All federally regulated financial institutions (FRFI) received a letter recently from the Office of the Superintendent of Financial Institutions (OSFI) detailing concern about how household debt is spiraling upward in Canada. The letter is a reminder that FRFI’s should pursue full due diligence when they evaluate mortgage loans and issue funding and insurance, according to Guidelines B-20 and B-21.
Here’s what the letter had to say:
Given the current economic environment in Canada, with record levels of household indebtedness and growing risks and vulnerabilities in some housing markets, OSFI’s supervisory scrutiny in the area of mortgage underwriting will continue. Moving forward, OSFI will place an even greater emphasis on confirming that financial institutions conduct prudent mortgage underwriting, and that their internal controls and risk management practices are sound and take into account market developments.
Specifically, there are five areas in which OSFI would like lenders to apply diligent consideration as they analyze mortgage applications.
When lenders do not verify income accurately, this can impact credit risk assessment negatively as well as endanger compliance for anti-money laundering and counter terrorist financing, mortgage insurability and other capital requirements. Particular care should be taken to track incomes reported outside of the Canadian borders. Mortgage underwriters should not allow collateral value to serve as a stand-in for validation of borrower income.
Debt service ratios
Mortgage underwriters should calculate incomes conservatively and verify them thoroughly. One particular area of emphasis should be claimed rental income from the property that will serve as the collateral for the mortgage. When underwriters use the current five-year interest rates to evaluate the ability of a borrower to take care of the loan’s obligations, they do not adequately test the loan given that interest rates are quite likely to rise during that time period.
Just because a loan has a loan-to-value ratio below 65% does not mean that lenders should not apply the same sort of due diligence that they use for loans with a higher ratio. While collateral value has a role in the process, the capacity that a borrower has to service the loan and the borrower’s character play a stronger role.
LTV Calculation and appraisals
OSFI asserts that when housing values go up quickly, that makes property appraisals less reliable. They urge the use of an approach that leads to a conservative LTV calculation, rather than following the assumption that housing values will flatten out or keep rising, instead of possibly going back down to their earlier levels.
Risk Appetite and Portfolio Management
Because newer approved mortgages tend to show a higher risk profile, OSFI reminds mortgage insurers and lenders to take another look at their policies for underwriting and insuring to ensure that they take on loans that match the risk appetite that their policies suggest with their practices.
Additionally, OSFI indicates that they are putting together policy initiatives to improve the calculation of the capital that mortgage insurers and major banks hold on hand in order to see them through potential defaults. November 2016 and January 2017 are the implementation dates for the new measures, which will include Risk Sensitive Floors, BCBS Revisions to the Standardized Approach for Credit Risk and Capital Requirements for Mortgage.