these risks, OSFI is proposing several debt serviceability measures with a view to enhancing the credit quality of residential mortgage assets and underwriting practices of federally regulated lenders. Further, any new measures are intended to reinforce Principle 3 of Guideline B-20, which provides that FRFIs should adequately assess a borrower's capacity to service their debt obligations on a timely basis. This assessment should account for varied financial and economic conditions and/or higher interest rates.
The Minimum Qualifying Rate, commonly referred to as the "mortgage stress test" was introduced in 2018 to ensure a minimum threshold in this respect. The consultation document states that the stress test has helped, but additional measures may be needed. Accordingly, OSFI is seeking feedback on three measures: (1) possible restrictions on mortgage size (loan-to-income (LTI)) and debt load (debt-to-income (DTI)); (2) debt service coverage restrictions, in relation to a borrower's gross income and total debt; and (3) interest rate affordability stress tests, to gauge a borrower's ability to afford higher debt payments in the event of financial shocks.
Mortgage Size (LTI) and Debt Load (DTI) Possible Changes
To make borrower payments more manageable and to limit lenders' potential losses upon default, limits may be placed on mortgage debt relative to borrower income (loan-to-income or "LTI") or total indebtedness relative to borrower income (debt-to-income or "DTI").
OSFI is also considering a lender-level volume restriction on high LTI lending (often called a "flow limit" or speed limit"). These restrictions would give lenders discretion to underwrite a certain number of loans that exceed a reasonable threshold, but which may be allowed currently under residential mortgage underwriting policies (RMUPs) based on other criteria. For such restrictions to function effectively, OSFI is considering a consistent definition of "income" for calculating LTI, a "high" LTI threshold, and an industry-wide LTI volume limit.
As part of the consultation, OSFI is seeking input on a specific proposal to adopt a "high" LTI threshold of 4.5x with a 25% quarterly volume limit on originations that exceed the threshold.
Over the last several quarters, all of the D-SIBs have reported increases in their provisions for credit losses. Although the latest data available shows that mortgage arrears remain at record-low levels, with rising interest rates and dropping housing prices1, some Canadians will face a different borrowing scenario when their mortgage terms expire; and there are further implications for variable rate mortgages. By proposing changes to Guideline B-20 now, OSFI may help FRFIs work with borrowers to anticipate challenges the will face on renewal or if monthly payments become insufficient.
Debt Service Coverage Restrictions
OSFI's related news release emphasized the heightened risk of debt serviceability.
FRFIs currently use debt service coverage ratios in reviewing a borrower's creditworthiness, including Gross Debt Service (GDS) and Total Debt Service (TDS), but existing limits are only prescribed by the Minister of Finance for insured mortgages. Guideline B-20 currently allows FRFIs to establish debt serviceability metrics for uninsured mortgages, although they are expected to assure OSFI that GDS and TDS average scores for all mortgages underwritten and/or acquired do not exceed their stated maximum.
OSFI is proposing a new lender-level volume restriction on loans with high debt service ratios. As outlined in its consultation paper, for this measure to operate effectively OSFI is specifically considering:
- Formulas and definitions for GDS and TDS, and whether to adopt those that currently exist for insured mortgages;
- Appropriate GDS and TDS thresholds for uninsured mortgages, which could involve graduated or tiered limits; and
- An explicit amortization limit used for qualification in the Guideline that, in combination with debt service ratio restrictions, would limit excessive leverage.
This proposal could further limit how much a borrower's mortgage payment or other obligations can be as a percentage of income, in order for FRFIs to meet any new thresholds.
Interest Rate Affordability Stress Tests
The MQR is a minimum interest rate applied to debt service calculations to test the borrower's ability to service higher debt payments if in the case of negative shocks to income or increases in interest rates or expenses. This stress test is currently applied in the GDS calculation at underwriting.
OSFI is considering introducing a minimum affordability test. Per its consultation paper, OSFI is specifically considering the follow elements:
- The creation of an explicit principles-based expectation that lenders establish, monitor and report on different MQRs (in addition to the current MQR) according to various risk characteristics and product types;
- An expectation that the MQR be applied to a borrower's total debt service (i.e., any other debt obligations) in addition to gross debt service; and
- Tests of affordability and other debt serviceability measures for non-mortgage retail lending outside of Guideline B-20.
Reporting requirements for different MQRs could give OSFI greater insight on emerging vulnerabilities, building on FRFI financial statements reflecting any defaults in previous quarters and IFRS 9 credit loss projections. Actual arrears are a lagging indicator, sometimes requiring at least several months of missed payments.
Tests tied to total debt serviceability could link the inter-related risks of products like home equity lines of credit (HELOCs) that exist alongside mortgages and have grown in popularity. If interest rates continue to rise, debt-service calculations based on total debt serviceability would offer another way to mitigate Canadians' record level indebtedness.
Implications and Next Steps
OSFI is seeking feedback on the proposed changes, including whether these will achieve OSFI's policy objectives and whether there are alternatives that OSFI should consider. One question raised is whether the proposed lender-level volume restriction should allow FRFIs discretion to underwrite a certain number of loans that exceed any new thresholds, provided they are still permissible under their RMUP policies, and therefore potentially reduce the number of borrowers looking to provincial credit unions or less-regulated private lenders in response to the more restrictive federal rules.
The consultation paper notes several times that alternative measures available to OSFI could involve increasing capital requirements for FRFIs. It provides statistics on the higher volume of high LTI loans held by smaller and medium-sized FRFIs, noting that these risks could be addressed through the capital framework. OSFI recently raised the Domestic Stability Buffer applicable to the D-SIBs by 50 basis points to 3% of risk-weighted assets effective February 1, 2023, while also increasing the range in which it can set the buffer to between 0% to 4%.
Comments are to be provided by April 14, 2023 to Bfirstname.lastname@example.org. A draft revised Guideline B-20 will subsequently be issued for further public consultation. OSFI has also indicated that it may publish interim guidance based on the consultation.*
*The authors gratefully acknowledge the contribution of Brittany Vanword, Articling Student.
1. Robert McLister, "How new mortgage rule proposals could affect housing financing", The Globe and Mail (12 January 2023).
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