Banks hold most of the cards in mortgage game
To understand the housing market and where itâ€™s headed, itâ€™s a good idea to take a close look at the big banks.
As providers of more than 60% of home loans in Canada they are major players, determining everything from who gets to be a buyer to what people can afford to pay.
Itâ€™s no surprise that mortgages are the biggest single asset class held by the banks. According to the Bank of Canada, the chartered banks had $495-billion of mortgages on their balance sheets as of this month, or about half of all outstanding home loans â€”and that doesnâ€™t include the billions of dollars of home loans that the banks have sold into the Canada Mortgage Bond program.
Mortgage finance is big business for the banks, and itâ€™s also a cash cow for several reasons. For one, because banking is an oligopoly in Canada, players pretty much get to decide how much they will charge. Unlike the United States where thousands of lenders compete tooth and nail for business, the industry in this country is concentrated in the hands of the banks and the credit unions, with a handful of smaller players focusing on borrowers the banks donâ€™t want to deal with.
Bill Downe, chief executive of Bank of Montreal, recently explained it this way to an investor conference: “We donâ€™t believe we compete on price.â€
Another reason banks like the business is because the riskiest mortgages are insured by the Canada Mortgage and Housing Corp., a Crown corporation. In the event of a worst-case scenario, it is the taxpayer who shoulders the risk of default. The idea is to make mortgages cheaper and therefore more affordable for those at the lower end of the income scale.
In practice the banks donâ€™t pass on all the positive lift from government support to their customers.
“The system is founded on a sovereign entity that guarantees risky mortgages,â€ said Peter Routledge, an analyst at National Bank Financial.
In the late 1990s, the banks added a new twist to the business model as they began securitizing, or selling, parts of their mortgage portfolio. Securitization had caught on in the United States long before it did in Canada, so lenders in this country were merely copying what they saw as a proven and highly beneficial innovation.
Essentially, it allowed them to swap baskets of loans that might not pay off for several decades for a lump sum. In other words, instant liquidity, which they could then use to make more home loans. The result: The market for Canada Mortgage Bonds has jumped to nearly $300-billion today from less than $10-billion in 2001.
During the financial crisis, while private sector investors fled, the Bank of Canada and the federal government kept the securitization market going, buying up tens of billions of dollars of securitized mortgages so Canadian banks could continue to lend. It proved to be a vital lifeline to the banks during the tough times, providing a key source of liquidity that was virtually absent from the global banking system.
As a way to keep the Canadian financial system going it was a great strategy, but there were unintended consequences.
For instance, banks soon came to rely on securitization to boost their results.
According to a 2009 BMO Capital Markets report, as much of 15% of quarterly bank profits were generated by securitization that year. The problem is that such gains are but a one-time boost instead of a steady stream of interest payments that would amount to a much bigger profit if the mortgages stayed on bank balance sheets.
“This isnâ€™t a positive development,â€ said the BMO report by analyst Ian de Verteuil (now with the Canada Pension Plan Investment Board).
Yet another concern is the impact on consumer behaviour. Because of the profits that mortgages and securitization generate, banks have enormous incentive to grow the business, which they do by keeping interest rates low and easing loan conditions. Consumers have responded by taking the cheap money offered and bidding up house prices across the country. So even as real estate was collapsing in the United States and much of Europe, the market in this country â€”apart from a brief period in 2008 and 2009 â€”continued to expand.
Canadian household debt compared to income is now sitting close to record levels, according to Statistics Canada, and thatâ€™s prompted a spate of warnings from rating agencies and others. This week the OECD said in a report that ballooning consumer debt has left Canadians with “growing vulnerabilityâ€ to adverse economic shocks.
Meanwhile, equity markets have been treading water since the start of the year and the economic recovery is looking increasingly wobbly. In a worst-case scenario a spike in mortgage defaults would likely result in a significant housing market correction.
The good news for the banks is that they are largely protected from such a situation because the riskiest mortgages are covered by CMHC insurance.
Experts, however, say that despite the concerns, Canadaâ€™s housing market remains relatively robust.
Over the past 12 months lenders along with the CMHC have taken steps to gently tighten mortgage conditions, shortening the maximum amortization and requiring borrowers to put up more capital. As a result, they say, the froth has come off the market and “balanceâ€ has returned.
The bottom line is that “the system is moving in the right direction,â€ said Mr. Routledge.
Source: National Post