About a month ago, while updating my spreadsheets with finalized financial data for 2011, I found a troubling trend in my bank holdings that’s been bothering my conscience ever since.
My exposure to three Canadian banks, TD Bank (TD), Royal Bank of Canada (RY) & Bank of Nova Scotia (BNS), has brought up a serious concern as I started looking deeper into their operations over the past five years on the value of how much they’ve been securitizing their residential mortgage portfolios.
Remember that securitization is the process of pooling debt (mortgages, auto loans, lines of credit, etc) into some sort of consolidated debt. Mortgage backed securities (MBS), collateralized mortgage obligations (CMO) and asset backed securities (ABS) are some of the terms investors have heard over the past five years that relate to the process of securitization.
Frequent readers of this blog will know that I track an abundance of information on all my investments over long periods of time in order to gauge past economic environments on current or future environments. What I’ve found is a troubling pattern in the financial data from my three banks as well as CIBC (CM) and Bank of Montreal (BMO).
The Canadian Mortgage and Housing Corporation (CMHC) is known by most home buyers because of the need to purchase insurance for their mortgage. CMHC provides mortgage loan insurance to lenders to protect against default for any mortgage where less than a 20% down payment is made. But this is only one part of the business they conduct; they also generated a large volume of Mortgage Backed Securities (MBS). CMHC then turns these MBS products into Canada Mortgage Bonds (CMB) to sell to individual and institutional investors through Canadian Housing Trust (CHT). CHT is a CMHC run program.
A general breakdown of how the securitization process goes:
- The Mortgage Lender (bank, trust or lender) originates the mortgages
- Mortgages of similar term and quality are arranged into groups of mortgages
- The Mortgage Lender decides which groups it wants to keep on its internal balance sheet
- The Mortgage Lender then sells the remaining groups of mortgages as mortgage backed securities (MBS) to Canadian Housing Trust (CHT)
- CHT sells Canadian Mortgage Bonds to investors to generate funds to purchase mortgages
- CHT uses cashflow from MBS to make interest payments on CMBs to investors
- Process repeats
How the Canadian Housing Trust Mortgage Backed Securities program works specifically can be found here: The NHA Mortgage-Backed Security Guide
It’s important to note that because CMBs are fully guaranteed by the Government of Canada (GoC) investors are paid less interest on CMBs which results in a lower cost of funds for the lender. Also note that the Mortgage Lenders, after securitizing fixed and variable rate residential mortgages, only purchase mortgage insurance themselves for conventional mortgages because non-conventional mortgages are insured by CMHC.
As of July 2008 the size of the Canadian Mortgage Bond (CMB) program was roughly $136 billion.
As of September 30th, 2011 the program has swelled to $202 billion; roughly 16% of Canada’s real gross domestic product (GDP) in 2011.
Download PDF – Canadian Bank Residential Mortgage Growth
Canada’s biggest five banks (BMO, BNS, CM, TD & RY) currently have a portfolio of residential mortgages on their balance sheets of approximately $485.3 billion, up only $75.9 billion over the past five years or 18.5%.
The CMB program over the same time period is up over 45%.
While the big five aren’t the only financial institutions originating mortgages there appears to be a large discrepancy between the assets they feel comfortable (or are able) holding on their balance sheets and the amount they are securitizing into mortgage backed securities.
It appears clear that Canadian banks have off-loaded a significant amount of their exposure to residential debt over the past five years. In the face of such brisk residential mortgage origination this makes the off-loading even more apparent.
There are likely a number of key motivators responsible for this behaviour.
Canadian financial institutions, mainly banks & insurance companies, have come under pressure from governments on the amount of regulatory capital they require. The banks could be increasing their securitization process in order to maximize the number of mortgages they can originate based on their regulatory capital limitations. The more mortgages moved off the balance sheet, the more new mortgages that can be written without running into trouble with regulators.
There was an abundance of fixed rate preferred shares issued over the past four years that had puzzled me; especially when you consider the absence of any extra yield investors demanded for their capital. At the time I chalked it up to the change in regulatory capital, but now I’m left wondering if there was a second motivation; raising more working capital.
This surge in off-loading exposure to residential debt could be directly linked to the perception of risk. Remember that the Canadian Mortgage and Housing Corporation (CMHC) guarantees mortgages that have purchased the proper amount of insurance. The Canadian banks, whether right or wrong, likely view this guarantee as golden. The Canadian housing market hasn’t truly been tested like the markets in Europe or the USA with dramatic foreclosures and significant price declines. Although a number of US and European institutions have received bailouts the Government of Canada still chooses to reassure Canadians that are banking system is the most conservative in the world.
The compensation model for bank and insurance executives is generally rewarded on growing the business. In order to grow financial institutions need to aggressively expand the collection of interest and fees from their product portfolios by biding on more business. The introduction of 30 year mortgages (previously 40) and extremely low fixed rate mortgages (3%) help to attract this business despite the risks that rising interest rates would provide. With a guarantee from CMHC on any non-conventional mortgage that has mortgage insurance the banks likely figure the Government will simply pick up the tab of any resulting fall out.
The market is extremely competitive and if one bank is willing to give business to a customer at a lower margin or higher risk than others will likely follow in an attempt to not lose business. When a bank is presented with a practice with a reasonable prospect of turning a profit, with tax payers on the hook and they can avoid running into trouble with regulators then I think it is not difficult to see how the dramatic rise in the amount of Canadian Mortgage Bonds has occurred.
The quest for yield (investment income) has left a variety of investments at prices that both defy logic and border on the insane. Dividend investors, especially those who watch the preferred shares market closely, know that there has been a huge movement towards yield in the past few years and a lot more attention to this style of investing in the media. No one can blame an investor for seeking yield when investment returns have been so poor and fixed income yields barely results in any real return when you consider inflation and taxes. At some point common sense needs to come back into the equation.
Canada Housing Trust (CHT) bonds, currently yielding around 1.25%, are extremely risky assets in my opinion. Minor changes to CHMC rules, restrictions on lending or transparency on bank practices (see above) could affect demand in any number of negative ways.
When you consider the true risk an investor takes on with the purchase of a CHT bond at a 1.25% yield you suddenly realize the disturbing disconnect between true market fundamentals and a real estate bubble. CHT bonds are extremely risky at this point in the economic cycle.
As of the end of February (2012) my exposure to common equity of Canadian banks shares sat at 10.4% of total assets in my Dividend Growth Portfolio (DivG); down from 12.4% from the summer of 2011.
This reduction has been completed on purpose as I get more and more risk adverse. Given the continuous positive outlook many economists on the sell-side of the industry are providing at presentation after presentation I really wonder if DIY investors have an adequate grasp of the risks presenting themselves given current market conditions.
A reasonable asset allocation to the financial sector might be only 10-15% of your portfolio if you were concerned about the above developments. As an investing peer mentioned to me last week, “This might be an ideal time for investors who share the same concerns to do a little rebalancing.”
Contributions made to this post by S. McKibbon & Think Dividends.
Your analysis is wrong. The problem starts with your assumption that mortgages disappear from a banks balance sheet the moment they are securitized. Whereas under ‘normal’ sucuritization circumstances that may be true, this is not the case with NHA-MBS, as the issuing bank remains liable for any late payments by the mortgage lender: the bank has to pre-pay to the investor. Therefore the bank keeps the mortgages on its balance sheet, and has to fulfill the Total Capital Adequacy obligations of 4.6%-10% depending on the size and quality of the bank.
What I don’t understand is how can banks charge these huge penalties when they break a mortgage? Is this then passed on to the NHA-MBS? or does the bank just profit from the penalties. One doesn’t think they have to worry if they get a mortgage rate of 2.89% however the banks are using the posted rate to gage the initial discounted amount from their mortgage to calculate the large penalties. MBS are not benefiting from this penalty so where is this profit going?
I would like to know more about this securitization process as I heard that by selling the mortgage to a third party the bank is not only making a killing off the compound interest for decades but then makes more money still from this process. Not bad when you consider they also create the money out of thin air to begin with. They had a nice scam going on don’t they.