Let’s talk about the new mortgage regulations that came into effect earlier this year. Home buyers who are contributing 20% or more for their down payment have to pass a “stress test” in order to qualify for mortgage financing with one of Canada’s federally regulated banks.
Under the stress test, eligibility for financing isn’t based on the interest rate being offered. Instead, it’s based on whichever of two interest rates is higher: either the five-year conventional mortgage rate posted by the Bank of Canada or one that’s 2% above the one being offered by the lender.
The Office of the Superintendent of Financial Institutions (OSFI) created the stress test to slow mortgage credit growth. It’s worried about risks to Canada’s financial system posed by rising interest rates (borrowers en masse being unable to make their mortgage payment) or the next recession (lots of layoffs, with the unemployed unable to make their mortgage payments).
If these risks were to materialize, OSFI is worried big banks would drastically reduce mortgage lending (also known as a “credit crunch”)—which would make a difficult economic situation even worse.
OSFI’s mandate is limited solely to safeguarding Canada’s financial system from risks. It pays absolutely no mind to how tighter mortgage regulations may affect home sales activity or prices.
To skirt the stress test, home buyers can seek non-federally regulated mortgage lenders (non-FRFIs), such as credit unions or private lenders, but they will be charged higher lending rates for mortgages when compared to FRFIs.
Simply put, OSFI’s new stress test means some borrowers are likely taking on debt that is harder to manage than would be the case in a world without the stress test. This means financial risks are merely being shifted away from FRFIs and toward home buyers and non-FRFIs.
Meanwhile, OSFI can herald its stress test as “mission accomplished” from the standpoint of safeguarding FRFIs from credit risks—irrespective of its effect on borrowers, private lenders and other non-FRFIs.
The new stress test is anchored to something policymakers have no control over; namely the five-year conventional mortgage rate as posted by the Bank of Canada*. That’s because this rate is linked to five-year bond yields, which the Bank of Canada has no control over (or arguably any interest rate beyond its trend-setting overnight lending rate for that matter).
Let’s go back to OSFI’s motivation for the stress test—trying to reduce the likelihood of a credit crunch should Canada face harsh economic times. It’s well understood that international financial markets are highly integrated. An unexpected jump in Canadian interest rates due to an increase in international interest rates would spell bad economic times for Canada. The inability of more prospective mortgage applicants to qualify for financing due to the stress test would make a bad economic time that much worse.
Should such a scenario occur, my faith in OSFI to quickly relax mortgage regulations may not be as strong as yours. Regardless, making good policy is difficult, but that doesn’t mean policymakers shouldn’t try.
To my mind, the stress test could have been better designed in the first place.
* Which is either the most commonly advertised five-year rate among Canada’s big banks, also known as “mode” or, when there are multiple modes, the mode that’s closest to the average of big banks’ advertised five-year mortgage rates.