Canada’s Mortgage Backed Securities (MBS)

A few weeks ago, there was a feature article in one of the national newspapers on Mortgage Backed Securities in the Canadian marketplace.

I must have had at least 4-5 clients email me this article, and the same number of blog readers asked me to comment on it.

Everybody heard “mortgage-backed securities,” and immediately conjured up images of Brad Pitt and company in The Big Short, and figured this was serious news.

But guess what?  MBS’ have been around in Canada for a long, long time…

MonopolyMan

How does that saying go?

“I know a little, about a lot.”

Or is it, “I know a lot, about a little.”

Well I’m not sure what category I fit into.  Sometimes I think it’s both.

But when it comes to blogging, and discussing complex topics that often have a loose association with real estate, but that I want to explore anyways, I’m usually up for the task.

When it comes to Mortgage Backed Securities, however, I can’t in good consicence speak to you guys about what’s going on in the industry, where we were, where we’re headed, and most importantly – the differences between Canada’s MBS’, and those that are associated with the financial crisis in the United States in 2008.

So I’ve called upon my trusted mortgage broker for his thoughts.  Although thankfully, it’s not just thoughts, but rather an entire blog post.

Thanks to Ben Sammut from Mortgage Architects for providing the following…

 



Mortgage Backed Securities: Be Very, Very Afraid…….In A Way

Mortgage Backed Securities!  Deposit withdrawals!  Sub-prime mortgages!

Are you scared yet?  Well you should be.  It’s frightening that the majority of people do not know enough about these terms to know what they actually are or that they play a crucial role in a working economy.

BMO recently announced that they would be packaging their non-insured mortgages and selling bonds to the public, backed by these mortgages.  The mechanics behind this are very simple:

-A borrower with less than 20% down takes out an insurance policy on their loan.  If they ever default, the insurer (CMHC) pays the bank.  This poses zero risk to the bank.

-If the borrower has 20% or more down (or is refinancing their property), they are not required to take out insurance and the bank instead assumes this risk.  This is typically justified by charging the client a slightly higher interest rate.

-BMO has decided to double dip by charging slightly higher rates AND selling the risk to the public in the form of mortgage backed securities.

-Mortgage Backed Securities are bonds sold to the public that are backed by a large fund of combined mortgages.  Essentially, if the fund does well, the bond holders do well.  If they fund does poorly (i.e. massive defaults), the bond holders do poorly.

Now it’s worth noting that BMO’s mortgages, and the majority of mortgages in Canada for that matter, are fairly safe.

We have 6 major banks in Canada that fund a multitude of different mortgage lenders.  But the entire show is run and regulated by our Ministry of Finance as well as it’s guard dog CMHC (Canada Mortgage and Housing Corporation).

Yes, it is easy to obtain a mortgage today given low rates and real estate markets across the country increasing in value.  But the scrutiny through which Canadian lenders have doled out money is quite high; we have some of the lowest fraud and default rates in the developed world.

To play devil’s advocate, taking on the risk for the banks is obviously…risky.  It’s in the name!  But let’s compare numbers.

There are three components that differentiate the US housing market pre-2007 and our current housing market with respect to mortgage backed securities:

1) The size of MBS funds being traded.
2) The number of players in the game.
3) The way in which mortgages are underwritten/registered.

1) The Size of MBS Funds Being Traded

At the height of the US housing boom in 2007/08, Lehman Brother’s had amassed over $85 billion in mortgage funds from which they sold their mortgage backed securities.  This was an accumulation of their own lenders’ money as well as sub-prime loans purchased on the open market.

We’ll speak more about purchasing loans in a moment.

But in the meantime, the $85 billion was sold to pension funds, retirees, mutual funds, etc., and played a very large role in the overall investing economy of the US.  For scale, BMO has announced that they are packaging less than $2 billion of their mostly AAA loans.

Up until 2007/08, mortgage lending and home buying were rampant and loosely regulated.  The US has hundreds of banks, trust companies, and credit unions all regulated by their own shareholders and local/state regulators – whereas Canada has six.

2) The Number Of Players In The Game

Let that sink in. We have six banks in Canada that own and administer the majority of uninsured mortgages.

This obviously allows for more oversight, regulation, and government intervention. It also allows for more efficient systems as well as greater investment in security and fraud-prevention.

It’s a lot more difficult to sell a skunk loan 6 times and repackage said loan again and again until it eventually looks clean.

And speaking of repackaging loans…

3) The Way In Which Mortgages Are Underwritten

Mortgages in the US are a completely different animal than in Canada. On the northern side of the border, we originate a mortgage for a specific term (usually 1-5 years) and upon renewal of said term, both bank and borrower can part ways or renegotiate the terms of their mutual mortgage.  The repayment can take upwards of 30 years, but this time is broken up into terms.

In the US, however, a typical mortgage loan is originate as a 30 year term and traded among lenders.

For example, you may take out a 30 year loan from Sun Trust this year.  By next fall, your mortgage could be sold to Quicken Loans, Wells Fargo, or Chase Bank. But more realistically, it could be sold to the Oklahoma Teacher’s Pension, the Denver Steel Workers’ Union, or the New York Jewish College Fund.

In fact, throughout your 30 year mortgage, you could be sold to 6, 7, or 10 different creditors.  There is a degree of transparency in this but you can easily see how each seller passes the risk on to the next again and again to remove themselves from any exposure.

When we begin to package these loans again and again, and sell them into other funds, the confusion (and inability to oversee) is magnified.  So imagine the chaos when $85 billion was combined and sold from literally hundreds upon hundreds of independent sources…

Frankly, the move from BMO was an inevitability after Justin Trudeau’s government took away their ability to bulk insure their loans back in October/November.

Is it bad for rates?  A little.

Is it bad for the bank? Not at all.

Is it bad for the borrowers? Not really, it’s actually business as usual.

Is it bad for Canada’s economy?  Not in the slightest.


 

If you want to read more on this, there was a great article published in May of 2016 by InternationalInvestment.net, entitled: “Mortgage Backed Securities: Time To Let Them Off The Naughty Step?”  It’s worth a read for sure.

Bottom line: I personally believe that when the first article about MBS’ popped up in a Canadian newspaper a month ago, it was the first time it garnered a lot of attention.  Those that don’t know about MBS’ (which is most people), immediately thought this was something new, and something that perhaps was delivered to the Canadian economy a decade after the United States had their financial debacle.

Now, add a slew of articles and attention to the Home Trust crisis a couple of weeks later, and now a lot of people wanted to connect the two, along with the red-hot Canadian real estate market.

The market is red hot, mortgage backed securities are being sold in Canada, and financial institutions are going under.

Put those three things together, and you’ve got the foundation for a spectacular financial crisis.

Only the MBS’ aren’t anything new.  And now Home Trust is doing business.

So while I’m not blaming the media for this one (which is rare, on my part), I think a lot of people who read headlines, but don’t delve deeper, were looking to make connections, and as a result, conclusions, that weren’t there.

I welcome your thoughts on the MBS market here in Canada.  And specifically for those in the know, how our MBS’ differ from that of the United States in 2008.

And for those of you who didn’t read any of the above, and were just skimming for something of interest, here’s Selena Gomez explaining a CDO:

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  1. Frances says:

    Quite a few years ago, I looked into mortgage-backed securities and found that they were sold for a price that reflected the current interest rate. Meaning that they paid whatever the going interest rate was for things like GICs. Which hardly made them much of a investment vehicle. If that is still true, they aren’t a very good way to invest – GICs are safer.

  2. Alexander says:

    Real estate in the only engine left in Canada. Oil and production industry are not going to recover soon, so everything that makes shorting real estate industry easier makes me worry. Making new mortgage-backed securities vehicles by BMO certainly attracts unnecessary publicity and adds a new ammunition to the exclusive “shorting” club.

  3. Jack says:

    I agree that Moody’s downgrade of the banks is more significant than the BMO MBS announcement. We don’t even have to guess what the downgrade means — Moody’s told us the reasons.
    The BMO MBS is a non-story, at least so far. When we know the yields, that may tell us something. That is, if anybody buys them. Will anybody buy them, or is this a kind of bookkeeping exercise within the BMO group?

  4. Ralph Cramdown says:

    A few corrections.

    The Globe and Mail article succinctly pointed out what was new and unusual about these MBS: The aren’t insured by the government. Uninsured MBS have been believed to be unsellable in Canada for a long time now.

    The borrowers in the pool are not AAA borrowers. Unless your name is “The Government of [Canada, BC or Saskatchewan],” Moody’s does not consider you a AAA credit. 95% of the tranches in the issue were rated Aaa, some was B- and some was unrated. If you’re asking how a financial institution which is both the issuer and the trustee and servicer for a mortgage pool of non-AAA credits and which itself is non-AAA can issue bonds which are 95% AAA, I think that’s a good question. If you’re asking what sort of a respectable credit rating agency would let a client dictate that some tranches remain unrated, instead of insisting that it rate all the tranches or none of them, I think that’s a good question too. If you think that Moody’s might want to keep BMO happy as BMO’s capital markets division probably advises a lot of issuers on which ratings services should get their business, I’d have to agree. If you think that BMO was picking its best loans to put into the pool, instead of the worst ones it could get away with and still get an Aaa rating, think again. If, when the press release says “over 50% of the mortgages are from Ontario and Quebec,” you think that it doesn’t preclude 40% of them being from Alberta and BC, you’re starting to think like a defensive investor.

  5. JCM 800 says:

    The downturn in the Toronto real estate market that we’re currently beginning to see is unlikely to threaten Canada’s financial system in the way that happened in the US in 2008. Mortgage-backed securities are less common and our banks are better capitalized.

    The result is more likely to resemble what happened in Toronto in 1989 — a garden-variety recession.

  6. […] post Canada’s Mortgage Backed Securities (MBS) appeared first on Toronto Real Estate Property Sales & Investments | Toronto Realty Blog by […]

  7. Chris says:

    I don’t think MBS are that bad, as it’s just another way of securitizing the loan (instead of relying on CMHC).

    Personally, a more pressing concern is the recent credit rating downgrade of our big six banks:

    http://www.bnn.ca/moody-s-downgrades-canada-s-big-6-banks-on-consumers-debt-burden-1.748450

  8. Kramer says:

    That’s Selena Gomez explaining a Synthetic CDO… which are still not the devil incarnate if used for the right reason.

    And as we found out… using them as a way to clone asset backed securities where the assets are going to default…. IS NOT THE RIGHT REASON!

    1. Kramer says:

      I wish that Margot Robbie in a hot tub had continued her explanation. She could have explained that crucial element more simply…

      That when the banks ran out of even the riskiest s#it mortgages to build CDOs (because they ran out of apple pickers with no downpayment to give $750K mortgages to)… that the short positions that started building up actually allowed the banks to CLONE their dogs#it CDOs by taking the opposite side of the shorts… which they could do endlessly!

      What a GONG SHOW.

      Canada is not even in the same galaxy of that situation.

      1. Kramer says:

        Imagine Bre-X… the claim of 100’s of millions of ounces of gold… resulting in a huge stock price.

        A bunch of smart people short the stock because they know there is no gold.

        The banks say sweet, look at all those shorts… we can take the opposite sides of those shorts 20 times over and create 20 times more shares of Bre-X to sell!

        Just revisiting all this makes me sick.

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