Bay Street bond dealers and investors are raising concerns about a proposed change to Canada’s housing finance system that would transform the $260-billion Canada Mortgage Bonds market and see the federal government financing a significant portion of the country’s mortgage lending out of its own borrowing.
In the federal budget, published in March, the government proposed consolidating Canada Mortgage Bonds (CMB) into the government’s general debt program. CMB are issued by an arm of the Canada Mortgage and Housing Corporation, a Crown corporation, which uses the proceeds to help finance private mortgage lenders.
By bringing the CMB program in-house, the Department of Finance is hoping to eke out some additional revenue, which it says could help fund affordable housing initiatives.
Despite being guaranteed by the federal government, CMB are sold to investors at a slightly higher interest rate than Government of Canada bonds. Ottawa sees that difference, or spread, as money left on the table, waiting to be captured.
Critics aren’t so sure about the government’s math. Ottawa doesn’t pay the higher interest rate on CMB; that ultimately gets passed to the end mortgage borrower. And replacing $40-billion worth of annual CMB issuance with additional Government of Canada bond sales could reverberate through the market, driving up broader borrowing costs and eroding potential gains for the Treasury.
Moreover, there are concerns about the loss of CMB: a pillar of the fixed-income market for the past two decades, popular with both domestic and foreign investors. And there are questions about whether Ottawa should be in the arbitrage game at all, trying to profit off the yield spread between its own debt and mortgage-backed securities.
“The government then becomes, to some extent, a financial entity. Call it what you will: a bank, a hedge fund … an investor,” said Benjamin Reitzes, managing director of Canadian rates at Bank of Montreal.
“Is that something that’s in the best interest of Canadians and of taxpayers? Is that what the government should be doing with their borrowings?” he asked.
The proposal, outlined in a single paragraph in the budget, is still in development. A government official said that the Department of Finance has not settled on a structure for consolidating the CMB program, although they said internal discussions are about how to manage new issuance, not about buying up outstanding CMB. The Globe and Mail is not naming the official so that they could speak on background.
The government plans to consult with market participants over the summer and come back with a more fleshed-out plan in the fall economic update.
If the plan proceeds, it would be the second major change to the bond market in a year. Last fall, the federal government stopped issuing Real Return Bonds, a type of security that offers protection against inflation. While the government said there wasn’t enough interest in the program, the decision was widely panned by market participants.
The end of the RRB program followed by the surprise CMB proposal has led some to question how much Ottawa understands financial markets. Todd Evans, managing director of the Investment Industry Association of Canada, wrote a pair of letters to the Department of Finance expressing concern about the CMB proposal and about the government’s engagement with Bay Street on its debt management strategy.
“The IIAC’s concern is that these decisions are being made absent enough thought of how the downstream consequences will affect secondary market liquidity, specifically of legacy securities,” Mr. Evans wrote in an April 26 letter that was made public last week.
To be sure, Bay Street dealers aren’t impartial observers on this issue. The bond desks at Canada’s banks earn millions of dollars in fees every year helping CMHC manage the program and selling CMB around the world.
But investors are also wary of the change, said Vinayak Seshasayee, who leads Canadian portfolio management for U.S. bond giant Pacific Investment Management Company, also known as PIMCO.
“If there is overwhelming support for it, it can be done without major disruption to the market. But that said, so far, at least what we’re hearing is the majority of investors are actually in favour of continuing the program and retaining the CMB as a separate issuance,” Mr. Seshasayee said.
The government has consolidated Crown corporation borrowing before, bringing the debts of CMHC, the Business Development Bank of Canada and Farm Credit Canada onto its own books in 2008.
But the Canada Mortgage Bond program – which was carved out when CMHC debt was consolidated – is on a different scale. There are around $260-billion CMB outstanding, roughly a quarter of all debt explicitly guaranteed by the federal government. CMB are also part of the plumbing of Canada’s financial system.
CMHC launched the program 22 years ago to improve mortgage securitization in Canada.
One way lenders fund new mortgages is by packaging up existing loans – specifically loans that are insured by CMHC or other private insurers – into mortgage-backed securities (MBS) and selling them to investors.
Mortgage securitization began in Canada in the 1980s but failed to attract much investor interest for the first decade and a half. In 2001, CMHC was given the task of improving the MBS market, in the hope of funnelling more private capital toward Canadian home lenders – especially smaller ones that, unlike banks, don’t have large deposit bases to draw on.
CMHC set up the Canada Housing Trust as a middleman. The trust buys mortgage-backed securities from lenders and funds the purchases by selling a new type of asset to investors: Canada Mortgage Bonds. Essentially, it is transforming an unattractive MBS into a more attractive type of bond, which pays interest regularly and trades in a larger more liquid market.
“It’s been a very successful program,” Romy Bowers, chief executive of CMHC, told The Globe and Mail’s editorial board last week, although she added that “it’s always good to do a review.”
“I do think that it is within the right of the government to say, ‘You know what, we have a different housing situation, there’s different affordability needs. Is that program set for purpose based on the needs of Canadians at this point in time?’” she said.
The government says it wants to ensure “stable access to mortgage financing” through any potential change to the CMB program.
But Ed Devlin, founder of Devlin Capital and a senior fellow at the C.D. Howe Institute, said the government needs to tread carefully on this front. If it becomes more difficult for lenders to sell mortgage-backed securities, that could push up funding costs and flow through to home buyers who are already struggling with higher interest rates.
“The mortgage market is in a fragile state right now,” Mr. Devlin said. “It might be a good move from a big picture perspective if they can get the structure right. But even if they had a decent structure, there’s execution risk of doing it at the wrong time.”
It’s not yet clear how CMB consolidation would work. One option is for the government to provide money directly to the Canada Housing Trust, instead of having the trust sell CMB to investors. The government, in turn, would raise the required money by issuing more of its own bonds.
In theory, the government could capture the roughly 30 basis-point yield spread between its own bonds and CMB by acting like a bank: borrowing money at a lower interest rate and investing it at a higher rate. (A basis point is 1/100th of a percentage point.)
But bond experts warn that those gains could be ephemeral. If the government issues $40-billion more bonds a year, that could push up the yields on all government debt, increasing overall debt servicing costs.
“While you might be saving 30, 35 basis points on the $260-billion in CMB debt, you might be spending an extra 5, 6, 7, 10 basis points on Government of Canada debt. And then the revenue that you think you’re getting is gone,” said Mr. Reitzes of BMO.
A move up in government bond yields would also impact other borrowers, including provinces and companies, which price their debt relative to government bonds, according to Warren Lovely, chief rates and public sector strategist with National Bank of Canada.
“Given the heightened sensitivity to higher interest rates in today’s economy, even a seemingly modest increase in borrowing rates (if fully passed through and sustained) could cost all Canadian debt issuers roughly $500-million to $1-billion a year by year five,” Mr. Lovely wrote in a note to clients last week.
“Ironically, that might fully offset the notional interest savings that motivated the proposed CMB consolidation in the first place.”