The Canadian federal budget delivered on March 21, 2013 had a couple of very significant highlights (or perhaps more appropriately characterized as lowlights) for the Canadian structured finance industry.
Restrictions on Use of Government-Backed Mortgage Insurance
Buried on page 141 of the Conservative budget (did they honestly think no one would notice?), under the heading “Reinforcing the Housing Financing Framework”, is a very short one-page summary of new measures intended to “increase market discipline in residential mortgage lending and reduce taxpayer exposure to the housing sector”.
While the heading promises all good things, “market discipline” is a two-edged sword, particularly in the Canadian housing market where homeowners, home builders, banks and other financial institutions have long become accustomed to living off of CMHC’s generous mortgage insurance program. What the Conservative budget proposes is nothing short of the most dramatic overhaul of the Canadian housing and residential mortgage markets that we have seen or are likely to see in our lifetimes. It makes everything that the Conservative government has done to CMHC and covered bonds over the past 18 months, at the direction of Mr Flaherty, look like mere tinkering in comparison. That is, if they actually do it….
So what’s changing? The principles are there, but the details are not. These principles boil down to the following. First, CMHC will “gradually” limit portfolio insurance of low ratio mortgages to those mortgages that will be held in securitization programs sponsored by CMHC. While the announcement is ambiguous, this appears to cover portfolio insurance issued by CMHC and other private mortgage insurers backed by the federal government, such as Genworth MI Canada. Second, the Conservative Government proposes to limit any “taxpayer-backed insured mortgage”, whether high ratio or low ratio, from being used as collateral in any securitization, other than a CMHC sponsored securitization.
What does it mean? The devil is always in the details, but instead of “reinforcing” the Canadian housing markets, these proposals actually propose the opposite - a substantial withdrawal of CMHC and other “taypayer-backed mortgage insurers” from the Canadian mortgage market. Low ratio mortgages are a substantial part of this market and the “gradual” withdrawal of portfolio insurance (whether provided by CMHC or others) will, just as gradually but directly, increase the costs of borrowing, as the lenders take on more default risk and seek “market” compensation for it. Perhaps Mr. Flaherty didn’t think that Canadian financial institutions really understood the message he has been trying to send about low interest rates, but there is no mistaking it this time.
Unfortunately, Canadian homeowners will bear the full cost of these changes. There should be no doubt that, regardless of the political spin, that Mr. Flaherty wants this result. Whatever a mortgage lender’s cost of its capital actually is, you can be sure that it will be passed on directly to mortgage borrowers. And there is no question that these changes will result in an increased cost of capital for Canadian mortgage lenders. CMHC has mortgage insurance exposure of roughly $550 billion. CMHC’s Canada Housing Trust securitization program (CHT) accounts for no more than $215 billion of this exposure. The remainder of CMHC’s insured loans are held by Canadian financial institutions or in their historical covered bond programs. Financial institutions rely heavily on CMHC insured mortgages because it reduces their cost of capital and makes their assets more liquid. Even at current leverage levels for our financial institutions, insured mortgage lending has always been a very easy, risk free way for Canadian financial institutions to make a profit. Once low ratio mortgage insurance is limited to a level where it becomes a real market constraint (that is, assuming that “gradual” implementation of these changes does not mean “not in my lifetime”), more selective mortgage lending and higher interest rates in the Canadian residential market is inevitable. So, Canadian homeowners should start saving because they will be paying more.
The same thing will happen on high ratio mortgage loans. As CMHC’s mandate is cut back and its concentration of high ratio loans grows, its overall insurance portfolio will look smaller but a lot riskier than it is today. Inevitably, it will raise insurance premiums to cover this increase risk. Again, Canadian homeowners will pay.
Where are the market reinforcements? The Conservative budget proposes to “reinforce” the Canadian housing framework. What will fill the gaps left behind as CMHC retreats from this market? Over what period of time will these proposals be implemented? Other private mortgage insurers are currently in the market, but most of the larger players are still “taxpayer-backed” to the tune of 90%. Will they even be allowed to fill in the gaps or will they be similarly constrained by the proposals? We simply don’t know, as the budget is painfully thin on details. Will private (non-CMHC) securitization conduits be able to fill the gaps? Contrary to the budget commentary, this private conduit market (unlike the Banks) is a shadow of what it was pre-recession. If they are able to step into the gap, the capital will be provided on market terms that are higher than those in the current insured conduit programs.
As a final note, sceptics will find it hard to take these proposals too seriously, given the widespread potential political impact of these changes and the wiggle room that the budget commentary provides. The reality is that, whether you rent or own a house in Canada, these proposals matter to a very broad swath of the Canadian electorate, and when it comes right down to it, no one is going to want to pay the piper if real pain is involved.
Forward Agreement Transactions
The recent budget may significantly reduce one financial product transaction type that had become prominent in the Canadian capital markets, described as character conversion transactions in Budget 2013.
Many closed end funds and other structured products in the market have utilized derivative contracts in order to convert what would otherwise be an ordinary income inclusion into a capital gain. This was essentially achieved by entering into an agreement (typically a forward agreement) to buy or sell capital property at a specified future date. The purchase or sale price of the capital property under the forward agreement would not be based on the performance of the capital property (such as a basket of listed common shares) over the time period of the forward agreement but by reference to the performance of a reference portfolio of investments. This portfolio would typically contain investments that if held directly would produce ordinary income.
To ensure the appropriate tax treatment of the derivative-based return on a forward agreement, Budget 2013 proposes to treat this return as being distinct from the disposition of a capital property that is purchased or sold under the forward agreement that has a duration of more than 180 days. Generally, if a forward agreement is used and the value of the capital property to be delivered is based entirely on the performance of a reference portfolio, the taxpayer would have an income inclusion equal to the amount by which the fair market value of the property delivered when the forward agreement is settled exceeds the amount paid for the capital property. In addition, Budget 2013 proposes that the income described above be added to the adjusted cost base of the capital property to prevent double tax on the sale by the taxpayer of such capital property.
Practically speaking, a mutual fund that has entered into a forward agreement with a counterparty and receives capital property on the settlement of the forward agreement will have an income inclusion equal to the difference between the fair market value of such property and the amount paid for the property under the forward agreement. The mutual fund will then distribute that income, along with any returns of capital, to its unitholders. As a result of the proposals in Budget 2013, distributions to unitholders resulting from partial or full settlements of a forward agreement by a mutual fund that previously would have been capital gains distributions will now be income distributions. Return of capital distributions are not affected.
These measures will apply to forward agreements entered into on or after budget day. They will also apply to a forward agreement entered into before budget day if the term of the agreement is extended on or after budget day. If the offering of new units of an existing mutual fund with a forward agreement results in the extension of the forward agreement, such forward agreement will be subject to the Budget 2013 proposals.