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Canada's rising star.


In little more than four years, the mortgage-backed securities (MBS) market in Canada has achieved growing stature in a way that seems impervious to the jarring shifts of the investment playing field.

MBS issues backed by the federal government of Canada have racked up sales of $5 billion from the time they were introduced in 1983 to the end of last year, according to Doug Hughes, a Canadian MBS expert. Despite 1991's lackluster market, sales as of May had already topped $6 billion.

Hughes is formerly the general manager of the Canada's Mortgage-Backed Securities Center operated by the Canada Mortgage and Housing Corporation (Cannie Mae), the federal government's housing agency located in Toronto. Cannie Mae is also the administrator for the Canadian mortgage-backed securities program. Thus, the agency may be described as a kind of Canadian hybrid of both FHA and GNMA in the United States.

Securitized, residential first-mortgage loans are insured by Cannie Mae and are originated by banks, trust companies, credit unions and mortgage brokers and are then combined into pools for sale to investors. Cannie Mae guarantees full and timely payment of principal and interest to the MBS investor. When MBS are issued, the mortgages are converted into fully guaranteed, flexible and liquid instruments. Each MBS represents an undivided interest in a pool of mortgages. Although U.S. and Canadian mortgage-backed securities are structured in much the same way, there are differences in the standard mortgage terms and prepayment penalties (see Table 1).

Table : TABLE 1

Comparison of U.S. and Canadian MB

Ginnie Mae Canadian MBS

Standard Mortgage Terms
Standard term 30 years 5 years
Standard amortization 30 years 25 years
Principal due at maturity 0 94% of orig. balance
First prepayment date Immediate After 3 years

Prepayment Penalties

Full prepayment None 3 months interest

Partial prepayment:
 Amount allowed Unlimited 10% minimum
 Penalty None None

Given the total $225 billion in Canadian residential mortgage loan debt, $6 billion in securitized debt is, comparatively speaking, insignificant. But at the rate MBS issued in Canada have skyrocketed - the growth curve practically forms a 45-degree angle - some industry sources' predictions that they will become the largest single source of residential loan funding by the year 2000 doesn't seem the least bit fanciful.

Meeting housing's need

In the early 1980s, the Canadian federal government saw that there was a pressing need to lower interest rates and help provide affordable housing for its citizens. During that period's 22 percent interest rate environment, Cannie Mae's role was expanded through an amendment of the National Housing Act (NHA) to provide the unconditional guarantee of timely payment when pools of government-insured mortgages were created. In taking this step, Cannie Mae looked to accomplish three broad objectives: to lower interest rates in general, to accomplish the return of long-term mortgage financing and to facilitate the smooth functioning of a secondary mortgage market.

In 1987, Cannie Mae began its guarantee program on MBS pools of residential, government-insured, first mortgage loans. Later the guarantee was expanded to include guarantees on MBS of two types of mortgages: regular and social housing pools. MBS on social housing pools were first issued in 1988, and they consist of mortgages of government-subsidized social housing projects. The key feature of these mortgages is the elimination of prepayment - making them an attractive security for investors.

Other parties had joined the MBS market as well. In 1985, GMC Investors Corporation in Toronto began issuing securities called Guaranteed Mortgage Certificates (GMC) that were guaranteed by Citibank Canada, a subsidiary of Citicorp. At that time, company President Ivan Wahl said that U.S. mortgage-backed securities had become the most popular investment instruments in Wall Street history and claimed that "the GMC will be as successful in Canada [as Ginnie Maes are in the U.S.]."

The GMCs had limited potential, but in general, mortgage-backed securities were catching on fast - especially those carrying the Cannie Mae guarantee. Toronto-based FirstLine Trust, which Wahl now heads up, began issuing Cannie Mae-backed securities in 1987. Cannie Mae sources say sales have picked up steadily since then, and FirstLine issuances accounted for more than 30 percent of the total Canadian MBS issuance in 1990, according to Burns Bry, Limited, a Canadian investment firm.

Banks take the plunge too

The mortgage-backed securities market has seen a radical change in attitude on the part of investors in the last six months or so. For example, in an interview late last year, Wahl told Mortgage Banking that Canada's chartered banks were preoccupied with shaky, third-world real estate and corporate loans and only halfheartedly dabble in MBS. Cannie Mae data reflected that; at the end of 1990, trust companies held a 76.7 percent grip on investment market share. Banks had a 20.1 percent share, and life insurance companies had 3.2 percent share of investment.

Since then, however, banks have lunged into this investment pool with both feet. According to Cannie Mae, in February, banks' share of the market rose to 45.7 percent - nearly doubling in two months - and trust companies' share was reduced to 54.3 percent of the market for Cannie Mae-backed securities.

Why have the banks come alive so abruptly? Banks discovered that trust companies tended to stay away from MBS social housing pools. The banks were "stuffed with cash and realized they had to acquire assets, because loans on single-family housing had shrunk," said Hughes. Because banks were left with deposits they had to invest, they chose securities that backed mortgages on viable social housing projects where the mortgages were insured by Cannie Mae.

Therefore, rather than lose the business, banks have decided to take a 15 basis point spread, instead of the usual 200 basis points, Hughes said, and are now investing in social housing MBS to have those assets on their books. The can also use this investment to strengthen their community relations efforts.

Thus, what started as a program to provide shelter for low-income house-holds has taken off as an attractive investment opportunity. In 1989 more than half a billion dollars in lower-cost financing for this housing sector was generated on the strength of its non-prepayable, fixed rate of return appeal to investors. Social housing pools provided bond equivalent yields of approximately 10.1 percent as of April 30, 1991. At year-end 1990, the percentage of social housing MBS was nearly half of the total government-backed issuances, with approximately $294 million issued in the fourth quarter alone, according to Cannie Mae (see Chart 1). Of the two types of MBS, prepayable and non-prepayable, the social housing mortgages fall into the non-prepayable MBS category. These can be compared to the government-insured prepayable MBS that provide for 10 percent prepayments on the principal at the first and second anniversaries of the mortgage and on any amount after the third anniversary. A three-month interest penalty is imposed, however, even on the prepayable mortgage.


Mortgage-Backed Securities Inception-December 1990

Profile: FirstLine - a market leader

Several trust companies give FirstLine a competitive run in the prepayable market. On the other hand, Wahl says financial institutions, with huge staffs and overlapping layers of bureaucracies, "don't perceive MBS as a window of opportunity. They are not set up internally to make it worth the effort." FirstLine has designed its operations to track mortgage commitments, interest rate exposure, the bond market and many other administrative details, says Wahl. Its management says the company's success as an issuer of MBS is evidence that it has been well "worth the effort."

Wahl says FirstLine hopes to increase the size of its franchise network. Currently the network consists of 13 mortgage centers that originate product across Canada. Wahl plans on increasing the number of centers in the network to 50 by the end of 1991.

FirstLine also buys large blocks of mortgages from provincial governments that want to get out of non-profit rental housing loans. The company has purchased more than $460 million of these kinds of portfolios over the past three years from three provincial governments.

By charging 120 basis points as a yield on its investment vehicles such as its large mortgage portfolio, Wahl said FirstLine covers its overhead and makes a profit.

Market picture is bright

Cannie Mae data show that MBS produce higher yields than Government of Canada (GOC) bonds. During the third quarter of 1990, for example, the spread over GOC equivalent yields were 75 basis points for social housing (closed) MBA pools, 85 basis points for five-year, market residential (open) pools and 100 basis points for a 10-year term. Closed pools are those in which the borrower does not have the option to prepay principal. These securities, therefore, offer more predictable prepayment behavior, which makes them attractive to investors. Open pools consist of mortgages where the borrower has prepayment privileges, which are passed on to the investor when exercised.

Recent revisions to Cannie Mae-backed MBS include a fully open, 10-year, 10 percent rate buy-down mortgage that was marketed by a Toronto-area home builder in conjunction with the MBS program. (The usual Cannie Mae mortgage term is one to five years, with the first three years closed.)

In September 1990, Cannie Mae responded to market pressures and reduced the minimum eligible mortgage term for MBS. After lenders reported how popular these mortgages were with their customers, the Cannie Mae policy was changed so the term could be as low as six months, down from four-and-a-half years. This also had the effect of encouraging more capital market participants to originate funds at a lower cost. Are these shorter-length terms popular with investors? "Yes" says a source at Cannie Mae, although the shortest-term mortgage securitized as of this spring has been a 10-month term, according to the agency.

The wider range of terms in the Canadian secondary market is intended to stimulate efficiency and liquidity of mortgage markets by attracting more investors. The terms also help reduce interest rate risk for financial institutions, increase the number of issuers, make more mortgage funds available at lower rates and open up access to homeownership.

"MBS have been enormously successful in the United States over the past 20 years and in Canada over the past four. Even in the United Kingdom, where the approach to business is quite different, the building societies, as they call lenders over there, are beginning to wake up to their potential," says Wahl.

Canada is currently considering a number of programs and products for inclusion in the already proven and successful MBS program. Sales of Canadian MBS have ben noted domestically as well as in the United States, Hong Kong and other international markets. The future of this burgeoning market will no doubt be watched with interest by its financial market neighbor to the south, along with the rest of the world.

Albert Warson is a Toronto-based writer and editor specializing in real estate development issues.
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Title Annotation:the growing Canadian mortgage-backed securities market
Author:Warson, Albert
Publication:Mortgage Banking
Date:Jun 1, 1991
Previous Article:Branching out.
Next Article:1991 residential finance survey.

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