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Big Changes for CMHC & Covered Bonds – The Impact

CMHCCanada’s national housing agency is getting so big and so important to the financial system that the government wants to keep a sharper eye on it.

As a result, CMHC, which is also the nation’s largest default insurer and guarantor of mortgage-backed securities, is being moved under the supervision of OSFI – the country’s top financial regulator.

This will “contribute to the stability of the housing market and benefit all Canadians,” Finance Minister Jim Flaherty said Thursday.

Here’s a look at some of the potential effects.


First off, if this new legislation passes, the Department of Finance gains direct control (through OSFI) over the “safety and soundness” of CMHC’s commercial activities, securitization program and any new mortgage-related programs that CMHC wants to launch. CMHC is currently overseen by Human Resources Minister Diane Finley which, to some, has never made a whole lot of sense due to the specialized financial nature of CMHC’s business.

Today’s news may subject CMHC to more micro-management of its commercial activities than it has ever had to deal with. Some expect today’s announcement to also result in even greater public disclosure of CMHC’s insurance activities. Both are a good thing from a systemic risk control standpoint.

Another potential impact – and this is just a guess – is that OSFI puts CMHC’s “higher-risk” mortgage insurance under further scrutiny. In time, that could potentially affect programs like self-employed stated income insurance, for example.

Flaherty told reporters today that reorganization of CMHC’s governance is justified: “I’ve been concerned about the CMHC for some time in the sense that it’s become an important financial institution in Canada, and it was not subject to the same supervision by the Office of the Superintendent of Financial Institutions.”

Indeed, this legislation comes in an environment of growing uneasiness over Canada’s housing and mortgage exposure, especially with CMHC nearing its $600-billion government-imposed insurance limit.

“The issue that pushes them near the lending limit is the desire of some financial institutions to purchase portfolio insurance for their low-ratio mortgages. That is not the way most people usually think of CMHC,” Flaherty said.

This announcement is “a recognition that CMHC has become a significant financial institution,” Flaherty added. “CMHC was created to assist in social housing [but] it’s become much more than that.”

The Privates

The Wall Street Journal reports that CMHC has a two-thirds market share of the default insurance business, a figure that has reportedly been dropping due to the agency’s pullback from portfolio insurance a few months ago.

CMHC’s share may now slide a bit more if OSFI further tightens the reins on its programs. That could be a pleasant development for shareholders/owners of competing private insurers Genworth and Canada Guaranty.

For the record, however, few lenders we’ve talked to think CMHC’s insurance policies will change significantly in the near-term as a result of this news.DBRS

Covered Bonds

To reduce financial system risk, insured mortgages will no longer be allowed as collateral for newly issued covered bonds. Reuters reports that this change “could potentially become law by the end of June.”

(Covered bonds are a way for banks to raise money to lend out as mortgages. They are a $63-billion market in Canada, according to DBRS.)

This curtailment would immediately raise the cost of funding conventional mortgages through covered bonds. Fortunately, however, it shouldn’t dampen the market significantly over the long-run. “There is no reason why covered bond issuance should fall,” one dealer told us following the announcement.

It’ll be interesting to see how much more expensive it will be to issue covered bonds under this new framework. As usual, consumers will probably be on the receiving end of any such cost increases, says David Tulk of TD Securities. “You might find the banks will pass on the impact of the higher cost of financing onto consumers through higher mortgage rates,” he explained to Reuters.

But TD Bank chief economist Craig Alexander told Canadian Business, “This isn’t going to make a big difference to either the real estate market or Canadians. Banks will continue to offer covered bonds, but they just won’t be able to use CMHC-insured products in those bonds.”

That said, it will certainly have some competitive effects, at least until the covered bond market gets used to not having the government as a guarantor of last resort. “The relative funding advantage that the Canadian banks have had in the past is going to compress now,” said BMO Capital Markets analyst George Lazarevski to the Wall Street Journal.

Analysts seem to think the net effect will be about a 10-20 basis points yield increase on mortgages funded through covered bonds. It’s also worth noting that today’s policy change virtually eliminates covered bonds as a funding source for high-ratio mortgages.

All-in-all, Alexander says that any funding cost increase “will help to temper lending a bit (all else equal).”

On a positive note, “…This legislative framework will increase investor interest in Canadian covered bonds,” according to the Canadian Bankers Association. That’s because the new regulations should “better [define] who can issue covered bonds (banks and co-operative credit societies), and [specify] bankruptcy and insolvency protection for covered bonds,” says DBRS.

There will also be a new registry to track covered bond issuance from approved issuers.

One glaring omission of today’s legislation is word on whether banks will be able to sell more covered bonds than they do today. Currently, institutions are capped at issuing the equivalent of 4% of their assets in the securities. Many had hoped that limit would be bumped up to help lenders better diversify their funding sources.

Sources:  CBC, Financial Post, WSJ, WSJ #2Reuters, Bloomberg, Covered Bond Report, Canadian Business, DBRS

Rob McLister, CMT