Residential Mortgage Underwriting Practices and Procedures

Document Properties

  • Type of Publication: Letter
  • Date: June 21, 2012
  • Reference: Guideline for Banks / T&L / Co-op / Life / P&C
  • To: Federally-Regulated Financial Institutions (FRFIs)

On March 19, 2012, OSFI published draft Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures. The comment period ended on May 1, 2012. OSFI received over 70 submissions from various stakeholders following the release of the draft. I would like to thank everyone who provided comments and suggestions.

OSFI reviewed the submissions and, on June 6, 2012, provided an interim update of decisions taken on key issues. Today, OSFI is publishing the final version of Guideline B-20, as well as the Annex to this letter, which provides a summary of the comments received by the public and an explanation of how these issues were dealt with in the final Guideline.

Full implementation of Guideline B-20 by FRFIs is expected by no later than fiscal year-end 2012, with the relevant public disclosures beginning in Q1, 2013. The deadline of fiscal year-end 2012 allows time for FRFIs to implement any systems or process changes that may be required. In the meantime, FRFIs should conduct self-assessments of compliance with this Guideline and establish a plan to address any deficiencies before the implementation deadline.

However, where possible, FRFIs should comply with the principles and expectations set out in this Guideline as of the date of this letter. For greater clarity, it should be noted that Guideline B-20 will not be applied on a retroactive basis to existing in-force residential mortgages.

  • Mark Zelmer
  • Assistant Superintendent
  • Regulation Sector

Annex: Guideline B-20 – Summary of Consultation Comments and OSFI Responses

Industry Comments OSFI Response
General Comments

Principles-Based, Risk-Based Approach versus Prescriptive, Rules-Based Approach:

Several commentators indicated that Guideline B-20 should be principles-based rather than prescriptive and that there should be greater clarity that FRFIs should apply a risk-based approach to the components of the Guideline.

A few commentators noted that FRFIs differentiate themselves based on their risk management frameworks and capabilities, including the ability to identify and differentiate between the risk profiles of individual borrowers. They suggested that the Guideline should enable FRFIs to continue to apply discretion and expert judgement in their management of their overall residential mortgage portfolio and at the individual borrower level.

OSFI has provided greater clarity in the Guideline. Principles 2, 3, and 4 should be evaluated by FRFIs using a holistic, risk-based approach – unless otherwise specified in the Guideline.

In some areas, OSFI’s expectation is more rules-based. Some examples include: maintaining loan documentation, the loan-to-value (LTV) threshold of the non-amortizing HELOC component of a mortgage, and public disclosure requirements, among others.

The overall approach for Guideline B-20 is consistent with that of other OSFI Guidelines.

Costs on FRFIs and Borrowers:

A number of commentators noted that they expect Guideline B-20 will impose higher costs on both FRFIs and borrowers and that the Guideline could lead to unintended consequences, such a driving a higher proportion of consumers into unsecured lending products or to unregulated lenders that often charge higher rates for comparable mortgage products.

Given that residential mortgage lending represents a material portion of activities at many FRFIs, it is important that lending practices in this area be governed prudently and with appropriate risk controls. This will help to promote the safety and soundness of FRFIs and the Canadian financial system more broadly.

OSFI’s responsibilities under its mandate include advancing and administering a regulatory framework that promotes the adoption of policies and procedures designed to control and manage risk. Guideline B-20 is consistent with this mandate.

Practices among FRFIs are largely consistent with many of the practices set out in the final version of this Guideline and, as such, OSFI expects there will be limited incremental costs associated with complying with this Guideline. OSFI believes that any such costs would be small relative to the costs and disruptions to FRFIs and borrowers if inappropriate lending practices were to emerge in a systematic way.

Section 1. Purpose and Scope of the Guideline

Domestic vs. International Application of the Guideline:

A few commentators noted that draft Guideline B-20 sets out expectations for both the domestic and international residential mortgage operations of FRFIs. The commentators suggested that OSFI reconsider the proposed application to international markets, due to the numerous regulatory, legal, and competitive differences across countries. They suggested that applying the specific requirements of the Guideline to the foreign operations of a FRFI could put the FRFI at a competitive disadvantage in other markets.

Some commentators suggested that international operations should instead be reflected in FRFIs’ Residential Mortgage Underwriting Policies (RMUPs). Such a method would provide FRFIs with the flexibility to adapt policies to each national and economic context and would acknowledge the role of the local regulator in each market.

OSFI’s mandate includes, first and foremost, protecting the rights and interests of depositors, policyholders and creditors of FRFIs.

OSFI has revised Guideline B-20, which now applies primarily to FRFIs’ Canadian operations.

However, the international mortgage lending and acquisition activities of FRFIs will be expected to be reflected in FRFIs’ Residential Mortgage Underwriting Policies (RMUPs), including in their governance and risk management frameworks (i.e., business strategy and risk appetite). FRFIs are also expected to provide public disclosures of their international operations, as outlined in the Guideline.

Stakeholder should be aware that the Financial Stability Board (FSB) has established Sound Residential Mortgage Underwriting Practices. The report is contained on the FSB site: (http://www.financialstabilityboard.org/publications/r_120418.pdf).

FSB member jurisdictions are expected to adhere to these FSB Principles, and apply standards in their own national contexts. FRFIs would be expected to comply with any residential mortgage standards set out by foreign regulators in other jurisdictions.

Application of the Guideline to FRFIs that are Mortgage Insurers:

A few commentators noted that the contents of Guideline B-20 apply primarily to residential mortgage underwriting. To help clarify the roles and requirements of mortgage insurers, they suggested that the responsibilities of mortgage insurers be separated from the general requirements of FRFIs that underwrite or acquire residential mortgage loan assets.

Sound mortgage underwriting practices are critical for residential mortgage originators, acquirers and mortgage insurers. However, given the Guidance’s focus on the residential mortgage origination process, Guideline B-20 will only apply to FRFIs that are mortgage originators or acquirers of mortgage loan assets.

A separate guideline applicable to FRFIs that are mortgage insurers will be published for consultation at a later date.

Section II – Principle 1: FRFI Governance and the Residential Mortgage Underwriting Policy (RMUP)

Board of Directors’ Role in Reviewing and Approving the RMUP:

A number of commentators noted that the RMUP proposed by OSFI would be a detailed, granular, and comprehensive document relating to all aspects of how the FRFI conducts its residential mortgage lending and acquisition, and as such, would not be suitable for the Board or a Board Committee to review and approve. Those commentators noted that procedural issues and parameters at very detailed levels are matters that should be left to FRFIs’ Senior Management. They suggested that Board oversight is best captured through the approval of the FRFIs’ Risk Appetite Framework and that FRFIs should have the flexibility to leverage their general risk policy architecture and approach to frameworks, policies and procedures in generating the RMUP.

OSFI expects that FRFIs’ Senior Management will be responsible for the development and implementation of the RMUP. However, the Board of Directors of the FRFI plays a critical role in providing high-level guidance to, and oversight of, Senior Management with respect to matters relating to mortgage underwriting and portfolio management.

As such, OSFI expects the Board of the FRFI to review and discuss the RMUP or any changes to the RMUP. The Board is expected to understand the decisions, plans and policies being undertaken by Senior Management with respect to residential mortgage underwriting and/or the acquisition of residential mortgage loan assets, and their potential impact on the FRFI. OSFI expects the Board to probe, question and seek assurances from Senior Management that these decisions are consistent with the Board’s own decisions and Board-approved business and risk strategy for the FRFI, and that the corresponding internal controls are sound and being implemented in an effective manner.

RMUP as a Standalone Document:

Some commentators noted that draft Guideline B-20 structures the RMUP as a single, standalone document, which does not fit well into FRFIs’ overarching risk policy structure.

As noted in footnote 4 of the final version of Guideline B-20, the RMUP can be one consolidated document or a set of mortgage policy documents.

Section II – Principle 2: FRFIs’ Assessment of Borrowers’ Identity, Background and Demonstrated Willingness to Service Debt

Loan Documentation – Re-qualification at Renewal:

borrowers to be re-qualified at renewal. Many commentators noted that requalification diverged from existing practice in Canada and would represent a significant change, imposing an administrative burden on lenders and consumers, and resulting in higher costs. They noted that, except for mortgage loan originations and refinancings (where a loan contract is being altered or where additional funds are being requested), renewals typically do not involve reassessing or re-underwriting individual non-delinquent mortgage loans (e.g., rechecking borrower credit scores, re-verifying income, reappraising the property, recalculating the loan-to-value (LTV) ratio, or obtaining related new loan documentation).

Some commentators suggested that the vast majority of borrowers represent acceptable renewal risk with strong repayment history and that it would not be practical or meaningful for FRFIs to follow the same documentation process for all borrowers in good standing who are simply renewing their mortgage.

Current practice regarding residential mortgage renewals has served FRFIs well. OSFI agrees, for example, that having a strong payment record is one of the best indicators of creditworthiness. OSFI expects that FRFIs will have a clearly defined risk-based approach for current and future mortgage renewals and FRFIs themselves will remain responsible for deciding what level of review to place on borrowers’ qualifications at the time of renewal.

FRFIs’ renewal practices should be articulated in internal policies governing their underwriting of residential mortgage loans. FRFIs, however, will be expected to refresh their borrowers’ credit metrics periodically (not necessarily at renewal) so that FRFIs can effectively evaluate their ongoing credit risk.

Section II – Principle 3: FRFIs’ Assessment of Borrowers’ Capacity to Service Debt

Income Verification and Debt Service Coverage:

Some commentators noted that the income verification requirements in the draft Guideline appear to be overly prescriptive, in particular, for certain classes of borrowers (e.g., self-employed). These commentators suggested that caution should be exercised in interpreting income from income tax information, which may not accurately reflect the actual capacity of various borrowers to repay debt. They also suggested that the verification of income and use of income in debt service tests needs to consider these differences.

A borrower’s income is a key factor in the assessment of a borrower’s capacity to repay a mortgage loan, and verification of the borrower’s income helps detect and deter fraud. (For example, the verification of income will help reduce the potential for similar problems in Canada that arose in other countries, where borrowers’ stated income differed substantially from their actual income).

The language in draft Guideline B-20 in respect of the verification of income has been revised and is less prescriptive. The underlying principle, however, has not changed – FRFIs should make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income.

Additional Assessment Criteria:

Some commentators suggested that a number of factors outlined in the “Additional Assessment Criteria” section of the draft Guideline were either subjective or would present difficulties and complexities to FRFIs in meaningfully incorporating such items into credit underwriting decisions. For example, there is uncertainty and complexity with predicting borrowers’ potential loss of employment, future composition of their households, and predicted income over the term of the mortgage, including in retirement.

Measures of income and debt service coverage metrics provide FRFIs with criteria for assessing a borrower’s capacity to repay a residential mortgage loan. However, such metrics have their limitations. For example, these metrics often do not incorporate factors such as mandatory payment obligations or a borrower’s assets, which are important for assessing a borrower’s capacity to pay.

In some countries, assessment of capacity to pay has moved towards a “net surplus” methodology. This requires the consumer to demonstrate a surplus of funds after deducting tax, debt repayment and living expenses, and is generally expressed as a ratio (the “Net Surplus Ratio”). See Financial Stability Board, Thematic Review on Mortgage Underwriting and Origination Practices, page 19. http://www.financialstabilityboard.org/publications/r_110318a.pdf

To enhance or supplement income and debt service coverage metrics, OSFI expects FRFIs to consider additional assessment criteria in their assessment of borrowers’ capacity to repay their loans, such as borrowers’ assets.

The final version of Guideline B-20 has been clarified and is less prescriptive in respect of the set of specific additional assessment criteria FRFIs should consider in their credit decision-making processes.

OSFI recognizes the challenges in FRFIs assessing certain factors (e.g., the stability of income) and expects FRFIs to conduct such assessments to the extent possible.

Amortization – Home Equity Lines of Credit (HELOCs):

A number of commentators indicated that a risk-based approach should apply to the amortization of HELOC products. Some noted that as proposed, a prescriptive requirement for FRFIs to amortize HELOCs would apply equally to high net worth borrowers with substantial income and assets as it would to more leveraged and riskier borrowers. There were suggestions that amortizing HELOCs should be left to the discretion of FRFIs.

Some commentators noted that there could be unintended consequences from requiring HELOCs to amortize, including: the churning of customers (i.e., customers that change lending institutions to avoid the amortization requirement); movement towards unsecured products, which are prudentially riskier for FRFIs and costlier for borrowers; and the transfer of activity from the regulated to unregulated sector.

Some commentators suggested that the requirement to amortize HELOCs would require product redesign and system changes that would be costly and would take significant time to develop, test and implement.

The draft Guideline has been revised to clarify that HELOCs at or below an LTV ratio of 65 per cent will not be required to be amortized, as the revolving aspect of a HELOC is a fundamental feature of the product.

A further description of OSFI’s expectations in respect of HELOCs, including the LTV limit on the HELOC component, is provided below, under the sub-heading, “Home Equity Lines of Credit (HELOCs) and LTV.”

Section II – Principle 4: FRFIs’ Sound Collateral Management

Property Valuation / Appraisals:

Some commentators indicated that on-site appraisals, which were prescribed as the default option in the draft Guideline, have their shortcomings, including a tendency to be more subjective (i.e., based on the appraiser) and to confirm current market value, without any recognition of the state of the market (e.g., an overvalued marketplace). Some of these commentators suggested that a broader set of tools, such as comprehensive automated property risking models that consider “property risk” for both valuation and market conditions, are said to be more prudent.

On the other hand, other commentators indicated that automated valuation models can fail to provide an accurate measure of value, since they do not take into account physical characteristics of the house (e.g., interior) that can greatly affect house values. Moreover, some models may be based on inaccurate information (e.g., inaccurate measure of the lot surface area). As such, to obtain an accurate assessment of current value, these commentators suggested an on-site appraisal is needed.

As the residential property provides recourse for repayment of the loan if a borrower defaults (i.e., property acts as collateral), OSFI expects FRFIs to conduct a proper and thorough assessment of the underlying property to mitigate risks.

There are a number of methods to assess the value of residential properties, including on-site appraisals by qualified FRFI staff, third-party appraisals, use of databases, and automated valuation techniques, based on models, among others. Each provides different benefits.

OSFI believes that FRFIs should generally not rely on any single method for property valuations. No substantive changes have been made to the Guideline.

In assessing the value of a property, FRFIs are expected to take a risk-based approach, and consider a combination of valuation tools and appraisal processes appropriate to the risk being undertaken. FRFIs are expected to have clear and transparent valuation policies and procedures in this regard.

Non-Conforming Loans and LTV:

Some commentators suggested that non-conforming mortgages should not be restricted to less than or equal to 65 per cent. They suggested that mortgage customers are less likely to abandon their properties if they have a minimum 20 per cent of the value at stake (i.e., 80 per cent LTV) and that it is appropriate, in certain circumstances, to permit higher LTV values for non-conforming mortgages. Some commentators also noted that such loans and products play an important role in the Canadian residential mortgage market, addressing particular borrowers.

By their very nature, non-conforming loans are riskier loans than conforming loans.

OSFI believes the 65 % LTV limit for non-conforming mortgages to be prudent.

FRFIs should have internal policies with respect to underwriting and/or acquiring “non-conforming” loans, as defined by the FRFIs themselves.

Home Equity Lines of Credit (HELOCs) and LTV:

A number of commentators suggested that a HELOC requirement of a maximum of 65% should be applied on a portfolio basis, rather than on a transactional basis. Such an implementation would provide greater flexibility, particularly for those borrowers that use HELOCs as a cost effective substitute for a short-term revolving line of credit. Some commentators suggested that FRFIs should continue to be permitted to manage their HELOC portfolios using a risk-based approach.

OSFI is maintaining its position that the HELOC component of a mortgage be restricted to a maximum loan-to-value ratio of 65%.

HELOCs are inherently riskier products, given their revolving nature, persistence of debt balances and their ineligibility for mortgage insurance.

For greater clarity, additional mortgage loan credit (beyond the LTV ratio limit of 65 % for HELOCs) can be extended to a borrower. However, the loan portion over the 65 % LTV proportion should be amortized.

Section II – Principle 5: FRFIs’ Risk Management

Purchase of Mortgage Assets Originated by a Third Party:

A few commentators noted that the requirements regarding acquiring mortgages originated from a third party could affect liquidity in the secondary mortgage market. In particular there could be less flexibility in dealing with an insolvent lender, securitizations and covered bond structures.

OSFI is maintaining its requirement that the Guideline applies to FRFIs that acquire mortgage assets originated by third parties. As a matter of principle, FRFIs that own the resulting risk of residential mortgage lending should adhere to the Guideline. FRFIs’ business focus could otherwise shift to the acquisition of residential mortgage loan assets, which would undermine the application of Guideline B-20.

Section III – Guideline Administration

Disclosure Requirements:

Some commentators suggested that disclosure requirements should be framed so that FRFIs are not placed at a competitive disadvantage relative to non-FRFIs and competitors in international markets that may not face similar disclosure requirements.

A few commentators also suggested that FRFIs should not be required to divulge sensitive competitive information. Specifically, a description of the primary credit quality indicators used to assess and monitor credit quality is proprietary information developed as part of a FRFI’s strategy to monitor and assess credit quality, the disclosure of which would reveal sensitive information to competitors.

In addition, some commentators suggested that it is important that disclosures among FRFIs be consistent and use common definitions, in order to facilitate “apples-to-apples” comparisons for analysts and the public.

For greater transparency, clarity and public confidence in FRFIs’ mortgage operations, OSFI is maintaining disclosure requirements in Guideline B-20. These will now focus on the domestic residential mortgage operations of FRFIs and key mortgage metrics (e.g., LTV ratios and amortization).

However, the disclosure requirements will not include information that is considered proprietary to FRFIs, the disclosure of which could cause a competitive disadvantage for FRFIs relative to non-FRFIs and international competitors that do not face similar requirements.

Implementation:

Some commentators suggested that the Guideline should not be applied retroactively – to transactions that have already been entered into or where funds have been committed (e.g., amortization of HELOCs).

Some also suggested that FRFIs should be provided sufficient time to make changes to internal systems, policies, processes and documentation standards, as needed, to meet the Guideline’s principles and OSFI’s expectations.

FRFIs will be provided sufficient time to make changes to their internal systems, policies, processes and documentation standards.

Full implementation of Guideline B-20 by FRFIs is expected by no later than fiscal year-end 2012, with the relevant public disclosures beginning in Q1, 2013. The deadline of fiscal year-end 2012 allows time for FRFIs to implement any systems or process changes that may be required. In the meantime, FRFIs should conduct self-assessments of compliance with this Guideline and establish a plan to address any deficiencies before the implementation deadline.

However, where possible, FRFIs should comply with the principles and expectations set out in this Guideline as of the date of this letter. For greater clarity, it should be noted that Guideline B-20 will not be applied on a retroactive basis to existing in-force residential mortgages.