New Rules on Financing of Insured Mortgages Could Have Far-Reaching Impact

On June 6, the federal government published in the Canada Gazette regulations amending both the Insurable Housing Loan Regulations¹ under the National Housing Act (NHA)² and the Eligible Mortgage Loan Regulations³ under the Protection of Residential Mortgage or Hypothecary Insurance Act.⁴ The first set of amendments applies to mortgage loans insured by Canada Mortgage and Housing Corporation (CMHC), and the second set of amendments applies to mortgage loans insured by licensed private mortgage insurers (currently Genworth Financial Mortgage Insurance Company Canada and Canada Guaranty Mortgage Insurance Company). Since both sets of amendments are nearly identical, we will refer to them collectively as the "Regulatory Amendments." The Regulatory Amendments are expected to come into force on January 1, 2016.

What You Need To Know

• The language used in the Regulatory Amendments could have a much broader impact on mortgage lenders than is indicated in the Regulatory Impact Statement that accompanies the amendments.
• The consequences of non-compliance could lead to borrowers who have paid upfront insurance premiums losing the benefit of their mortgage insurance.
• The transitional provisions could have harsh consequences for both mortgage lenders and mortgage funders.

Background

Mortgage insurance can be used to insure: (1) high loan-to-value (High LTV) mortgage loans (i.e., loan-to-value ratio greater than 80 per cent); or (2) low loan-to-value (Low LTV) mortgage loans (i.e., loan-to-value ratio of 80 per cent or less). Federally regulated lenders are required to insure High LTV mortgage loans. Some lenders also choose to insure Low LTV mortgage loans. Low LTV portfolio insurance is a mortgage insurance product lenders use to insure a pool of mortgages at some point after the mortgages have been provided to the borrowers. Typically, borrowers under High LTV mortgage loans are required by their lenders to cover the upfront cost of mortgage insurance that is established to insure the mortgage through all renewals until it is fully amortized. In the case of portfolio insurance of Low LTV mortgage loans, the lender identifies the loans to be insured as a pool and pays the upfront insurance premium to insure all mortgages in the pool until full amortization.

In its 2013 budget, the federal government announced that it would prohibit the use of taxpayer-backed insured mortgages as collateral in securitization vehicles that are not sponsored by CHMC. The federal government has always established the eligibility requirements for mortgage loans to be eligible for government-backed mortgage insurance, for example, by imposing minimum down payments or maximum amortization terms. In the Jobs, Growth and Long-term Prosperity Act passed in April 2012, the government passed amendments to the NHA that introduced a statutory regime for covered bonds. Included in the covered bond regime was a prohibition on the use of insured mortgage loans as collateral for covered bonds.⁵ This was a response to the fact that several billion dollars of covered bonds secured by insured mortgages had previously been issued by some large Canadian banks. This was the first time the government regulated how insured mortgages could or could not be financed. The purpose of the 2013 federal budget provision appeared to be to finish the process started with the covered bond legislation by further restricting the ability of mortgage lenders to finance insured mortgages other than through CMHC securitization programs.

CMHC currently operates two securitization programs. The first involves the issuance of mortgage-backed securities under the NHA (NHA MBS) by issuers authorized by CMHC (approved issuers) pooling insured mortgages and issuing NHA MBS specifically backed by these mortgage pools. The second involves the issuance by Canada Housing Trust—a special purpose entity sponsored by CMHC—of term bonds (Canada Mortgage Bonds or CMB) secured by NHA MBS.

Both NHA MBS and CMB are fully guaranteed as to timely payment of principal and interest by CMHC, a guarantee that carries the credit of the federal government. It is beyond the scope of this bulletin to describe these programs in detail, other than to make two observations. First, the government through CMHC indirectly dictates the amount of NHA MBS and CMB that can be issued in any year. Currently, the demand by issuers exceeds the permitted issuance levels and so an allocation process administered by CMHC is being used to allocate the use of these programs. As a result, mortgage lenders can have no certainty about their ability to receive sufficient allocations to fund all of their insured mortgages through one of these programs. Second, not all insured mortgages meet the eligibility criteria for being included in a mortgage pool backing NHA MBS (there is a complete chapter in CMHC’s NHA MBS Guide dedicated to eligibility criteria for mortgage loans backing NHA MBS).

In its Regulatory Impact Statement, the Department of Finance lists the objectives of the Regulatory Amendments as follows:

• Prohibit the use of taxpayer-backed insured mortgages as collateral in securitization vehicles that are not sponsored by CMHC.
• Restore lender use of government-backed portfolio insurance to its original purpose, funding through CMHC securitization programs.
• Provide a transitional period for affected lenders to adjust to these measures.

Mortgage lenders who do not have the ability to fund their mortgages through deposits will be particularly affected by the Regulatory Amendments. However, there are a number of problems with the Regulatory Amendments that should be of concern to deposit-taking mortgage lenders as well:

• The language used in the Regulatory Amendments extends far beyond mortgages being used as collateral for securitization vehicles and could have a much more far-reaching impact on mortgage lenders than indicated in the Regulatory Impact Statement.
• The consequence of non-compliance set out in the Regulatory Amendments is the retroactive ineligibility of mortgage loans for insurance, leading to a loss of the insurance which could have undesirable consequences for more than just mortgage lenders.
• The transitional provisions do not reflect the realities of existing commitments made by mortgage lenders and mortgage funders, and could have harsh consequences for both.

Description of Regulatory Amendments

Adding to the list of requirements that must be met for a mortgage loan to be eligible for government-backed mortgage insurance, the Regulatory Amendments add a requirement stipulating that "if the loan is part of a pool of loans on the basis of which securities have been issued after December 31, 2015, all such securities issued on the basis of the pool must be guaranteed by CMHC."

This introduces the only retroactive eligibility criterion for insured mortgage loans whereby a mortgage loan that satisfied all eligibility criteria at origination could later become ineligible. Another way to think of this is that the Regulatory Amendments are introducing a unilateral amendment to the terms of existing insurance policies that would disqualify a claim on these insurance policies if the new eligibility criterion is breached at any time with respect to the affected mortgage loans.

For comparison purposes, we note that this is not a problem with respect to the existing prohibition in the NHA against using insured mortgage loans as collateral for covered bonds. The consequence of non-compliance with those provisions is that the non-compliant bonds would not have the statutory protection afforded to bondholders (that is, they would not be "statutory" covered bonds). The insurance for any mortgage loans that were transferred to a covered bond pool in violation of those statutory provisions would not be retroactively invalidated by those provisions. In those circumstances it would only be the Regulatory Amendments that would invalidate the insurance.

The Regulatory Amendments also provide that Low LTV portfolio insured mortgage loans must be securitized via a CMHC program within six months of being insured. This requirement would also apply to portfolio-insured mortgage loans released upon the maturity of NHA MBS. The consequence of non-compliance is that the mortgage insurer will be required to cancel the insurance. There is no discussion in the Regulatory Amendments of a refund of premiums if the lender does not receive a sufficient allocation of NHA MBS or CMB to satisfy this requirement or if any portfolio insured mortgage loan does not meet all the eligibility criteria for these programs; presumably that is an issue to be taken up with the applicable insurer.

There are exceptions to the "six months to securitize" rule. Portfolio-insured mortgage loans that fall into arrears are permitted to remain insured despite no longer being eligible for NHA MBS pools. Another exception is provided where, as long as 97 per cent of the lender’s insured Low LTV loans meets the above securitization requirement or any of the exceptions, portfolio insurance coverage may be provided for up to a maximum of 3 per cent of a lender’s insured Low LTV mortgage loans, even if the above securitization requirement is not met for those loans.

The transitional provisions of the Regulatory Amendments stipulate a high-water mark for any insured loan pool balance as at June 30, 2015. Where there are securities issued on the basis of a pool of loans prior to January 1, 2016, the eligibility requirements described above will not apply to insured loans in that pool between January 1, 2016 and December 31, 2017 so long as the total amount of insured loans that are part of the pool does not exceed the June 30, 2015 high-water mark. Similarly, the new eligibility requirements will not apply to insured loans in that pool between January 1, 2018 and December 31, 2020 so long as the total amount of insured loans that are part of the pool does not exceed 50% of the June 30, 2015 high-water mark.

Discussion

1. The Regulatory Amendments are much broader than they are represented to be in the Regulatory Impact Statement.

The stated objective of the Regulatory Amendments is to prevent the use of insured mortgages as collateral in securitization vehicles that are not sponsored by CMHC. However, the Regulatory Amendments make no mention of the terms "collateral," "securitization vehicles" or "asset-backed securities" even though there are definitions in the market that could have been used.⁶ Instead, the Regulatory Amendments use the words "part of a pool of loans on the basis of which securities have been issued." This is a vague and potentially over-reaching phrase.

We believe that the intention of the drafting is to make the scope of these provisions broad, and that the drafting is based on the wording of section 14(1) of the NHA, which reads as follows:

"The Corporation [CMHC] may — with the Minister of Finance’s approval and on any terms or conditions that are specified by him or her — guarantee payment of any or all of the principal or interest, or both, in respect of securities issued on the basis of housing loans." [emphasis added]

We believe that the language in section 14(1) of the NHA is intentionally broad to permit CMHC to guarantee not only NHA MBS (which represent ownership interests in housing loans together (often) with an issuer prepayment indemnity), but to also guarantee CMB (which represent more than a simple ownership interest in housing loans due to the swap arrangements that are required).

We understand that aside from covered bonds, the main target of the Regulatory Amendments is the financing of insured mortgages through asset-backed commercial paper conduits (ABCP Conduits). DBRS estimates that there are currently approximately $8 billion of insured mortgages funded this way.⁷ We estimate that this represents approximately one per cent of all insured mortgage loans in force in Canada. Given that the total size of the Canadian ABCP market is approximately only $28.8 billion, DBRS has expressed concern that if insured mortgage loans disappear from ABCP Conduits without being substantially replaced with other financial assets (such as uninsured mortgage loans), there could be a material adverse impact on the liquidity of the entire Canadian ABCP market.⁸

It is difficult to determine what forms "the basis of which securities are issued" in the context of ABCP Conduits. ABCP is not normally issued in separate series for separate asset pools. The ABCP issued by an ABCP Conduit is secured by all assets of that Conduit. If only 1% of the assets of the ABCP Conduit comprise insured mortgage loans and 99% of the assets comprise other financial assets, would all of the ABCP of the ABCP Conduit constitute "securities which have been issued on the basis of the pool of [insured] loans"? If not, how much of the Conduit’s assets would have to consist of insured loans to meet this test? The Regulatory Amendments provide no guidance.

If it is the objective of the government to preclude even a single insured mortgage loan from being sold to an ABCP Conduit after December 31, 2015, we expect that the government’s interpretation would be that any amount of issued ABCP backed by any amount of insured mortgage loans would taint all of the insured mortgage loans in the pool.

However, nothing limits these securities to being issued by securitization vehicles. All banks issue an array of debt and equity securities that are arguably issued on the basis of the assets of the bank, including its insured mortgage loans. The distinction between banks and ABCP Conduits could have been made clearer if the Regulatory Amendments had used the phrase "the loan is part of a pool of loans comprising collateral for securities." That could have caught ABCP and excluded bank securities (other than covered bonds). Closer to the ABCP Conduit example, mortgage investment corporations are restricted under the Income Tax Act to primarily owning assets comprising mortgage loans. Are the Regulatory Amendments intended to prevent mortgage investment corporations from owning insured mortgages?

2. Consequences of breach.

While the loss of portfolio insurance on Low LTV mortgage loans for failing to securitize in time aligns the consequences with the responsible parties, the same cannot be said for the loss of insurance on a High LTV mortgage loan. If the insurance on a High LTV mortgage loan is retroactively invalidated as a result of actions of the mortgage originator or an ABCP Conduit, this would unfairly prejudice the mortgagor who paid the premium for the mortgage insurance at mortgage origination. In the circumstance where such a mortgagor discovers at mortgage renewal that his or her mortgage insurance is no longer valid and he or she is therefore unable to renew or refinance the mortgage, he or she would only be able to look to recover from the mortgage originator or ABCP Conduit whose actions invalidated the insurance. We would expect that this would be an entirely unsatisfactory remedy for mortgagors who paid the initial insurance premiums on High LTV mortgage loans. Eliminating the potential for this type of situation could have been easily accomplished by limiting the Regulatory Amendments to portfolio insured Low LTV loans.

3. Transitional provisions.

The imposition of a high-water mark of June 30, 2015 does not recognize the commercial reality that mortgage lenders make mortgage commitments months in advance. While it is theoretically possible for mortgage lenders to continue to sell insured loans to ABCP Conduits between July 1, 2015 and December 31, 2015, it is unlikely that an ABCP Conduit sponsor would be willing to accept any such insured loans if the result would be that the pool balance would exceed the balance as at June 30, 2015. As a result, there may be many mortgage lenders with outstanding commitments that they may find difficult or impossible to fund.

The transition rule for securities outstanding between January 1, 2018 and December 31, 2020 seems to assume that sellers of loans to ABCP Conduit have the ability to control the size of their securitized mortgage pools. There is normally no right of an ABCP Conduit to require a seller of mortgage loans to repurchase mortgage loans that met the ABCP Conduit’s eligibility criteria when they were sold. Unlike governments, ABCP Conduits do not have the power to unilaterally amend contracts retroactively. Also, because of true sale concerns, sellers would not have the unilateral right to repurchase previously sold mortgage loans. Even if an ABCP Conduit sponsor and a seller could reach an agreement relating to the repurchase of insured mortgage loans by the seller prior to December 31, 2017, it is not obvious that all such sellers would be able to fund such repurchases.

_________________________

¹ SOR/2012-282.

² R.S.C. 1985, c. N-11.

³ SOR/2012-281.

⁴ S.C. 2011, c. 15, s. 20.

⁵ S.C. 2012, c. 19.

⁶ See, for example, National Instrument 51‑102 which defines "asset-backed security" as "a security that is primarily secured by the cash flows of a discrete pool of mortgages, receivables or other financial assets, fixed or revolving, that by their terms convert into cash within a finite period and carry rights or other assets designed to assure the servicing or the timely distribution of proceeds to securityholders."

⁷ DBRS, Monthly Canadian ABCP Report, February 2015.

⁸ supra.

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