Will the Mortgage Stress Test Be Revisited?

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A series of regulatory changes, including interest rate hikes, foreign buyer taxes, and the stress test, have led to a slowdown in activity across Canada's real estate markets.

That's the conclusion of a new report from Mortgage Professionals Canada (MPC), which raises the question of whether government intervention in the mortgage market has gone too far, and whether it could lead to unwanted economic consequences down the road.

Specifically, MPC, the industry group representing mortgage brokers and mortgage lending professionals, argues that the stress test relies on "the wrong interest rate" and is only deepening the market slowdown.

The report questions the basic premise behind stress tests, which are meant to assess whether borrowers could still afford their payments if rates rise in the future. According to MPC, mortgage defaults are far more strongly linked to job losses than to changes in interest rates.

In 2018, home sales fell 11%, yet total outstanding mortgage debt at year's end still came to a substantial $1.55 trillion. As a reminder, the stress test requires both first-time buyers and existing mortgage holders to qualify at the contract rate plus 2%. Yet the research cited in the MPC report calls that threshold excessively high. What's more, it ignores the fact that five years from now, borrowers' incomes will also be higher, and by then they'll have paid down a meaningful share of their principal.

If average wage growth in Canada runs at around 2% a year, then five years from now, a typical borrower's income will be more than 10% higher than it is today. On top of that, over those five years, borrowers will have paid down a meaningful chunk of principal, roughly 13% to 14% under fairly standard contract terms.

The stress test ought to account for higher future income and a lower outstanding balance five years out. So if the goal is to test whether a borrower could still make their payments if rates rose 2% five years from now, then the contract rate plus 0.75% should be more than sufficient for qualifying today.

According to MPC, many first-time buyers have either failed to qualify for the home they wanted, or have been pushed out of the market altogether. Those who can't buy are forced to rent instead, adding further pressure to an already tight rental market, where rents rose 3.4% last year.

One of the main justifications given for introducing the stress test was that rising interest rates would increase the cost of servicing debt, potentially leading to foreclosure for many homeowners.

The MPC report challenges that assumption, arguing that mortgage default rates aren't nearly as sensitive to changes in interest rates. In reality, they're far more sensitive to job loss, which means the stress test can't actually guarantee that mortgage payments will be kept up. What's more, Canada's mortgage delinquency rate currently sits at a historic low of 0.24% (1 in 424 borrowers) - a figure that has been steadily declining since 2009.

The fallout from a real estate slowdown ripples through the entire economy, including jobs in the real estate and construction sectors, along with revenue generated from property transfer taxes and the like. And, naturally, there are plenty of unintended consequences as well, such as increased demand in the rental market.

Stability in the labour market is what underpins stability in the real estate market. If the government agrees that job losses affect a borrower's ability to service debt far more than rising interest rates do, that incomes are rising, and that the outstanding principal balance shrinks over time, then there's a clear case for revisiting the stress test threshold.

The federal government does appear to be watching the real estate and mortgage lending markets closely. According to three direct sources cited by Reuters in late January, the government was considering extending the same mortgage stress test rules that banks must follow to private lenders as well. The main goal is to prevent destabilization of real estate markets amid a sharp rise in new mortgages issued by private lenders.

Officials from the finance department, the financial regulator, the central bank, and the federal housing agency have been discussing whether the growth in private lenders over the past year poses a threat to economic stability, according to sources who asked to remain anonymous given the sensitivity of the matter.

According to economists, private lenders, typically a group of wealthy individuals, currently make up roughly a tenth of Canada's $1.5 trillion mortgage market. Banks still dominate by a wide margin, but the volume of mortgages issued by private lenders has grown sharply since new rules made it harder for banks to issue loans.

Private lenders currently fall outside the scope of the B-20 guideline, since they're regulated by provincial authorities rather than the federal Office of the Superintendent of Financial Institutions (OSFI). Bringing them under federal oversight would require a change in the law.

One source says that under the first option being considered, the federal government could ask the provinces to adopt B-20-style rules of their own. In that case, private lenders would also be required to qualify borrowers at a higher rate, the contract rate plus 2%, the same as banks currently do.

A less strict alternative under consideration involves recommending that provinces require more thorough vetting by private lenders, to confirm borrowers can actually repay their debt, without imposing a formal stress test.

That said, according to Finance Minister Bill Morneau, no additional regulatory measures targeting private mortgage lenders are currently on the table.

He said as much to reporters in Ottawa. Asked whether he was concerned about the growth of this sector in Canada, Morneau said he isn't currently considering any specific measures on this front. "We're always looking at the entire mortgage space to make sure our system is adequately protecting Canadians. That means we obviously need to think about the space we regulate directly, and how these changes affect other sectors that provide this type of lending," he said. "But I'm not currently considering anything definitive on this front."

Alternative and private financing today often serves as a genuine lifeline for borrowers with good credit and solid income who've been pushed out of the banking sector by the stress test. Home equity lines of credit, in particular, have become especially popular, widely used by self-employed borrowers who want to avoid breaking an existing mortgage with a good rate, while still accessing the equity in their home to cover pressing financial needs, pay down accumulated debt, or grow their business.