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.
To 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.
Getting 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.
If 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.
If 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.