Bank regulator proposes heightened scrutiny of mortgage market

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Canada's financial regulator is proposing strict rules to tighten lending practices in the housing sector, a move that could cool the red-hot market after months of warnings about rising consumer debt.

The new rules would require banks to take a closer look at how much a property is worth before issuing a mortgage – and to know more about the monthly finances of borrowers before the money is doled out.

For the first time, the Office of the Superintendent of Financial Institutions has put together a framework on mortgage underwriting principles, which if approved would set extensive due-diligence requirements for lenders.

In particular, the regulator is issuing a warning about home-equity lines of credit, known as HELOCs, and asking banks to do more to ensure that they are thoroughly scrutinizing borrowers.

The move is part of an international effort to avoid another crisis like the subprime mortgage fiasco that clobbered the U.S. economy and major banks. But it comes as the Canadian banking sector is locked in a heated mortgage price war heading into the spring home-buying rush, with five-year fixed rates as low as 2.99 per cent. Lenders are pushing to gain market share while the market remains strong.

"Spring is our busiest season," said Marcia Moffat, head of home-equity financing at Royal Bank of Canada, the country's largest lender. "The competition tends to intensify as we approach the spring market, so that's what you're seeing."

But policy makers and regulators are concerned about the debts consumers are taking on as a result of persistently low rates. The fear in Ottawa is that many borrowers will struggle to keep up their payments once rates rise substantially, posing a threat to banks and the economy. At the same time, economists say that Canada's housing market – most notably in Toronto and Vancouver – is overpriced. If house prices fall at the same time as interest rates rise, borrowers could find themselves under water.

The draft rules, which OSFI put out for comment until May 1, are designed to ensure that banks are collecting detailed information about a borrower's identity, background, and willingness and ability to pay their debts on time. The rules also deal with due diligence the banks should conduct on the value of properties. And OSFI is telling banks that they will have to disclose more information publicly about the risks contained in their mortgage portfolios.

OSFI's guidelines lay out the details that it wants banks to check when considering a mortgage application. They include items such as home heating bills and other variable expenses.

The banks are still digesting the OSFI draft report, but Ms. Moffat said she is supportive of rigorous lending standards. "We have quite a disciplined credit adjudication approach. There's always opportunity to tie things up in a bow, and perhaps that's where this goes."

Unlike the central bank and Finance Department, OSFI does not normally concern itself directly with consumer debt loads. The regulator's job is to protect the safety of banks, not consumers. But it is warning that if consumers take on more debt than they can chew, banks will suffer.

While HELOCs can provide consumers with an alternative source of funds, "these products can also significantly add to consumer debt loads," OSFI said.

Unlike mortgages, which must be paid by a certain date, HELOCs are revolving in nature and that can spur consumers to keep their debt balances higher for longer, and pose "greater risk of loss to lenders," OSFI said. "As well, it can be easier for borrowers to conceal potential financial distress by drawing on their lines of credit to make timely mortgage payments and, consequently, present a challenge for lenders to adequately assess credit risk exposure."

Home-equity lines of credit have risen sharply in recent decades. The growth rate of HELOCs spiked above 30 per cent in 2005, and was above 20 per cent in 2009 but has since levelled off to about five per cent, which is roughly in line with the rate at which mortgages are growing, said Toronto-Dominion Bank chief economist Craig Alexander.

Ottawa took steps to rein in the growth of HELOCs early last year, when Finance Minister Jim Flaherty made a number of rule changes in an effort to cool the mortgage market and prevent borrowers from getting in over their heads. One of the changes was that the government would no longer guarantee mortgage insurance on home equity lines of credit.

That rule change shifted the risk of home equity lines from taxpayers to banks, and it succeeded in encouraging more prudent lending. (Mortgage insurance, the vast majority of which is backed by the government, protects the bank in the event the homeowner defaults.) In its guidance Monday, OSFI told banks that "mortgage insurance should not be a substitute for sound underwriting practices."

RBC's Ms. Moffat said several items beyond the rate need to be looked at when a mortgage is issued, including the flexibility of the terms. "Ultimately it comes down to cash flow," Ms. Moffat said. "You need to make sure that you've got enough flexibility that you can continue to make payments on your mortgage through the term."