Stress Test for Borrowers the Latest Hurdle for Mortgages, Canada’s Housing Market

Regulatory imbalance creates opportunity for credit unions, alternative lenders

A sales center sign is shown outside a house under construction in Beckwith, Ont., on Jan. 11, 2018. The mortgage business faces challenges from rising rates and the newly implemented stress test from the federal regulator. (The Canadian Press/Sean Kilpatrick)

The residential mortgage market in Canada faces a rocky 2018 as it deals with a new stress test for borrower eligibility amid a backdrop of rising interest rates. The fallout from the new rule has implications for housing markets across the country, homebuyers, and lenders who scrap for market share.

The new B-20 guideline from the federal regulator Office of the Superintendent of Financial Institutions (OSFI) that came into effect Jan. 1 “creates a borrowing power reduction for everybody in Canada to the tune of about 20 percent,” said Paul Taylor, president and CEO of Mortgage Professionals Canada, in a phone interview. The guideline is intended to curb lending to riskier (highly leveraged) borrowers given the vulnerabilities of the Canadian housing market.

Having to qualify for an uninsured mortgage at the greater of 2 percent higher than the contract rate or the Bank of Canada’s five-year mortgage rate (5.14 percent as of Feb. 7) acutely affects first-time homebuyers and growing families looking to trade up. Most of the large banks currently have a posted five-year fixed rate of 3.49 percent.

The Toronto Real Estate Board (TREB) estimates that using 2017 average prices, borrowers would be required to qualify at $450 to $950 more per month depending on the type of home.

Federal regulators have to live with some unintended consequences given the diversity of housing markets across Canada and the blunt nature of their policy tool. One of those is the stress test indirectly benefiting the wealthy more than up-and-coming middle-class Canadians.

As a result of the stress test, Taylor sees an interesting dynamic playing out in which house prices in Toronto and Vancouver won’t suffer as much as those in calmer markets across the country.

The real problem in Toronto and Vancouver, Taylor says, is lack of supply. “You can’t kill demand just by making it more fiscally difficult for people to get there,” he said. “You actually make it easier for the wealthy by taking some of the lower middle class people out of the market. That tends to stall prices, which actually really helps investors.

“You create an environment where the rich get richer.”

The 5.2 percent year-over-year price increase in Toronto was largely driven by condos. Condo sales and prices are also rising in Vancouver as buyers get pushed into less expensive homes.

In areas where the buyer base isn’t as deep, such as in the Prairie and Atlantic provinces, the number of qualified buyers is going to be reduced and price erosion will likely follow, adds Taylor.

Housing markets in Calgary, Edmonton, Winnipeg, Halifax, Quebec, and Ottawa have all experienced low single-digit price appreciation in the last year, unlike headline-grabbing and highly vulnerable Toronto and Vancouver. The B-20 guideline combined with higher mortgage rates could dampen the vast majority of housing markets across Canada while having less of an impact on the hottest ones.

While it’s still early days for fallout from the B-20 guideline, the spring season should give a better picture of the impacts.

Adjustment Period Creates Opportunity

In an email, Scott Windsor, spokesperson for one of the largest credit unions in Canada—Meridian—said OSFI’s B-20 guideline “does not technically apply to our business,” however, it “will consider that guideline” as a responsible lender. The company’s website emphasizes that it is provincially regulated and offers buyers more purchasing power for their dollar. The race to gain market share is on.

Two things are happening as a result: Alternative lenders are picking up business as some borrowers who remain good credit risks are not able to pass the stress test and less expensive homes, such as condos, are in greater demand.

Mortgage expert and founder of RateSpy.com Robert McLister says the government’s securitization programs, run by Canada Mortgage and Housing Corp. (CMHC), could be a wildcard if they limit access to non-federally regulated entities that do not apply the stress test. As a cost-effective funding source, securitization is more important to the smaller financial institutions that qualify for it and they’d fall in line rather than lose the funding tool by not conforming, says McLister citing a conversation with a credit union executive.

McLister, who has been critical of the stress test on uninsured mortgages, says that mortgage investors were already comfortable with the underwriting of mortgages.

“I’m aware of various large and mid-tier credit unions not following B-20’s stress test,” McLister said in an email. He doesn’t believe investors will penalize them significantly, nor should they. “Pre-B-20 underwriting was generally sound and investors know it.”

Taylor believes the marketplace will eventually dictate that all mortgage lenders adhere to the rule.

“I don’t think there’s going to be a competitive imbalance in perpetuity,” Taylor said. This phenomenon could come about as dictated by the big banks buying mortgages from credit unions or provincial regulators conforming to OSFI’s dictum, which Quebec has done.

And as a result, Taylor doesn’t expect the big banks to respond to the credit unions not following B-20 by loosening their underwriting standards.

The new stress test for uninsured mortgages is the seventh rule change since July 2008 from the federal government. Prior changes include shortening amortization terms, requiring higher down payments to avoid mortgage insurance, and implementing stress tests for insured mortgages.

The stress test is seen as a temporary hurdle for the market. The labor market and economy in Canada are very strong and wages are rising, making the average borrower more resilient.

McLister doesn’t expect a significant drop in mortgage originations. “If all the past [regulatory] changes are a guide, borrowers will adapt to these new rules faster than we expect,” he said.

McLister also says a slight drop in mortgage originations shouldn’t trigger a downturn in the housing market. For that, an economic trigger is needed. And that seems highly unlikely given the robust labor market and economic fundamentals in Canada presently.

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