OSFI in da House

Warning: longish post dealing with mortgage lending. If you are having trouble sleeping, please read on...

The Financial Post has run a story on OSFI (Office of the Superintendent of Financial Institutions) taking an increasing interest in Canada's housing market (emphasis mine):

Canada’s top banking regulator is on a fact-finding mission to gauge the scope of foreign investment in residential real estate.

Industry sources say the Office of the Superintendent of Financial Institutions is sizing up the market, most likely as part of its active campaign to “stress-test” the country’s big banks to measure how they would be affected by volatility in various market segments.

OSFI is taking a broad look at bank exposure to household debt and how the financial institutions are monitoring loan portfolios amid growing concerns over the ability of Canadians to handle their debt load.

In the case of the housing market, sources point to global trends that could affect investment in Canada — such as China’s recent policies to curb speculative real estate investment in that country — as evidence that Canada is operating in a fast-changing market that could be adversely affected by decisions made in other countries.

They suggest OSFI wants to know how big a factor foreign investment in Canada’s housing market is, and how big it is likely to become, so the regulator can measure the potential impact on banks if demand were to dry up.

“It’s something they are trying to get information on,” said a source close to the situation. “It’s not something they can find out so easily.”

Rod Giles, a spokesman for OSFI, said the regulator does not comment on specific supervisory actions, but he confirmed that the “housing market including real estate linked lending activities” is among a set of “emerging issues, risks and markets across the Canadian financial system” that is being monitored by the Ottawa-based regulator.

I'm not sure the concentration on foreign ownership is the biggest story. It might be for all I know but OSFI seems to be taking a much broader look at bank lending (and likely non-bank lending too, as much as it is able) to ascertain how at risk banks -- and households and government -- are to house price declines. It is interesting to look at what OSFI is likely looking for in terms of the Canadian housing market. Some reasonable possibilities are:

• Total exposure banks have to falling house prices.
• Whether certain regions are contributing to large distortions on banks' balance sheets.
• Whether foreign investors are playing a direct part in leveraged speculative activity.
• What exposure governments may have to falling prices.
• What exposure homeowners may have to falling prices.

OSFI is likely gauging whether banks will themselves be in distress if prices fall nation-wide or in certain regions identified as being in a speculative bubble (like Vancouver). On this front it does not appear so, at first glance. Banks have little exposure to high ratio loans due to the requirement for mortgage insurance. Lower ratio loans are typically on 5 year or less terms so, for the most part, loans can effectively be called before prices drop drastically.

OSFI is likely also determining how exposed the entire economy and the government will be to dropping house prices. CMHC-insured loans are required to have borrowers qualify at the posted 5 year rate even if they take a variable rate mortgage. However there is no explicit requirement that the same longer-term diligence is performed with low-ratio mortgages. According to a mortgage broker friend of mine banks will often qualify people at the variable or "blended" rate for TDSR/GDSR.

On this front, OSFI has some reason to be concerned for homeowners and the government. When rates rise, homeowners may have trouble qualifying at elevated rates. Banks will effectively call the loan on renewal, require mortgage insurance or, in some cases, foreclose or instigate a homeowner to sell on a short timescale for those who don't qualify at the 5 year mortgage rate. In this scenario, the mortgage market experiences a "squeeze" as few will be able to qualify at the higher rates and CMHC-insured loans increase in prevalence as borrowers see their equity vanish. Either way there is incentive for the government to step in with a higher level of guarantee or risks a replay of the credit squeeze of late 2008 and early 2009.

What could OSFI recommend? When it comes to reducing government exposure to falling house prices, OSFI would likely be looking closely at how well TDSR/GDSR for borrowers match up with the 5 year mortgage rate. If there is a discrepancy, I expect some arm-twisting to ensure banks' future loans of all terms can be smoothly transitioned to any other term length.

OSFI could also regiment lending in other ways; for instance, touted recently by Mark Carney in a recent paper (PDF) (hat tip commenter RP1 on The Economic Analyst), using countercyclical capital buffers (where banks are required to keep larger capital reserves when private debt ratios are elevated from their long-term average). It would certainly be embarrassing if the Bank of Canada's governor would preside during a situation of high private debt ratios, experience a subsequent house price crash and concomitant fallout, all without said beneficial countercyclical reserves in place.

See also:

Putting 贰 and 贰 together

Carney says a four letter word