Memo 1: Housing downturn poses “key risk” to Canadian economy
On April 18, Canada’s national banking regulator, the Office of the Superintendent of Financial Institutions (OSFI) released its second Annual Risk Outlook (ARO), outlining what it believes are the largest headwinds facing the Canadian financial system – and what the regulator plans on doing about it.
Topping the list was a topic that has dominated headlines (and homeowner worries) over the past year: the severe downturn in real estate prices and demand, following their huge run-up during the pandemic.
“The housing market changed substantially over the past year,” writes OSFI in their report. “Following record increases during the pandemic, house prices declined significantly in 2022. OSFI is preparing for the possibility that the housing market will experience continued weakness throughout 2023.”
The regulator also highlights how sharply the Bank of Canada’s rate hiking cycle has impacted borrowers’ abilities to pay down mortgage debt; the central bank increased its benchmark cost of borrowing a historic eight times between March 2022 and January 2023, bringing its Overnight Lending Rate from a pandemic low of 0.25% to 4.5% today.
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“This is a growing concern from a prudential perspective,” says OSFI. “Mortgage holders may not be able to afford continued increases on monthly payments or might see a significant payment shock at the time of their mortgage renewal, leading to higher default probabilities. Given the significant impact of real estate secured lending (RESL) activities in the Canadian financial system, a housing market downturn remains a key risk.”
Memo 2: Trigger rates will have lasting consequences
OSFI also hasn’t been shy about pointing to dangers posed by more borrowers hitting their trigger rates (when rising rates whittle a variable borrowers’ monthly payment to the point where it only covers mortgage interest). This has impacted a whopping eight in 10 variable fixed-payment borrowers who took their mortgages out between 2020 - 2022, according to a study conducted by National Bank.
One way lenders have addressed this is by extending the amortization period for affected borrowers, helping them avoid spiking monthly payments by spreading them out over a greater period of time.
But OSFI says this is just a band-aid solution – and that borrowers and lenders alike will need to pay the piper in due course.
In comments made to an audience at the CD Howe Institute last week, OSFI assistant superintendent Tolga Yalkin said, “It won’t surprise you to hear that we are not wearing rose-coloured glasses. The growth in highly leveraged borrowers increases the risk of weaker credit performance.
“While lending institutions are well capitalized and financially resilient, the higher cost of borrowing – and any potential economic downturn – could lead to more borrower defaults, potentially a disorderly market reaction, and even broader economic uncertainty and volatility.”
Memo 3: Renewed expectations for tougher mortgage rules
These recent comments have strengthened expectations that tougher mortgage rules could be in the cards before the year is through.
Back in January, OSFI announced it was considering making tweaks to its Guideline B-20, which outlines the borrowing and risk requirements for banks underwriting residential mortgages, as well as qualification rules for borrowers, including the mortgage stress test.
Reportedly, the regulator is mulling over whether it will increase the debt servicing ratio requirements for borrowers, which will make it tougher for those carrying larger debt loads to qualify for a mortgage. It is also considering limiting how many of these higher-leveraged borrowers banks can have in their portfolios. This means fewer borrowers may make the cut at A-lenders, and will need to turn to the B-side and alternative mortgage market.
Last but not least, OSFI may also change up the threshold criteria for the mortgage stress test; currently, borrowers must prove they can carry their mortgage at a rate of 5.25%, or 2% above the one they’ll receive from their lender, whichever is higher. However, following last year’s rapid rate increases, the 5.25% threshold has become obsolete, with all current market rates above 3.25%.
OSFI wrapped up consultations on these potential changes late last week, and will be releasing a report on its recommendations, meaning borrowers should keep their eyes out for changes in the months to come.