Three months ago, Finance Minister Jim Flaherty told banks to tighten lending on their own. Now he’s doing it for them.

The Department of Finance (DoF), in concert with OSFI, released a buffet of mortgage rules Thursday. By our count, there are eight salient changes that, when combined, will have a measurable impact on housing.

The motivation for these moves is captured in Flaherty’s press briefing comment: “I have been listening to the market, and quite frankly I don’t like what I hear.” Loose translation: The debt and housing train is in danger of running off the rails.

The DoF’s solutions to this problem will influence our market for years to come. Below are 20 musings on the new mortgage rules, sprinkled with a few tips and predictions:

1. Hurried Implementation:

The government knew full well that borrowers would try to front-run these restrictions. So it provided only 18 days lead time until the changes take effect. Most lending execs had no idea that new mortgage insurance rules were imminent. As a result, lenders were not fully prepared.

Because of this, and because banks like to appear prudent to regulators, there’s a chance some lenders may implement rules (like the 25-year amortization restriction) before the July 9, 2012 deadline.

2. The Stampede:

Seemingly every mortgage adviser in the country is blasting out emails advising clients about these changes. The sense of urgency will spike mortgage volumes near-term. But high-ratio borrowers who rush to get a 30-year amortization or 85% loan-to-value (LTV) refi should be warned:

Underwriting during the interim period (June 21-July 8) may be especially vigilant, in an effort to weed out the marginal borrowers who spring from the woodwork

For the next three weeks, the lenders with the best rates, or those that are less efficient or less staffed, could have abnormal underwriting delays (keep that in mind if you have financing condition deadlines)

In most cases, mortgage rule changes are not a reason to rush a home purchase.

3. Rate Warfare:

If you’re a well-qualified borrower, you’ll be happy to know that you just became more appealing to lenders. These rules will shrink the pool of prime borrowers. As a result, we’ll see bankers and brokers battle harder for your business. That means the rate wars that Flaherty “discourages” will intensify, whether banks publicize it or not.

4. Side-Effects:

Shorter amortizations, higher qualification rates and lower debt ratio limits will restrict buying power. To that, Flaherty says: “Good. I consider that desirable.”

Canada’s 9.6 million existing homeowners, however, may not deem it so desirable—not if these actions trigger a bigger or longer-than-normal selloff that jeopardizes their home equity.

Equity is the biggest source of retirement savings for millions of Canadians. For this reason, even Flaherty would admit that these proposals are essentially a calculated gamble.

On the other hand, waiting for the market self-correct has its own risks, namely a much longer economic recovery if the speculative balloon is punctured.

Either way, the market is propelled by payment affordability. Reducing buying power will weigh on prices. Whether other supply/demand factors offset this pressure is unknowable.

The DoF wants Canadians to believe the side-effects won’t be extreme. And, if market reaction is anything like the 2008, 2010, and 2011 mortgage changes, it won’t be.

Flaherty states that “less than five per cent of new home purchasers” will be affected by these changes. If he simply means buyers of brand new homes, five per cent equals ~9,600 people a year (based on CAAMP’s 2012 housing starts estimates).

If Vegas made an over/under line on that 5% figure, we’d bet the “over.”

In the new-build market, there are 95,000 first-time buyers each year alone. If you include new and resale purchases, there are roughly 261,000 newbie buyers annually. These are people who are disproportionately affected by these changes, albeit a minority of them.

On top of this you have a minimum of five per cent of repeat buyers (20,000+ a year) that will likely be curtailed by the rule changes to amortizations, qualifications rates, stated income, and debt ratios.

5. The Amortization Effect:

Reducing amortizations to 25 years from 30 chops the maximum theoretical mortgage by roughly 9% (versus ~7% when amortizations dropped from 35 to 30 years). That’s equivalent to paying almost 1% more on your mortgage rate.

Put another way, a qualified family earning $75,000, with no debt, will qualify for $49,000 less mortgage by being forced to take a 25-year amortization.

According to CAAMP, 40% of new mortgages last year had amortizations over 25 years. Of all the new rules, this will have “the most direct impact on the Canadian housing market,” states RBC. It “will raise the barrier to entry into Canada’s housing market.” (That is Flaherty’s point, of course.)

TD thinks it could take up to a year for changes like this to negatively impact prices. But some expect a more imminent result.

Robert Kavcic of BMO Nesbitt Burns notes: “After the 35-year amortization was eliminated last March…existing home sales fell by more than 3 per cent over the subsequent two months.”

6. Market Stability:

Most industry observers, ourselves included, believe in the merits of shifting some housing risk to the private sector and building savings rates. “Our economy cannot . . . depend indefinitely on debt-fuelled household expenditures, particularly in an environment of modest income growth,” explains BoC chief Mark Carney.

The government adds that these new rules will bring “long-term stability” to Canada’s real estate market. Note: They say “long term” because they know the effects could be adverse in the short term. The DoF calls that risk “manageable,” however.

Home prices, which are already self-correcting in various regions, will see additional pressure as payment affordability drops. (Ironically, a correction in prices would then, in theory, improve affordability.)

Flaherty has “tapped the brakes at precisely the right time,” says BMO CEO Frank Techar. From our viewpoint it’s more like stopping short than a little tap.

All one can hope for is that the brakes don’t lock up, with mortgage affordability being so intimately related to home prices.

That’s partly why the Canadian Association of Accredited Mortgage Professionals (CAAMP) feels the government has “overreached” with this latest round of changes. In a statement Thursday it said:

“CAAMP believes that Canadians understand the importance of paying down their mortgages. These changes, together with new OSFI underwriting guidelines…may precipitate the housing market downturn the government so desperately wants to avoid.”

But heck. With housing-related activity comprising 1/5 of GDP and resale housing adding ~$20 billion in spending and 165,000+ jobs this year, what’s the worst that could happen?

7. So Much for High-Ratio Refis:

Refinances above 80% LTV will soon be a memory at prime lenders. Refinance volumes will then fall off a small cliff. The last time the Ottawa lowered LTVs on refis, insured refinances tumbled 22% (source: CMHC).

The result will be more people being saddled with high interest debt that they can’t refinance. (Insert your favourite home-ATM analogy here.)

We’ll also see home improvement spending slow. The renovation business is a $66 billion industry and $17+ billion a year is financed with mortgages and HELOCs. (Reining in overleveraged and chronic home renovators is healthy. They are a small wedge of the refi pie, however.)

If you own an average priced home, you’ll be able to refinance $18,780 less debt to your mortgage. If your rate on that debt is 19.99%, for example, the 80% LTV refi restriction could cost you an extra $9,000+ in interest (or more if it takes greater than five years to pay off that rolled-in debt).

On the upside, a loan-to-value ≤ 80% would save you $5,587 in default insurance premiums.

Now more than ever, it will pay to have a competant mortgage adviser run the math and compare all your refi options.

8. Non-Prime is Where It’s at:

Alternative lenders like Equitable Trust and Home Trust are lovin’ life. Their target market has just expanded as regulators force banks to turn away more near-prime borrowers.

If alternative lenders can manage defaults through the eventual housing downturn, they’ll profit handsomely from this volume boost. We’re talking borrowers who are less rate sensitive (because they have fewer options) and at least three times more profitable than “A” borrowers.

In addition, given greater demand for Alt-mortgages and a constant funding supply, we may see “B” lenders exert more pricing power for a period of time.

From a broker perspective, this growth in near-prime lending is the silver lining of these rule changes. Comparison shopping is important for prime mortgages but it’s utterly essential when it comes to non-prime mortgages. And brokers are the only significant source for this service.

9. Exceptions:

If you need a mortgage and have less than 20% equity, then as long as you apply before July 9, you will qualify under the old rules.

That’s true even if your purchase offer isn’t final. “…The new parameters will not apply, even if the conditions of [a purchase] agreement have not been waived,” says the DoF.

If your application does not conform to the new insured mortgage guidelines, however, you’ll have to close by December 31, 2012. (See: these rule FAQs.)

Note: If your income situation, debt ratios or loan amount change, and you need to modify your mortgage after July 9, you may be bound by the new rules (even if you were already approved under the old rules).

10. Pre-approvals:

If you get pre-approved before July 9 and want to avoid the new rules, you’ll need to:

a) Have a purchase agreement dated before July 9, and b) Apply for a full mortgage approval before July 9.

11. HELOC Pullback:

HELOC sales will drop once banks implement the B-20 guidelines. The reason: Fewer homeowners will meet the lower 65% loan-to-value (LTV) limit and higher qualification rates.

Fortunately, OSFI tells us it will not require existing HELOC holders with LTVs over 65% to drop down to 65% LTV.

Borrowers are still able to submit HELOC applications today at 80% loan-to-value. There’s no telling for how long. As the October 31, 2012 implementation deadline approaches for the big banks, we’ll see 80% LTVs start disappearing. It could happen sooner than some expect.

In the coming days, we’ll run a piece on how HELOC LTV changes impact the Smith Manoeuvre and similar leveraged investing strategies.

12. CB D/Ps R.I.P.:

According to one high-level bank exec we spoke with, Cashback downpayment mortgages look to be dead, effective October 31, 2012 (possibly much sooner). But no lender has announced anything on this, as of yet.

Cashback refinances, however, may live—unless the DoF ends up restricting them too.

Barring that, cashback refis may get more common as time goes on.

Borrowers can use CBs to refinance to 85% LTV, via an 80% LTV mortgage plus 5% cash back. They’ll have to pay a cashback interest rate (1.70%+ higher on 5-year terms), but the “free” cash effectively reduces that rate premium to about 50 basis points. CB users also avoid the insurance premiums that typically apply to 85% LTV refinances.

Just beware of the cashback clawbacks if you get one of these mortgages and discharge it before maturity.

13. Debt Ratio Double-Whammy:

Debt ratios are one measure of how much mortgage you can afford. The new 39% gross debt service (GDS) limit will only impact high-ratio borrowers with a 680+ credit score. (High-ratio borrowers with scores below 680 are already capped at a 35% GDS.)

Dropping from 44% to 39% will restrict a subset of the market. Most people won’t be affected, however. The reason we say that is because the typical high-ratio buyer has a total debt service (TDS) ratio in the mid-30% range, according to analyst research we’ve seen. The latest CAAMP data on the subject estimates the TDS for all buyers combined at 32.5% (as of 2010).

That said, not everyone is immune from this GDS restriction. The new 39% cap will lower the maximum theoretical mortgage by roughly $57,000, or 12%, for a household earning $75,000. (This assumes a 3.09% 5-year fixed rate with a 25-year amortization, no debt and 5% down.)

If you combine that with the amortization reduction (from 30 to 25 years), it’s quite a one-two punch—amounting to a 20% reduction in maximum theoretical purchasing power.

You better believe that will impact home prices, other things being equal. The good news is that the number of people this effects is relatively small and a 10% price drop would largely offset it. As mortgage rates rise, however, the GDS limit becomes more constraining.

14. Long-am Options:

After July 9, there will still be some lenders offering 30-year amortizations to people with 20% equity. But not the major banks.

If history is a guide, banks will enforce 25-year amortizations on all mortgages. Some might even do it before July 9.

15. Bundles:

According to OSFI, lenders will no longer be able to offer “a combination of a mortgage and other lending products (secured by the same property) in any form that facilitates circumvention of the maximum LTV ratio limit…”

There is question on how this will impact “bundle mortgages.” A bundle refers to an 80% LTV non-prime mortgage with another lender’s 5% second mortgage behind it. This lets non-prime lenders offer 85% LTV lending solutions.

Bundles exist partly to avoid mortgage insurance. Federally-regulated lenders must insure mortgages over 80% LTV by law. If another lender holds the 5% second, it’s a way around that limitation. (Borrowers can also arrange 5% seconds on their own if they like.)

As a side note, and slightly unrelated: This 80% uninsured LTV limit is rumoured to be one reason why TD shut down TDFS. The speculation was that OSFI didn’t like the fact TDFS was offering 85-90% LTV uninsured mortgages—albeit through a structure that was technically onside of the regs.

The OSFI spokesperson we asked wasn’t able to offer clarity on the bundle question, other than to say, “The language in the guideline is clear.”

We can tell you, however, that many in the industry are anything but clear on it.

If one interprets OSFI’s rule as preventing lenders from promoting bundles (as we’ve defined them), that would seem unreasonable. The risk to the regulated first mortgage lender is negligible because the highest risk money (the extra 5% LTV) comes from a totally separate, private and uninsured lender with segregated capital. Moreover, the first mortgage lender underwrites its risk as if it were lending at 85% LTV or above anyway.

16. Million-Dollar Babies:

…are going down with the bathwater. People buying $1 million-plus properties will soon have to plunk down 20%. Otherwise, they’ll no longer qualify for high-ratio insurance.

That said, the Department of Finance tells CMT: “…$1 million properties with a down payment of at least 20% would still be eligible for (low-ratio) mortgage insurance offered by CMHC and private mortgage insurers.”

Flaherty says that wealthy people’s access to mortgage insurance is “not my concern…If someone can afford to pay a million dollars…they don’t really need CMHC. That’s not what CMHC is there for.”

If that’s true, Jim should probably update CMHC’s mandate. Last time we looked, its mandate was: “to allow as many Canadians as possible to access home-ownership on their own” and “in all parts of the country.” Vancouver and Toronto happen to be parts of the country, and they’ve got more $1+ million homes than homes under $300,000.

From a nationwide standpoint, high-ratio million-dollar mortgages are a small fraction of the pie. In Toronto and Vancouver, however, million-dollar home sales are 6-18% of the market respectively. 53% of single-family homes in Vancouver-proper are over a mil. (for now anyway).

By all accounts, a cut-off at $1 million is purely arbitrary. A million-dollar mortgage buys a lot less than it used to. Granted, it implies you’re better off than most, but it doesn’t make you “rich,” especially if you have to live in a major city.

There’s no public data on insured million-dollar mortgages, but CMHC tells us: “Of our total insurance-in-force distribution, five per cent of our mortgage portfolio had a loan amount exceeding $550,000 at origination. This includes high-ratio, low-ratio and multi-unit.” As a pure guess, high-ratio million-dollar mortgages are probably near or less than one per cent of CMHC’s overall portfolio.

Of course, even a fraction of one per cent of Canada’s 9.85 million homeowner households is tens of thousands of homes. If this news spooks a portion of those owners into selling more urgently, or concerned buyers defer buying, or buyers who need high-ratio insurance can’t get it, some high-end markets will suffer.

It’s worth noting that many million-dollar borrowers have sufficient net worth to make a 20 per cent down payment. They simply prefer to leverage their capital in other ways. Where that buyer has assets, impeccable credit and strong employment, those are very profitable low-risk insurance premiums for the government—premiums the government will no longer collect.

At day’s end, assuming strong underwriting and conservative appraisals, the justification for this change is questionable. Alternatives could have been: (a) setting the $1M threshold higher, (b) raising premiums on $1M+ properties, or (c) scaling back insured loan-to-values over $1 million.

17. Appraisals:

OSFI says, “In general, FRFIs should conduct an on-site inspection on the underlying property…” Lenders can still use automated appraisals, but OSFI expects them to use live appraisers if an application is deemed higher risk.

It will be interesting to see if more high-LTV mortgages are appraised. Currently, lenders and default insurers rely on auto-valuation systems on most of these applications.

18. Renewals:

If you have a high-ratio insured mortgage with an amortization over 25 years, you shouldn’t have a problem renewing with your existing lender.

You’ll also still be able to switch lenders and keep an existing amortization over 25 years, assuming:

You don’t increase your loan amount.

Your loan-to-value doesn’t increase (which could happen if home prices dive), and

You have a regular mortgage (i.e., it’s not a collateral charge mortgage).

Of course, if you need to increase your mortgage in the future and have less than 20 per cent equity, you’d be limited to a 25-year amortization. People should keep that in mind if they’re buying with a 30-year amortization today and thinking of upgrading their property down the road.

19. Changes for Self-employed:

Banks who still have flexible business-for-self (BFS) underwriting policies today (there aren’t many left), probably won’t for long. OSFI has put more pressure on lenders to obtain “reasonable…income verification” from self-employed borrowers, such as an NOA and business formation documentation. Banks have been checking those docs very closely for income reasonability.

Mainstream lenders may stiffen BFS qualifications in other ways as well. As a result, many self-employed borrowers who tax-manage their earnings (i.e., don’t pay themselves enough salaries or dividends) will find mainstream stated income programs ineffective. That’ll force some otherwise-qualified borrowers into the arms of alternative lenders with much higher interest rates.

Some critics might ask, “Why should the government take risk for self-employed borrowers?” To that, one could argue, why should the government take risk for any mortgage borrower?

The answer is beyond the scope of this article (which is long enough already), but in a nutshell: There are substantial economic and social benefits to making home ownership accessible to low-default-risk borrowers who contribute to job growth and pay a profitable insurance premium to the taxpayers of this country. Default risk is not linked to one-factor (income). It’s determined by a borrower’s total credit profile (assets, debts, cashflow, income stability, equity, beacon score, and so on).

20. Interest Savings:

The DoF’s press release heralded the “$150,000” that “typical” families could save in interest, thanks to it winding amortizations back to 25 years. That’s great, but this is no consolation for qualified borrowers who are forced to allocate cash flow towards a mortgage instead of better uses.

The fact that shorter amortizations save interest is simple mathematics. But that doesn’t make a 25-year amz the optimal strategy (or lower risk) for all.

Many qualified borrowers are better off with a long amortization and lower payments. They can then budget that money towards a higher-returning use, which might include education, retirement investing, a small business or a contingency fund.

Flaherty says that “most Canadians” borrow responsibly. Unfortunately, those responsible people will be restricted by these rules nonetheless.

Ottawa could have made borrowers qualify at a 25-year amortization, and leave the option of 30-year amortizations for payment flexibility. Like it sometimes does, however, the government took an easy shotgun approach to regulation with few provisions for exception cases. But it wasn’t really about that. The real aim behind the amortization change was to slow the market, plain and simple. Policymakers probably barely considered the micro-economic repercussions for individual borrowers.

*******

Despite the short-term pain and any critical comments above, it is clear that housing volatility will be reduced by these moves, over the long term. And that’s a positive…if you look far enough out.

The questions are, how long is long-term, how unpleasant are the side effects, and could those side effects have be minimized by a more incremental implementation?

Whatever the case, credit is due to the DoF, OSFI and Bank of Canada on two fronts: #1) They want to do the right thing, and #2) they are by no means intellectually challenged. All three consulted with some of the top minds in the country before making these decisions.

Their analysis has led them to conclude that deflating the housing market is appropriate at this uncertain juncture. Hopefully, their decision to substitute mortgage regulations for monetary policy works out. As Flaherty told reporters Thursday, it all comes down to a “judgment call.”

Robert McLister, CMT