Mortgage fraud a key threat to Canada's financial system

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Canada's banking and insurance regulator highlighted fraudulent mortgage practices as a key threat to the country's financial system, prompting consultations with lenders over how to ensure that the system can withstand a severe housing market downturn.

"It has come to light that institutions have been, I would say inadvertently, making mortgages to people whose income has been falsified," said Jeremy Rudin, superintendent of financial institutions.

"One of things we've been doing is encouraging sound risk management. And as we set out in our guideline on mortgage underwriting, income verification – checking to make sure the borrower has the ability to carry the loan – is an important part of sound underwriting."

His comments follow an extraordinary series of co-ordinated announcements on Friday from the federal Finance Minister, the Office of the Superintendent of Financial Institutions (OSFI) and Canada Mortgage and Housing Corp., designed to curb risks associated with red-hot housing markets in Toronto and Vancouver.

The changes will raise minimum down payments for some buyers, raise fees associated with securitized government-backed mortgages and could require lenders such as banks to hold more capital against insured loans.

While surging home prices are part of the reason for the response, fraudulent mortgage applications have also driven the need to buttress Canada's financial system.

In cases where mortgage down payments represent less than 20 per cent of the value of the purchased home, the loan must be insured against default. The risk of default is then transferred to an insurance company, leaving the lender with low capital requirements.

However, Mr. Rudin pointed out that the insurance company is not obliged to pay claims if there has been negligence on the part of the lender – say, by turning a blind eye toward detecting fraud related to the borrower's income.

"That's a problem for our capital regime as it stands now, because the capital is in the wrong place," Mr. Rudin said. "The capital requirement is on the insurer, who doesn't have to pay; and there is low or zero capital requirement on the lender, whose insurance is no longer valid.

"We want to adapt the capital requirement so that the capital will be in the right place."

In its announcement on Friday, OSFI said that it would consult federally regulated financial institutions and the broader public in 2016, with final rules expected no later than 2017.

Part of the consultations will also revolve around linking bank capital levels to increases in local property prices. The change implies that mortgages associated with Toronto and Vancouver would require lenders to hold additional capital to ensure that they can absorb losses if there is a housing market downturn.

"We have in the existing capital requirements a strong measure of conservatism already built in," Mr. Rudin said.

"But at the same time, house prices have been rising rapidly for an extended period of time, and in some markets you see this continued rise even though incomes have not been rising nearly as rapidly. This begins to use up some of that margin of conservatism," he said.

Mr. Rudin, who began his seven-year term as head of OSFI about 18 months ago, added that the regulator's job is to anticipate the severe but plausible scenarios that could affect Canada's financial system, rather than take positions on where house prices are headed.

"Part of my transition into this job has been to teach myself to stop thinking about what is likely to happen and to focus exclusively on what could happen within a realm of plausibility, and what we need to be doing about it now," he said.