Canada and the United States both would like to shift more mortgage risk back to the private market, and they might be able help each other do just that.
Private-label residential mortgage-backed securities once loomed large in the United States. The securities have made something of a comeback, but the market remains smaller than it was before the downturn, in part due to lingering investor concerns about credit.
Canada's equivalent market has had better credit performance, but always has been small. So even though there may be more interest in building a non-governmental securitization market, there is little in the way of existing operations to support much of one.
These circumstances point to a cross-border opportunity, according a U.S. mortgage industry veteran who has worked with PL RMBS, distressed debt and loss mitigation. Frank Pallotta, chief executive of the Ramsey, N.J.-based CMF Management Co. LLC, says he has been exploring the possibility of bringing the infrastructure for non-governmental securitization more commonly used in the U.S. to Canada in response to new interest in it there.
Infrastructure for the accumulation, securitization and distribution of newly originated mortgages exists in the U.S. But it hasn't been used in part because investors burned during the U.S. collapse are still gun-shy and pricing has not been at a level competitive with other forms of funding, he said. There is no real private label securitization infrastructure in Canada, but Canadian investors believe in the long-term performance of private mortgage securitizations in a way U.S. investors do not.
"The Canadian market is much more investor-friendly," Pallotta said.
The reasons for that are worth U.S. policymakers and market participants' consideration given the U.S. Treasury's interest in restoring PL RMBS, and the fact that U.S. investor confidence is considered so central to that effort.
Both countries are currently seeking to cultivate more non-governmental securitization.
Canadian regulators are interested in reducing mortgage industry reliance on government insurance programs, said Jim Murphy, president and CEO of the Canadian Association of Accredited Mortgage Professionals. And Canadian lenders also have been moving away from traditional sources of funding like deposits and the selling of shares, according to data from Canadian ratings agency DBRS, the Bank of Canada, and government agency Canada Mortgage and Housing Corp. These traditional sources have decreased to about 60% of funding from about 76% in 2008.
Private securitization makes up just 1% of mortgage funding today in Canada, but Pallotta thinks it could grow. Covered bond use has been growing faster than private securitization in Canada but there are restrictions on the former's use. The Canadian bank regulator limits banks’ use of covered bonds to 4% of total assets, and covered bond legislation restricts what types of players can issue covered bonds, said Vanessa Purwin, a senior director at Fitch Ratings. Covered bonds ratings are more closely linked to the issuer's credit than securitization ratings are.
Large banks and smaller mortgage bank lenders dominate the mainstream mortgage market in Canada, and less mainstream borrowers are served by smaller lenders known as mortgage investment corporations. Pallotta seeks to serve the smaller mortgage banks and MICs by buying, aggregating and securitizing their loans.
MICs run funds that are constantly hungry for new sources of liquidity through which they can fund mortgages. They generally close and hold in their funds' portfolios loans obtained on a wholesale basis from mortgage brokers. The MICs generally fund those loans by selling preferred shares in their funds.
If MICs could sell off their loans to a non-governmental securitization vehicle like Pallotta's, it would give them another source of funding for their mortgages. Smaller mortgage banks could expand their product mix and geographic footprint.
The opportunity for U.S. players to provide infrastructure for private securitization in Canada is limited even if the market grows, given market participants' preference to work primarily with local partners and investors, Pallotta said.
But U.S. players also can learn a lot to benefit their own mortgage market just by observing Canada. Some strategies may not translate due to differences in the two markets but others do. (Prepayment risk is different in Canada, for example, because loans have typically been renewable after five years and have 25 year amortization periods.)
Here are some key reasons Pallotta says investors may be more comfortable with non-governmental securitization in Canada than they are here.
Clear, Consistent Rules the Market Respects
"The biggest difference between the U.S. residential market and the Canadian residential market is the relationship that exists between the regulator, the lender, and the borrower," Pallotta said.
This relationship is generally less adversarial than in the United States because they usually agree on the legal parameters for transactions, and those parameters are fairly static, he said.
"That's one of the big reasons why the Canadian market is better from an investor participation standpoint, because the rulebook doesn't change," he said. "The borrower knows what they're supposed to do, what their supposed to submit, the lender knows what they're supposed to do."
Shorter Foreclosure Timelines
Because workouts don't take quite as long in Canada, investors feel they have more certainty about mortgage performance.
"In Canada it's almost unheard of that someone is not making a payment and still in their home after six or nine months," Pallotta said. (Canada technically lacks a foreclosure process, but has something similar called the power of sale.)
"When you have three-year foreclosure timelines in the state of New Jersey, that's not in the investor's best interest," he said. "It might be in the borrower's best interest, because they need help, but Canada I think does a better job of marrying what's best for the consumer with what's best for the lender and what's best for the investor."
Canadian RMBS loss levels are far lower than in the United States, and fewer borrowers default, perhaps in part due to stricter underwriting standards.
Loan-to-value ratios in the U.S. during the housing boom that preceded the 2007 and 2008 bust were notoriously high, leading to great losses when housing depreciated during the downturn. But Canadians have kept LTVs low in private securitizations, which can't by law include loans with mortgage insurance.
"The weighted LTVs on a nonagency deal, or they call them non-insured in Canada, are much lower than they are in the U.S.," said Pallotta. "If an investor has a 65% LTV and they know that they can get their hands on the asset within six months, then the main bet they're making is a bet that prices don’t fall 30% in six months."
Low LTVs are particularly important now. A key risk for the Canadian RMBS is that home prices north of the border have been running up for a fairly long time, although the run-up has slowed more recently, said Fitch's Purwin. Originations for 2014 are expected to be relatively flat or slightly down from prior years.
Canada's appraisal process is less regulated than the United States' and more reliant on automated valuation models "but they didn't get in trouble like we did. Their lending standards are more conservative," said Jennifer Creech, chief executive and president at InHouse, an appraisal management technology and services firm in the U.S. with cross-border business ties.
The U.S. could learn from Canada about lending standards. But if private securitization becomes more widespread up north Canadians might want to take a page from the U.S. in terms of the regulation and rigor surrounding appraisal review given the importance of the collateral to securities' value, she said.
No Risk Layering
Layered risks, where multiple underwriting criteria were loosened simultaneously, were notorious in the United States between 2005 and 2007. Canadians do allow underwriting exceptions, but only one at a time, said Pallotta.
"There's an understanding of the risk-reward profile of any loan that gets bought. If a loan goes stated [income], the other risk requirements attached to that loan are adjusted accordingly. Stated income absolutely means more money down. If you have stated income absolutely you have a higher credit score," he said.
Unlike in the United States, Canadian lenders want to work with the ratings agencies as they accumulate loans for securitization rather than asking for a review after the fact, Pallotta said.
"I think everybody in the U.S. just tried to squeeze every dime they could out of every possible transaction and that just leads to a misalignment of incentives." he said. "I think Canadians understand if everybody plays well in the sandbox together and everybody including the borrower plays by the same rules, the opportunity could lead to greater forms of liquidity."