How alternative mortgage lenders work

If you’re self-employed, a recent immigrant, or you have a less-than-stellar credit profile, you probably won’t qualify for a mortgage from one of the big Canadian banks. That of course, does not mean that you’ll never be able to buy a home — it just means that you will likely have to borrow at a higher interest rate from mortgage companies known as “alternative lenders”.

The inner workings of alt-lenders have come under intense scrutiny lately because of a fraud scandal that financially drained Home Capital Group, one of Canada’s biggest alternative mortgage lenders. So how exactly to alternative lenders work? How are they able to bear the risk of issuing mortgages to Canadians who aren’t in solid financial health?

VICE Money took a hard look at the balance sheet of another big alt-lender in Canada, Equitable Bank, in order to understand how susceptible these companies are towards the risk of mortgage defaults.

As it turns out, Canada’s alternative mortgage lenders are allowed to sell off the risk associated with some of their mortgages to private investors, thanks to a rule change by the Office of the Superintendent of Financial Institutions (OSFI) that took place in 2013.

Understanding Equitable’s business model

Like most financial institutions, Equitable sells investment products derived from the bank’s mortgages. One kind of product that Equitable sells is derived from prepayable mortgages — they are flexible loans that allow borrowers to make irregular payments, but often charge a higher interest rate.

Jonathan Rotondo of the Canada Mortgage and Housing Corporation (CMHC) told VICE Money that before mortgages can be securitized as investments they must be insured, either by the CMHC (who insure roughly 50 percent of residential mortgages in Canada) or through one of two other federally-regulated insurers — Genworth Canada or Canada Guaranty.

Once this is done, Equitable can sell these government-guaranteed investments to private investors.

That’s exactly what Equitable started doing in earnest in 2015 — it sold the potential risks or rewards associated with these mortgage products to other investors. By doing this, the bank was able to remove these “securitized mortgages” from their books, reducing their financial risk. This process is called derecognition.

The practice of derecognizing securitized mortgages from lenders’ balance sheets was allowed before Canada adopted the International Financial Reporting Standards (IFRS) in 2011, which forced lenders to keep these mortgages on their books. This change effectively lowered lenders’ capacity to make new loans because lenders are required to keep a certain amount of money on hand to meet regulatory requirements.

In 2013 one financial institution decided to ask Canada’s financial regulator, the Office of the Superintendent of Financial Institutions (OSFI) to change the 2011 rule. This institution was Home Trust, a subsidiary of Home Capital Group — they wanted to get approval to de-recognize some of the securitized mortgages they held by selling the risks and rewards of those mortgages to third parties.

The more “mortgage offloading” lenders could engage in, the more their lending capacity could increase, meaning they could issue more mortgages to average Canadians and generate greater profits. OSFI approved the proposal.

How Equitable Bank gains from “derecognizing” mortgages

Equitable’s annual reports show that in fiscal 2014, the bank did not derecognize any securitized prepayable mortgages. But by the end of 2015, the bank had derecognized $9.1 million worth of them, and in 2016 Equitable derecognized $748 million worth of the mortgages, a year-over-year increase of more than 8000 percent. This process allowed them to wash their hands of any risk or reward associated with the mortgages and gain greater lending capacity.

The bank’s 2016 annual report describes the process:

“We executed transactions that transferred the risks and rewards of securitized prepayable mortgages to third parties and allowed us to [derecognize] the assets, in order to proactively manage our regulatory Leverage Ratio.”

This practice is legal and isn’t necessarily a problem if all of the mortgages Equitable approves are based on solid borrower credit. But because the bank specializes in lending to high-risk borrowers, the potential for problems is greater than for banks who lend to less-risky borrowers. One of the primary reasons why private investors are willing to purchase these mortgage-backed investment products are because they are insured by the CMHC and other government-backed insurers.

Indeed, Tim Wilson, Vice President and Chief Financial Officer at Equitable Bank told VICE Money that it is the insurers who will be on the hook for any losses resulting from defaults or a fall in home prices associated with the mortgages Equitable derecognized.

In fact, Wilson confirmed that all of Equitable’s prepayable mortgage securitizations are done through the CMHC and that some of the risks and rewards tied to Equitable’s derecognized mortgage securities are sold to institutions such as hedge funds. He did not provide examples of specific buyers, citing confidentiality agreements.

Why buy mortgage-backed securities?

In a rapidly rising real estate market, the potential rewards associated with Canadian mortgage-backed bonds and securities make them attractive investments. What’s more, investors are insured against any losses tied to the underlying mortgages through mortgage insurance companies which are backed by Canada’s federal government.

According to the CMHC, mortgage insurers are responsible for the risks of Equitable’s derecognized mortgages, and noted that if insurers get overwhelmed by losses, Canadian taxpayers will get stuck with the bill.

“CMHC mortgage loan insurance is backed by the federal government at 100% while the private insurers (Genworth, Canada Guaranty) are backed [by the federal government] at 90%,” the CMHC’s Jonathan Rotondo told VICE Money.

Equitable has publicly stated that the bank has policies in place to prevent bad underwriting, including a policy that separates Equitable’s sales and underwriting teams. But Equitable’s 2015 annual report explained that the practice of derecognition will continue to be a central part of the bank’s business strategy in the future.

“Going forward, we intend to regularly engage in transactions that allow us to derecognize prepayable Multi and Single Family mortgages using this and other transaction structures.”

In other words, don’t expect alt-lenders to alter this part of their business model anytime soon.