Is the mortgage industry running out of money?

The Canadian mortgage industry has long been lauded for its stable lending criteria and ability to hold the fort during the worldwide recession. Through the wonderful blue sky of 2.99% 5 year fixed money however, is a storm of international and national constraints that may cause a slowdown in mortgage and housing markets.

We have all heard of Europe’s troubles. In a way, Canadians have been able to benefit from this as mounds of cash left European bond markets to park in North American bonds, which are considered lower risk. This has caused Canadian and American bond yields to plunge to levels hovering below inflation (5 year bond yields are around 1.3% right now). Many banks “securitize” mortgage loans, and sell them to investors as what is called a mortgage-backed security. Because they are similar to bonds, fixed mortgage rates tend to rise and fall with bond yields. Today, take a bond yield, add about a 2% spread (cost of funding the mortgages, and of course, profit) and that’s where most major banks are pricing their fixed rates.

So why the fuss? Low rates are good for Canadians, right? The issue with international volatility is that as perceived risk with purchasing these mortgage-backed securities rises, it becomes harder to find buyers. Making matters worse, new global standards released in 2011 (Basel III) increased the percentage of money banks need to keep in their bank accounts for each dollar lent on mortgages. One of the primary reasons Macquarie Financial left the mortgage market last summer was due to these new rules – it made more sense to use those reserve funds to earn a higher return in one of their other 100 divisions.

Basel III changes

But even Greece going bankrupt could have a much lower impact than what is happening at home. News spread on Jan 31^st that CMHC is starting to worry that they are closing in on their $600 Billion cap, currently sitting at about $541 Billion. CMHC is required by law to stay below this cap. Many consumers are oblivious to the fact that many major lenders insure bulk books of their mortgages, even at less than 80% financing where CMHC is not necessary. This stems back to the securitization process – it is significantly easier to sell a mortgage to investors if it is backed by CMHC.

This could change the Canadian housing and mortgage markets significantly. Raising the $600 Billion roof will not be easy politically, as Canadian citizens are on the hook if CMHC cannot afford to cover default losses. If the money supply begins to shrink, most lenders still want to keep their “AAA” business:  income qualified, 20% down payment, owner occupied residences, etc. When the money supply begins to shrink, it happens on the back end. We saw this come under fire when the financial crisis started taking it on the chin in late 2008. Subprime lending nearly disappeared in Canada, commercial lending books were frozen, and lending for rental properties began tightening.

Some lenders have already begun making changes to their lending criteria, but if CMHC is not granted a ceiling increase we may see:

–          Less competition as non-bank lenders are forced to reduce lending

–          Higher rates as banks find it more difficult to find buyers for uninsured mortgage bundles

–          Tighter restrictions on who banks lend to (like self employed and rental programs)

Could this be the government’s way of slowing down a heated housing market without raising rates? Either way, it may be a good time to review your mortgage(s) and act soon if you worry about what may come.