Starting on January 1, 2018, the Office of the Superintendent of Financial Institutions (OSFI) has set a new minimum qualifying rate, or “stress test” for all prospective home buyers, even those with a down payment of over 20%.
Stress testing is a best practice risk management tool. Stress tests are not predictions or forecasts, they involve searching out extreme “what if” scenarios that have a very remote chance of happening, and planning for them. Diligent stress testing is an essential part of CMHC’s risk management program and allows CMHC to evaluate its capital levels against multiple scenarios. Effectively, they confirm if CMHC’s capital holdings are sufficient for even the most extreme scenarios.
Stress tests are used by financial institutions to gauge how their business would fare under extremely difficult conditions. They provide a formalized mechanism for companies to look at risks and to assess the impact of the different extreme events.
Why Conduct Stress Testing?
The credit crisis underlined the need for institutions, like CMHC, to conduct stress tests to ensure they are able to handle emergencies and remain solvent through severe economic challenges. Since 2008, regulators have set strict requirements regarding the type and severity of risk scenarios that institutions must use annually.
CMHC follows the guidance set by the Office of the Superintendent of Financial Institutions (OSFI) with respect to stress testing and, as such, uses certain severe and extreme scenarios in its stress testing. CMHC develops its own stress testing cases for business planning purposes.
Stress testing also provides an opportunity to assess a firm’s operational resiliency to respond to a crisis; for example, how well will processes, systems and people handle unexpected events or emergencies?
Stress Testing at CMHC
Corporate-wide stress testing scenarios are developed early in the year, are vetted internally, and are approved by CMHC’s Board of Directors.
In 2017, CMHC tested its mortgage loan insurance and securitization businesses against several extreme scenarios, including the following stress events:
A rapid increase in interest rates in the United States coupled with unsustainable debt levels in China cause large negative demand shocks globally. Downturns in the United States and China subsequently cause protectionism, widespread use of tariffs and euro-zone break-up.
Steep oil price fall
An unexpected excess supply causes a sharp drop in the price of oil to below $20, followed by prices in the $20-$30 range for about 2 years prior to recovery.
Multiple scenarios of a high-magnitude earthquake that disrupts critical infrastructure and services in a major urban centre, including broader financial impacts as a result of its effects on homeowners and businesses were run. Reporting reflects the most severe outcome of the simulations.
U.S.-style housing correction (mortgage loan insurance only)
A 5 percentage point increase in the unemployment rate with a 30% decline in house prices.
The results of this year’s scenarios on CMHC’s regulatory capital requirements (% MCT) confirm that CMHC’s capital holdings are sufficient for even the most extreme scenarios.
It would take a very severe housing downturn and a sustained high unemployment rate to start eroding CMHC’s capital in a significant manner or impact CMHC’s capacity to underwrite new mortgage loan insurance business.
*In millions, unless indicated
The underlying variables within each of the stress testing scenarios were developed based on a combination of hypothetical modelling and historical economic analysis.
2018 Stress Testing
The Office of the Chief Risk Officer works with different business areas across the Corporation, including an internal model validation team, to develop new or revised scenarios for CMHC’s annual stress testing exercise. The scenario themes being developed for 2018 are expected to be similar to the 2017 scenarios, with only minor changes to the economic assumptions and variables used in the models reflecting the current global economic environment.