Canada’s banking regulator is scrutinizing the risks that spiking monthly payments could pose to some borrowers who have variable-rate mortgages and considering whether banks should hold more capital against those loans to absorb possible losses from defaults.
The Office of the Superintendent of Financial Institutions cited the possibility of a housing market downturn as the top risk it is watching in the year ahead in its annual outlook, released Tuesday. Superintendent Peter Routledge said OSFI is preparing for “sustained weakness” in housing markets through the rest of 2023 – but not predicting that will happen.
In particular, OSFI is focusing on variable-rate mortgages that have fixed payments over multiyear terms. Those loans were popular among borrowers in recent years, but as interest rates have jumped higher and payments stayed fixed, the amortization periods to pay off those loans have stretched longer – many of them beyond 30 years.
When those mortgages come up for renewal, lenders typically reset amortization periods to their original terms. That triggers a sudden and sometimes severe spike in monthly payments for borrowers.
OSFI said it is “actively assessing the risks” those loans could pose to the financial system, and considering whether the capital banks hold against them is sufficient, “or revisions are warranted.”
“Our concern there is not so much for the immediate term, it’s for two to three years out, as those mortgages mature and need to be repriced,” Mr. Routledge said on a conference call with reporters. “And so what we are asking our institutions right now is to define the size of that risk and to develop strategies for lessening the downside of payment shock.”
Mr. Routledge said many of those mortgages have five-year terms, and in Canada’s current strong employment market, “people’s salaries are going up,” which may help soften the blow when monthly payments jump higher at renewal.
Yet as interest rates weigh heavily on borrowers, he said, “we would expect institutions, as they look at this particular portfolio of loans, to identify where risks in that portfolio are increasing and then put more capital against it.”
On Tuesday, Bank of Canada senior deputy governor Carolyn Rogers told a parliamentary committee in Ottawa that ultralong amortizations are “something to keep an eye on for sure,” and central bank officials asked banks about the issue at a meeting last week. She said banks try to give borrowers options such as refinancing the loan or adjusting payment terms.
“I think the banks are acutely aware that mortgages that are not getting paid down, they’re not amortizing down, is not a sustainable situation over the long term,” Ms. Rogers said. “But as we understand it, they’re working closely with these borrowers.”
What percentage of homeowners have paid off their mortgage?
The outlook OSFI released Tuesday is the second annual edition it has published, and this year’s outlook describes nine key risks, adding two new ones: liquidity and funding risk, which tracks whether banks have sufficient cash and assets that can easily be turned into cash to meet unexpected obligations, and the concern that issues from other, lightly regulated financial institutions could spill over to the closely regulated banking system.
Liquidity and funding risk, ranked second in importance by OSFI, is in sharp focus since a bank run caused Silicon Valley Bank to collapse in March, and Swiss banking giant Credit Suisse AG needed to be rescued through a forced merger with UBS Group AG. The turmoil in banking that followed showed the pressure banks face as monetary policy tightens.
As more banking is done digitally, “the speed and amplitude of investor and depositor reactions” to stresses in the banking system is increasing, OSFI’s report says, challenging banks and regulators to adapt “with agility and urgency.”
The regulator said it “will intensify” its focus on liquidity with screening for early warning signs, reviews of contingency funding plans, and expected revisions to capital and liquidity guidance in the coming months.
So far, “Canadians are servicing a higher cost of debt quite handily” in spite of the run-up in interest rates, Mr. Routledge said. Yet he warned that “we’re not through this yet, risks are still out there, and we’re very, very mindful and alert to them. ... We’re not at all relaxed.”
Commercial real estate was ranked as the third most severe risk in OSFI’s outlook, with office buildings as well as construction and development assets under the most pressure as hybrid work arrangements take hold and demand for housing cools.
Contagion from potential problems at non-bank financial institutions ranked fourth, made more serious by the rapid growth of institutions such as hedge funds, pension funds, insurers and other investment firms. Those institutions often compete with banks for loans and investments, but under lighter regulation, and they are important counterparties to major banks through derivatives and other products.
Risks OSFI ranked fifth through ninth are corporate and commercial credit, digital innovation, climate, cybersecurity and third-party risk.
With reports from Mark Rendell.
James Bradshaw