New restrictions brought in to cool the real estate market are having unintended effects.
Overheated real estate markets are seeing regulators tighten restrictions to ensure buyers can sustain interest rate fluctuations as well as the debt load they take on to buy a house. Much of the attention has been focused on the management and limitations on money borrowed to finance the purchase of homes. The Bank of Canada has expressed concerns over highly indebted households. And the bank regulator, the Office of the Superintendent of Financial Institutions, is further protecting banks from negative impacts that can result from lending in volatile market conditions.
The intended result is that it has become more difficult for the average buyer to secure a mortgage from traditional institutions. And although the controls are aimed at the two major overheated markets — Toronto and Vancouver — they do affect purchases across the country where some markets have been struggling.
A perhaps unintended consequence is that more people are seeking out alternative means to finance homes, such as private lenders, which are not subject to the federal banking regulations. The concern is that the risks the new guidelines are designed to reduce are now being transferred to the shadow banking market — a vast network of non-bank lenders from credit unions to private investors that are not subject to the same tough regulations as the banks.
“I think the government of Canada has a number of times expressed concerns with the state of Canada’s mortgage market,” observes Adam Jackson, a structured finance lawyer with Blake Cassels & Graydon LLP in Toronto. “OSFI itself has said they are concerned with elevated financial risks for Canadian banks in the current market; in particular, the losses that some Canadian banks might ultimately be exposed to if the Canadian housing market deteriorated.”
There is concern, however, that many of the new restrictions are responding to the activity in the Vancouver and Toronto areas, making it difficult for those in other areas coming out of an economic slump. Calgary, says Walsh LLP residential real estate lawyer Lou Pesta, sees itself as collateral damage to the increased restrictions.
“The Alberta market has been quite subdued in contrast to Vancouver and Toronto over the last two or three years over the depressed energy prices and the feeling is we’re just lost in the shuffle,” says Pesta. “There’s a concern that Ottawa may just kill us in terms of putting up obstacles that are not really designed to deal with us.
“It’s a difficulty the federal government faces because they want those rules to be consistent across the country but they have different markets across the country, quite dramatically different markets,” he adds. “It is a bit of a source of frustration here.”
As the area deals with “the new reality” of cheaper oil, the city’s real estate market is seeing some sustained growth, with sales up 10 per cent over last year with modest price increases. They see no big oil boom on the horizon and there is no sense of an impending runaway market in Calgary, Pesta says. Restrictions on approvals and rule changes make it more difficult for people to qualify for mortgages and there are fears that may impact the area’s recovery.
In Halifax, there is also a feeling that the series of initiatives will slow down a market not in need of being slowed down. Persistently low interest rates and fewer controls meant that many first-time homebuyers could get more bang for their buck buying larger houses. Now, there are challenges as people try to upgrade, observes Allen Campbell, whose Halifax law practice with BOYNECLARKE LLP largely involves residential real estate.
From the historical perspective, Campbell sees any interest rate of less than eight per cent as pretty good. So he asks his clients to look at the equity of the home to plan for an upward climb in interest rates. But he has noticed that, as restrictions are ushered in, there is an uptick in second mortgages, credit union work and more activity involving secondary lenders.
That likely is directly related to the fact that obtaining a mortgage is becoming increasingly more challenging with the rule changes, says Toronto real estate lawyer Sarita Samaroo-Tsaktsiris, founder of SST Law Firm. In addition to the big banks and other lenders such as smaller banks and credit unions, private lenders are also playing a role, she says, often helping to finance short-term loans. So while banks typically give a loan-to-value ratio of 80 per cent, non-bank and private lenders are not subject to federal regulation and could extend loans that reflect up to 95 per cent of the value of the property.
“Given now that the stress test has increased, people have to seek out other means of financing. There are not the stringent requirements that the institutions have or even the B-lenders have. Private lenders just simply require that there is equity in the property and they don’t look as much at your income and your ability to pay as they do the equity that’s available in the property,” says Samaroo-Tsaktsiris, who often acts for those lenders.
She says there are risks for lawyers because the legal insurer providing coverage for lawyers in Ontario doesn’t provide protection for claims or losses incurred by private lenders. So she’s instituted a series of procedures and policies she expects her lender clients to follow. That includes having an information statement confirming the first mortgage is in good standing and there are no arears. She also requests a tax certificate, a status certificate to ensure that common element expenses are paid to date, a proper appraised value of the property and a request for an assignment of the rent registered on title to ensure rent can be collectable by the lenders in the event of default on rental property.
Deals have been declined as well in instances where outstanding judgments have been uncovered during execution searches. “There are requirements; it’s just that they’re not as stringent as an institutional lender’s requirement,” she says. “As long as you have done your due diligence searches to ensure that in fact everything is in good standing and there will not be an interest ahead of your private lenders interest, then, typically, it’s safe to act for private lenders.”
Ontario’s law society does require additional paperwork to confirm that the lawyer doesn’t provide any advice on any losses they may incur. But seeking permission from the primary lender isn’t a requirement. If future controls of non-banking lenders are considered, she adds, stipulation might serve the purpose.
Some borrowers will pay the higher interest rate and fees to hedge against the market to leverage property for equity, adds Ali Sodagar, a Vancouver lawyer with Sodagar & Company Law Corporation who works with private and syndicated lenders. He believes that market is growing, with plenty of borrowers looking elsewhere as federally regulated institutions use more stringent approval criteria.
And although the loans are backed by an appraisal report, there are inherent risks, so both sides need to be informed in private financing deals and ensure all the players have independent legal advice. He expects that more players, including pension funds, may also get in on the game. “At some point, they [regulators] need to recognize as well that if we tighten this up too much, it may just create another problem,” he says. “The landscape may change or shift, there may be more private lenders; but by the same token, you’re going to find more of the pension funds perhaps participating.”
A syndicated mortgage, which involves a borrower going to more than one place to access money, is likely to become more common as purchasers search for alternative forms of funding, says Anar Dewshi, principal of Dewshi Law where she practises real estate law. “If the main banks don’t take you, then what options do you have?” she says. “With any mortgage transaction, you have to tell them what the risks are. With this there’s increased risk, because it is a private mortgage with a higher interest rate.”
And while the OSFI stresses that it does not regulate non-bank lenders, Jackson believes there is some potential for its new guidelines to have an impact upon some of its residential real estate lending business. Many of the non-bank financial institutions also finance their businesses with the banks, by way of securitization. “What this guideline says is that any banks that acquire mortgages originated by a third party, including from a non-bank originator, have to make sure that the underwriting standards of that third party are consistent with the bank standard and the guideline.
“So what that means is the non-bank originators will also have to ultimately comply with the new rules, even though they’re not directly regulated by OSFI, if they want to sell mortgages to the banks,” says Jackson. Although that still leaves organizations that raise money outside of the banking structure free of those restrictions. “That doesn’t mean that they have to comply if they don’t sell mortgages to the bank, so arguably there’s an opportunity here for non-bank originators because if you aren’t a bank and you have other sources of liquidity to finance your business that don’t require a sale of mortgages to the bank, you could, for example, lend without stress-testing to a borrower that’s not insured without applying a more rigorous stress test.”
Bank regulator tightens rules
Last year, the Office of the Superintendent of Financial Institutions, which regulates Canada’s banks and mortgage insurance companies, responded to record levels of household indebtedness and growing risks and vulnerabilities in some housing markets, circulating a letter to the industry noting that it would increase its scrutiny in the areas of income verification, non-conforming loans, debt service ratios, appraisals and loan-to-value ratio calculations and institutional risk appetite.
The OSFI placed an even greater emphasis on confirming that financial institutions conduct prudent mortgage underwriting, and that their internal controls and risk management practices are sound and take into account market developments, says spokeswoman Annik Faucher. Implementation of the new guidelines was set to be announced this fall.
A stress test previously required for insured mortgages is now to be extended to uninsured mortgages. That includes a stress interest rate for all variable and fixed-rate mortgages. Also, the qualifying rate for all uninsured mortgages should be the contractual mortgage rate plus two per cent. There is also a focus on loan-to-value measurements and in valuing property for mortgage underwriting. The OSFI also indicated it wants to prohibit co-lending arrangements designed to circumvent regulatory requirements. The move follows the Bank of Canada’s long-awaited boost in interest rates this summer, resulting in higher mortgage rates.