A Proposed New Threat to Lower Mortgage Rates?
We’ve spoken at length about the importance of customer choice when it comes to mortgage rates. Smaller, broker-only lenders, as well as credit unions, may not have the brand recognition boasted by the big banks - but they traditionally offer lower mortgage rates that can provide consumers with significant savings.
However, a proposed rule in Ottawa’s March Federal Budget may stifle these other lenders’ abilities to continue as they are and remain competitive. The new rule will limit the securitization of mortgages sold to investors for lender capital - a move that will impact the overall affordability of housing in Canada and healthy competition between banks.
The ABCs of Asset Backed Commerical Paper
The new mortgage rule targets a method of funding used by the lenders, which in turn gives them the means to provide lower rates to consumers. Here’s a basic breakdown of how it works: after obtaining your mortgage from a lender, that mortgage is then seen as an asset - one that will mature when you pay off your home. To further monetize this, the lender will then sell your mortgage to investors. These investments are known as Asset Backed Commercial Paper, and selling them gives lenders the cash flow needed to justify their lower rates, passing the profits down to the consumer.
How Mortgages Are Secured
At this point, a savvy investor would note - what about mortgages that default? Wouldn’t these make ABCP investments considerably riskier? After all, the sale of bad ABCP is a factor behind the U.S. housing crash, when vast amounts of sold subprime mortgages defaulted en masse.
In Canada, though, the key lies in how our mortgages are insured. A mortgage is considered to carry a higher level of risk when less than 20 per cent of the downpayment is paid by the homebuyer. These “high ratio” mortgages are required to have default insurance, which covers the lender’s losses if the buyer defaults. The most commonly used insurance provider is the Canadian Mortgage and Housing Corporation (CMHC), which is fully backed by the government (aka the taxpayers).
To qualify for CMHC coverage, buyers must pay at least five per cent of their home’s value. For those who can’t quite come up with the cash, though, there are alternatives - Genworth and Canada Guaranty are examples of private insurer options.
However, Ottawa’s new rule will prohibit the use of any insurer other than CMHC in the securitization of mortgages sold to investors, creating limitations for lender funding.
How This Affects Consumers
The most obvious way consumers will feel the pinch is through a potential increase in mortgage rates - lenders may be forced to take their competitive offers off the table if fewer mortgages qualify for sale to investors.
The government appears to have imposed this plan to create “market discipline” - by forcing all lenders to use government guidelines, they are attempting to create stability within the housing market. As stated by the Department of Finance, “The Government is making these changes to increase market discipline in residential lending and reduce taxpayer exposure to the housing sector. Funding channels that use taxpayer-backed insured mortgages should be subject to minimum standards and Canadian oversight in order to promote financial stability.”
This may also be an attempt to slow the rate wars rising up among small lenders and brokers that push mortgage rates to unprecedented lows. Finance Minister Jim Flaherty has publicly chided big banks for dropping their rates and countering efforts to stem household debt in Canada - but these smaller lenders have traditionally dodged the bullet.
While the effects of the rule change will be minimal to start - only $6-billion worth of mortgages are funded with ABCP, out of $200 billion annually - it’s a form of funding that is gaining popularity among lenders. The true effects on the market, and affordability for consumers, will become apparent in time.