Canadian real estate buyers were “ running out of land” last year, but now they’re running out of money. The Bank of Canada (BoC) and the Office of The Superintendent of Financial Institutions (OSFI) are currently reviewing the limits of covered bonds that can be issued. Banks have become increasingly dependent on these bonds for cheap funding of mortgages. As we approach the limit of these bonds that can be issued, regulators are looking to raise the limit. Great, problem solved. Except there’s a few tiny issues with raising the limit here.
Canada’s Covered Bond Program
Uninsured mortgages in Canada are funded by a variety of sources, but senior notes and deposits are the big ones. Senior notes are unsecured, and consequently have to pay a nice premium to be paid out. After all, if the issuer goes bankrupt, there goes your investment. Investors need a small risk premium for that. Deposits need cash, which only grows as quick as your clients can make money. Neither method can scale at the rate banks push mortgage growth post Great Recession. That’s when Canada got covered bonds.
Covered bonds are used to fund uninsured mortgage lending, issued by financial institutions. The debt remains on the bank’s books, but are also “covered” by the mortgages themselves. In the event investors aren’t paid, they have “dual recourse.” That means they can go after the bank, and have a claim against the mortgages. The bank and the mortgage going belly up at the same time is unlikely, so this is considered ultra-secure. Ultra-secure investments have low yields, making them perfect for a lot of lending.
The Rise of Canada’s Covered Bond Market
Virtually non-existent in Canada before the Great Recession, covered bonds have seen rapid growth. In 2007, covered bonds funded 1.1% of mortgages at banks. By 2017, that number inflated to ~$140 billion, about 9.1% of bank mortgage portfolios. Most of these are denominated and sold in Euros, to European investors. Banks have become increasingly dependent on covered bonds for mortgage funding. So dependent, they need regulators to review how much they can issue.
Funding At Canada’s Big Six Banks
Aggregate of funding sources for Canada’s Big Six Banks, expressed in percentage points.
Source: Regulatory filings of Canadian banks, Bank of Canada. Better Dwelling.
Covered bond issuance is getting close to the limit. Those 9.1% of mortgages funded by covered bonds, represents between 2.9% and 3.3% of total assets at the Big Six. Banks are currently limited to a covered bond issuance of 4%. The BoC estimates that gives banks room to issue another $50 billion of the instrument. For context, Q1 2018 saw $26.5 billion in uninsured mortgage originations at traditional lenders… just in Greater Toronto. Now, covered bonds aren’t the only source of funding for these mortgages. Banks have been increasingly dependent on them though, not leaving a lot of room for growth.
Canadian Mortgages Backed By Covered Bonds
The percent of mortgage dollar volume backed by covered bonds.
Sources: Canada Mortgage and Housing Corporation, websites of registered issuers, regulatory filings of Canadian banks and Bank of Canada calculations. Better Dwelling.
Rather than banks growing other sources of funds, regulators want to raise the limit. Earlier this year OSFI cryptically announced they were taking a “hard look at this limit.” When we asked directly, they couldn’t confirm if that meant higher or lower. The snitches at the BoC weren’t so tight lipped, instead explaining it would be an upward revision.
Riskier Than We’re Letting On
Sounds great, let’s just raise the limit and we’ll be good to go. Not exactly, it’s a huge risk if they aren’t sure that the Canadian economy is booming, and real estate prices are stable. Covered bonds are well, covered. In the event that an asset in the cover becomes non-performing, it gets replenshed. That’s bankster for “if a mortgage used for cover defaults, they have to replace it with a good one.” That mortgage is likely to come from the bank’s unsecured pool.
Remember when we discussed uninsured mortgages coming from expensive senior notes or deposits? Those less profitable mortgages get moved to the covered pool in this event. This can potentially create a higher ratio of unsecured debt, which is also subject to its own limits. As the BoC’s Toni Ahnert noted, this “increases the challenges a bank faces in responding to rapid depositor withdrawals or the failure of unsecured debt holders to renew their debt.”
The rapid withdrawal of cash doesn’t seem like a real scenario to the average consumer. After all, unemployment has never been lower, and wages are booming. However, growth of the M1+ supply (near cash) is quickly slowing. As interest rates climb, this indicator is likely to show further slowing of cash deposits. The recent phenomenon of Canadians using high-interest subprime loans, and buying negative carry real estate investments further depletes deposits. In the event of an economic hiccup, people will also need to draw on savings. All of this makes a “rapid” withdrawal scenario more realistic.
Regulators are considering doing one of the most Canadian things I can think of regarding debt. Forget limiting growth to income and other traditional methods of funding mortgages. That would require banks to stop handing out mortgages to everyone that walks into a branch. Instead, they’re looking to raise the limits on how many covered bonds can be issued.
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Why is everyone so oblivious to the fact that it has to end at some point? We’re pushing growth when it no longer makes sense.
Like Grizzly’s post just after yours points out, there is always a way to make it LOOK like there is still growth, even if it is not.
Just keep buying the same asset around and around, each time at a higher price.
It LOOKS like growth, even though there are no NEW assets joining the pot.
On paper, investors are getting richer and richer each time around.
Of course, traditional indicators would no longer apply, because the system broke a long time ago, and all of the leading indicators have become lagging indicators.
In fact, the ONLY leading indicator is the fact that prices on exuberant investments keep going higher and higher, without any inflation indicators on basic non-exuberant stuff.
In other words, people seem to be getting richer and richer, even though their actual cash flow income is exactly the same.
They are getting richer on fake money.
I think this year we should just lend everyone 1 million dollars to buy a property. Next year we will lend everyone 1.2m dollars. 1.4m the following we year and boom!. YOY appreciation and we can continue our economic model of trading each other homes.
It’s a perfect plan, how could it not work?
The climb in 2015/2016 explains a lot. Who wants to bet that’s why they were handing out mortgages like hot cakes over that period?
In this case, they essentially exported Europe’s QE problems to Canada. Global capital flows. Beautiful, ain’t it?
Well I knew we were importing a ton of easy money from China (huge debt expansion and outflows) and the US (rates and QE) but didn’t realize we were also tapping the EU. Makes sense though, a ton of US companies are now selling bonds in euros because they can offer lower yields thanks to the ECB. Really is the “Triple Crown” for our housing market.
If we can figure out away to include Japan than it can be “The 4 Horsemen”
@Grizzly The real beauty is CAD dropping in value. Since they’re denominated in Euros, the banks are going to be ponying up a top on the principal.
Do you think that would put more pressure on BOC to continue raising to protect our dollar’s value?
Eurozone looks like it could have some serious headwinds on the horizon. I guess we should hope that things go equally bad there?
Makes sense. (Rolls eyes)
Covered bonds, ultra secure for foreign investors. Contributing to Canada’s housing bubble, and creating taxpayer risk. If these start popping, you better believe we’ll be on the hook for the liquidity needed when they transfer the assets to the covered pool.
They have to figure out a way to help the banks make more money without raising interest rate.who wants to deposit money when the return is so low.everyone has been using stock market, Real estate and bitcoin instead.
Keep the machine going as long as possible. Total lack of long term vision.
Mica,
I totally feel you on your statement However, whether its housing or the stock market and economy in general, I’m realizing that predicting the downfall of any of these things is impossible.
To me its clear that there is an interest from the government and the banks to keep the market propped up and to keep pushing the prices higher. They will fight tooth and nail with every trick and strategy that they can come up with to do so.
At the end of the day, I feel like theres so many reasons why to expect this whole market to come crashing down due to alot of things are repeating process of what happened in 2007, But after being a spectator from the sidelines, I feel myself questioning the whole thing over again with a new angle that perhaps it may never happen due to the powers that be are the ones in control whether they want this ship to sink or keep rising forever.
Afterall, theres someone up that pyramid that can always print more money out of thin air, it costs them nothing, and it keeps the slaves slaving away, and the debt to grow larger and larger so they always have a reason to keep working.
So far I don’t see indication that government is trying to boost RE market further. In fact they are doing exactly the opposite and the market is resisting at all costs.
I agree, government is very powerful but so far it’s playing on Bears’ side.
keeping up appearances of controlling the situation is all they are doing, but that is just my opinion
You can only bail the boat out for so long,eventually it will sink.
Well lest just hope everything goes well and this will result beneficial, otherwise it would be real trouble.