Home Capital’s MBS Strategy Could Set Precedent

Home-TrustInternational Financial Reporting Standards (IFRS) have raised the cost of mortgage lending for financial institutions.

That’s because IFRS now require that securitized mortgages (mortgages sold to investors) be held on the lender’s balance sheet. Prior to 2011, this wasn’t the case.

Having more mortgages on the balance sheet boosts a lender’s assets and raises its “asset-to-capital” ratio.

That’s a problem because asset ratios are capped by regulators. Keeping securitized mortgages on the books means that lenders have to put up more capital, or lend less—either of which hurt profitability.

This is “the major constraint” right now on Home Trust’s lending ability, said CFO Robert Blowes at parent company Home Capital’s Investor Day on Wednesday.

But Home Capital has a creative idea to alleviate this problem. It’s one that could be pioneering in Canada if approved by regulators.

balance-sheetTo get securitized mortgages off its balance sheet and improve regulatory leverage, Home hopes to sell interest-only strips (IOS) on those mortgages.

IOS will give investors the right to receive a portion of the interest on Home Trust’s mortgages. (A piece of the interest will go to the mortgage backed securities (MBS) holder and Home will sell the other piece to the IOS holder, for cash up front.)

The act of selling this interest to third-party investors qualifies those mortgages “for off-balance treatment under IFRS,” says Blowes.

Home is “hopeful” that this will also give it capital relief from a regulatory perspective, but Blowes adds that’s “not clear yet.” Home has received a “positive response” from its auditors and legal advisers, but OSFI will ultimately have to confirm that these mortgages (assets) would not be included in Home’s asset-to-capital ratio.

“We are currently talking with [OSFI],” Blowes told investors. “We have submitted a proposal…and we expect that we’ll have some further information on this in the next couple of months.”

“This would be a precedent-setting transaction,” he says. As such, OSFI “is stepping quite carefully…”

If successful, this would increase Home’s lending capacity by $500 million to $1.5 billion “over a period of time.” That’s $1.5 billion compared to roughly $8 billion of securitized mortgages currently on its balance sheet.

Mortgage-GrowthGetting securitized prime mortgages off the balance sheet would allow Home to increase its “originate-to-service” prime mortgage business, while also selling more non-prime mortgages. Non-prime mortgages are the end-game because they’re three times more profitable. They have a 3.00-3.25% margin versus just 1.00% for prime mortgages, Blowes explained.

Home would use this strategy on prime high-ratio insured mortgages only, for the foreseeable future anyway. That’s because there is virtually no market for uninsured MBS in Canada.

It would still make upfront interest income when it sells IOS, but Home’s servicing income would be key.

“Servicing business is a good reliable low-risk business,” Home Capital President/CEO Gerald Soloway told CMT. Servicing makes Home about 15 basis points each year per mortgage.

“There is also the opportunity to renew the mortgage at maturity,” said Soloway. Renewals are more profitable, in part because the lender doesn’t have to pay as much in finder’s fees. At renewal, Home would once again securitize the mortgage and sell another IOS.

“(IOS sales) would make it more attractive to do insured securitized loans. It would create more competition and consumers would benefit.”

The consumer is a huge winner in the end, says Soloway, because lenders would pass some of the lower funding costs on to borrowers by way of lower rates.


Stock Traders Working At ComputersIf OSFI did confirm Home’s balance sheet treatment, the next hurdle might be finding more buyers for the IOS. The buying pool in Canada is small. There’s never been a need for it to develop…until IFRS.

A major dealer we spoke with told us, “The MBS investment community is growing, but with an IO strip it’s really a subset of individuals that can value the mortgage, penalties and default characteristics. They’d likely (need to) hold them until maturity.”

“I think at the present time…it is a difficult sale,” agrees Soloway. “As there are more strips out there, more people will familiarize themselves with the economics and there will be more buyers.”

“When we spoke to Canadian companies, we couldn’t get a firm bid. Our buyer is a non-Canadian buyer who understood it completely. They’ve been doing it in the States, they have their own program and they’ve done their own analysis,” he added. “In the United States, there is an active market for these strips.”

Unlike the garbage mortgage-backed securities that led to the U.S. financial crisis, however, IOS are not a “black box.” Quite the contrary. They are transparent and insured securities with collateral that is originated using sound regulated underwriting practices. Moreover, due to the way the IOS is structured, regulatory scrutiny, market scrutiny and the desire for servicing revenue, Home would have a vested interest in keeping defaults low.

For IOS to really take off, however, an active secondary market would have to form. Pending OSFI’s response, Soloway is confident that one would start to develop.

“Due to the publicity of this, we’ve had several Canadian buyers come forward and say ‘If this goes through, give us a call. We’re interested.’”

The dealer we spoke with had an opinion that was unequivocal: “If this goes forward, it will be a game-changer.”

“MBS issuance would increase dramatically,” he added.

That, of course, remains to be seen. Others we’ve talked to are more skeptical of the potential magnitude since not all lenders need to sell IOS.

CMHCIf MBS issuance did take off, one may wonder how much CMHC would guarantee. (Investors generally won’t buy Canadian MBS without a CMHC guarantee.)

The government currently lets CMHC guarantee $600 billion worth of NHA MBS. As of March 31, CMHC had utilized $373 billion of this $600 billion. (Note: CMHC’s guarantee limit is different from the $600 billion “insurance in force” limit that’s made headlines recently.)

If IOS prompted lenders to securitize more, it could eventually exhaust CMHC’s guarantee ability. Then it would become a question of whether the government would increase this ceiling.

Practically speaking, the risk of additional MBS guarantees is low. The mortgages in question would already be insured regardless. Moreover, the government would control risk with thorough lender audits, as it does now, and it (taxpayers) would earn a separate fee for the guarantee—on top of CMHC’s insurance premiums.

As for the chances that OSFI will confirm this strategy, Soloway told investors humbly, “I don’t want to make any comment that might in any way aggravate OSFI…We have to wait for their decision. They have a lot of policy considerations.”

He added, “We wouldn’t have gone through all this trouble and expense if we didn’t think we had a very good chance. But it’s not a done deal.”

Sidebar: Home is also planning whole loan sales (i.e., selling mortgages to third-party funders). Home would then service and renew these mortgages. It says renewals are “particularly attractive” since the lower finder’s fees increase its revenue. Home will move forward with this initiative “in the not too distant future.” This could boost its prime mortgage volumes even further.

Rob McLister, CMT

  1. Interesting news. I wish them luck. They have some top-notch management running the show over there.

  2. As long as they ensure that the IOS and the MBS are affected identically by loan modifications, which is conceptually difficult but not impossible. One of the problems in the US with their CDOs was that different tranches were affected differently by loan mods, so the trustee couldn’t agree on mods as they weren’t necessarily beneficial to all tranches. I imagine if HCG just guaranteed they’d swap in a good mortgage for any that went bad, they’d be stuck on balance sheet.
    I hope you all recognize the irony here. Canada has done just about everything that the US has leading up to its housing crisis, the exceptions I know of being CDOs. Now here’s someone introducing a CDO.

  3. Ralph you are in over your head on this topic.
    CDOs and I/O strips are both securities backed by some other underlying assets, but that is where the similarity ends. I/O strips are a simple type of mortgage backed security. They are not a CDO.
    CDOs are complex securities backed by pools with a variety of credit exposure and fixed income assets, including different types of MBS, corporate debt, and/or credit card debt. They can be leveraged or unleveraged, and even be backed by other CDOs or credit default swaps, making them much harder to value.
    I/O strips like those contemplated here would be simple pass-thru securities backed by a specific type of mortgage, in this case high-quality 100% guaranteed prime mortgages. That effectively makes IOS investment grade securities.
    By contrast, only the most senior tranches of CDOs could be considered investment grade. The U.S. CDOs you reference had tranches backed by low-quality, often hard to quantify collateral, making them completely extraneous to this discussion.

  4. “[…]but with an IO strip it’s really a subset of individuals that can value the mortgage, penalties and default characteristics” — A “major dealer” as quoted in the article. But he’s probably in over his head, too, right?
    Which part, exactly, don’t you agree with? The part where stripping the bond creates two classes of creditors whose interests may be opposed if loan mods are required? The part where, even though CMHC may guarantee your payment, eventually, there’s no guarantee of TIMELY payment because these instruments won’t be going through CMHC’s MBS factory?
    You’re buying a piece of a CMO. Even though the underlying mortgages may be rated AAA by virtue of a CMHC guarantee, HCG is only BBB+, and will it even be allowed to guarantee the SPE? I smell op risk there. But hey, the agencies are on it; I hear one of them just downgraded Spain yesterday — good thing they’re foreseeing future risks that us amateurs can’t yet see coming.

  5. “Now here’s someone introducing a CDO.”
    You lost all credibility with this erroneous and intentionally misleading statement. Your rants warrant no further response.

  6. You seem… confused. If you’re labouring under the erroneous impression that something can’t be a CDO if the only underlying assets are prime residential mortgages, you’re just wrong. Try googling.
    Aside from that, let’s look at the purpose of the proposed securitization structure, shall we?
    – “If I bundle up these mortgages and sell them to an investor, do I have to allocate capital?”
    – “Yes.”
    – “OK, what if I bundle them up, strip them, and sell each part to a different investor?”
    What’s your defence of this idea? Its purpose is solely to circumvent a perhaps too-narrowly crafted rule which was created precisely to prevent the consequences of exactly this type of behaviour.
    “Moreover, due to the way the IOS is structured, regulatory scrutiny, market scrutiny and the desire for servicing revenue, Home would have a vested interest in keeping defaults low.” FUNNY! Originators in the US were charging a lot more than 15 bps/yr, and it wasn’t enough “vested interest,” apparently.

  7. Ralph,
    IOS are not designed to evade regulations. They are a strategy to work more efficiently within OSFI regulations by selling off the risk and reward of mortgage assets. This selling off of interests is why said assets would qualify (pending OSFI’s confirmation) for off-balance sheet treatment.
    Home Capital has exceptional underwriting and loan loss metrics, and some of the best capital multiples in the industry. It would be a gross mischaracterization to suggest Home Capital is not compelled to minimize defaults. Associating IOS and Home’s underwriting policies with irresponsible U.S. practices is a similar distortion.
    It’s imperative to expose irresponsible lender practices where they exist, but we do so with facts and evidence. This is not the forum to cast unsubstantiated doubt on the policies of reputable lenders. Guide your comments accordingly.

  8. I didn’t mean to cast aspersions on HCG in particular, and I’ve no reason to believe they’ve got any but the best of intentions.
    However, the originate-to-distribute model, with upfront fees and low (in this case, very low) ongoing servicing fees contains less incentive to minimize defaults than does the originate-to-hold model. That isn’t an accusation, it’s a tautology.

  9. Another great article Rob. It’s terrific that we, as mortgage professionals, have someone like you keeping us up to date on the technical side of mortgage origination so we can all better understand our own business.
    The management at Home Trust represents some of best people in our business, not just because they are smart, agressive and hardworking but also because they are here for us; the mortgage broker, in a very important and unique way. Funding mortgages at reasonable rates for consumers who need an alternative lender. They do a great job for the broker, the consumer and their shareholders.

  10. What’s your point? All lenders have admin fees. Some of these charges are servicing fees that don’t even apply to regular customers.
    Unless you’re going to do a side by side comparison of all prime and non-prime lender fees then you’re wasting our time.

  11. “Unless you’re going to do a side by side comparison…you’re wasting our time”
    Your the “Independant” Broker, that would be your job. Funny how it takes a branded Banker to point that out.
    “All lenders have admin fees”
    Really, what Big Five Bank charges $225 NSF fee, $120 yr. Maintenance fee or a $300 Insurance Administration Fee?

  12. You must have a problem with bouncing cheques to be that concerned about NSF fees. The other two charges are servicing fees that don’t generally apply.
    But please don’t let the facts stop your pointless fee crusade.

  13. Hi Banker and BBroker,
    We try to keep forums on point and fees are a bit off-topic. Here’s a link to the miscellaneous thread if you want to continue the discussion.
    Many thanks,

  14. First time comment…following your views for long time. Great piece of work Rob as always. Some of the people (read Ralph) tried to show their intelligence by bring complicated issues…however, it seems they don’t understand how mortgages are originated and distributed (incl funded) by lenders like Home…

  15. Banker, your comments are ususally very astute so I can only assume you are unaware that Home Trust specializes in mortgages for those clients who do not qualify for mortgages at other FIs and as such their servicing fees must be adjusted upwards as a normal business practise.

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