Stressing over the mortgage stress test

Canada’s hot housing market of a couple of years ago is stabilizing, in part thanks to stress test changes introduced in 2018. But the test’s effects have stoked criticism that further changes might be needed.

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Benjamin Tal, deputy chief economist at CIBC, describes Canada’s housing market as experiencing “a very healthy adjustment,” and notes that the housing markets of Toronto and Vancouver have slowed the most, which isn’t surprising.

“Those two cities were experiencing significant price appreciation and activity in 2015 [and] 2016,” he said. “Now, we are simply undoing those years in those two cities.”

Most of the slowdown in those two markets can be attributed to gravity, Tal said, because “prices simply reach a point where [they] became totally unaffordable.”

For the market overall, another contributing factor to the market’s stabilization is regulation—specifically the most recent update to the mortgage stress test whereby potential homeowners with down payments of 20% or more must qualify at either the five-year benchmark rate published by the Bank of Canada or the lender’s interest rate plus 2%.

In a report, Tal put the test in context: “In today’s market, you can get a five-year fixed rate of 3.5%, but you must be qualified at 5.5%.”

In step with the change, the value of new mortgages in Canada decreased by $25 billion or 8% last year, with about half of that decline attributable to the stress test, Tal said. Further, “many markets remain out of reach to many potential first-time homebuyers,” he said in the report.

As such, a critique of the recent stress test changes might be a worthwhile exercise to consider if adjustments are required.

“This is a significant test that is slowing down the market,” Tal said. “And the question is whether or not it’s too much.”

To find out, he considered the context and consequences of the test.

For example, the slower pace of mortgage originations growth started before the most recent stress test changes were introduced. “Originations hardly grew at all during 2017,” Tal said in the report.

Further, when borrowers don’t pass the stress test, they consider alternative lenders, with potentially negative results from both a personal and policy perspective.

Personal consequences include higher interest amounts. “Our research would suggest that many [borrowers] are not willing to compromise on a smaller mortgage [but] are willing to go to the alternative market and pay 7 [or] 8% to get the mortgage and the house that they want,” Tal said.

Clients should clearly be informed about how alternative lenders’ high rates and other contract stipulations will affect them. “Using alternative lending has to be a decision that’s taken very seriously before doing it,” Tal said.

And, as more borrowers seek out alternative lenders, they gain a greater share of the mortgage market, increasing risk in the housing market.

“Alternative lending is the fastest-growing segment of the mortgage market now,” Tal said. In Ontario, for example, alternative lenders account for about 12% of mortgage transactions (15% in the Greater Toronto Area), up from 10% a year ago, the report said.

The result is a transfer of risk from the regulated segment of the market to the unregulated segment of the market, Tal said.

Regulation of alternative lenders could be part of the solution, as could easing the stress test. For example, the requirement that borrowers must qualify at a rate 200 basis points higher than the base rate could be lowered, Tal said, adding in the report that “there is no real science behind that number.”

In a Mortgage Professionals Canada report released on May 29, economist Will Dunning suggested the qualifying rate should be 75 basis points higher than the base rate, which would account for future growth of borrowers’ incomes. Average personal income has risen by a cumulative 12.5% over the last five years, which isn’t factored in to the stress test, Tal said in his report.

In the meantime, Tal continues to describe the slowing housing market as healthy: “It’s simply a market that is looking for direction, a market that is in price-search mode. It’s not over yet.”

Also read:

Mortgage debt manageable, stress test should remain: C.D. Howe

Why it’s time to revisit the mortgage stress test

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