Backgrounder Residential Mortgage Insurance Strength of the Canadian Housing and Mortgage Markets
Canadian housing and mortgage markets are performing well:
- • Current Canadian house prices are in line with economic factors such as low interest rates, rising incomes and a growing population, a view supported by the International Monetary Fund.
- • Demand for residential housing continues to be strong. For example, housing starts are expected to remain above the 200,000 mark for the seventh consecutive year.
- • The percentage of bank mortgages in arrears1 is stable at 0.27 per cent, near the lowest levels experienced since 1990 and well below the highs of 0.65 per cent experienced in each of 1992 and 1997.
The historically prudent and cautious approach taken by Canadian financial institutions to mortgage lending, combined with a sound supervisory regime, has allowed Canada to maintain strong and secure housing and mortgage markets. Sub-prime2 mortgage origination has been low in Canada, comprising less than 5 per cent of the market in recent years. As a result of the conservative approach taken by domestic lenders, and the resulting relative strength of the domestic housing and mortgage markets, Canadians have benefited from broad access to world-class mortgage finance products at competitive prices.
Recent Developments in the Mortgage Market
Since the fall of 2006, the mortgage markets have experienced a period of accelerated financial innovation. The marketplace has been quick to adopt these innovations, which permit such features as:
- • Longer amortization periods (from 25 years up to 40 years).
- • Higher loan-to-value ratio loans (up to 100 per cent).
- • Niche products for near-prime3 borrowers.
1Most lenders generally consider a mortgage to be in arrears after three missed monthly payments.
2A "sub-prime" borrower is one whose record of managing credit is weaker than the industry standard for mortgage lending.
3The "near-prime" market is made up of borrowers whose record of managing credit is close to the industry standard for mortgage lending, but still below that standard.
4"Low-ratio" mortgages are loans with a loan-to-value ratio of less than 80 per cent at the time of origination.
5Less stringent requirements will also apply to low-ratio mortgages that are insured as portfolios.
- • Streamlined loan documentation requirements with respect to borrowers' income and employment.
What is Mortgage Insurance?
Mortgage insurance (which is sometimes called mortgage default insurance) is a credit risk management tool that protects mortgage lenders from losses on mortgage loans. If a borrower defaults on a mortgage, and the proceeds from the foreclosure of the property are insufficient to cover the resulting loss, the lender will submit a claim to the mortgage insurer to recover its losses.
Role of Mortgage Insurance
The law requires federally regulated lenders to obtain mortgage insurance on loans where homebuyers make down payments of less than 20 per cent of the purchase price of the home (i.e., high loan-to-value ratio loans). Lenders generally require high-ratio borrowers to pay for the premium for the mortgage insurance, which can be added to the mortgage balance.
Mortgages are sometimes insured after origination through what is often called "portfolio insurance." High- and low-ratio4 mortgages are often combined to create a portfolio that is sold to investors (i.e., securitized).
How is the Government Involved in Mortgage Insurance?
Mortgage insurance is available to regulated and unregulated lenders in Canada from Canada Mortgage and Housing Corporation (CMHC) and from private mortgage insurers. Since CMHC is a Crown corporation, the Government is ultimately responsible for all of CMHC's obligations including its mortgage insurance claims.
To make it possible for private insurers to compete effectively with CMHC, the Government also backs private mortgage insurers' obligations to lenders through guarantee agreements that protect lenders in the event of default by the insurer. The Government's backing of private insurers' business that is eligible for the guarantee is subject to a deductible equal to 10 per cent of the original principal amount of the mortgage loan.
The New Mortgage Insurance Guarantee Framework
The new mortgage insurance guarantee framework will establish a boundary on the risk characteristics of the mortgage and of the borrower that are acceptable when the Government guarantees the mortgage insurance policy. These requirements will apply to all government-backed mortgage insurance policies (whether issued by CMHC or private insurers) for high-ratio mortgages5 on residential properties with up to four units.
6 Reducing amortization from 40 years to 35 years on a mortgage loan of $200,000 with a 6 per cent interest rate results in a $41 increase in a borrower's monthly payment, but the borrower will save $49,000 in interest payments.
The Key Amendments to the Mortgage Insurance Guarantee Framework
There are four mortgage and borrower characteristics that define the key parameters of the new mortgage insurance guarantee framework:
A) Loan-to-Value Ratio
Government-backed insurance is currently available on mortgages where the loan-to-value ratio is up to 100 per cent. This limit will be reduced to 95 per cent. Borrowers may borrow the 5 per cent down payment, but it will not be insured under the new guarantee framework.
B) Amortization Period
Amortization is the period or length of time it will take to pay off the entire mortgage loan. The amortization period should not be confused with the "term" of the mortgage, which sets out the period over which a fixed interest rate or variable rate option will apply. A typical mortgage has a term of five years but an amortization period that is usually much longer.
The maximum amortization period for mortgages insured with government backing will be reduced from 40 years to 35 years.6
C) Credit Score
A credit score is a numerical value that measures a borrower's credit risk at a given point in time based on a statistical evaluation of information in the individual's credit file. It has been proven to be predictive of loan performance and is considered by some mortgage insurers and lenders to be the single best determinant of default risk. Credit scores are well-established industry tools and are generated in Canada by three private firms.
Canadian lenders have not originated many government-backed mortgages for borrowers with low credit scores. To ensure this practice continues, the new framework will establish a credit score floor of 620. There will also be a limited "basket" to provide for exceptions to this rule, recognizing that there are some borrowers with credit scores below 620 that otherwise represent low credit risks.
7This includes high-ratio mortgages that begin with "interest-only" payments and home equity lines of credit (HELOCs).
8Total debt service ratio is the proportion of gross income that is spent on debt service and housing-related fixed or essential payments.
D) Loan Documentation
The initiative also includes minimum loan documentation standards to ensure that there is evidence of reasonableness of property value and of the borrower's sources and level of income.
E) Other Parameters
The new guarantee framework also includes other parameters that are required to give full effect to the initiative. These include:
- • Excluding high-ratio mortgages where no amortization is required in the first few years from the government guarantee.7
- • Setting a maximum of 45 per cent on borrowers' total debt service ratio.8
Moving to the New Framework
The new mortgage insurance guarantee framework is planned to take effect October 15, 2008. This would allow existing mortgage pre-approvals with the common 90-day duration to be used or expire. Exceptions would be allowed after October 15 where they are needed to satisfy a binding purchase and sale, financing, or refinancing agreement entered into before October 15, 2008.
Consultations with the Mortgage Industry
During the transition period, the Department of Finance will consult with industry stakeholders about the implementation of the new mortgage insurance guarantee framework.
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