Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), recently unveiled a new proposal detailing changes to Capital Adequacy Requirements (CAR) and the Mortgage Insurer Capital Adequacy Test (MICAT). These changes will impact mortgage lenders and insurers and address the risks related to mortgages in negative amortization.

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Key Highlights

• The OSFI’s new proposal aims to improve the resiliency and stability of the Canadian mortgage finance market.
• The changes would require banks to hold more capital for mortgages in negative amortization.
• The proposed changes could signal a heightened risk for variable-rate mortgages in Canada.

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Overview of the OSFI Proposed New Capital Requirements 

OSFI’s proposal involves two parts: one that impacts lenders with changes to the Capital Adequacy Requirements (CAR) and the second that impacts insurers with changes to the Mortgage Insurer Capital Adequacy Test (MICAT) guidelines. For lenders, these changes mean they will need to hold more capital to align with the increased risk of mortgages in negative amortization with LTVs above 65%. These changes will increase the maximum loan-to-value (LTV) ratio in the MICAT formula for mortgage insurers. This change will align the formula with the highest allowable LTV ratio for insured mortgages, increasing from 100% to 105%.

OSFI New Proposal 

OSFI’s proposal involves two parts: one that impacts lenders with changes to the Capital Adequacy Requirements (CAR) and the second that impacts insurers with changes to the Mortgage Insurer Capital Adequacy Test (MICAT) guidelines. 

For lenders, these changes mean they will need to hold more capital to align with the increased risk of mortgages in negative amortization with LTVs above 65%. These changes will increase the maximum loan-to-value (LTV) ratio in the MICAT formula for mortgage insurers. This change will align the formula with the highest allowable LTV ratio for insured mortgages, increasing from 100% to 105%.

Background on OSFI

OSFI is an independent agency of the Canadian government that was established in 1987. Its primary role is to contribute to the safety and soundness of the Canadian financial system. OSFI supervises and regulates federally registered banks and insurers, trust and loan companies, and private pension plans subject to federal oversight. 

One way OSFI fulfills this mandate is by setting capital adequacy requirements, which are rules that determine how much capital lenders must have on hand to cover the risks they take on.

Summary of Proposed Changes

One of the main takeaways from OSFI’s proposed changes is the emphasis on managing the risk of mortgages in negative amortization. Lenders will need to hold more capital to align with the increased risk associated with these loans, particularly those with a loan-to-value (LTV) ratio above 65%.

Potential Impact on Mortgage Lenders and Insurers

For mortgage lenders, the changes will mean holding more capital to cover the increased risk associated with negative amortization mortgages. This could lead banks to reduce the number of mortgages that are at risk of falling into negative amortization, thereby indirectly protecting consumers from the potential downsides of these types of loans. 

Mortgage insurers would be subject to higher requirements for mortgages with balances that have grown to more than the original loan amount. The changes are proposed to align the MICAT capital formula from 100% with the maximum permitted LTV ratio for insured mortgages of 105%. 

Why OSFI is Proposing Changes? 

OSFI’s primary goal with these proposed changes is to ensure lenders have sufficient capital to manage their risks effectively. By requiring more capital for mortgages in negative amortization, the regulator hopes to improve the resilience of the Canadian mortgage finance market. The suggested proposal will encourage banks to reduce the number of mortgages that would otherwise go into negative amortization. 

Why Do Variable-Rate Mortgages (VRM) Signal Risk in Canada? 

Due to their unpredictability, variable-rate mortgages (VRMs) can be risky for lenders and borrowers. As interest rates fluctuate, so does the interest on VRMs, while their monthly payments remain unchanged. This can be especially problematic in an environment where interest rates are rising, as it can significantly increase the interest component on their monthly payments without impacting the total monthly payment. 

Overview of Variable-Rate  Mortgages

VRMs are mortgages where the interest rate can change over the loan term while mortgage payments remain the same. VRMs can be attractive to borrowers when mortgage rates are low or expected to fall, but they can also pose risks if interest rates rise. As mortgage rates increase, initially, this decreases the amount going toward the principal, and then even the interest portion of the mortgage payment is no longer covered, increasing your amortization. 

Negative Amortization for VRMs

Negative amortization occurs when the loan balance increases rather than decreases over time. This can typically occur with VRMs if the interest rate rises to the point where the borrower’s mortgage payment is insufficient to cover the interest portion. The unpaid interest is added to the loan balance, which leads to hitting your trigger rate or trigger point and negative amortization.

Benefits and Drawbacks of VRM Mortgages for Consumers

Variable-rate mortgages can offer benefits, such as lower initial interest rates compared to fixed-rate mortgages and the potential to save money if interest rates fall. However, they also come with risks, including the potential for higher payments if interest rates rise and the risk of hitting trigger rates, trigger points, and negative amortization.

Impacts on the Canadian Mortgage Finance Market

The proposed changes by the OSFI could have an impact on the Canadian mortgage finance market. By requiring lenders to hold more capital for risky loans, they will have less money available to lend out, which means they will make less money. This could mean that they will, in turn, price this risk into mortgage rates and pass the cost on to borrowers to make up for any potential losses.

Potential Risks to Borrowers and Mortgage Holders

The question remains: Will the risk posed by borrowers holding VRMs affect only those types of mortgage holders or everyone as a whole? It’s very likely that mortgage rates as a whole may be impacted since the bottom line for lenders’ revenues is reduced.

The changes will not increase monthly payments for mortgage holders. However, there could be potential risks for borrowers seeking new loans, particularly those considering variable-rate mortgages. As OSFI raises capital requirements for risky loans, lenders may become more conservative in their lending practices, potentially making it harder for some borrowers to get approved for a loan.

Risk to Uninsured Mortgage Holders

The proposed changes could impact uninsured mortgage holders with a 20% or more down payment. As lenders are required to hold more capital for risky loans, they may tighten their lending requirements and increase interest rates and fees, passing on the additional risks in the pricing of interest rates. 

Risk to Current Mortgage Term Holders

For those who currently have a mortgage term, the proposed changes will not increase mortgage payments. However, when it comes time to renew their mortgage, they may find that lenders have tightened their lending requirements and increased interest rates due to the increased capital requirements.

Risk to Contract Mortgage Rate Holders

Contract mortgage rate holders or those who qualified before the stress test requirements came into effect could also be impacted by the proposed changes. If lenders have tightened their lending requirements, they may find refinancing or renewing their mortgage harder and face higher interest rates.

Frequently Asked Questions

Welcome to our Frequently-Asked Questions (FAQ) section, where we answer the most popular questions designed and crafted by our in-house mortgage experts to help you make informed mortgage financing decisions.

Final Thoughts

The proposed changes by the OSFI signal a proactive approach toward managing potential risks in the Canadian mortgage market. While these changes could lead to tighter lending requirements and possibly higher mortgage rates as lenders price in these changes to their risk management models 

OSFI’s proposed changes aim to increase the market’s resilience and protect consumers. As such, they represent a significant step towards ensuring the stability of Canada’s financial system. While these regulation changes may remedy past errors and rebuild Canadians’ eroded trust in their financial future, they will undoubtedly impact and tighten mortgage pricing, qualification, and processes.

If you’re ready to set out on your homeownership journey or mortgage renewal, why wait for these proposals to come into effect, better yet, why not reach out to nesto’s mortgage experts today to find your best mortgage rate.

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