Special Purpose Vehicles
In an asset securitization, a lender packages a pool of financial assets and sells them to a special purpose vehicle (SPV), which in turn issues asset-backed securities to investors. The proceeds received by the SPV are used to pay the lender for the pool of assets. Cash flows from the pool (principal and interest payments, proceeds from insurance claims, etc.) are used by the SPV to make principal and interest payments on the securities. This structure has been used with a wide variety of asset classes, including residential and commercial mortgages, credit card receivables, vehicle loans, equipment leases, and trade receivables.
Securitizations are well suited to asset pools that are:
- large enough to warrant the time, cost, and complexity of a securitization;
- sufficiently diverse to avoid excessive volatility; and
- transferable, and otherwise unencumbered.
Lenders with suitable asset pools are attracted to the securitization structure because it provides an (often cheaper) alternative to traditional funding sources such as bank lending, corporate bonds, and equity issues. An effectively structured securitization can have the added benefit of legally insulating the lender from the assets concerned.
Securitizations involving assets with a strong collection history, or credit enhancements such as overcollateralization or a third-party guarantee, can receive a high credit rating. This makes the securities issued by the SPV attractive for investors, who also derive comfort from the security over the underlying assets.
The legal issues involved in an asset securitization are numerous and complex. Counsel working in this area provide advice and assistance regarding deal structure, the perfection and assignment of security interests in the pool, public offering documentation, the enforcement of rights to realize on underlying collateral, and due diligence.
Asset securitization practice embraces advising stakeholders on structuring and implementing asset securitization transactions including structuring and financing special purpose vehicles; documenting the acquisition of assets and the issue of the appropriate securities; ensuring regulatory compliance; and advising rating agencies. Lawyers in this practice act for asset originators, dealers, trustees, agents, liquidity lenders, credit enhancers, rating agencies, and others.
“Toward a More Flexible Mortgage Market”
In May 2019, Canada’s Governor of the Bank of Canada, Stephen S. Poloz, delivered Remarks entitled “Risk Sharing, Flexibility and the Future of Mortgages”1 to the Canadian Credit Union Association and Winnipeg Chamber of Commerce. Here is an excerpt from those Remarks:
Given how different the various regional housing markets can be, it is worth looking to see whether Canada’s mortgage market could become more flexible, giving people more choices and increasing the economy’s ability to adjust.
Canadian homeowners and financial institutions have been well-served by our mortgage market. But it is still important to think about ways to innovate and make a good system better so that borrowers and lenders can make choices that better suit their circumstances.
Of course, there have been innovations in Canada’s mortgage market over the years. Mortgage brokers have appeared on the scene. Financial institutions are doing more business online and reducing the time between application and approval. And mortgages combined with home equity lines of credit, or HELOCs, have become popular. These give Canadians ready access to the equity they have built in their homes, helping people make major purchases and smooth their consumption over time.
Still, there has been significantly less innovation in terms of the actual mortgage product itself. We could look at ways to develop a more flexible mortgage market that gives more choice to customers, lenders and investors, while making the market safer and more efficient.
Diversify mortgage durations
One basic idea would be to encourage more diversity in mortgage durations. It is true that most financial institutions offer fixed-rate mortgages longer than five years. But 45 per cent of all mortgage loans have a fixed interest rate and a five-year term. In comparison, just 2 per cent of all mortgages issued last year were fixed-rate loans with a term longer than five years.
There are historical reasons why the five-year fixed-rate mortgage has been so dominant in Canada. These include legislation from the 1800s that gives borrowers the right to prepay loans after five years without penalty. This provision means that lenders will charge more for longer loans to guard against the risk of a loan being paid back early. And the trend toward five-year loans was reinforced by the Canada Mortgage Bond (CMB) program, which mainly provides five-year funding for financial institutions.
Still, there are compelling reasons why it would be helpful to make more use of longer-duration mortgages. From the consumer point of view, a longer term means they face the risk of having to renew at higher interest rates less often — the longer the term, the fewer renewals take place over the life of the mortgage. Of course, a longer-term mortgage will carry a higher interest rate, but some homebuyers may be willing to pay more to lower their risk. And a longer-term mortgage might not be much more expensive in the long run depending on the details of the loan and the prepayment penalties that apply. At a minimum, we could do more to make people aware of the longer-term options that are available — many people I talk to do not know that longer-term mortgages exist.
As a policy-maker, I see how longer-term mortgages can contribute to a safer financial system and more stable economy. Simple math tells you that of all those five-year mortgages, roughly 20 per cent will be renewed every year. That is a lot of households. If all the mortgages were 10-year loans, only 10 per cent of these homeowners would renew every year.
Another point with longer-term mortgages is that more equity is built up by the homeowner between renewals. This equity position gives the borrower more options at renewal. Therefore, the longer the original mortgage term, the less relevant a mortgage interest rate stress test becomes. In other words, longer-term mortgages shift the risks shared by the lender, the borrower and the system as a whole. All of these dimensions are worth further study.
Develop a private market for mortgage-backed securities
One obstacle to financial institutions offering longer-term mortgages relates to their funding costs. The textbook example of funding is a bank that takes in deposits from customers and turns them into mortgages and other loans. The reality is more complicated. Many institutions seek out wholesale deposits in addition to their regular retail consumer deposits. The biggest banks also get funding by issuing bonds. And, since 1987, Canadian institutions have had the ability to issue government-supported mortgage-backed securities (MBS).
A mortgage-backed security lets institutions package mortgages they have made and sell them to other investors. The investors receive the income from the mortgage payments. The proceeds of the sale become funding that the original institution can use to write more mortgages, or for other purposes. This process is basically invisible to homeowners — they keep making mortgage payments as before.
Current rules say that only insured mortgages can be used in government-supported MBS. Since 2001, the Canada Housing Trust — which was set up by Canada Mortgage and Housing Corporation (CMHC) — has been buying insured mortgages from institutions to use in the Canada Mortgage Bonds that I mentioned a moment ago. CMBs have been highly successful — more than $230 billion worth of CMBs are outstanding, equal to about 15 per cent of total mortgage debt.
With CMBs and other forms of government support for mortgage financing, the cost for funding insured mortgages is quite low. This has lowered mortgage rates for consumers. However, funding for uninsured mortgages, particularly at smaller banks and mortgage finance companies, is comparatively expensive. It is true that since 2007, Canadian institutions have been able to fund uninsured mortgages by issuing covered bonds. But it can be difficult for smaller institutions to do so because they do not have the same economies of scale as the big banks. What is more, OSFI has capped the percentage of covered bonds that any single institution can have among its assets.
So, it could be helpful for both lenders and borrowers for Canada to develop a private market for mortgage-backed securities. This could be a more flexible source of longer-term funding for uninsured mortgages, particularly those issued by smaller banks, credit unions, and mortgage-finance companies. This is an increasingly important point because the market share for uninsured mortgages is increasing, and they cannot be used in CMBs.
Poloz, Stephen S. “Risk Sharing, Flexibility and the Future of Mortgages.” Bank of Canada, May 6, 2019. https://www.bankofcanada.ca/2019/05/risk-sharing-flexibility-future-mortgages/.