By Nivedita Balu
TORONTO (Reuters) -Canada's financial regulator is urging lenders to tackle risks from mortgage extensions at the "earliest opportunity" as many borrowers try to navigate higher mortgage costs after the Bank of Canada's surprise rate hike last week.
The Office of the Superintendent of Financial Institutions' (OSFI) urgency underscores the concern about the risk accumulating in Canadian lenders' books as the central bank has resumed interest rate hike after a four-month pause. Canada's central bank has raised interest rates to a 22-year high of 4.75% and analysts are betting on another 25 points increase next month.
Many major Canadian banks allowing holders of variable rate mortgages to extend their amortization period to keep their repayments at the same level, temporarily blunting the impact of higher borrowing costs but adding risks to borrowers later on.
"OSFI expects a more prudent and active account management approach, including resolving negative amortization at the earliest opportunity as well as recognizing the higher risk of these loans in loss provisioning," the regulator said in a statement to Reuters.
"Our ongoing conversations with financial institutions have highlighted the importance of being proactive in managing all types of mortgage accounts, and to act before levels of borrower stress become unmanageable."
The regulator had warned in April that though the short-term fix to extend mortgage payment periods helped borrowers, it would keep them in debt for longer.
Roughly half of the borrowers in early 2022 opted for a variable mortgage, taking advantage of the central bank's low interest rates and discounts offered by lenders, but that number declined, with only 16.7% of borrowers opting for a variable-rate mortgage in January of this year, according to Canada's housing agency CMHC.
As the interest rate rises, the mortgage payment no longer covers the interest payment portion, which results in the mortgage balance and negative amortization.
Desjardins analyst Royce Mendes noted that the big six Canadian banks had more than 20% of their mortgage portfolio with repayments greater than 30 years in the first quarter as a result of variable-rate loans that have become non-amortizing, up from roughly 2% of the mortgage portfolios the prior year.
At the same time, variable-rate holders are facing at least 30% increases in payments to remain on their original schedule. As a result, some might opt to extend repayments, Mendes notes.
To be sure, the amortization would still likely be kept below 30 years.
Data from Bank of Canada in May showed about one-third of mortgages have seen an increase in payments compared with February 2022 - just before the Bank started raising its policy interest rate. The central bank anticipates nearly all mortgage holders will have seen their payments increase.
Major banks have said that very few customers are opting to extend their mortgages, but analysts have warned the challenges will remain throughout the year.
"We continue to view mortgage lending as a moderate revenue headwind for the Canadian banks... with added risk to the economy as mortgages renew at higher rates, pressuring disposable income," KBW analyst Mike Rizvanovic said.
At the same time, Canada's biggest banks have set aside more funds to cover bad loans this quarter, anticipating more defaults and weakness in commercial real estate.
"We believe risks are still elevated with the prospect of more rate hikes adding to the headwind on mortgage renewals," Rizvanovic said.