OSFI warns of longer-term risks as banks extend mortgage terms to help borrowers

Canada’s banking regulator is warning that although extensions to mortgage payment periods have helped borrowers absorb surging costs, the fix is short-term and will keep them in debt for longer, threatening both their financial stability and that of the banking system.

In remarks during a conference hosted by the CD Howe Institute on Thursday, Tolga Yalkin, an assistant superintendent at the Office of the Superintendent of Financial Institutions, said higher costs of borrowing and a potential recession could deal a blow to already stretched homeowners and spur defaults.

“It won’t surprise you to hear that we are not wearing rose-coloured glasses. The growth in highly leveraged borrowers increases the risk of weaker credit performance,” Mr. Yalkin said. “While lending institutions are well capitalized and financially resilient, the higher cost of borrowing – and any potential economic downturn – could lead to more borrower defaults, potentially a disorderly market reaction, and even broader economic uncertainty and volatility.”

While many lenders have allowed variable-rate mortgage holders to extend their amortization periods to keep payments from soaring as interest rates climb, Mr. Yalkin said the measure addresses only short-term affordability concerns, while leaving borrowers to pile up even more debt and accrue higher interest payments.

Most of the big Canadian banks offer variable-rate mortgages with fixed monthly payments – meaning that, when interest rates rise, more of the borrower’s monthly payment is used to cover the interest expense and less goes toward repaying principal. The mortgage payment remains constant because the amortization period is extended.

“We have been clear that we appreciate lenders working with clients to help them stay in their homes while ensuring actions taken remain within the institution’s risk appetite, which we recognize can sometimes be a challenging path for lenders to navigate,” Mr. Yalkin said.

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Amortization periods have been climbing at many of the big banks. In January, the proportion of residential mortgages with amortization periods longer than 30 years reached 32 per cent at Bank of Montreal BMO-T, 30 per cent at Canadian Imperial Bank of Commerce CM-T, 29 per cent at Toronto-Dominion Bank TD-T, and 25 per cent at Royal Bank of Canada RY-T, according to their regulatory filings.

In January, OSFI proposed tougher lending requirements that would make it even harder to get approved for a mortgage. Those changes, which the regulator is still considering, would tighten underwriting rules by limiting the share of highly leveraged borrowers a bank can have in its mortgage portfolio, toughening debt servicing metrics and bolstering the mortgage stress test for riskier loans.

The stress test requires borrowers to prove they can make their monthly payments at interest rates at least two percentage points higher than their actual mortgage rates. Many first-time homebuyers have been priced out of the market as a result of higher borrowing costs and tight lending requirements. For the same reasons, homeowners have had difficulty renewing their mortgages. They need to be stress-tested if they switch banks or change their mortgage terms.

Critics have questioned the need for these measures, saying that low delinquency rates demonstrate that tighter underwriting standards are unwarranted and overly restrictive. But OSFI would rather take the initiative in addressing potential issues, Mr. Yalkin said, especially since, as he put it, “arrears are a lagging indicator of risk.”

“We wouldn’t be doing our job as the prudential regulator if we assume past credit performance will be future,” he said. “And low delinquency rates can quickly turn, as we saw in the 2008 global financial crisis in the U.S.”

He also highlighted OSFI’s January proposal to apply stricter requirements to a lender’s overall mortgage portfolio, in addition to requirements measured against individual borrowers’ mortgage applications, such as the stress test.

Mr. Yalkin said this could give lenders more leeway to approve a certain number of loans that exceed any new thresholds. The consultation period on the proposed adjustments to the regulator’s guidelines, known as B-20, ends Friday, and OSFI is planning to release a report on the feedback it has received from industry stakeholders.

“We at OSFI understand that the decisions we make around B-20 affect a large number of Canadians,” he said. “We really do believe that this early form of consultation will help us better land in an optimal place where Canadians have access to mortgages and we continue to have a resilient lending sector.”