Advisor Jason Pereira says regulator should have done more to slam door on risky debt-dependent practice
Last week, the Office of the Superintendent of Financial Institutions (OSFI) announced a handful of changes aimed at lowering the level of market risk associated with the distribution and use of innovative real estate-secured lending products.
Among the products at issue in OSFI’s update are combined loan plans (CLPs), otherwise known as readvanceable mortgages, which incorporate features of mortgages and home equity lines of credit (HELOCs). In the update on its website, which clarifies how these and other products will be treated under Guideline B-20, the regulator set a 65% LTV limit on lending through readvanceable mortgages; any and all lending beyond that threshold, OSFI says, should be both amortizing and non-readvanceable.
That begs a question: what does the update mean in terms of curbing the risks associated with strategies – like the Smith Manoeuvre – that leverage home equity to make investments?
According to Jason Pereira, partner and senior planning consultant at Ontario-based planning practice Woodgate Financial, the update doesn’t amount to much of anything.
“Basically, it effectively prevents people from borrowing more than two thirds of the equity value of their home, and we're already pretty close to that,” Pereira told Wealth Professional.
Pereira estimates that inappropriate use of leverage has consistently been among the top three complaints made to any investment regulator in Canada. That stems from the fact that advisors have traditionally been massively incentivized to convince clients to take on debt in order to juice up their investments, which increases the amount of compensation the advisor could potentially get from trailing commissions or asset-based fees.
“With the use of HELOCs, it’s possible to get several hundreds of thousands of dollars invested right away,” he says. “This was abused to high heaven for years and years.”
While there have been crackdowns on the practice, and compliance and regulations have improved over time, Pereira says investors still get trapped into leveraged investment schemes by a minority of nefarious advisors. At his own practice, clients are educated on the use of leverage to invest (“we want them to understand it’s an amplifier of both returns and risk”), and very few clients ever go for the option.
“It’s not going to have an impact on the Smith Manoeuvre whatsoever,” he says. “OSFI did something, but what they did was barely existent.”
Clients who were put all-in on stocks off of a leveraged home equity strategy at the peak of the housing market, Pereira says, are likely looking at double-digit declines in both their housing equity and financial portfolios today.
He also argues that the lightly-regulated ability for Canadians to take out debt on their home equity has been one of the accelerants leading to the epic levels of housing activity and scorching-hot prices in the past year.
“Did they think that people basically leveraging their principal residences, and their residences thereafter, wasn’t contributing to the massive expansion in investment property demand? Of course it was,” Pereira says. “This is a problem that began a long time ago, and OSFI should have set the cap a hell of a lot lower than 65%.”