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By Kevin Fettig July 26, 2024

Why CMHC Should Explore Synthetic Risk Transfer for Mortgage Securitization

Under the National Housing Act (NHA), a key objective of CMHC is to promote the efficient functioning and competitiveness of the housing finance market. CMHC’s securitization activities through the NHA MBS (mortgage-backed securities) and Canada Mortgage Bonds program are crucial vehicles for achieving this goal.

Alongside its securitization business, CMHC operates a mortgage insurance business. The scope of this business has narrowed as the government has restricted the types of residential mortgages eligible for these programs.

The changes to the insurance program are important because mortgages must have default insurance to qualify for securitization. Technically, this is a requirement of the program and not necessarily a requirement for CMHC’s timely payment guarantee. Additionally, any guarantee under the NHA that covers the principal, interest, or both for securities based on housing loans requires approval from the Minister of Finance.

What hasn’t been explored is how to create an NHA MBS on mortgage pools that use alternative risk transfer mechanisms to mitigate credit risk. In the US, Fannie Mae and Freddie Mac have partnered with private capital sources to transfer mortgage credit risk, develop broad and liquid markets, and reduce taxpayer risk.

A Proposed Approach for Canada

We propose introducing similar tools to support mortgage securitization growth in Canada without increasing the government’s credit risk exposure. For the past 15 years, banks have been issuers of risk transfer securities. While these securities have mainly been issued by European banks, Canadian banks have also participated as issuers.

At its most basic level, synthetic risk transfer involves the purchase of credit risk protection on a portfolio of loans. The lending institution purchases protection for the portfolio of loans on its balance sheet, specifying the amount of losses transferred to the investor and the amount it retains. This risk transfer process is the same as portfolio insurance, where mortgage insurance covers losses from borrower default on a portfolio of mortgages. For an NHA MBS, the insurance coverage is transferred along with the mortgages when the MBS pool is sold to an investor.

Mitigating CMHC’s Credit Risk Exposure

A synthetic risk transfer, through either insurance or a financial guarantee, would mitigate CMHC’s credit risk exposure while allowing it to build a foundation for a deeper mortgage securitization market. CMHC would need to work with the industry to define new mortgage pool types.

Does this create an increased exposure to loss for CMHC and taxpayers? Providers of these risk transfer solutions would need to have expertise in this space. Since banks and US housing agencies already use these tools, there is a pool of experienced parties available. What about the timely payment guarantee risk? Certainly, work would need to be done to quantify this risk. However, given that CMHC has never had a claim on its timely payment guarantee, we expect any incremental risk would be minimal.

But why should CMHC do this? There are three key reasons:

  1. Mandate fulfillment. CMHC has a mandate to promote the efficient functioning and competitiveness of the housing finance market and contribute to the stability of the financial system, including the housing market. Expanding the mortgage securitization market through new credit risk transfer mechanisms allows for a broader housing finance market. This increases demand for mortgage securitization and helps to develop a broader investor base that will eventually support a private sector securitization solution.

  2. Attract private sector capital. To expand housing, we need to build a broad housing finance market that will attract private sector capital. Much of our national housing strategy relies on government funding. This solution aims to create greater scope for institutional investors to fund residential mortgages.

  3. Transfer credit risk. Developing a market for credit risk transfer in the mortgage market lays the foundation for the government to transfer mortgage insurance credit risk to the private sector.

This strategic approach not only aligns with CMHC’s mandate but also paves the way for a more resilient and expansive housing market in Canada.

 
 

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