Stress test tweaks come amid new market realities
Rise of private mortgage lenders, politics could be factors behind Morneau’s move
TORONTO Mortgage stress tests have been defended by Canadian regulators even as a frustrated real-estate industry pushed for changes and as the measure became a campaign issue ahead of last year’s federal election. So why have the feds decided now is the time to tinker with the minimum qualifying rates borrowers have to face?
Finance Minister Bill Morneau and the Office of the Superintendent of Financial Institutions announced Tuesday that they are preparing to replace the benchmark rate used with the stress tests for both insured and uninsured mortgages. The new “floor” for the stress tests is scheduled to come into effect April 6, likely giving consumers more purchasing power and presenting a potentially lower minimum qualifying rate for homebuyers to clear.
Those stress tests are intended to ensure borrowers can keep paying back their loans if interest rates rise or they lose income. And according to Morneau and OSFI, the change to the floor of the tests is needed because the benchmark is no longer as in tune with housing market conditions as it might have been.
The outgoing benchmark for the tests is based on the five-year mortgage rates Canada’s six biggest banks advertise publicly, otherwise known as their “posted” rates. This does not take into account the actual rates borrowers could be getting from the big banks; lenders’ special-offer rates can be a few percentage points lower than the posted ones.
OSFI said in an industry notice that posted mortgage rates had historically been around 200 basis points higher than actual five-year contract rates. However, the regulator says the “gap” has recently “widened to exceed two per cent on a sustained basis,” which could mean the floor is not keeping up with the times.
The switch to a new five-year benchmark, which will be based off of applications for mortgage insurance (plus an adjustable two-percentage point “buffer”), aims to better reflect market realities. The feds say the rates offered at the application stage are consistent with final contract rates.
“This follows a recent review by federal financial agencies which concluded that the minimum qualifying rate should be more dynamic to better reflect the evolution of market conditions,” a federal press release stated. “This adjustment to the stress test will allow it to be more representative of the mortgage rates offered by lenders and more responsive to market conditions.”
The current benchmark is the mode, or the most common, fiveyear rate used by the Big Six. It is compiled by the Bank of Canada, and currently sits at 5.19 per cent.
Under a different methodology, that hurdle for borrowers could be shorter. OSFI and analysts have projected the new floor, which will also be calculated by the central bank, would be around 4.89 per cent, or 30 basis points lower than the present benchmark.
The new system for insured mortgages would set the minimum qualifying rate as either the new benchmark or the borrower’s contract rate, whichever is higher. For uninsured loans, it would also be whichever is higher: the new benchmark or the contract rate plus two percentage points.
A note from the economics unit of the Royal Bank of Canada said the new system may be more responsive, but that it “could also be more volatile.”
“Depending on the specifics, it may also boost demand in the near term,” the RBC note added.
Stress tests have also affected the housing market in ways the government and OSFI may not have intended, although neither mentioned those effects in announcing their decisions to adjust the minimum qualifying rates.
One phenomenon prompted by the stress tests has been borrowers turning to private mortgage lenders that are not federally regulated and, therefore, not forced to use the stress tests.
Bank of Canada staff research from 2018 found private lenders were increasing their market share in the Greater Toronto Area following the implementation of a revised mortgage underwriting guideline that included the latest version of the uninsured mortgage stress test.
An April 2019 report from a Canadian Imperial Bank of Commerce economist found alternative lenders such as mortgage investment corporations gaining share in Ontario as well. A fast-growing alternative lending business, they wrote, could lead to “a transfer of risk from the regulated to the less regulated segment of the market — from where there is light to where it’s dark.”
Tweaking the benchmark on the stress tests could help federally regulated lenders claw back some of their business.
“The lower qualifying rate should shift a portion of the mortgage market from private unregulated lenders back into the regulated mortgage market,” National Bank Financial analyst Jaeme Gloyn wrote in a Tuesday note.
There is the additional possibility that politics could have played a role in the stress-test decision.
Stress tests have curbed the growth of home prices. While that’s good for people trying to buy a home, those who already own have seen less price appreciation than they would have without the stress tests.
The federal Liberals have also been forced to balance their environmental priorities with those of aggrieved oil and gas-producing provinces such as Alberta, where Premier Jason Kenney has argued they deserve an exemption from the stress test altogether. Tweaking the measure instead could serve as another compromise.
“For many middle-class Canadians, their home is the most important investment they will make in their lifetime,” Morneau said Tuesday in the press release. “Our government has a responsibility to ensure that investment is protected and to support a stable housing market.”
Another report released Wednesday by the Bank of Nova Scotia’s economics unit said the tweak to the benchmark was “getting unfairly panned in some quarters,” as it is not an “outright loosening” of the latest version of the uninsured stress test and that there has been a “definite weakening” of the housing market in recent months.
“The change was just to rein in what was becoming an inappropriately and progressively stricter test with an effective rate surcharge at the point of qualifying that was becoming well in excess of the originally intended 200 basis-points target,” the report stated. “There is no need for a stricter stress test. Morneau was right to take this step.”
More housing-related regulation could be on the way.
Morneau noted in the release they will continue to monitor the market and make additional changes where it is appropriate. For instance, the platform Prime Minister Justin Trudeau and the Liberals ran on for re-election last year vowed to “limit the housing speculation that can drive up home prices” with a national tax on vacant homes owned by non-canadians who are not living in Canada.
Gloyn also noted that an OSFI assistant superintendent had singled out home equity lines of credit and ongoing “deficiencies in independently verifying income, and in ensuring that the source of verification is difficult to falsify,” in a speech last month.
“In addition, we believe OSFI is monitoring the recent increase in loans with a loan-to-income ratio greater than 450 per cent,” the analyst wrote. “In time, the Federal Government may announce restrictive measures to offset the stimulative impact of a lower qualifying rate.”