In depth analysis of the new mortgage stress test with David Larock

Andrew la Fleur: On today’s episode we go in depth with David Larock, mortgage broker about the new mortgage rules and how they’re going to impact the market. Stay tuned.

Speaker 2: Welcome to the True Condos podcast with Andrew la Fleur. The place to get the truth on the Toronto condo market and condo investing in Toronto.

Andrew la Fleur: All right, it’s my pleasure to welcome back to the show, returning guest David Larock. David is a mortgage broker with Integrated Mortgage Planners. He has been in the mortgage business for about 20 years. He’s a great expert to have on the show. David, we’re happy to have you back here again.

David Larock: Thanks Andrew, good to be back.

Andrew la Fleur: It was great, last episode we talked a lot about interest rates and what was happening there, maybe we’ll touch on that again today but obviously big one we want to talk about are the new mortgage rules, the so called stress test. Should we be stressed out or not? Maybe is the key question. Why don’t we start by for people who are uninitiated, don’t know what are the new mortgage rules that have just come down the pipe exactly? What are they?

David Larock: There are three rules. Two of them aren’t getting much play at all and one of them is getting all the play. In the interest of being thorough, why don’t we go through all three? The first two I’ll go through quickly. The first change is basically reminding lenders if they didn’t already know, reminding, first of all the changes that were made were made by the Office of the Superintendent of Financial Institutions and that’s a mouthful. We called them OSFI for short which is an acronym of their name. Basically OSFI regulates all of the federally regulated lenders in Canada. That’s most of them. Everybody but the credit unions because the credit unions are regulated provincially and private lenders. The first change from OSFI was basically to say that lenders can’t use creative solutions to get around loaned value limits.

For example, if a borrower needs to have 20% down in order to qualify for a certain product, the lender can’t come up with creative ways of giving them unsecured credit to get them to that 20% threshold. As I said in this week’s blog post, common sense it was just a bridge too far to assume that lenders would use common sense because really they shouldn’t be doing that, borrowers are supposed to be putting down money with cash on the barrel not with other borrowed funds. The first change was simply a reminder to them that they can’t do that. An explicit reminder. It’s a relatively minor change, I don’t think most lenders were doing it word on the street, it was mostly the banks at the branch level. Basically that’s just a bit of a hand slap for them.

Secondly, the second change was that OSFI said that it will now require lenders to enhance the loan devalued measurement and limits so that they will be dynamic and responsive to risk. They specifically mentioned in their explanation of what that meant because sometimes that wording can be a little bit obtuse for most of us, they said that basically they want lenders to start distinguishing between regional housing markets. For example, the loan devalue ratio is simply the percentage of the value of the property that is borrowed. If somebody borrows 500,000 on a million dollar property, the loan devalue is 50%. That can change quickly because if house prices drop precipitously, let’s say house prices drop by 20%, all of a sudden loan devalue ratios that at one point looked they were very much in line with long term averages, can suddenly look very much out of whack.

What OSFI’s really saying with this second change is that in the event that regional housing market is suffers a price correction, OSFI wants lenders to be able to track regional LTVs, in other words, if a lender has broad lending across the country, it can’t hide a regional disparity in an overall number. It has to be able to identify what the loan devalues are specific to each region. And if a region’s loan devalue ratio is unusually high, then those lenders are expected to restrict loan devalues in those regions until the LTV ratios come back in line. For example, the most recent example we saw this was in Alberta during the oil price shock and what happened is as house prices fell, lenders then scaled back the loan devalue ratio in Alberta. In other words, they said if you want to have access to certain products, now you have to increase your down payment because we’re worried about house prices.

Interestingly, lenders did this of their own accord. This was before OSFI mandated this change. What makes me a little bit nervous about this change and while nobody’s really talking about it now, we may be talking about it later is I’m concerned that maybe OSFI now wants to be a little bit more proactive about managing regional LPV ratios. In other words, maybe they’re going to start saying, “Well even though house prices haven’t dropped by much, we’re worried they might drop so we’re going to restrict loan devalue ratios in those regions preemptively.” If they do that, that may materialize the very risk that they’re hoping this policy with help guard against.

Not sounding any alarm bells here, but definitely watching this change with some caution because as I said in my post this week, regulators are no better at timing the market than we are and if they’re going to more actively manage these LTV ratios that lenders, that could be destabilizing and a concern. Again, no cause for alarm at this point but the fact that they’re explicitly mandating something that lenders were already doing of their own accord, causes me to question why a little bit.

The third change is the big one and that’s the stress test. Basically most of your listeners will be familiar with the stress test for high ratio borrowers. If you’re putting down less than 20%, you have to show that you can afford for rates to go up significantly and even though your mortgage rate is probably still below 3%, if you’re looking for a five year fixed rate, your application is qualified on a rate of 4.89% today. In other words, you have to show you can afford for rates to go to 4.89% if you go into debt, at below that 3% rate. What OSFI has now done is they’ve said, even if you don’t need default insurance, we are now going to mandate that every borrower, that a federally regulated lender lends to, has to qualify using a stress test and if you are a conventional borrower instead of having a 25 year am, you can still have a 30 year am, but we’re now going to qualify you on the greater of this stress test rate, which is 4.89% or at the rate on your mortgage that you’re applying for, plus 2%.

Interestingly, and somewhat baffling to me, they said that they added that greater of clause, where they take 2%, the contract rate on the mortgage you’re applying for plus 2%, they said that they were doing that to avoid people going into shorter term mortgage products or to avoid people being pushed into shorter term mortgage products in order to qualify. What I find baffling is that that greater of clause does exactly that. Today if you apply for a three year rate, you can get them as low as say 2.79% and five year fixed rates for a lot of uninsured borrowers are closer to 3.09%. 2% plus 2.79 is 4.79, ie that three year borrower would then qualify at the stress test rate of 4.89 ’cause that’s the, it’s the greater of 2%, your contract rate plus 2% or 4.89. That three year borrower, 2% plus the contract rate is 4.79 so then they would default to the stress test rate of 4.89.

The borrower who wants the five year fixed rate at 3.09 plus 2% would be at 5.09 so technically a borrower who’s borrowing right at the margin of their affordability would be able to afford to qualify for a three year fixed rate but not a five year fixed rate. What I find baffling is often said this change is meant to avoid people being pushed into shorter term rates to qualify and that’s exactly what their change has done. I’m shaking my head a little bit at Jeremy Rudin, I hope he reads my post at some point and I’m surprised that more people talking about the changes haven’t highlighted this because it is confounding to me that the policy would do the exact opposite of what OSFI has stated it is intended to do.

That’s the gist. In term of who that test will affect, one thing people need to remember is most borrowers aren’t pushing the envelope. They aren’t going right to the edge of the table in terms of what they can afford. It’s estimated that anywhere from one in six uninsured borrowers will be affected by this change. To be clear, that’s still a lot of borrowers, the uninsured market is still more than half of the overall mortgage market. A lot of those borrowers, it still affects a broad swath of borrowers. Some think it could be as many as one in four although the closest we can get to estimating who these borrowers are is the Bank of Canada study, it was done last year, where they looked at the increase in the number of borrowers at the margin who were just being able to qualify and that’s one of the reasons why this change came about.

Is they said, we’re seeing, our regulators said, OSFI and the Bank of Canada working together or all of our regulators looked at it and said, we’re seeing an increase in the number of borrowers who are right at the upper edge of their affordability which is somewhat expected when house prices were going up by so much. They wanted to address that problem. This change impacts those borrowers, the guys who are really at the edge of the table that if you use the Bank of Canada’s study from last year, that number’s probably closer to one in six. The banks say that 90% of their borrowers will be unaffected but this change is targeted straight at them and they’re talking their book there. Their CEOs are worried about their share prices and what people think is going to happen to their mortgage volume and I would not take their word for it on this one.

Andrew la Fleur: Interesting. One in six borrowers may be affected by it. Is that one in six of all borrowers or just one in six in the non-insured borrowers? People putting 20% down, is that what you mean?

David Larock: I would say good question. I would say one in six borrowers who are putting down 20% or more. Again, that’s the majority of borrowers and one in six is not a small number, it is definitely going to affect affordability in the market and overall demand. The question everybody asks is what is this going to do to house prices? It will slow the rate of house price appreciation. Will it lead to an outright decline? Hard to say. There’s no question that borrowers want to slow the rate of borrowing, there’s no question. I also have no doubt in my mind that if this sixth round of changes doesn’t do that, there’ll be a seventh round and an eighth round until they get exactly what they’re looking for. That slowing in the overall rate of household debt accumulation. In answer to your question Andrew, yes, my estimate is one in six borrowers who have down payments of 20% or more.

Andrew la Fleur: Just from your anecdotally, you have a high volume mortgage practice, would you say it’s similar numbers in the clients that you’re dealing with on a monthly and yearly basis? How many people are putting more than 20% down and who are borrowing to the very edge? Who if you suddenly chopped 20% of their borrowing power off would be severely affected?

David Larock: That an interesting question. I do business across the country but most of my business is in Toronto and of my Toronto business, most of it is in midtown Toronto. Those borrowers, for the borrowers that I’m dealing with, I went back and looked at my recent vintage of applications and I had very few who would be affected. Again, I wouldn’t want to extrapolate my portfolio of mortgages to the overall market because in midtown Toronto you get a lot of buyers who are buying their second home or their third home on the ladder. There’s lots of equity built up and generally speaking they’re farther along in their career. But I do work with lots of first time home buyers and not every first time home buyers is putting down less than 20% and even when I look at that group, it’s hard to find many at all that will be affected.

I’m often impressed by young borrowers being very practical in terms of how much they’re comfortable borrowing. The question I get is not how much would a lenders lend to me, what’s the most I can afford? It’s, we’ve done a budget, we’re comfortable spending X amount of dollars every month, let’s say, 2,000 or $2,500 a month, what can we afford based on wanting that to be our monthly mortgage cost? When people go about it that way they end up nowhere near the edge of the table in terms of what the lender will lend to them ’cause as I often say to borrowers, when the lender looks at the maximum they’ll lend you, they don’t care if you save for retirement, ever go out for a nice dinner or ever take a vacation. They’re only concern is is your income high enough to ensure that we’ll keep getting our payments on a timely basis. If the answer to that question is yes, then they’re done.

For real people, individual borrowers, people don’t want to be house poor. They don’t want to be locked into a corner where they can’t have any quality of life. Because the vast majority of people I talk to approach mortgage financing that way. That frames their thinking in a much more responsible way than the media generally talks about. The media likes to focus on that marginal story of that buyer who really pushed the envelope because they want a headline and the more salacious the story is, the better it sells, sad as that is common in our society. But on a day to day basis, those aren’t principles that I see come through my door.

Andrew la Fleur: Is this effectively shutting down he bank of mom and dad? What are your thoughts on that?

David Larock: I don’t think so. If affordability shrinks then one of the ways to combat that is to increase the down payment so if anything it increases the need for the bank of mom and dad for some borrowers. But because getting to that 20% threshold now no longer eliminates the need for the stress test, it reduces the effectiveness of the bank of mom and dad in all but cases where the bank of mom and dad has enough funds to simply buy the house outright and can simply toggle up the amount of a down payment to account for the higher standard. If the bank of mom and dad was getting their child just over 20% so that they could qualify without the stress test, definitely. The bank of mom and dad is now effectively been shut down but otherwise demand for some banks of mom and dad will increase because the stress test will shrink affordability and the bank of mom and dad might have to increase the down payment to enjoy that difference.

Again though, the bank of of mom and dad is, it’s a clever phrase that gets used a lot in the media and I definitely see banks of mom and dad in what I do, but it’s certainly not underpinning the market. It is a factor, but it is not the factor.

Andrew la Fleur: Interesting. Last time we spoke, few months back we talked a lot about interest rates. Why don’t you give us an update on where you think interest rates are heading moving forward and how your thoughts and predictions from a few months ago, how they played out or not.

David Larock: I said a few months ago that I thought concerns that rates were going to spike were overblown. There’s been lots of reasons for that being the case. I continue to believe that’s the case even more so now. If you go back and look at my Monday morning updates, I walk people through very systematically why I think rates aren’t going to go up as much as people think. One of the key points that I made last time was that the Canadian dollar had appreciated more rapidly than the Bank of Canada was expecting, that that would slow or exports and that as that happened, it would slow our economy down. In fact, that’s exactly the case. The last time the Bank of Canada did their economic forecasts, they had the loonie at 73 cents, it’s been hovering at 80 cents for the last couple months. It’s at 79 today but pretty much right there.

We had a bang up second quarter, 4.5% GDP growth in the second quarter but interestingly the loonie spiked right at the end of the second quarter, export volumes have dropped since, the economy has slowed considerably and the loonie hasn’t really sold off, it’s well above where it was the last time the Bank of Canada made its forecast. We’ll find out tomorrow, we’ll get the Bank of Canada’s latest update. They’re not expecting to raise rates, I certainly don’t think they will. But we’ll also get their monetary policy report which will include their new forecasts and we’ll see what kind of adjustments they’ve made because there’s no question in my mind the economy has slowed and I’m of the belief that it will continue to slow. As far as how these changes impact rates, the impact will only take pressure off of rates and here’s the reason why.

When you look at what’s been driving our economy since the Great Recession in 2008, it’s been consumer spending. Consumer spending accounts for about 58% of our overall GDP activity. Consumer spending is only paid for in one of three ways. Number one, by rising incomes. Number two, by a draw down in savings. And number three, by increased debt. When you look at what’s happened with incomes since 2008, they’ve risen by about 10%. Over that time, consumer spending has expanded by about 25%. Incomes have definitely been a factor but not the factor. Since 2008, our overall saving rate has increased from 3% to 4.5% so clearly it wasn’t a draw down in saving ’cause savings have gone up during that period. When you look at debt levels, and I did a post recently and I showed a graph on what has happened to household debt since 2008, they’ve gone right up. There’s a chart in they start in the bottom left corner and they went to the top right corner. There’s simply no denying that. Debt has driven consumer spending, has been the primary driver of consumer spending since 2008.

The changes that were announced last week are designed to slow the rate of household debt accumulation. I’m a long term guy and that’s probably going to be good for our economy in the long term even if it means there’s going to be short term pain. It’ll be short term pain for long term gain. But there’s no denying that household debt has been the primary driver of consumer spending for the last decade. If the government is determined to slow the rate of household debt accumulation, then that will slow consumer spending. If consumer spending slows and consumer spending drives almost 2/3 of our overall economic momentum, we will see a slowdown in our growth rate, in our GDP growth rate. Also, the Bank of Canada is very bullish about consumer sentiment and business sentiment, they saying businesses are starting to invest and all of these virtuous economic cycles are going to be underpinned by business investment, I can’t see businesses investing, all these sentiment surveys say that businesses are feeling more optimistic and they’re planning on investing. But if consumer spending slows and slows sharply I can’t see those businesses following through on those plans.

If consumer spending has been driving economic growth and consumer spending has been underpinned by rising household debt levels and if our regulators now determined to slow our rate of household borrowing, consumer spending will slow and with it our economic momentum will slow. As that happens, there’s no way the Bank of Canada will tighten, if anything, they may actually turn around and say, go from being neutral to saying we need to lower rates to stimulate economic growth and the bond market, I don’t think the bond market will be raising yields because investors certainly, the number one reason yields go up is investors are worried about inflation.

In a slowing economic environment, inflationary pressures are what we have is disinflation, not inflation and all of those factors together would portend lower rates not higher rates. Where as before, I thought rates might go up, but go up much more slowly than the regular Pollyanna is saying, “The sky is falling and everybody has to lock in today,” were saying. I’m more convinced now that rates are likely to either stay where they are or even go down a little bit in the near future as a direct result of these changes.

The last point I’ll make is some have felt that higher interest rates would be a way to address household borrowing and that’s always been a blunt tool because rates feed into all kinds of other parts of our economy and quite frankly, raising rates to full bore would hurt other parts of our economy even if it achieved that goal. The fact that we now have these macro provincial changes happening and our regulators are restricting actions to borrowing, that makes it even less likely that interest rates would ever be seen as a solution. The urgency for higher rates to slow household borrowing has effectively gone away if the changes made by our regulators achieve that end.

Andrew la Fleur: Why do you think, speaking of household debt, why do you think that OSFI and the feds in general are so obsessed with mortgage debt, housing debt, but never seem to bring up the subject of other forms of debt such as credit card debt and sources of debt that are really causing economic pain for people. 25% interest rates versus 3% mortgages that are tied to assets that have 2,000 years of history of increasing in value? What are your thoughts on that?

David Larock: It’s a great question and it’s one that our industry has asked for a long time. There’s several reasons. Number one, the amount of mortgage debt outstanding versus the amount of other forms of consumer credit outstanding, mortgage debt is much, much higher than other forms of consumer credit. On a proportionate basis, mortgage debt is an elephant and overall other forms of consumer credit even though their rates are higher, even though that kind of credit, there are more insidious lenders and it causes more hardship, if mortgage debt is an elephant, other forms of consumer credit are probably, I don’t know, maybe the size of a lion, comparably. That’s number one.

Number two, when there are large scale defaults in consumer credit the economy has a hiccup and hits a speed bump but it generally keeps chugging along because that kind of default is generally limited, it doesn’t lead to widespread contagion and lenders can generally certainly large lenders, can bear the brunt of that. Large scale mortgage defaults have much more significant effects on economies, look at the US economy, it still hasn’t recovered from its balance sheet crisis in 2008 and housing still hasn’t recovered there. It’s fed into all parts of the economy. A default in mortgage debt is like a nuclear bomb and an increase in defaults in consumer credit is more like a cruise missile. In answer to your question Andrew, mortgage debt has the potential to harm an economy much more significantly. A, because it’s much larger and B, because it feeds into other parts of the economy.

That said, I’m concerned that for example, the amortization periods on things like auto loans keep extending. At some point, people are going to be paying off their car loans after their cars are no longer working. If you can get a 10 year am on a car, I don’t know, I have a Subaru Forrester, bought it new, drove it into the ground, 12 years later it had a cracked engine, it would’ve had to pushed the thing down the street to get it to go. That was a very good car with low miles and I only got driven. 10 year ams for me on cars are to me, impractical and they’re going to lead to hardship for people because they’re going to be paying their leases off long after the cars are no longer working. Or there’s a significant risk of that.

It’s time for the government to address that concern although I will add the caveat, my industry talks way too much about it and does so, if it’s to say, well we should regulate mortgage debt, we should regulate other forms of consumer credit instead. I don’t think that a credible informed person should be saying that. Mortgage debt is more significant, there’s and denying it and while consumer credit needs a look, I don’t think it’s responsible to suggest that consumer credit is where we’re going to where regulation is needed  and mortgage credit is fine.

Andrew la Fleur: Interesting. David, we’ve run out of time, but again, appreciate your time today. Thank you for your insights and if people want to get of you, what’s the best way for them to do that?

David Larock: I would say they can either Google David Larock, my last name spelled exactly as it sound, L, A, R, as it sounds, L, A, R, O, C, K. Or they can go to my website at morplan.ca, morplan.ca.

Andrew la Fleur: Great. Thanks David and we’ll talk to you again soon.

David Larock: Thanks Andrew.

Andrew la Fleur: Great, thanks David and we’ll talk to you again soon.

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