Ottawa’s new, stricter mortgage-insurance rules have been a bitter pill to swallow for some homebuyers, as well as a new challenge for lenders.
The prescription is meant to be preventative, to ensure what the federal government describes as a “healthy, competitive and stable housing market for all Canadians” amid soaring real estate prices in cities like Toronto and Vancouver. Exacerbating high home prices is record household debt that is now higher than Canada’s GDP, according to Statistics Canada.
But the changes, which require a so-called stress test for new insured mortgages, have thrown some buyers to the sidelines. That, in turn, is expected to mean a drop — or at least a delay — in business for loan providers, in particular credit unions that rely heavily on the residential mortgage business. “I would expect credit unions to experience fewer mortgage loan applications,” says Helmut Pastrick, chief economist at Central 1 Credit Union. “These new rules will dampen demand at the margin and hence, going forward — not just during this market adjustment phase but thereafter — demand will be lower than was previously expected.”
Credit unions across Canada are working through the changes internally and with their members, with both positive and negative implications. For many, stress tests are already a key part of the mortgage-lending process. While lower lending volumes would impact all credit unions, some say any drop in business today will help strengthen the business for the long-term.
Protecting lenders from default
To recap: Ottawa changed the rules for consumers that require an insured mortgage, which in most cases is a buyer with a down payment of less than 20 percent. The purpose of mortgage insurance is to protect lenders in the event of default. Lenders must now run a stress test to ensure these borrowers can handle mortgage payments based on the Bank of Canada’s posted five-year fixed interest rate, which was 4.64 percent at the time the changes were announced this past October. That’s about two percentage points greater than the discounted rates offered by lenders at the time.
Canadian households had $1.68 in credit market debt for every dollar of disposable income. – Statistics Canada
Before the mortgage rules came into effect this past October, only variable-rate mortgages and those with terms of less than five years were stress-tested at the higher rate, Pastrick says. “The consequence, though, is to reduce the number of eligible borrowers by making it more difficult to qualify at the higher posted five-year rate.”
Buyers don’t have to pay the higher rate. The goal is to ensure they could still afford their mortgage payments if interest rates rise. The changes stem from Ottawa’s concern over soaring home prices, especially in Toronto and Vancouver, which together represent about 40 percent of the national housing market. Record household debt levels are also a problem. Statistics Canada says the ratio of household credit market debt to disposable income rose to 167.6 percent in the second quarter of 2016 (the latest gures available), up from 165.2 percent in the first quarter. That means Canadian households had $1.68 in credit market debt for every dollar of disposable income.
The new mortgage rules means a borrower will need about 20 percent more income to purchase the same home, Pastrick says, “or have to settle for a home priced 20 percent lower.” Buyers have two choices: buy a less-expensive place, or delay the purchase until more money can be saved for a bigger down payment.
Both scenarios have an impact on credit unions across Canada, where Pastrick says residential mortgages can represent 70 to 90 percent of credit union businesses.
Still, he believes the banking and credit union systems are “very sound” and can withstand these and other recent policy changes made in Ottawa in recent months. “Their financial soundness has improved ever since the 2008-2009 recession due to various regulatory changes and requirements,” Pastrick adds. “That includes the quality of mortgage credit.”
Mild correction but no crash
It’s the sixth time since 2008 that the federal government has changed mortgage insurance rules, says Pastrick. However, the latest move is “the harshest” since then, due to the stress test and other measures designed to constrain mortgage credit supply. “The direction of change on the market impact is clearly negative; only the magnitude is in question.”
While sales and prices have continued to surge, fuelled in large part by low interest rates, Patrick is expecting a “mild correction” this time around, with sales dropping 10-to-20 percent, housing prices falling five-to-10 percent and housing starts slipping 10-to-20 percent “before stability emerges around mid-2017.”
Buyers have two choices: buy a less expensive place, or delay the purchase until more money can be saved for a bigger down payment.
Unlike some housing market doomsayers, Pastrick doesn’t see a major market correction or crash — at least not based on what the government has done lately to cool the country’s hot housing market. For that to happen, Pastrick says of a potential housing market crash, “far more negative developments such as an economic recession or crisis event would need to play out. This housing market cycle is still intact, though it has taken a substantial hit.”
How credit unions are adjusting
There’s a good and bad side to the regulations, depending on how you look at it, says Ryan McKinley, senior mortgage development manager at Vancouver City Savings Credit Union (510,000 members, $20.9 billion in assets). The bad news is that some buyers will need to put more money down, or hold off on a home purchase. What’s good, McKinley says, is that buyers will be better prepared financially for when interest rates eventually do rise. “There is a positive there for some people as far as their own affordability is concerned,” McKinley says.
In the meantime, Vancity will continue to talk to members, not about the maximum mortgage they
can qualify for but rather how much they can bear based on their lifestyle and expenses, now
and in the future. McKinley says it’s breaking down the mentality about getting the maximum mortgage and getting members to think about what they can actually afford. “Although this is going to impact buyers in terms of what they can technically afford, it won’t change the conversation we have and how we approach the amount of money to lend.”
At Alberta’s Servus Credit Union, (372,961 members, $14.6 billion in assets), regional sales manager Roger Marion says they’re not only talking to members about the impact of the new mortgage rules but also builders and real estate partners on the front lines. “It’s important that we give to that community and make sure they fully understand the impact as well,” says Marion. For example, builders will also need to better understand how much more of a down payment potential buyers will need for a typical home, to help with their developments and sales. “We’re giving them that data so they can have that conversation and also educate their purchasers.”
Marion notes that credit unions rely on the building and real estate industries, as well as the buyers themselves. “We owe it to those communities to make sure we are spending time letting them know our perspective on changes that could impact their business.” As for members, Marion says many have been forced to set aside their home ownership goals as a result of the new mortgage rules. “We’re seeing disappointment with those consumers,” he says. “Our role is to explain to them that they may need to buy something less expensive, or delay the purchase until they can afford the full amount.”
For many members looking to buy a home there may be some “short term pain,” says Candis Jaman, consumer credit adjudication manager at Affinity Credit Union in Saskatchewan (116,665 members, $4.9 billion in assets). “We are hoping that, through education and working with members, we can continue to get them into home ownership — maybe not today but perhaps a year from now,” Jaman says.
Jaman adds that the changes are particularly hard to understand for younger buyers who have never seen higher rates and may have trouble understanding why their mortgages are based on a scenario that hasn’t yet happened. It’s the lender’s job to show how different payments will be if — and eventually when — rates do rise, says Jaman. “When we can sit down and show them what the cash difference means, they can see better why the rules came into place.” In one example, the difference in payment was $500 per month under the new stress test. “That’s significant.”
Jaman says that members need to be comfortable with the higher costs and be able to manage them now and into the future. “A mortgage is only one piece of your debt servicing but it is your biggest debt and longest debt you will have,” she says. “It comes down to lifestyle and what you are prepared to give up in order to own that home.” ◊
OTHER MORTGAGE MOVES TO WATCH
While changes to mortgage insurance will have the greatest market impact, there are other new measures that have shaken up the mortgage market in Canada. Helmut Pastrick, chief economist at Central 1 Credit Union, outlines the other changes and the potential impact on buyers and especially lenders.
Level the Playing Field for Loan Eligibility
All insured mortgages must meet the same loan eligibility criteria as high loan-to-value insured mortgages (more than 80 percent of property value). Previously, mortgage insurance criteria for low loan-to-value ratio mortgages (less than 80 percent) were not as stringent as for high loan-to-value ratio mortgages. Low-risk mortgages are often pooled by lenders and packaged as mortgage-backed securities with portfolio insurance and sold to investors. This change will make it more difficult to package such loans and serve to reduce the supply of mortgage credit because lenders will be less able to sell loans and free up capital to make new loans. Depending on mortgage demand conditions, this measure could increase mortgage rates.
New Reporting for Capital Gains Exemption
The capital gains exemption for the sale of a principal residence is available only to Canadian resident individuals and trusts for one property in any given year. The Canada Revenue Agency (CRA) will require a taxpayer to report the disposition of a property for which the principal residence exemption is claimed. The CRA currently does not require this reporting where a property is eligible for the full principal residence exemption. This measure will impact the sale of properties used as vacation or cottage homes and possibly investor-owned properties previously reported as capital gains exempt.
Spreading Risk among Lenders
The last measure, lender risk sharing, refers to requiring mortgage lenders to take a portion of loan losses on insured mortgages that default. Currently, lenders transfer all of the risk of insured mortgages to mortgage insurers and indirectly to taxpayers through the government guarantee. The government previously raised this option and will make a determination following a consultation period.
It is very likely the government will require lenders to absorb some of the losses on insured mortgage defaults. Current expectations are that about 10 percent of the loss will be absorbed by the lender and the insurance fund will cover 90 percent of the loss. This will require lenders to hold more capital in reserve or to have a higher cost of capital reflecting the higher risk. Either way, it will reduce the supply of mortgage credit, putting upward pressure on mortgage rates.