How Canada’s new mortgage rules could shake up the “shadow banking” sector

Finance Minister Bill Morneau introduced new regulations to try to stem the risk from an overheated housing market. But beware unintended consequences

Finance Minister Bill Morneau speaking in Calgary in January 2016. The Bank of Canada is looking to the federal government for fiscal leadership

Finance Minister Bill Morneau. (Paul Chiasson/CP)

When Finance Minister Bill Morneau unveiled tough new mortgage eligibility criteria for homebuyers and lenders on October 3, the goal was to take some of the energy out of the speculation-driven residential real estate market, especially in large urban regions like Greater Toronto and Vancouver. The changes, which took effect on October 17, will have a significant impact on the country’s mortgage industry, too—either helping fuel the growth in private, unregulated lending or causing a shakeout in that sector, with potentially problematic ripple effects.

The big question now is whether the borrowers turned away by traditional lenders because of the stricter rules will just abandon or delay their home-buying dreams, or seek out more expensive loans issued by the private lenders that are neither regulated nor required to carry mortgage insurance. The answer depends entirely on whether the government’s move succeeds in its goal.

The new guidelines will make it tougher for mid-range buyers to secure loans, especially from banks or “monoline” lenders—regulated financial institutions, such as First National Financial and Equitable Group, that only write mortgages. The rules jack the qualifying rate on all new five-year mortgages for homes under $1 million to the Bank of Canada benchmark—currently 4.64%. Previously, the rule only applied to high-ratio loans, in which down payments are less than 10% of the home’s value. The changes will therefore limit the size of the mortgages some borrowers can take out. The federal government is also adding restrictions on when it will insure low-ratio mortgages, stipulating that such loans must have an amortization period of less than 25 years and that the property must be owner-occupied, among other criteria.

Some lenders say they’ll be taking a big hit from these regulations, regardless of market response. First National—Canada’s largest non-bank mortgage lender, originating $22 billion in loans each year—reacted swiftly, announcing Tuesday that Morneau’s moves will impact about 41% of its insured residential mortgages and that it anticipates a drop of as much as 10% in originations of this kind, because its loans will no longer qualify for insurance. (The company’s stock dropped on the news, and it temporarily halted loans for rental properties and to self-employed people who can’t verify income, according to Bloomberg.)

Some observers predict that such borrowers will be forced to tap networks of small investors who lend through mortgage brokers, as well as mortgage investment corporations—in other words, the most remote corners of Canada’s shadow banking sector, which accounts for 40% of Canada’s banking space. (Loans from non-deposit-taking institutions have doubled since 2012, according to a CIBC report issued last year.) Private, unregulated lending represents a 10th of that total, according to the Bank of Canada.

If real estate speculation continues to boil, especially in Greater Toronto, Morneau’s measures “will force more volume out of the traditional banking space and…into this unregulated space,” predicts credit market analyst Ben Rabidoux, a principal at North Cove Advisors. That shift, in fact, has been underway since 2014, when the feds introduced regulations that made it much more difficult for self-employed individuals and new immigrants with savings but no employment income to obtain mortgages, even if they had substantial down payments.

Such an outcome could prove to be a classic unintended consequence: Morneau’s reforms—meant to reduce or contain the accumulated risk created by precipitously over-leveraged homebuyers—may unwittingly increase the overall systemic risk in the economy by driving red-lined borrowers to the sort of uninsured subprime mortgages that have proliferated in the shadow banking sector. “I think private lending is going to explode,” says Jake Abramowicz, a Toronto mortgage broker. He’s not convinced the new measures will do much to cool the city’s red-hot condo market or affect sales of homes with asking prices above $1 million.

If, on the other hand, the market does cool, as has happened in Vancouver since British Columbia imposed a foreign buyers tax, the supply of capital for loans from private lenders could contract quite rapidly.“Private lenders will readjust their appetite for lending,” predicts Bruce Joseph, president of the Anthem Mortgage Group in Barrie, Ont. “The shadow banking sector may actually shrink.”

Joseph characterizes the capital in this corner of the shadow banking system as “flighty”—so-called mom-and-pop investors attracted by the combination of rising home prices, flat interest rates and the opportunity to offer short-term non-amortized mortgages at 5%, often at loan-to-value ratios exceeding 95%, to desperate borrowers. Rabidoux says he works with mortgage brokers who tell him these unregulated mom-and-pop lenders grew from 4% of their total volume in 2014 to 33% this year: “I know people who borrowed against their homes to invest in these mortgages. There’s all this capital sloshing around.”

Rabidoux adds, “If there’s a downturn, it’s not hard to envision these mom-and-pops asking for redemptions, which means borrowers won’t be able to renew.” For some of the first-time homebuyers who have had to source expensive short-term mortgages in this part of the private-lending sector, he says, it will now become “very difficult” to refinance when rates change. That could lead to an uptick in distressed home sales.

Abramowicz foresees another sort of ripple effect in the event of a market correction: As homeowners with those short-term private subprime mortgages struggle to figure out how to refinance in a much more constrained market, they may opt to default and cut back on consumer spending. “Buyers who are smart won’t go to private lenders,” he says. “They’ll adjust their behaviour.”