Canada’s mortgage stress test is saving us from financial ruin. Will the haters finally admit it?

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The fury was so palpable, and so widespread, that Carolyn Rogers had to do something. So in 2019 she schlepped to Bay Street to address the unrelenting criticism of Canada’s new mortgage rules.

The year prior, the federal Office of the Superintendent of Financial Institutions, where she was head of regulation, had tightened its mortgage guidelines in various ways. The most significant change was the introduction of a “stress test” for more borrowers. Under the new rule, lenders had to ensure a larger number of their clients could keep making payments even if interest rates spiked.

When the rule was proposed, property values in Toronto and Vancouver had been soaring for years, so there was at least a modicum of acceptance that something had to be done. But by 2019 the housing market had cooled significantly and the real estate industry was furious about OSFI’s heavy hand.

Ms. Rogers, who left OSFI later that year and is now senior deputy governor at the Bank of Canada, wasn’t having it. “This is simply prudent,” she told an audience at the Economic Club of Canada in Toronto. “The stress test is, quite simply, a safety buffer that ensures a borrower doesn’t stretch their borrowing capacity to its maximum, leaving no room to absorb unforeseen events.”

Soaring rates or diving home prices: which will affect your mortgage approval more?

In finance, such anomalies are referred to as black swans. Now, with inflation at multidecade highs, we’re wrestling with one for the ages. To combat rising prices, the U.S. Federal Reserve just hiked its benchmark rate by 0.75 percentage points, the most in one shot since 1994, and it is widely expected to keep pushing the rate higher throughout the summer. The Bank of Canada is expected to hike its own rate at a meeting next month, with more hikes to come.

If Canada still had the mortgage rules that existed when the housing market took off a decade ago, we would have every reason to be terrified right now. But we don’t, because, even in the face of serious backlash, regulators applied the lessons learned from the 2008-09 global financial crisis. They prioritized controlling systemic risk.

The country’s mortgage rules don’t just safeguard the housing market, the state of which Canadians are currently obsessed with. They also help to protect the broader financial sector. Mortgages are by far the largest assets on bank balance sheets – and, as the global financial crisis illustrated, a housing meltdown can fuel financial contagion.

Because Canada has conservative mortgage rules, coupled with other safeguards introduced after the financial crisis, such as bigger capital buffers at each of the Big Six banks, the country’s financial sector can withstand a financial calamity (should one arise).

The Bank of Canada just stress-tested the country’s largest lenders and found they were in good enough shape to withstand a severe economic downturn where the unemployment rate jumps to 13.5 per cent – almost triple the current level – and house prices fall 29 per cent from their peak.

Looking back, what’s clear is that stringent mortgage rules weren’t the main reason the housing market cooled in 2019. Higher interest rates were the leading culprit.

We often forget it now, because the pandemic has been so disruptive, but for a brief period in 2018 the global economy looked like it was on fire. After a decade of drudgery, central banks around the world finally started hiking rates to restore some sense of financial normalcy, but it created a bit of chaos.

Did Canada’s mortgage rules contribute to cooling the housing market? Absolutely. But, if they were as pernicious as the haters believed, the rally that transpired during the pandemic never would have materialized. Instead, ultralow rates took precedence, and their impact was so powerful that hardly anyone noticed when OSFI tightened its mortgage rules yet again in the spring of 2021.

Until then, borrowers taking on new, uninsured mortgages had to prove they could qualify for their loans at rates two percentage points above their lenders’ offers, or at the five-year Bank of Canada benchmark rate, whichever was higher. After the rule change, lenders could no longer rely on the Bank of Canada rate, and borrowers instead had to qualify at the higher of 5.25 per cent or two percentage points above their contract rates.

Only a year ago, the threat of a 5.25-per-cent mortgage rate seemed a little absurd. Now that central banks are hiking at a pace rarely seen before, it no longer seems so crazy. Posted rates for five-year fixed mortgages from Canadian banks are hovering around 5 per cent.

The black swan has emerged, but it hasn’t shocked the system. And that’s not for nothing.

With reports from James Bradshaw and Rachelle Younglai

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