Mortgage default rates are sensitive to job losses, not interest rate changes—stress tests might not be much of a safeguard.
That’s the conclusion of a new report from the Mortgage Professionals Canada (MPC) that questions whether government interventions in the mortgage market have been too intrusive and could lead to further unintended economic outcomes.
Specifically, the MPC, an industry group that represents mortgage and service providers, contends the stress tests have relied on “the wrong interest rate,” and thereby exacerbated the slowdown.
The report questions the fundamental premise of the stress tests, which were intended to determine the debt worthiness of borrowers in case interest rates were to rise in the future. Mortgage defaults, the MPC argues, are influenced more by increases in job losses and not necessarily by changes in interest rates.
Housing sales in 2018 declined by 11 per cent, but the amount of outstanding mortgage credit at the end of 2018 was estimated to be a staggering $1.55 trillion.
While the decline in sales has adversely impacted mortgage brokerages and lenders, the MPC report suggests the effect on the larger economy could include many unintended consequences.
The stress tests require borrowers, both first-time homebuyers and those applying for in-transfer of existing mortgages, to qualify at a rate two percentage points higher than the contracted rate. However, the report argues the threshold is unduly high and ignores the fact that in five years, a borrower’s income would be higher and they would have paid a significant amount towards the principal.
If the average wage increase in Canada is about two per cent, in five years, a typical borrower’s income would be more than 10 per cent higher than today. Furthermore, in five years, the borrowers would have made a “substantial amount of principal repayment” — as much as 13 to 14 per cent in typical circumstances.
The stress test should account for higher incomes and reduced principal amount five years down the road. Thus, if one needed to test whether a borrower could service the debt if interest rates were to rise by two percentage points five years later, “a rate that is 0.75 points higher than the initial contracted rate” should have sufficed today.
The MPC report believes that many first-time homebuyers have either been prevented from qualifying for the home they desire or been shut out of the market altogether. Those who cannot buy are forced to rent, which increases pressure on the already tight rental markets, where rents appreciated by 3.4 per cent in 2018.
The justification for the stress tests is that an increase in interest rates will increase the debt servicing costs that might force some or many homeowners into foreclosures.
The MPC report, though, challenges this assumption and argues that mortgage default rates are not sensitive to changes in interest rates. Instead, they are more sensitive to job losses, and thus the stress tests might not be much of a safeguard. In fact, current estimates of mortgage arrears in Canada are historically low at 0.24 per cent (one in 424 borrowers) and have been falling since 2009.
Canada’s mortgage industry and consumer borrowing are fast evolving. Of the nine-plus million homeowner households, more than six million own with a mortgage. Household debt in Canada has expanded from $349 billion in 1990 to $2.19 trillion in 2018, such that mortgages now account for 65 per cent of household debt.
And then there are informal lenders or gifters in the form of the Bank of Mom and Dad. Almost 20 per cent of recent first-time homebuyers acknowledged that gifts and loans from family helped them with the down payment.
The consequences of a slowdown in housing markets affect the entire economy, including jobs in real estate and construction as well as the revenue generated by land-transfer and other related taxes. The unintended consequences, such as the increase in the demand for rental housing, are also numerous.
Stability in labour markets is the key to stability in housing markets. If regulators agree that the ability to service debt is affected more by job losses than the interest rates and that incomes grow and the principal amount owed declines over time, then there is merit in reviewing the stress test thresholds.