Moody’s Investors Service estimates that a severe economic shock could cause a 44% drop in Canadian house prices.

Moody’s House Price Stress Rate (HPSR), which estimates how far house prices will fall in response to a severe economic shock, projects that overall prices in Canada could fall by 44% in such a scenario (ranging from 38% in New Brunswick to 50% in the Yukon).

The estimates represent a combination of both fixed and variable factors, and uses the macroeconomic environments of Finland in 1989, Japan in 1991, and Hong Kong in 1997, to inform an analysis of how far house prices could fall in a given economic shock. Additionally, the rating agency says it has considered the macroeconomic environments of Ireland in 2006, and also Nevada and California as examples of severe economic shocks.

The variable factor addresses the extent to which current house prices have departed from sustainable market fundamentals, and assumes a portion of price growth will be lost in response to a severe economic shock. The fixed factor deals with the extent that structural features of the economy, such as oversupply of housing, contribute to further declines in prices.

The report notes that Canada, along with Australia, Spain and the UK, have the highest variable factor due mainly to their high growth in house prices over the past 10 years, which has outstripped fundamental drivers such as the growth in household income over the same period. In Canada for example, house prices are up about 100% in that period, while incomes have only risen by 55%.

Conversely, despite concerns about excess inventory in the multi-family/condominium sector, Moody’s says the overall housing supply, especially the single family segment, seems to be in line with demographic trends. “Construction sector employment averaged around 7% and construction sector contribution close to 6% of GDP. These numbers have remained stable despite the robust housing market of the past decade, indicating that housing growth is consistent with overall demographic/GDP trends and not driven by speculative capital,” it says.

It also notes that concerns over high leverage in Canada are offset by higher savings rates, and the availability of monetary policy tools to cushion against an economic shock.

The HPSR is used in Moody’s implementation of its residential mortgage collateral analysis model, and is included in its request for comment on its proposed approach to analyzing the credit risk of Canadian non-insured mortgage pools. Moody’s plans to use the proposed approach, along with its existing methodologies, to rate covered bond and asset-backed commercial paper (ABCP) transactions backed by these mortgage pools. It seeks comments by April 15.