The time is ripe for the emergence of a residential mortgage-backed securities (RMBS) market in Canada. For some, RMBS bring back nightmares of the subprime crisis in the United States, but the situation in Canada is very different even with overvalued housing markets in Toronto and Vancouver, according to two mortgage industry veterans.
What’s spurring the development of an RMBS market in Canada is the federal government cutting back on the amount of mortgages it insures. The government’s recent policy changes, like mortgage-rate stress tests for insured borrowers, indicate its shift in support toward safer mortgages.
The federal government wants to decrease its (taxpayers’) exposure to housing market risks. Therefore, there is a growing amount of uninsured mortgages.
“These measures promote the assessment and pricing of potential housing risks by the private market, further development of private mortgage funding markets, and greater market discipline,” said a Department of Finance official in an email.
In that vein, BMO plans to issue a $2 billion RMBS deal backed by prime, uninsured mortgages without any government or third-party credit support. The structure yields 95 percent AAA-rated bonds with credit enhancement coming from lower-rated bonds and excess cash flows generated by the difference between the mortgage rates and the deal’s expected bond coupon rates.
“The idea of additional uninsured MBS in the marketplace, actually I’m very comfortable with it. I think it’s a natural evolution in the marketplace,” said Paul Taylor, president and CEO, Mortgage Professionals of Canada, in a phone interview.
In its December 2015 Financial System Review, the Bank of Canada reviewed mortgage securitization (the process of turning mortgages into bonds) in Canada and suggested that the government could reduce its involvement in the housing market by reinvigorating private mortgage securitization.
From 2000 to 2015, the share of mortgages securitized with government involvement rose from 50 percent to almost 100 percent. New issuance of RMBS has been close to non-existent in Canada in recent years.
“The development of private vehicles depends in part on the growth rate of uninsured mortgage credit and the extent to which it outstrips financial institutions’ existing funding sources,” according to accounting firm KPMG in its review of the government’s Canada Mortgage Bonds program.
However, more uninsured mortgages mean a bigger funding challenge for smaller lenders who don’t have the type of capital markets access the big banks do. The big banks have been increasing their funding of uninsured mortgages by issuing covered bonds, a type of corporate debt backed by mortgages.
Alternative Funding Source
Steel Curtain Canadian Mortgage Group, a division of Greater New York Area-based Steel Curtain Capital Group, LLC, plans to launch Canada’s first private-label multi-seller mortgage securitization conduit. Its founder and owner, Frank T. Pallotta, sees the conduit as becoming a viable alternative for small lenders’ funding.
“We are not earmarking insurable loans for this program,” Pallotta said in a phone interview. The category of mortgages being targeted is “near-prime” and may also focus on loans that are no longer insurable due to the government’s tighter restrictions.
Working with investors, Pallotta sees potential for better risk versus return with near-prime (also known as “alt-A”) mortgages, which have higher rates than prime, insured mortgages.
For example, the prime BMO deal has a weighted-average loan-to-value (LTV) ratio of 66.5 percent, credit score of 741, and mortgage rate of 2.50 percent.
The near-prime mortgages Steel Curtain has been reviewing for nearly a year now have a 4.75 percent mortgage rate, 69 percent LTV, and 650 credit score.
Pallotta, who worked through the subprime crisis in the United States, said the introduction of no-documentation with no-money-down loans there was a tipping point. The near-prime mortgages he intends to work with mostly fall into the two strongest documentation categories based on the rating agency DBRS’s scale.
For many years well before the subprime crisis, RMBS had a solid reputation. Pallotta said Canada has the elements for a successful RMBS market: strong legal and regulatory frameworks, strict underwriting standards, and borrowers who pay their mortgages.
Canadian borrowers can’t legally walk away from their obligations like their American counterparts in many states did when the value of their homes dropped below the amount remaining on their mortgages (negative equity).
Pallotta and Taylor both said it, “Canadians pay their mortgages.”
Default rates on Canadian mortgages have been very low historically. According to DBRS, the percentage of mortgages over 90 days past due is 0.28 percent as of October 2016.
Housing Bubble?
The elephant in the room is Toronto’s scorching housing market, which might be cause for concern to investors buying bonds backed by uninsured mortgages.
But Taylor thinks it’s much more likely that house prices in Toronto and Vancouver level off as opposed to crash.
“I have a difficult time envisioning people actually losing value in the property that they own. But even if they do, I still think that the vast majority of those people are going to continue to pay their mortgages,” Taylor said. And that’s what’s important for the success of RMBS.
The April 20 measures from the province of Ontario, which included a 15 percent tax on foreign buyers that dampened Vancouver’s housing market and an expansion of rent control, aim to temper Toronto’s fiery market.
Pallotta is also skeptical about a severe downturn in Canadian housing.
“If you continue to see LTVs in the mid- to high-60s when home prices go up, I think it’s a concern, but it’s not a huge concern because the borrowers still have skin in the game,” Pallotta said.
“In the U.S. when the bubble really started to move up and home prices really jumped up, LTVs also started to leap up, so you had that misalignment [of incentives].”
Pallotta added that, in Canada’s case, the incentives between lenders, borrowers, investment bankers, and investors are sufficiently aligned such that any housing bubble is less of a concern for RMBS.
The BMO deal also provides an example of the kind of structure Pallotta envisions. It’s a familiar structure that has been around for decades and doesn’t involve any of the complex features that garnered infamy during the financial crisis.
“The structures we’re looking at are very ‘vanilla’; way pre-crisis,” Pallotta said.
“I expect in the longer term all of the large banks will be issuing their RMBS,” Taylor said.
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