Why CMHC’s Latest Move is Good for Variable-Rate Borrowers

Last week our federal government made another regulatory change as part of its continuing effort to cool real estate markets across the country. This latest tweak caps the amount of mortgage volume that CMHC will guarantee for each lender under its National Housing Act Mortgage-Backed Securities (NHA MBS) program.

First, a little about the NHA MBS program, a somewhat complicated but hugely important securitization vehicle, which has given large Canadian lenders a viable alternative when they exceed their Canada Mortgage Bond (CMB) program allocations.

The NHA MBS program is important because lending is a spread business, meaning that lenders derive their profit from the difference, or spread, between the rate they have to pay investors for the use of their money and the rate of interest they charge borrowers when they lend that same money out as mortgages. The cheaper a lender’s cost of capital, the more flexibility they have either to book higher profits or to pass on lower rates to borrowers.

Mortgages that are sold into the NHA MBS program are secured against default by the full faith and credit of our federal government, making them pretty much bullet proof. As such, investors are willing to accept yields that are lower than they would be without this guarantee.

Back to the most recent change. The federal government (through CMHC) announced that it is now limiting the dollar amount of new NHA MBS guarantees that it will offer to each lender to $350 million this month. More importantly, it has also made it clear that it will continue to enforce limits on these guarantees in future.

Many lenders can fund their entire mortgage portfolio under their Canada Mortgage Bond (CMB) program allocation, a preferable alternative because using the CMB is cheaper than funding mortgages through the NHA MBS program. But larger lenders regularly exceed their CMB limits and since 2001, they have mostly relied on the NHA MBS program when they run out of CMB room. As such, this change will primarily impact Canada’s largest lenders who will now have to incur higher funding costs when their NHA MBS allocations run out. Since any alternative funding mechanisms will be more expensive, by an estimated 0.20% to 0.30%, those costs may well be passed on to end-consumers in the form of slightly higher mortgage rates.

Although higher rates are never happy news in my business, I support this move. The Bank of Canada (BoC) has long identified our rising household debt levels as the greatest domestic threat to our economy and the federal government has been trying to moderate our residential real estate markets for years. Our choice is to either continue applying the liquidity brakes until we engineer a controlled slowdown in real estate price appreciation, or to ignore all warning signs and charge full steam ahead while hoping for the best.  We saw what ignorant bliss caused in the US and I believe that our regulator is acting intelligently and responsibly under our current market conditions.

When you think about it, the NHA MBS program essentially gives large lenders a form of government stimulus by lowering their cost of capital and increasing their liquidity and it’s hard to argue that our real estate markets need any more stimulus at this point. The NHA MBS program has already doubled in size since the start of the financial crisis in 2007, so it’s not as though our real estate markets haven’t benefitted from this program. No long-term good could result from allowing this program to continue growing exponentially. As I have written many times before when supporting the federal government’s somewhat unpopular regulatory changes, it is better to suffer some short-term pain to avoid a longer-term crisis.

Two final thoughts about my support for this change. First, since guarantees by the federal government are ultimately backstopped by all Canadian taxpayers, the NHA MBS was really assigning a risk to all Canadians in order to create a benefit (cheaper mortgage rates) for only a subset of Canadians (home owners). Second, if lenders are allowed to rely indefinitely on ironclad government protection against credit losses, it’s easy to imagine that lenders might unduly increase their tolerance for risk when they are placing an increasing proportion of their bets with someone else’s money. This phenomenon is commonly referred to as “moral hazard”. In that light, limiting the future growth of the NHA MBS program seems to be an entirely reasonable decision.

Now for some good news.

The BoC has consistently warned that it would raise its overnight rate, on which variable-rate mortgages are priced, to slow the rise in household borrowing levels. I have long argued that this was an empty threat because it would inflict too much collateral damage on other areas of our still fragile economy. Instead, I predicted that our federal government would continue to apply increased regulations.

This latest change provides further confirmation that the BoC is unlikely to raise its overnight rate for any reason other than that our economic fundamentals demand it. For example, when we have 2%+ GDP growth, 2%+ inflation, consistent and healthy job creation, etc.

Given the current state of our economy, that day still appears to be a long way off and that is very good news for variable-rate mortgage borrowers.

GoC five-year bond yields rose one basis point last week, closing at 1.76% on Friday. The range of available five-year fixed rates tightened a little as well, with most offerings now between 3.29% and 3.39%. The federal government’s decision to limit the growth of its NHA MBS in future will create higher costs for some, but not all lenders. Given that, working with an independent mortgage planner who has access to a wide range of lenders will help you find the lenders who are least affected in the here and now by this change.

Five-year variable-rate discounts shrank a little last week, with the best available discount dropping from prime minus 0.60% to prime minus 0.55% (which works out to 2.45% using today’s prime rate). Despite this, I still believe that the variable rate is a compelling option in today’s interest-rate environment, and on the flipside, my best available five-year variable rate now comes with more favourable terms and conditions (which you can read about in my latest Deal of the Week).

The Bottom Line: The federal government’s decision to limit the growth of its NHA MBS program will create slightly higher costs for some lenders but nonetheless, is a prudent change designed to protect the long-term stability of our real estate markets. This latest change also confirms that our federal government believes that regulatory changes, not tighter monetary policy by the BoC, are the best way to counteract the housing-bubble risk, and as such, further reduces the risk that variable rates will rise for the foreseeable future.