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…
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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