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Mortgage-backed securities: a Canadian perspective.

The Canadian mortgage market is unique in many respects. The basic mortgage instrument and the handful of lenders holding large market share set the market apart.

But like the American market, it appears ripe for major growth in its MBS market.

The mortgage-backed security market in Canada has been in a dramatic growth phase since its introduction in 1985. Though Canada was much later in joining the international trend toward mortgage securitization than the United States, the growth in Canada's MBS market thus far has demonstrated that a significant market segment is showing rapid signs of development.

This article views the MBS market in Canada from the perspective of a Canadian issuer. Further developments in other international markets will be interesting to watch as the beginnings of a truly global MBS market are starting to take shape.

The growth of mortgage securitization outside the United States has developed slowly and certainly not to the same extent as in the United States. The Canadian situation will be dealt with in further detail later on; however, a quick review of developments in other parts of the world is in order.

The second most successful foray into the mortgage securitization market has occurred in the United Kingdom. There, however, broad-based government support and stabilization have been absent, and none of the mortgage-backed security instruments that have developed there have enjoyed the full faith and credit of the British government. Such backing would provide the stability sought by prudent investors.

Something worth noting in the development of the mortgage security market in the United Kingdom has been the fact that the traditional mortgage lenders in that country--the building societies--have not embraced the MBS methodology at all. The net result has been that "new lenders" have been developed, some of which have American sponsorship, such as The Mortgage Corporation Inc., which was sponsored and started by Salomon Brothers. This new breed of lenders captured significant market share in their first few years of operation, and their more-competitive rates and aggressive marketing style fueled the supply of mortgages for the mortgage securitization process in the United Kingdom early on. (More recently these nontraditional lenders have hit on more difficult times, which has affected volume.) However, in recent months, the building societies have become more aggressive in terms of interest rates, and in some cases, they have decided to securitize on their own without the government's involvement.

However, private enterprise has developed some innovative and profitable techniques for mortgage securities, and thus far about |pounds~8 billion of mortgage securities have been brought to the public capital markets. This represents only about 3 percent or 4 percent of the national market for mortgages in the United Kingdom.

Australia has had a similarly slow start. There is no single source of published figures, but certainly less than 1 percent of that mortgage market has been securitized at this point.

Recent efforts at growing MBS markets have begun in some European countries, such as France, Sweden, Denmark and Spain.

Canada's home mortgage market

The residential mortgage market in Canada has grown rapidly over the past 20 years and now approximates $285 billion in outstanding residential mortgages. It is, however, dominated by 12 major financial institutions, which control approximately 84 percent of the market. The largest of these players is the Royal Bank of Canada, which has approximately 11 percent of the Canadian market.

This situation, in which similarly structured financial institutions have gained an oligopoly, has led to a somewhat noncompetitive situation from the borrowers' point of view. Similar offerings by lenders in terms of interest rates, prepayment privileges and underwriting techniques have left the Canadian homeowner very little choice as to where to apply and the prospects for ultimate funding. As a result, interest rates on mortgages have exceeded 200 basis points over the similar-term Canadian government bond during the past five years.

The development of the Canadian residential mortgage market has taken some significant turns in the past 30 years. Before 1967, the major banks were not a significant factor in the mortgage marketplace because of a restriction on holding mortgages on bank balance sheets, as well as the inability to charge higher than 6 percent on any bank loans.

However, changes contained in the Bank Act of 1967 dramatically turned around the market-share positioning of the various players. The major banks now make up more than 50 percent of the overall market, primarily at the expense of trust companies and, notably, life insurance companies.

In the Canadian mortgage market, the other interesting departure from the U.S. formula has been the elimination of long-term, fixed-rate mortgages. In the early 1960s, Canadian financial institutions--such as trust companies, and later in the decade, banks--started funding mortgages primarily with similarly termed guaranteed investment certificates (GICs). Because they were unable to issue investment certificates to the public on their deposits for more than five years that would, in turn, be guaranteed by the government of Canada through the Canada Deposit Insurance Corporation (CDIC), these financial institutions found it convenient and prudent to provide mortgages that were no more than five years in length.

This process, in hindsight, appears to have been one of the smarter moves in the world of financial institution regulation and response. The U.S. savings and loan debacle very clearly pointed out the folly of the continued practice of funding long-term mortgages with short-term deposits. As a result, through most of the 1960s and 1970s, the bulk of the Canadian mortgages issued were five years in term; however, the mortgages themselves would be paid off over 25 years.

The limited term (five years) technically required a balloon payment at maturity. In practice, as long as a borrower made reasonably regular payments, most financial institutions used the opportunity at the end of the maturity term to renew the mortgage at a current market interest rate. No further documentation was required, and in many cases, the financial institutions involved did not even register an amending agreement showing the change of interest rate on the mortgage itself. This became an easy way to handle the individual mortgage.

In Canada, again in a departure from U.S. practice, the interest paid on individual mortgages has never been deductible for income tax purposes. As a result, there is a significant financial incentive to pay off the mortgage as quickly as possible because borrowers are using after-tax dollars.

A significant contribution

The establishment in 1946 of the Canada Mortgage and Housing Corporation with a mandate to provide mortgage insurance to Canadians made a significant contribution to the development of the housing market.

The significant recession and ultimate stagflation that occurred in 1981 and 1982 caused long-term interest rates to hit 18 percent on five-year mortgages and short-term interest rates to exceed 22 percent on individual six-month and one-year mortgages. At this point, very few borrowers were prepared to lock in interest rates for any significant length of time. As a result, the beginnings of a much shorter-term market developed in the early 1980s.

The average composition of the mortgage portfolios of most Canadian financial institutions today includes an average term to maturity of two to three years. As a result, there is a significant amount of renewal business, which many estimate totals $80 billion to $100 billion per year.

Limited prepayment rights

Unlike U.S. borrowers, Canadian borrowers do not have nearly as much flexibility in their right to repay a mortgage. Most of the mortgages written by the major financial institutions that are conventional (i.e., less than 75 percent loan-to-value) are technically closed; the borrower has no absolute contractual right to prepay the mortgage.

However, most Canadian banks and financial institutions are prepared to allow borrowers to prepay their mortgage, especially if they have sold their home subject to a significant interest penalty, which can often range from three to six months of interest. Most financial institutions make some provision to allow the borrower to prepay some specified amount on a per calendar-year basis (usually a range of 10 percent to 15 percent) without penalty.

The path of development

The development of the Canadian MBS market has been extremely slow in comparison with that of the United States. However, the Canadian MBS market began to grow rapidly from 1987 to 1993. Observing the successful development of the Government National Mortgage Association (GNMA) in the United States, it became clear that there were no unsurmountable legal impediments to the development of a secondary mortgage market in Canada. However, the caution of existing portfolio lenders to sell into the secondary market has contributed to the slowness of the development.

The government of Canada has tried many initiatives, including the 1973 incorporation of the Federal Mortgage Exchange Corporation. This entity was designed to stimulate and be a catalyst for the development of a secondary mortgage market.

The first publicly issued MBS in Canada was the Guaranteed Mortgage Certificate, issued by GMC Investors Corporation in late 1985. The security was an interesting hybrid of government-insured mortgages and timely payment guarantees supplied by Citibank Canada. The instrument was rated "double A (high)" by Dominion Bond Rating Service and subsequently as "AAA" by Canada Bond Rating Service.

Several years ago, the government of Canada announced in the budget of February 1984 that it would sponsor and initiate timely payment guarantees for MBS; however, the enabling legislation and the subsequent program were not established until early 1987.

The development of the federal government program through the Canada Mortgage and Housing Corporation (CMHC) was based on a model similar to the GNMA program in the United States. Under the Canadian version, all individual mortgages must be insured under the National Housing Act and the mortgages must be originated and serviced by a CMHC-approved lender.

Once the mortgages are put into homogeneous pools (similar maturities, similar interest rates, similar amortization periods, geographical diversification, etc.), the mortgages are pooled and securities are issued on the basis of an undivided interest in the pool. The process of paying the investors each month is carried out by a central payor and transfer agent (CPTA), a contract awarded to Montreal Trust Co. in 1986.

CMHC supplies a guarantee of the timely payment both of principal and interest on a monthly basis and of the total amount of the principal outstanding at maturity. As a result, each of these securities carries the full faith and credit of the Canadian government. Figure 2 shows the overall growth and newly issued securities, as well as the market share by issuer for the years 1987 to 1993.

There have been some interesting developments in the market outside of the CMHC MBS program. One such development has been the creation of the special-purpose trust established by Central Guaranty Trust that holds conventional mortgages and offers limited subordination for the purposes of passing through interest on a timely basis, as well as a full amount of the subordination up to a specific limit of 5 percent in the event of default on the individual mortgages.

The FirstLine NHA Mortgage Trust has also been established as a specific-purpose trust with a mandate to purchase NHA-insured mortgages and fund them with a combination of commercial paper and midterm notes. The midterm notes carry a six-month payment of interest and no principal prepayment prior to the maturity date. The commercial paper is rated at an "R1 (high") and the midterm notes are rated "Triple A" by both Canada Bond Rating Service and Dominion Bond Rating Service. Both Royal Trust and Van City Savings have also issued MBS, but mostly with some success in the Euro-Canadian bond market and limited distribution in Canada.

No Fannie or Freddie yet

Unlike the United States, Canada still has not developed a significant alternative to the CMHC program for the securitization of conventional mortgages. However, those issuers who are active players in the securitization market are currently absorbing the cost of the CMHC insurance premium on conventional mortgages in order to make them eligible for the CMHC MBS program.

CMHC charges a one-time insurance premium for the life of the loan that is based on the loan-to-value. The loan-to-value is considered a good indicator of risk levels and the insurance premium varies between 1 percent and 2.5 percent based on a range of loan-to-values from less than 65 percent to 95 percent.

Thus far, in a period of seven years, the Canadian MBS market has extended to approximately $16 billion in newly issued MBS, only a little more than 5 percent of the total value of all outstanding home mortgages. While the penetration of the mortgage market has been much slower than anticipated, the progress made so far is seen as a good indicator of a promising future.

It should be noted in passing that the Canadian government MBS is not subject to international withholding tax and, therefore, nonresident Canadian investors would not be subject to any Canadian withholding tax.

Recently the first CMO structures have been issued in Canada. Two CMO offerings totaling approximately $600 million were brought to market and the issuers were FirstLine Trust and the National Bank of Canada. With an upward sloping yield curve, this has been perceived as an effective execution of mortgage-backed securities.

Another particularly attractive aspect of a Canadian MBS for international investors is that it carries a zero percent risk-rating using the Bank for International Settlement standard for capital adequacy for international banks.

Two distinct markets

The development of the mortgage market in the United States has varied dramatically from that of Canada. This mostly traces to the restriction on developing national branch banking in the United States. As a result, the pace of development of national mortgage lenders was held back some and the mortgage business has remained highly fragmented. The recent trend of mortgage banking companies going public has clearly demonstrated the current capacity for national lending in the United States.

Canada, on the other hand, is extensively served by its five major banks--with approximately 10,000 branches among them--and two major trust companies. As a result, the Canadian mortgage business is highly concentrated: approximately 12 players make up the vast majority of the marketplace. This oligopoly has lead to significantly reduced competition in mortgage lending, especially in terms of pricing.

One interesting comparison between the U.S. and the Canadian mortgage markets is that historically Canadian default rates have been significantly lower than in the United States. For example, the Canadian default rate (defined as 90 days in arrears) for the fourth quarter 1992 was less than 1 percent on a national basis.

The U.S. MBS market was developed for entirely different reasons than the Canadian market, and yet the potential for the MBS market in Canada is significant. And even though the MBS market in Canada is developing in response to different stimuli, the net result to Canadian consumers would be very similar to the results enjoyed by American consumers: borrowers get lower interest rates, while investors get higher interest rates.

Potential to outgrow U.S. market

The Canadian MBS market has developed relatively slowly so far, mostly because of the reluctance of the existing large suppliers of mortgage money to sell their mortgages to institutional investors. However, a credible argument can be made that the ultimate share of the Canadian residential mortgage market that will be securitized will be even greater than in the United States. That argument rests on the following points:

* In the United States, the vast majority of mortgages have been 30-year, fixed-rate loans. As a result, those seasoned mortgages already written at a low interest rate would be almost impossible to securitize, because homeowners would have no incentive to trade them in for a new mortgage funded by MBS. The recent refi mania has obviously securitized much more of the market.

* Canadian mortgages, because of their much shorter duration, will all renew with their existing lenders at current market rates over the next five years. In fact, it is estimated that approximately $100 billion of mortgages renew each calendar year in Canada.

* A significant opportunity exists for Canadian MBS issuers to capture a significant portion of this market through aggressive marketing and pricing.

* The market for MBS in Canada is considerably broader than it is in the United States. This is so because in the United States the secondary market agency programs and the FHA are constrained by relatively low loan limits. The U.S. programs have always been intended for the low- and middle-income borrower, and as a result, the amount of the total U.S. mortgage market that can be securitized with government backing is significantly less than the total market. However, the private pass-through market in the United States does serve the jumbo nonconforming market increasingly well.

* In Canada, however, CMHC has followed a very enlightened view and has ensured that NHA insurance can apply on all Canadian residential properties, subject to certain underwriting criteria but without limit as to the size of the individual mortgage. These large mortgages, in turn, may be securitized using the CMHC MBS program. The public policy rationale for this is that the CMHC timely payment guarantee and the mortgage insurance fund are self-sustaining, and, therefore, the benefits of securitization--lower interest rates for consumers--should be made equally available to all Canadians.

* Another factor encouraging the securitization of mortgages in Canada is the very noncompetitive nature of the mortgage lending oligopoly that has arisen. Existing financial institutions that have large mortgage portfolios that roll over or renew on a very short-term basis are unlikely to cannibalize their own profit margins by offering interest rates to their renewal customers that are significantly lower than the existing market demands.

* Aggressive mortgage lenders in Canada who use MBS funding will continue to gain significant market share by offering interest rates lower than those of the existing players.

FirstLine Trust Company is a specific case in point. It has grown from $150 million of assets under administration in 1987 to more than $5 billion in 1993. During this period, its growth was fueled by averaging 30 basis points below every major bank and trust company in Canada for five-year mortgages. As a result, FirstLine enjoys approximately 30 percent of the MBS market.

Prospects for Canada's market

Estimations of the potential size of the MBS market in Canada vary dramatically depending on the underlying assumptions. Consistent with the competitive rate advantage that has been demonstrated so far by MBS issuers, capturing 25 percent to 30 percent of the ultimate market is certainly achievable during the next five to ten years. As a result, the market could develop to significantly more than $100 billion during the 1990s.

At some point, the capital-adequacy rules of the BIS will favor a strong emphasis on the off-balance sheet treatment available for MBS, and at that time, the major banks and trust companies will use MBS as an asset/liability tool to reduce interest rate risk and optimize capital allocation.

Ivan S. Wahl is chairman of FirstLine Trust Co. Based in Toronto, the company is a subsidiary of Manulife Financial.
COPYRIGHT 1993 Mortgage Bankers Association of America
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Author:Wahl, Ivan S.
Publication:Mortgage Banking
Date:Sep 1, 1993
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