Morneau's Big Guns Aimed At Housing

Yesterday, Ottawa unveiled major initiatives to slow housing activity both by potentially discouraging foreign home purchases and, more importantly, by making it more difficult for Canadians to get mortgages. As well, the Finance Minister is limiting the degree to which mortgage lenders can buy portfolio insurance on mortgages with downpayments of 20% or more. Ottawa has clearly taken out the big guns to slow housing activity, which is widely considered to be too strong in Vancouver and Toronto. Ironically, home sales have already slowed precipitously in Vancouver in recent months and the BC government introduced a new 15% land transfer tax on foreign purchases of homes effective August 6, the effects of which are yet to be fully determined. 

The measures announced by Finance Minister Morneau are more far reaching than anything considered to date and could well have quite a significant impact. Not only are these initiatives intended to close loopholes for foreign investors, which might help to make housing more affordable for domestic purchasers, but they will actually make homeownership less attainable for the marginal borrower, which is often younger Canadian first-time home buyers. 

Officials at the Department of Finance have been studying the housing market and have led a working group with municipalities and provinces, as well as federal agencies such as the Office of the Superintendent of Financial Institutions (OSFI) and Canada Mortgage and Housing Corporation (CMHC). This in-depth analysis has informed today’s announcement. 

 Measures Aimed At Foreign Homebuyers

• The income tax system provides a significant income tax benefit to homeowners disposing of their principal residence, in the form of an exemption from capital gains taxation. 
• An individual who was not resident in Canada in the year the individual acquired a residence will not—on a disposition of the property after October 2, 2016—be able to claim the exemption for that year. This measure ensures that permanent non-residents are not eligible for the exemption on any part of a gain from the disposition of a residence.
• The Canada Revenue Agency (CRA) will, for the first time, require all taxpayers to report the sale of a property for which the principal residence exemption is claimed. 

Measures Affecting All Homebuyers

The Finance Department says in its press release that, "Protecting the long-term financial security of Canadians is a cornerstone of the Government of Canada’s efforts to help the middle class and those working hard to join it." This is a "Nanny State" measure to protect people from themselves, as the Bank of Canada has long been concerned about the growing number of households with excessive debt-to-income ratios. It will make housing less attainable, at least in the short run. If it, therefore, substantially reduces housing demand, home prices could decline, ultimately improving affordability. This, of course, is not what the 70% of Canadian households that already own a home would like to see.

• Broadened Mortgage Rate Stress Tests: To help ensure new homeowners can afford their mortgages even when interest rates begin to rise, mortgage insurance rules require in some cases that lenders “stress test” a borrower’s ability to make their mortgage payments at a higher interest rate. Currently, this requirement only applies to a subset of insured mortgages with variable interest rates (or fixed interest rates with terms less than five years). Effective October 17, 2016, this requirement will apply to all insured mortgages, including fixed-rate mortgages with terms of five years and more. 
• A buyer with less than 20% down will have to qualify at an interest rate the greater of their contract mortgage rate or the Bank of Canada’s conventional five-year fixed posted rate. The Bank of Canada’s posted rate is typically higher than the contract mortgage rate most buyers actually pay. As of September 28, 2016, the Bank of Canada posted rate was 4.64%, compared to roughly 2% or so on variable rate mortgages.

For borrowers to qualify for mortgage insurance, their debt-servicing ratios must be no higher than the maximum allowable levels when calculated using the greater of the contract rate and the Bank of Canada posted rate. Lenders and mortgage insurers assess two key debt-servicing ratios to determine if a homebuyer qualifies for an insured mortgage:

• Gross Debt Service (GDS) ratio—the carrying costs of the home, including the mortgage payment and taxes and heating costs, relative to the homebuyer’s income;
• Total Debt Service (TDS) ratio—the carrying costs of the home and all other debt payments relative to the homebuyer’s income.

To qualify for mortgage insurance, a homebuyer must have a GDS ratio no greater than 39% and a TDS ratio no greater than 44%. Qualifying for a mortgage by applying the typically higher Bank of Canada posted rate when calculating a borrower’s GDS and TDS ratios serves as a “stress test” for homebuyers, providing new homebuyers a buffer to be able to continue servicing their debts even in a higher interest rate environment, or if faced with a reduction in household income. 

The announced measure will apply to new mortgage insurance applications received on October 17, 2016 or later.

• Tighter Mortgage Insurance Rules

Lenders have the option to purchase mortgage insurance for homebuyers who make a down payment of at least 20% of the property purchase price, known as “low-ratio” insurance because the loan amounts are generally low in relation to the value of the home. There are two types of low-ratio mortgage insurance: transactional insurance on individual mortgages at the point of origination, typically paid for by the borrower, and portfolio (bulk pooled) insurance that is acquired after origination and typically paid for by the lender. The majority of low-ratio mortgage insurance is portfolio insurance.

Lender access to low-ratio insurance supports access to mortgage credit for some borrowers, but primarily supports lender access to mortgage funding through government-sponsored securitization programs.

Effective November 30, 2016, mortgage loans that lenders insure using portfolio insurance and other discretionary low loan-to-value ratio mortgage insurance must meet the eligibility criteria that previously only applied to high-ratio insured mortgages. New criteria for low-ratio mortgages to be insured will include the following requirements:

1. A loan whose purpose includes the purchase of a property or subsequent renewal of such a loan;
2. A maximum amortization length of 25 years;
3. A maximum property purchase price below $1,000,000 at the time the loan is approved;
4. For variable-rate loans that allow fluctuations in the amortization period, loan payments that are recalculated at least once every five years to conform to the original amortization schedule;
5. A minimum credit score of 600 at the time the loan is approved;
6. A maximum Gross Debt Service ratio of 39 per cent and a maximum Total Debt Service ratio of 44 per cent at the time the loan is approved, calculated by applying the greater of the mortgage contract rate or the Bank of Canada conventional five-year fixed posted rate; and,
7. A property that will be owner-occupied.

These tighter mortgage insurance regulations will reduce the supply of mortgages and/or increase their cost to the borrower.

Consultation on Lender Risk Sharing

The Government announced that it would launch a public consultation process this fall to seek information and feedback on how modifying the distribution of risk in the housing finance framework by introducing a modest level of lender risk sharing for government-backed insured mortgages could enhance the current system.

Canada’s system of 100% government-backed mortgage default insurance is unique compared to approaches in other countries. A lender risk sharing policy would aim to rebalance risk in the housing finance system so that lenders retain a meaningful, but manageable, level of exposure to mortgage default risk.

This proposal by CMHC has been floated for some time and, needless to say, the Canadian Bankers' Association, is against it. The measure would certainly increase the risk associated with funding mortgages and therefore likely increase the capital required to be set aside against this additional risk. Therefore, in essence, it increases the cost to the lenders to finance mortgages. The lenders will undoubtedly attempt to pass off this increased cost to the borrower or reduce its supply of credit. Right now, the cost of mortgage insurance is borne by the taxpayer.

Bottom Line: These are very meaningful initiatives to slow housing demand, making it more difficult for Canadians to borrow. Finance Minister Morneau has taken out the big guns. I have no doubt that the pace of mortgage lending will slow from what it would otherwise be as a result of these government actions. However, these actions do nothing to address the shortage of housing supply in Vancouver and Toronto.

Housing has been a very important pillar for the Canadian economy, especially at a time when oil price declines have decimated the oil sector and manufacturing continues to struggle. This is a case of being very careful what we wish for-- I'm concerned that we might see more of a slowdown in housing than the government was counting on, which will certainly affect jobs and growth and reduce tax revenues at a time when budget deficits are mounting and fiscal stimulus has yet to do its job.