Three reasons why the mortgage stress test is good for Canada
There has been quite a bit of media attention to the stress test since Evan Siddall’s May 23 letter to the Parliamentary Standing Committee on Finance (https://www.cmhc-schl.gc.ca/en/media-newsroom/news-releases/2019/cmhc-statement-letter-standing-committee-finance-fina).
The letter is a great read and explains clearly the origin and intent of the stress test which was introduced in 2010 by the Department of Finance on insured mortgages and the subsequent stress test that was introduced in early 2018 by OSFI on uninsured mortgages.
In short, these stress tests oblige banks to use a higher interest rate than the contract rate to calculate the debt service ratio used to adjudicate customers for a mortgage. The CMHC - and most banks - use a debt service ratio of 35% of pre-tax income as the maximum cost of the mortgage, property taxes and heat.
The impact is best explained through an example: Imagine a family living in Ottawa who makes the Canadian average of $70k per annum. For simplicity of calculation, assume they have no other debt, no heating costs or property taxes, have saved up $108,000 for the downpayment, and they manage to negotiate a 3% rate for a 5 year fixed mortgage that amortizes over 25 years.
Before the stress test they could buy a house worth $540,000, which costs them $2,042 per month in mortgage payments, which would be 35% of pre-tax income.
The stress test requires the bank to add 2% to the contract rate of 3% when they adjudicate the mortgage. This family can now only buy a house worth $460,000 which cost them $1,666 per month in mortgage payments, which would be 29% of pre-tax income.
Note that with the stressed rate of 5% the debt service ratio falls to 29% of pre-tax income. Coincidentally 30% of pre-tax income is generally regarded as the maximum a middle class family should pay in housing costs. This goes to say that the stress test is not unnecessarily punitive for middle class households. In fact it puts them exactly where they should be.
Given that the household in this example now spends $80,000 less on a house, it is easy to see why real estate agents, mortgage brokers and builders are lobbying to remove the stress test.
However, there are at least 3 good reasons why the stress test is good for Canada:
Firstly and obviously, it acts as a buffer to ensure that mortgagors would still be able to pay their mortgages if rates go up. It also provides them some flexibility if their circumstances change, e.g. they have to change employment or they start a family.
Secondly, it provides a lever for the Department of Finance to stabilize home prices by managing the demand for housing. The Department of Finance already had a few levers to control demand, such as length of amortization and the availability of government guaranteed securitization options for banks. However, the stress test theoretically allows it to make much smaller and more accurate adjustments to demand.
Driven to its logical extreme we can imagine that the Department of Finance has access to a central database that contains all the current and historical housing and mortgage data in Canada. With a really smart analytics engine they would be able to produce stable home prices by continuously adjusting demand via the stress test rate.
Finally – and this is the most interesting implication – by shifting the demand curve down, it reduces the cost of a home and thereby redistributes wealth from builders and homeowners to first time home buyers. It has been argued that the stress test excludes first time home buyers from the market and allows for only (wealthier) established households to compete for homes. For this to be true the housing supply has to be homogeneous. The reality is that not all homes look the same and first time homebuyers - broadly speaking - don’t compete with established households for the same homes.
Imagine three first time home buyers who look roughly like our hypothetical family above who are bidding for the same home:
Seconds before they submit their bids, the Regulator rushes into the real estate agent’s office and takes them all to a Tim Hortons nearby. The Regulator asks each bidder to write down their bids on their napkin. The Regulator now takes the napkins and deducts $80,000 from each bid and hands it back to the bidder. They rush back to the real estate agent’s office and submit these adjusted bids. The same bidder wins the home, but he or she pays $80,000 less and the builder or established household who is selling the home makes $80,000 less.
The above is highly simplified, and one can argue that builders will simply stop building homes if they make less money. However, if building homes require young families to shell out more than 30% of pre-tax income on mortgage costs then there is something else seriously wrong in the system.