Sound Residential Mortgage Underwriting in a Changing Environment - Remarks by Superintendent Jeremy Rudin to the 2016 Mortgage Professionals Canada National Conference, Vancouver, British Columbia, November 28, 2016

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Sound underwriting has always been important, but it has never been more important than it is now.

Everyone involved in mortgage origination in Canada has a role to play in supporting the sound underwriting practices that OSFI requires of federally regulated lenders and mortgage insurers.

 

Introduction

Good morning. I am pleased to be speaking today about housing finance, and where better to address this topic than here in Vancouver? My thanks go to Mortgage Professionals Canada for this opportunity.

Housing finance issues are of great importance to many Canadians, whether they are homeowners, aspiring homeowners, or professionals working in the mortgage and housing industries.

As Canada’s prudential regulator and supervisor of banks and mortgage insurance companies, we at the Office of the Superintendent of Financial Institutions (OSFI) have an important role to play in advancing the public interest in mortgage finance.

Today, I will outline that role and describe our increased focus on the underwriting practices of Canadian financial institutions.

I will provide OSFI’s view on why sound underwriting is now more important than ever and how our tightened expectations around these practices will impact other players in the Canadian housing finance system. 

And, I will discuss how we work in coordination with other federal agencies on housing finance issues. 

OSFI’s role and mandate

For those of you unfamiliar with OSFI, here is our mandate in brief.

Our focus is on the safety and soundness of federally regulated financial institutions. We are charged by Parliament with protecting depositors, policyholders and other creditors to the institutions, while allowing those institutions to compete effectively and take reasonable risks.

By issuing principles-based guidance, by conducting regular supervisory oversight based on that guidance, and by setting capital requirements, we ensure that federally regulated banks and insurers are acting prudently, whether in their mortgage portfolios or other lines of business. 

Nearly 80 per cent of mortgages that are made in Canada are held by lenders that OSFI supervises. We also supervise all of the mortgage insurance companies. Accordingly, OSFI has a responsibility to keep a close eye on any systemic vulnerability in the mortgage market, along with developments that may affect individual lenders and insurers.

The importance of sound underwriting in the current economic environment

To fulfil our mandate, we need to ensure that our regulated institutions can manage through a wide variety of severe yet plausible scenarios, while continuing to provide financial services and maintain confidence in the system.

For some time, OSFI has been focused on the need for sound underwriting practices for all residential mortgage activities. Given the risks and vulnerabilities arising from the current environment, sound underwriting is now more important than ever.

Mortgage rates in Canada have been at historically low levels for over five years. This has led to significant increases in household debt, particularly mortgage debt. The Bank of Canada continues to flag this as a key vulnerability. The latest issue of the Bank’s Financial System ReviewFootnote 1 indicates that mortgage debt continues to rise more quickly than household incomes. Moreover, that growth is particularly evident among highly indebted households that have less capacity to cope financially with a loss of income or a hike in interest rates.

A pronounced or prolonged economic downturn could well involve a meaningful housing price correction. This could translate into significant losses for lenders and insurers. The risk of those losses would be driven by a combination of two factors:

  • the growing inability of borrowers to meet their debt obligations; and
  • the declining values of the real estate properties pledged as collateral in mortgage loans.

It is our job to get out in front of the risks.

Sound underwriting has never been more important

Sound underwriting focuses first and foremost on the borrower’s capacity and commitment to repay the loan. Collateral is an important backstop if the borrower’s ability to repay the loan becomes impaired. Accordingly, sound underwriting also requires close attention to the value of the property. However, collateral should not be viewed as an alternative to capacity and commitment.

Why? Because the value of the debt is fixed, but the value of the collateral is not. On average, Canadian house prices have tripled in less than eighteen years. There have been declines in some markets over that period but these have been neither prolonged nor severe.

When house prices have been rising for several years and interest rates have remained at all-time lows, complacency can set in. Lenders might be led to believe that weak underwriting standards will be mitigated by ever-rising collateral values.

Our view is the opposite. House prices in most Canadian markets have never been higher, supported by mortgage rates that have never been lower. In these circumstances, prudent lenders put less reliance on collateral values, not more.

OSFI is watching closely

Recognizing the elevated financial risks and vulnerabilities facing Canadian financial institutions, OSFI issued a letter to industry in July 2016, indicating that we were tightening our expectations and increasing scrutiny around residential mortgage underwriting practices Footnote 2.

Let me share some specifics on the areas we are monitoring, particularly: verifying borrower income and employment information, managing riskier or non-conforming loans, and ensuring adequate debt service ratios.

Income/employment verification

First, let’s address income and employment verification.

As I have mentioned, determining the capacity of a borrower to repay their loan is an essential element of sound mortgage underwriting. The foundation of this practice is verifying the borrower’s income and employment. This includes assuring that controls are in place to guard against misrepresentation by the borrower, or anyone else.

We recognize that gathering income and employment information for some borrowers can be challenging. For example, it can be difficult to have a high level of assurance for borrowers who are self-employed or who rely on income from sources outside of Canada.

Even in these more challenging cases, we are still looking for rigorous yet reasonable efforts to verify income and employment. We are also looking for evidence of strong compensating measures that bring the risk to within acceptable levels.

Non-conforming loans

In situations when a lender is faced with a challenging underwriting scenario ─ for example, when verifying income is difficult ─ riskier loans can be the result.

In these cases, we expect banks to identify their higher-risk, or non-conforming loans, and set their own clear limits on the amount of non-conforming mortgages they are willing to take on.

We expect lenders to closely monitor their risk intake over time to ensure they stay within their established limits.

Non-conforming loans also call for lenders to exercise specific compensating controls, such as higher down payments.

OSFI’s Residential Mortgage Underwriting Practices and Procedures GuidelineFootnote 3─ commonly known as Guideline B-20 ─ recognizes a distinction between conforming and non-conforming loans. 

And, we have set an upper limit of 65 per cent on the loan-to-value ratio for non-conforming loans.

However, lenders should not mistake our guidance as a safe harbour. For instance, a loan-to-value limit of 65 per cent may be too high for non-conforming mortgages in markets where prices have been rising rapidly and are therefore more vulnerable to a sharp price correction. As Guideline B-20 clearly states, adhering to the suggested limits in no way sets aside the lender’s obligation to lend responsibly. 

Debt service ratios

Another area of underwriting that we are focused on is debt-service ratios. Prudent mortgage underwriting requires an accurate assessment of a borrower’s ability to withstand plausible financial and economic shocks, including a rise in interest rates.

The recent uptick in mortgage interest rates should serve as a reminder that low rates are not a given, especially over longer periods of time.

A lender’s assessment of a borrower’s debt repayment capability must reflect the long-term nature of mortgage loans. It is the lender’s responsibility to determine how to adequately test this, remaining mindful of the current environment and looking out over the life of the mortgage.

Relying on standard practices that worked well when interest rates were at “normal” levels is probably not sufficient when rates are at historic lows.  

Loss absorbing requirements must be sensitive to local market risk

Along with our guidance around mortgage underwriting standards, OSFI also sets capital requirements for federally regulated mortgage lenders and insurers.

Our capital requirements are designed to ensure that lenders and insurers have sufficient capacity to absorb severe but plausible losses.

For this approach to work, we need to keep up-to-date on how severe losses could be in a plausible negative scenario. With residential mortgages, developments in the price of housing are crucial. In particular, potential losses become more severe during extended periods where house prices have risen rapidly, or are high relative to borrower incomes. As a result, the potential severity of losses can vary from market to market.

OSFI is making changes to our framework to ensure that capital requirements keep pace with those developments and so reflect the underlying risks. These changes have been implemented for our major banks, which are the banks that are authorized to use their internal models as input into their capital requirements. Similar changes will be implemented for mortgage insurers in the coming weeks. These changes will lead to greater consistency and conservatism in the protection provided to depositors and policyholders.

In both cases, our intention is that capital requirements remain risk-sensitive and properly account for situations where future property values are less certain.

These are measured and forward-looking responses to the changing environment.

Sound underwriting relies on complete and reliable information

OSFI’s scrutiny of sound underwriting by federally regulated banks and insurers will touch other participants in the mortgage origination and underwriting process.

For example, even though we do not directly regulate mortgage brokers or provincially regulated lenders, all players in the mortgage industry should understand what OSFI is requiring our federally regulated institutions to do. Why is this important? Knowing our expectations is particularly relevant to mortgage brokers who service our regulated institutions directly. But it is also important for brokers who deal with institutions OSFI does not regulate. In many cases, these institutions sell mortgage loans to the financial institutions that we do oversee.

An essential part of sound underwriting is having reliable information about the borrower and the property. This requirement can only be met if lenders and mortgage insurers verify that the customer-facing part of the process is doing its part.

The industry should therefore expect federally regulated lenders and insurers to convey these expectations to individuals interacting with customers, whether staff in a bank branch, bank-employed mobile mortgage specialists, or independent brokers.

While OSFI’s requirements apply only to federally regulated institutions, those institutions are responsible to ensure that the information they receive from anyone who interacts with the borrower is complete and reliable.

A coordinated approach with our federal partners

While OSFI is an independent regulatory agency, it does not operate in isolation. As you know, government involvement in Canada’s housing market policy extends to a number of federal and provincial agencies.

At the federal level, OSFI is joined by key authorities, notably the Department of Finance, Bank of Canada, Financial Consumer Agency of Canada, Canada Deposit Insurance Corporation and Canada Mortgage and Housing Corporation. Although each player has a distinct role and area of focus, we all work in coordination to maintain a stable financial system and an efficient and competitive housing finance market. 

A notable feature of the Canadian system is the prevalence of mortgage insurance. As you know, federally regulated lenders in Canada are required to hold insurance against borrower default for mortgages that are originated with a loan-to-value ratio over 80 per cent. This high ratio segment represents a significant portion of newly originated mortgages.

The Government of Canada owns the largest mortgage insurer, which is CMHC, and it also partly guarantees the liabilities of the other mortgage insurers. As a result, the government backstops all mortgage default insurance and, consequently, a sizable portion of the overall mortgage lending market. 

The Minister of Finance is responsible for determining how much of this risk the government should bear. He does this by setting a variety of limits — for example, minimum down payments for insured mortgages. The Minister makes these decisions in the context of his broader responsibilities for financial sector and economic policy.

OSFI plays a different yet complementary role: we regulate and supervise the risk-taking activities of banks and insurers. We look at the mortgage underwriting practices, processes and risk controls of the financial institutions with respect to all mortgages — whether they are insured against default or not.

While we exercise our responsibilities independently, we understand that OSFI is more effective when we engage with our federal partners, and act in a consistent and coordinated way.

Conclusion

Now I am going to conclude where I began.

We at OSFI recognize that we have an important role to play in housing finance. With regard to residential mortgages, our current focus is on sound underwriting. Sound underwriting has always been important, but it has never been more important than it is now.

Everyone involved in mortgage origination in Canada has a role to play in supporting the sound underwriting practices that OSFI requires of federally regulated lenders and mortgage insurers.

That includes OSFI, of course. And we, in coordination with our federal partners, are hard at work at our part: tightening expectations regarding sound underwriting, increasing the intensity of supervision, and making our capital requirements for residential mortgages more risk-sensitive and up-to-date.

Once again, I want to thank Mortgage Professionals Canada and everyone here today. I hope you have a very successful conference.

Footnotes

Footnote 1

See the Bank of Canada’s June 2016 Financial System Review

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Footnote 2

See OSFI’s June 2016 letter entitled, Reinforcing Prudent Residential Mortgage Risk Management 

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Footnote 3

OSFI Guideline B-20 sets out OSFI’s expectations for prudent residential mortgage underwriting, and is applicable to all federally-regulated financial institution that are engaged in residential mortgage underwriting and/or the acquisition of residential mortgage loan assets in Canada.

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