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“Risk-Off” in the Canadian Mortgage Market

risk-of-mortgage-insuranceThere’s a growing air of uncertainty in the mortgage industry, one we haven’t sensed since the tail end of the credit crunch.

Regulators, media and politicians are waving the caution flag on housing and mortgages, and the foundation of our market (CMHC) is suggesting they’re running out of insurance room.

This has much of the industry in a risk minimization (“risk-off”) mode. In turn, mortgages that are not insurable, income-qualified and owner-occupied are now attracting more scrutiny.

Here’s what we’re hearing…

On CMHC’s $600 billion insurance cap…

  • CMHCThe consensus among industry executives we spoke with is that CMHC will not receive near-term approval to write more than $600 billion worth of mortgage default insurance. Political and risk concerns are the most cited reasons for this.
  • That may change if CMHC approaches parliament with urgency to lift its cap. (We don’t have enough information to judge this probability, so we won’t.)
  • “The government doesn’t want lenders insuring low loan-to-values,” one capital markets expert told us, on condition of anonymity. Insuring low LTV mortgages suggests banks are abnormally concerned about risk and eager to find a way around OSFI’s capital guidelines (buying mortgage insurance lowers banks’ capital costs in many cases).
  • Lenders are reportedly disproportionately relying on low-ratio insurance to cover themselves on mortgages in Toronto and Vancouver where price risk means 80% LTV is less security than in most cities.
  • “There is a false comfort in loan-to-values.” It’s often better to have more room to service debt, than more equity, said the above source. “If I’m choosing between an 80% LTV with a 42% TDS and a 95% LTV with a 30% TDS, I’ll take the latter.”
  • We’ll find out how close CMHC is to its present $600 billion cap when it issues its 4th quarter financials (due by month’s end).

On covered bonds…

  • Bond-dealersPressure to increase the $600 billion ceiling may wane if the government decides it will no longer guarantee covered bonds. (We could hear more about that in the next 30-60 days when new covered bond legislation is rumoured to be due).
  • Covered bonds used up roughly $24 billion of insurance capacity in 2011.
  • The government’s position is that covered bonds don’t need to rely on insurance, and that’s true in some cases.
  • The Covered Bond Report cites evidence that RBC’s covered bonds (which are backed by uninsured conventional mortgages) demand yields as low as five basis points above insured covered bonds. (That’s a tight spread. Albeit, other issuers would likely pay more than RBC, given its strong credit rating.)
  • Our key source above told us: “The Feds are going to have to increase the covered bonds limit if they’re serious about not harming liquidity.”

On lenders’ backup plans…

  • contingency-plansWord is, a slew of lenders have been on the phone with Genworth and Canada Guaranty. They’re looking for a replacement to the bulk insurance they can no longer buy in size from CMHC.
  • We spoke with other knowledgeable sources who speculate that private insurers may only be able to fill demand for a year or so before hitting their own insurance limits.
  • Another question is, what cost premium will investors demand from lenders in order to buy mortgages backed by private insurers (who have a 90% government guarantee versus CMHC 100% guarantee). At the consumer level, a 10 basis point interest rate disadvantage is a turnoff in today’s competitive mortgage arena.
  • Non-bank lenders have been calling “every available liquidity source” one lender executive told us yesterday.
  • Another lender said: “Investors’ appetite for private insurance will dictate how much conventional business monolines do…Banks can withstand this because they will put it on their balance sheet….with no conventional rate premium.”

On CMHC portfolio insurance limits…

  • The ramifications of CMHC nearing its $600 billion insurance cap are potentially great. The most noticeable outcome so far has been CMHC’s first-ever bulk insurance rationing system. Depending on how CMHC allocates bulk insurance to lenders, it could:
    1. adversely impact smaller lenders who rely on portfolio insurance for liquidity OR provide an advantage to certain smaller/newer lenders (depending on whether their cap on buying bulk insurance is based on an industry average [which could be relatively large for a small lender])
    2. adversely impact major banks that use portfolio insurance for capital relief.
    3. adversely impact consumers by way of fewer product options and higher rates on low-ratio mortgages
  • Ron-SwiftRon Swift, CEO of Pacific Mortgage Group Inc., told us yesterday: “The result of these restrictions ultimately means there will be an impact on liquidity in the market place. I think this will first impact products that have the higher insurance costs, such as stated income & self-employed. They will either be stopped or the rates charged to these clients will have to be significantly increased. Either way, tightening liquidity, reducing mortgage options or increasing the costs will take some buyers out of the market, which will affect all of us.”
  • Thus far, we’ve seen a handful of non-bank lenders announce higher conventional (<=80% LTV) mortgage rates. More are expected to follow.

On stated income mortgages…

  • OSFI, Canada’s bank regulator, has been concerned about stated income mortgages for months.
  • firstlineFirstLine, a major lender and one of CIBC’s mortgage divisions, dropped a bombshell on brokers Tuesday. It announced that it’s suspending stated income approvals effective immediately. (Refis and switches among CIBC’s own brands are not impacted.)
  • We’ve already heard of other lenders either terminating their stated income programs or upcharging the rates.
  • As a side note: CIBC says its “changes affect FirstLine only,” which will really tick off brokers. It seems that CIBC’s decisions to: a) apply this policy only to brokers, b) severely undercut brokers on renewal, and c) apply rate favouritism to its retail channel, are destroying FirstLine’s long-standing goodwill among brokers. We hate saying that because we have all the respect in the world for the BDMs, underwriters and management we have had the privilege of knowing at FirstLine. This decision obviously comes from above their heads.

On the lead time CMHC gave to lenders…

  • last-minute-announcementCMHC seems to have been caught by surprise by the demand spike for bulk insurance. Lenders were reportedly given barely a month’s notice that they would be subject to rationing of this insurance.
  • Some had no idea how much less portfolio insurance they’d be permitted to buy until this week. It turned out to be drastically less, and it could materially impact their business models, especially for smaller lenders who rely on this insurance for securitization.
  • One lender exec said that CMHC should have provided at least 90 days notice so lenders could plan contingencies. That individual summarized the new default insurance allocation process with two words:  “Bad execution.”

On who wins in all this…

  • winnersB Lenders
  • The Big 6 Banks
    • On one hand, they lose due to higher capital costs—as CMHC tightens the tap on bulk insurance.
    • They could gain however in terms of market share on conventional mortgages. That depends, of course, on how widely available CMHC portfolio insurance is going forward.
  • Mortgage insurers Genworth (TSX: MIC) and Canada Guaranty
    • Demand for private insurance may increase, for at least the remainder of 2012 anyway.

It bears noting that the situation is relatively fluid at the moment. Things may change and nothing is written in stone. Perhaps we’ll see CMHC make a statement soon that reassures the market. In any case, we’ll know more as the next week unfolds.

Rob McLister, CMT