CMHC says stress test shows it can withstand extreme scenarios

The Royal Bank is increasing several of its residential mortgage rates, including fix posted rates as well as special offer rates. (AP / Nam Y. Huh)

TORONTO -- A sudden rise in interest rates could cause house prices to plummet on average 30 per cent nationally, according to stress tests performed by Canada's federal housing agency released Thursday.

Canada Mortgage and Housing Corp. said it studied the impact of two interest rate hikes -- a one percentage point increase over one quarter this year, followed by a 1.4 percentage point rise during one quarter next year.

CMHC said its mortgage insurance business would incur $1.13 billion in losses in such an event but that it could withstand the hit. A spokesman for the agency stressed that the scenario is an "extreme case" and would be unprecedented.

Interest rates have started to go up this week as a sell-off in the U.S. bond market has driven bond yields higher, making it more expensive for banks to access capital.

Two of Canada's biggest banks -- TD Bank (TSX:TD) and Royal Bank (TSX:RY) -- have hiked their fixed mortgage rates, anywhere from 0.05 percentage points to 0.4 percentage points.

There are concerns that as interest rates rise, some Canadian homeowners could encounter difficulty making their mortgage payments and face the risk of default.

"Households are so leveraged right now and house prices are at such incredibly high levels relative to household incomes," said David Madani, senior Canada economist at Capital Economics.

"Even a moderate doubling in interest rates -- which sounds like a lot but we're talking about maybe 200 basis points (two percentage points) -- could potentially pop the housing bubble."

The stress test conducted by CMHC was one of several extreme scenarios it examined over a time period from 2017-2021. They included a U.S.-style housing correction, a high-magnitude earthquake that destroys critical infrastructure in a major Canadian city and a drop in oil prices where they fall to US$20 per barrel next year and remain between US$20-30 for another four years.

Another scenario that the agency tested involved a "severe and prolonged" economic depression, which CMHC said would see house prices drop 25 per cent and unemployment rise to 13.5 per cent. The insurer said it would incur $3.12 billion in losses in that case.

CMHC said its capital holdings were sufficient to withstand all scenarios it tested. None of the scenarios should be considered a prediction or forecast, the agency added.

"Stress testing involves searching out extreme scenarios that have a very remote chance of happening and planning for them," Romy Bowers, CMHC's chief risk officer, said in a statement.

"Rigorous stress testing is an essential part of our risk management program and allows CMHC to evaluate its capital levels against these scenarios."