The Canadian Mortgage-Backed Risk Myth
Many Canadians are no stranger to debt. Canadian debt levels are among the highest in the world with household debt leading the way, notably mortgage debt. The majority of mortgage debt in Canada is held by banks on their balance sheet leaving minimal access for individual investors who want access to mortgage-backed securities (MBS). Are the banks protecting individual investors from an inherently risky asset class or do they prefer to keep it to themselves? To begin to answer this question we will look at indebtedness in Canada, why banks hold most of the mortgage debt in Canada and if the market should be more open to investors, or is it really too risky?
The information on Canadian household debt levels is clear, we have a lot of it. As of the end of Q2 2020 Canadian household debt as a percentage of GDP rose to 115% up from 100% in Q2 2019. Among the top 40 economies in the world Canada ranks 3rd highest in household debt to GDP behind top seeds Switzerland and Australia. In contrast the US ratio is 76.2% and the Euro area is 60.4%. Canada currently has the dual challenge of a relatively slow growth economy and rising demand for debt. Demand for mortgage debt hit a record in Q3 of 2020 of $28.7B. The gross level of debt partially dates to the resiliency of the Canadian market during the financial crisis. Between 2008 and 2014 the average growth in outstanding mortgage debt in Canada was 6%, whereas in the US it contracted by 2%/year over those same years. The Canadian government has recognized the issue and has tightened rules around mortgage debt in Canada. New rules include minimum credit scores, stress tests for high loan to value mortgages and increases in minimum down payments. The government is trying to proactively ensure continued health in the mortgage market, yet debt levels are growing as fast as ever.
Who holds all this debt? Globally there is a balance between mortgage debt that the banks hold on their balance sheet and that which it sells to investors through mortgage-backed securities. In Canada, based on the financial strength of the big 6 banks, the majority of mortgage debt is held by the banks, why? As investors, the banks love the risk that mortgage debt provides for the return it generates. In short, the banks would rather keep mortgage debt for themselves than exit that risk by selling it to the market. At the end of Q2 2020, 75% of total outstanding mortgage debt was held by chartered banks in Canada, add in credit unions and the number is close to 90%. The difference for the bank is secured vs unsecured lending. Where individual investors have grown comfortable investing in unsecured debt from governments and corporations that carry only the promise of payment, banks prefer lending against hard assets that they can sell if the borrower falters.
While sentiment is changing there is a contradiction between how retail investors’ view mortgage debt and how the banks’ view it, who is right? Since 2012 mortgage delinquency rates in Canada have averaged between 0.29% and 0.37% and are currently at the low end of that range. The regulators have a similar view: National Housing Act MBS and Canada Mortgage Bonds qualify as high-quality liquid assets for the calculation of the bank’s Liquidity Coverage Ratio (LCR). Simply, this means that the bank can leverage their mortgage holding to a far greater degree than if they hold corporate bonds or equity investments on their balance sheet. The “To Big to Fail'' regulations have resulted in banks holding almost no corporate bonds or equity investment on their balance sheet. In contrast the largest line item for the Canadian banks on their balance sheet is mortgage debt. The latest COVID-19 crisis saw the US government come to the rescue of the corporate debt market. This caused corporate bonds to rally, lowering the current yield for investors and in the eyes of many professional investors significantly increasing the risk to corporate bond ownership.
Make no mistake, while mortgage rates may currently provide a yield advantage to equal rated corporate bonds, they are still at all-time lows. However, given the fact that MBS are secured by hard assets, they have historically experienced low default rates and the regulators and banks both favour the risk over corporate bonds an analysis of individuals fixed income allocations may be appropriate. At approximately $16T in size there are ample opportunities for active managers within the global MBS market. To put that figure in perspective the MBS market is larger than the global corporate bond market and 5X the entire Canadian bond market. If MBS can help the banks to record profits year over year, they may help your portfolio.