More mortgage red tape could hurt homebuyers

Proposed ‘stress test’ not needed, says Neil Mohindra.

Amid widespread concern about housing affordability in Vancouver and across Canada, the Office of the Superintendent of Financial Institutions wants to raise the mortgage bar for many potential homebuyers by revising its guideline on residential mortgage underwriting.

The proposed revisions, which are intended to address risks associated with relatively high levels of household debt, include a “stress test” for uninsured mortgages (those with a minimum of 20 per cent down of a property’s value) to determine whether the borrower can meet payments if interest rates rise by two per cent. But is this additional test needed for OSFI to achieve its regulatory objectives?

As noted in a recent study published by the Fraser Institute, the origins of the guideline are American. Weak underwriting practices in the U.S. helped fuel the global financial crisis, as mortgage loans were bundled and sold to investors, including financial institutions around the world.

In response to the U.S. housing collapse, the Financial Stability Board, an international body dedicated to financial stability, introduced an international standard in 2012 meant to ensure weak mortgage underwriting standards would never again play such a significant role in a financial crisis. In Canada, OSFI responded to the FSB standard by introducing the guideline on residential mortgage underwriting. This was despite clear evidence, based on arrears data (payments at least 90 days overdue), that Canadian standards had not weakened to levels anywhere close to the U.S.

Now the OSFI wants to further stiffen the guidelines with a prescriptive “stress test” for those who put significant equity (again, 20 per cent or more) down when they purchase a home.

Besides a lack of evidence of a problem, a cushion against loss in the event of default already exists.

The consequences of this test include reduced buying power for some borrowers. It could also drive some borrowers to more expensive unregulated sources of credit and a less competitive regulated market. Some borrowers may be pushed into choosing mortgages with shorter or variable terms when available at lower interest rates to increase buying power despite higher vulnerability to interest fluctuations.

The case for the test is questionable. OSFI says its primary regulatory objective is to safeguard depositors and policyholders from loss on the funds they have entrusted to financial institutions. Besides a lack of evidence of a problem, a cushion against loss in the event of default already exists — uninsured mortgages require a minimum of 20 per cent down of a property’s value.

But ironically, the strongest reason why the proposed test is unnecessary is the robustness of OSFI’s existing regulatory framework. OSFI expects financial institutions to hold capital against unexpected losses that exceed international standards. OSFI guidelines require a lender’s board to define the risk appetite and set internal controls to ensure the risks taken by the institution are consistent with the board’s risk appetite. And OSFI does not wait for a serious problem to emerge, but intervenes early.

But requiring a specific test to address what is a temporary problem would mark an ominous turn toward a more prescriptive style in OSFI’s supervision of financial institutions. Concerns over high household debt are better addressed within OSFI’s regulatory regime by ensuring institutions have adequate policies and procedures to manage risk. Financial institutions would retain the flexibility to choose a mix of underwriting criteria in areas such as debt service coverage and loan-to-value ratios to ensure mortgage loans are consistent with the board’s appetite for risk.

In addition to better meeting the needs of the market, and increasing home-buying opportunities for Canadians, this would also allow institutions to respond more efficiently to changing conditions in the market through adjustments to underwriting criteria.