Banking regulator limits amount of highly indebted borrowers
Here is what OSFI's new mortgage test means for lenders and customers
Canada's banking regulator is taking fresh steps to ensure lenders don't take on too many highly indebted borrowers, particularly once mortgage rates start to come down and it gets easier to qualify for larger loans. The new portfolio test being introduced by The Office of the Superintendent of Financial Institutions will monitor quarterly loan-to-income ratios to ensure the percentage of a bank's uninsured mortgage loans that is in excess of 4.5 times borrower income stays below a specified threshold. The Financial Post's Barbara Shecter explains the new test, and what it means for banks and borrowers.
WHY IS THIS HAPPENING?
The change is one of a series of expected adjustments to mortgage guidelines that have been under discussion since last year. OSFI says the new portfolio test is intended “to prevent the buildup of highly leveraged loans during low interest rate periods.” The regulator is particularly concerned about loans that are more than 4.5 times borrower income because they raise the probability of borrower default and increase a lender's potential losses. As demonstrated by the prolonged period of low interest rates before steep increases beginning in the spring of 2022, such debt may be manageable in a low rate environment but becomes much more challenging for borrowers and their financial institutions when rates rise.
WILL THE TEST APPLY TO BORROWERS LIKE THE RATE QUALIFYING STRESS TEST?
No, the portfolio test does not create a new hurdle for the individual homebuyer trying to qualify for a mortgage loan. Instead, it will track the banks' uninsured mortgage portfolios. “This measure doesn't apply to any one person,” OSFI said in a March 22 statement. “It applies to the institution's portfolio of underwritten mortgages that originate that quarter ... and needs to be managed by the institution.” Mortgage strategist Rob McLister said there will be no prohibition on an individual taking on a mortgage if the loan exceeds their income by more than 4.5 times. Even with the new test, banks could allow an individual borrower to exceed the cap “so long as the entire portfolio averaged 4.5 times or less,” he said.
WILL ALL BANKS BE BOUND BY THE SAME CAP?
OSFI was considering a 25 per cent limit on originations that exceeded the loan-to-income threshold of 4.5 times for all banks, based on the total dollar value of quarterly originations. Instead, the regulator will monitor the banks individually and apply the test based on each institution's business model. The regulator says this approach will allow banks to continue to use existing underwriting methods in the current rate environment and to compete as they have been.
HOW MUCH OF AN IMPACT WILL THIS NEW TEST HAVE ON THE MORTGAGE MARKET?
Not much at first, according to McLister. But it will be felt once interest rates start to come down because the stress tests for individual borrowers will carry a lower qualifying rate, meaning the borrower will qualify for a larger mortgage — and that means loan-to-income ratios will go up. Still, McLister said there will be many borrowers out there who won't exceed a loan of 4.5 times income, especially if they have already paid down a chunk of their mortgage and renewed. This will bring down the overall ratio applied to a bank's portfolio and allow them to make more high-leverage loans, he said.
ARE THESE LOANS A PROBLEM NOW?
Industry-wide, uninsured mortgages with these high loan-to-income metrics had climbed to an average share of more than 30 per cent of originations as home prices rose during the pandemic, according to an OSFI consultation document published in Jan 2023. But this share has been falling fast and is only 12.55 per cent now, according to McLister. The average loan-to-income ratio for uninsured borrowers is 2.6 times, he said.
HOW ARE THE BANKS LIKELY TO REACT TO THE NEW PORTFOLIO TEST?
Some lenders could respond by charging a premium to certain high loan-to-income borrowers to help compensate for the implied risk of a borrower whose loan far exceeds the income ratio ceiling, McLister said. A premium charge could also help the bank limit the number of highly indebted borrowers in its portfolio. “In general, banks would probably want those exception cases to be higher quality and/or more profitable customers,” he said, adding that this could send some highly indebted borrowers to instead seek loans from non-federally-regulated financial institutions or non-prime lenders.
In general, banks would probably want those exception cases to be higher quality and/or more profitable customers.