By David Larock

Last week federal finance minister Jim Flaherty surprised real estate market stakeholders by announcing a fourth round of changes to the rules that are used to qualify borrowers who have less than 20 per cent equity in their property (commonly referred to as high-ratio borrowers).

You would have thought that Mr. Flaherty was announcing the arrival of the Four Horsemen of the Apocalypse when reading the reactions of most mortgage industry insiders, which I find surprising given that the first three rounds of rule changes did not broadside our real estate markets, as had been predicted each time, and have in fact proven quite prescient in hindsight.

Let’s quickly review how we got to this point:

Ultra-low mortgage rates have been the primary drivers of house-price appreciation across most Canadian real estate markets over the last several years. At first this cause-and-effect helped our economy when it was otherwise vulnerable, by stimulating demand in a wide range of housing-related industries. But while emergency-level borrowing rates can provide an effective short-term economic boost, if rates are left too low for too long they can also fuel asset bubbles (history provides many precedents on this point – and those who do not learn from history are doomed to repeat it).

Our political leaders and regulators have been grappling with a very difficult question for some time now: How do we keep our interest rates at the stimulative levels that our broader economy still desperately needs while guarding against credit and housing bubbles? Each time the answer has been the same: Tighten mortgage lending rules, give the market time to adjust and then tighten again if needed.

Over the past few months our leaders have (at long last) come around to the view that our interest rates are going to stay low for the foreseeable future and that if rising rates aren’t going to slow the market naturally (as was previously hoped), more tightening is needed.

Here are the changes that were just announced and that will take effect on July 9 (with my comments following each bullet point):

* The maximum amortization on a high-ratio mortgage will be reduced from 30 years to 25 years.

Mathematically, this change has the same impact on mortgage affordability as a .95 per cent rise in interest rates. That said, while 40 per cent of high-ratio borrowers opted for a 30-year amortization over the last year, the vast majority of these borrowers could have qualified using a 25-year amortization anyway, so this change should only affect marginal borrowers who would have been the most vulnerable to rate rises in future. (If Mr. Flaherty had asked me, I would have suggested lowering the maximum amortization on the rate used to qualify borrowers instead. This tweak would have allowed high-ratio borrowers to set their minimum mortgage payment using a 30-year amortization as long as they could qualify using a 25-year amortization…but I digress.)

There is also an inherent benefit in making this change at this time, which industry observers have not acknowledged. Looking ahead, when mortgage rates eventually do rise, the maximum amortization threshold can be increased back to 30 years to help cushion the impact of higher borrowing costs. This gives the federal government the option of using an incremental payment shock absorber at some critical future point.

* Mortgage refinancings will now be limited to a maximum of 80 per cent of the value of a property (down from 85 per cent).

Rapidly rising house prices create a wealth effect that allows homeowners to live beyond their means. While only a minority succumb to this temptation, at the margin these home owners form a large enough group to threaten the stability of our real estate markets and, left unchecked, even our overall financial system.

These borrowers typically rack up high-interest unsecured debt and when it becomes unmanageable, they roll it into their mortgage at today’s record-low rates. They wash, rinse and repeat until house prices stop rising and then when they can no longer access new money this way…boom goes the dynamite.

The decision to stop offering high-ratio mortgage insurance on refinance transactions is an attempt to reign in the conversion of credit-card debt into mortgage debt. This practice was commonplace during the U.S. housing bubble run-up and exponentially increased the long-term damage done to the U.S. economy when real estate prices corrected. Home equity extraction has been steadily rising in Canada over the last decade and the federal government is wise to take steps to limit the potential damage it can cause.

The overwhelming majority of my mortgage industry colleagues feel that credit-card debt, not mortgage debt, is the real problem that the federal government must address. This view is either naïve, blindly self-interested or both. Our industry has been abetting the growth of credit-card debt by converting it to mortgage debt.

High-ratio mortgages are subject to greater regulation because the risk on these instruments is taken by the federal government and ultimately, by Canadian taxpayers. The risk on credit-card debt, on the other hand, is taken by individual credit-granting institutions. That means that if over-consuming borrowers default on their credit-card debt the negative impact is essentially limited to the borrower and the lender, while a material increase in mortgage defaults can send shock waves throughout the economy (see the current U.S. example, where it is mortgage defaults, not credit-card write-offs, that have created Depression-like conditions).

Put another way, if you ask any regulator whether they would rather have credit-card defaults or mortgage defaults, you won’t have to wait long for the answer.

* High-ratio mortgage insurance will no longer be offered on properties valued at over $1 million.

History has shown that high-value properties are subject to greater price fluctuations when real estate markets soften and as such, highly leveraged high-end properties come with an inherently higher level of risk. Requiring a minimum down payment of 20 per cent is a way to help mitigate this increased marginal risk.

From a mortgage-industry perspective, this change gives balance-sheet lenders (large banks) an increased competitive advantage over lenders who need mortgage default insurance to securitize their loans. That means that high-end borrowers (and the mortgage planners who work with them) will now have fewer lenders to choose from. In spite of this, it is still seems to be the right thing to do in an environment where many inter-related risks appear elevated.

* The maximum gross debt service ratio will be limited to 39 per cent and the maximum total debt service ratios will remain at 44 per cent.

Until now, high-ratio borrowers with excellent credit scores could have their gross debt service ratios waived altogether. This has meant that their mortgage and other basic property costs could total 44 per cent of their gross income if they had no other debt. Now their mortgage and other basic property costs will be capped at 39 per cent, regardless of whether they have any other debt, and that slightly reduces the maximum mortgage amount for the relatively small sub-group of borrowers who have no other debt.

The two most common questions being asked regarding the coming changes are:

* How will this affect my existing mortgage at renewal?

Answer: Not at all. As long as you don’t need to borrow more money, your existing mortgage terms will remain in place, even if you switch lenders at renewal.

* How does this affect my existing pre-approval?

Answer: Pre-approvals that do not become live deals before July 9 will be subject to the new rules beyond that date; if, on the other hand, you have an accepted offer to purchase and you convert your pre-approval to a live deal before July 9, your high-ratio mortgage will not be subject to the most recent changes.

If you have other questions, you can check out this question and answer page on the Department of Finance website, or email me for more details.

Five-year Government of Canada bond yields rose 12 basis points last week, closing at 1.31 per cent on Friday. Despite this rise, lenders are still enjoying healthy gross spreads on five-year fixed-rate mortgages in the 3.09 per cent range. We also saw the launch of some new promotions on shorter-term fixed rates and this wider-than-normal variance at the short end of the interest-rate curve means that borrowers who shop around will be well rewarded for their effort.

Five-year variable rates are still being offered at only a shade below fixed rates (2.80 per cent vs. 3.09 per cent) and as such, I don’t think they offer borrowers enough of a margin of safety to justify their inherent risk.

The bottom line: There is an understandable fear that over-tightening mortgage rules will engineer the very house-price correction we seek to avoid but under tightening could eventually prove even more disastrous (and no one has more to lose than people who depend on a healthy real estate market to make their living).

The first three rounds of changes were initially unpopular but all have thus far proven to be prudent with the passage of time. While I am instinctively skeptical of government intervention in the market, Flaherty has so far consistently earned my respect where changing mortgage regulations are concerned. If this short-term pain helps to preserve our long-term gains, then I’m all for it.