Consultation on the Proposal to Consolidate Canada Mortgage Bonds

Invitation for Comments

Closing date: July 14, 2023

Email: CMBconsultation-consultationsOHC@fin.gc.ca

Written comments should be sent to:

Funds Management Division
Financial Sector Policy Branch
Department of Finance Canada
90 Elgin Street
Ottawa ON K1A 0G5

Submissions should preferably be provided electronically in PDF format or in plain text.

In order to respect privacy and confidentiality, when providing your submission please advise whether you:

• consent to the disclosure of your submission in whole or in part;
• request that your identity and any personal identifiers be removed prior to publication: and
• wish any portions of your submission to be kept confidential (if so, clearly identify the confidential portions).

Information received throughout this submission process is subject to the Access to Information Act and the Privacy Act. Should you express an intention that your submission, or any portions thereof, be considered confidential, the Department of Finance Canada will make all reasonable efforts to protect this information.

Overview

In Budget 2023, the government announced that it is considering consolidating Canada Mortgage Bonds (CMBs) into the regular Government of Canada (GoC) borrowing program. As CMBs are a more costly form of borrowing than regular GoC bonds, this proposal to consolidate CMBs is intended to reduce borrowing costs and redirect savings to priority affordable housing programs.

The government is now seeking the views of all interested parties on this proposal, including bond issuers, mortgage lenders, government securities distributors, investors, and other interested stakeholders, such as swap and repo counterparties in the CMB program. This breadth of different stakeholder groups will be important to ensure all possible benefits and risks associated with the proposal are considered before moving forward. The CMB program will continue to be delivered in alignment with normal practices and procedures until more information is provided. The government plans to provide an update on the proposal to consolidate Canada Mortgage Bonds (CMBs) into the regular Government of Canada (GoC) borrowing program in the fall of 2023.

Introduction

In 2001, Canada Mortgage and Housing Corporation (CMHC) launched the CMB program to help stabilize access to mortgage funding in all economic conditions. Canada Housing Trust (CHT), a special purpose trust created by CMHC, issues CMBs to the market and uses the proceeds to purchase National Housing Act Mortgage-Backed Securities (NHA MBS) from Canadian mortgage lenders. Currently CHT operates on a breakeven basis and earns no revenue, all costs associated with CMB issuance are passed directly to mortgage lenders/NHA MBS Issuers.

CMBs carry the full faith and credit of the Government of Canada and constitute a direct, unconditional obligation of Canada. However, CMBs are issued at higher borrowing rates/costs than GoC bonds. This can be seen as a risk-free arbitrage between Government of Canada AAA backed debt offerings. If the purchase of NHA MBS were funded through the issuance of GoC bonds rather than through CMBs, funding would be more efficient and the government could benefit from lower borrowing rates in order to generate revenues that could help to support important government priorities, such as affordable housing programs.

In order to achieve this, the government would continue to provide mortgage funding to lenders/Issuers, through the purchase of NHA MBS, at a cost similar to funding provided through the CMB program. However, the government would fund these purchases with GoC bonds, with the difference between interest paid on GoC bonds and the interest received from lenders/Issuers retained by the government as revenues. Actual revenues from CMB consolidation will depend on a number of variables. Using the current stock of roughly $260 billion CMBs and a recent observed spread of 30 basis points between CMBs and GoC bonds, the proposed change could enable the government to reallocate significant funds to other housing needs.

The government plans to maintain the current level of support provided to the Canadian mortgage market. The intent is to continue to provide funding to mortgage lenders at a cost that is in line with the current CMB program cost. This should ensure Canadian mortgage lenders maintain stable access to financing to ensure the Canadian mortgage market continues to function smoothly.

Similarly, the proposal will not increase the government's credit exposure to the Canadian mortgage market. All mortgages in the NHA MBS program are already insured by Government of Canada backed insurance, and the government guarantees the timely payment of principal and interest to investors for both NHA MBS and CMBs. Thus, the government's exposure to mortgage credit risk would not change as the result of CMB consolidation. The funding source used to purchase the NHA MBS, be it CMBs or GoC bonds, has no impact on this exposure.

In essence, the objective of this proposal is to replace one funding source (CMBs) with another one (GoC bonds) with lower borrowing rates, while ensuring stable access to mortgage financing and redirecting savings to priority affordable housing programs.

Objectives

The government has three objectives it will consider in the context of CMB consolidation. Those objectives are as follows:

1. More efficiently fund NHA-MBS purchases and redirect savings to priority affordable housing programs
• In addition to the difference in interest rate between GoC bonds and CMBs, savings could also be generated by removing syndication fees as GoC bonds are issued via auction.
2. Ensure continued stability of the Canadian mortgage market
• Minimize impact on price and quantity of NHA-MBS purchases.
• Consistent support to small and medium sized lenders, which promotes competition in the Canadian mortgage market.
3. Maintain the sustainable and flexible GoC borrowing program
• Consolidating the approximately $260 billion of CMB outstanding into the regular GoC borrowing program would represent an increase of about 20 per cent to the government's current market debt.
• From an annual perspective, the $40 billion of CMBs issued per year would represent about a 10 per cent increase to the government's planned debt issuance in 2023-24.
• The government will seek to structure any increase in issuance to reflect investor demand and maintain well-functioning markets for GoC securities.

Potential Impacts on Market Participants

CMB consolidation would represent a notable change in the Canadian fixed income market. The government is interested in the views of all market participants that interact with the CMB program to understand the potential implications of the consolidation of the CMB program, including other bond issuers, government securities distributors, investors, and mortgage lenders and other CMB program participants.

As we assess the benefits and risks of CMB consolidation, we would like to hear all views from market participants, including with respect to the following questions:

Assessing Market Impacts

• What changes might arise from CMB consolidation from your perspective and how you would expect to address them?
• If investors in CMBs are no longer able to purchase newly issued CMBs, what alternative investments would they turn to and what impact would this have on their portfolio?
• Would mortgage lenders anticipate making any changes to their regular operations as a result of CMB consolidation? How would this impact mortgage lenders' hedging operations?
• What impacts could CMB consolidation have on the Canadian fixed income market investor base, including international investor participation?
• Should the government decide to move forward with CMB consolidation, what considerations should be taken into account with regard to the timing of implementation?

Implementation of the Proposal

The government is seeking input in certain areas with regard to how CMBs could be consolidated into the regular borrowing program. Should the government decide to move ahead, CMB issuance would cease and would be replaced by new GoC bonds as CMBs mature. This means full consolidation would take approximately 10 years from the time it begins. The government is not considering a CMB purchase program at this time.

The government has previously used GoC bond issuance to fund NHA-MBS purchases twice in the past as part of the Insured Mortgage Purchase Program (IMPP). The IMPP was an emergency program that was used by the government during both the global financial crisis and the COVID-19 crisis in order to provide long-term stable funding to mortgage lenders, help facilitate continued lending to Canadian consumers and businesses.

However, despite this experience with IMPP, there are some key areas where the government is requesting feedback to ensure that the purchase of NHA-MBS through GoC issuance functions well under normal conditions in a way that meets the government's objectives.

CHT issues 5- and 10-year fixed rate bonds as well as 5-year floating rate notes (FRNs). It has reliably issued approximately $40 billion of CMBs each year. Should consolidation move forward, this issuance would need to be absorbed within the regular GoC borrowing program. In this year's DMS, the government announced projected gross domestic issuance of $414 billion split between treasury bills, 2-, 3-, 5-, 10-, and 30-year bonds (with 3-year bonds being discontinued following the first fiscal quarter). CMB consolidation could therefore represent an increase of approximately 10 per cent to the government's borrowing program. The government is considering how this additional issuance could best be distributed. This added issuance may also have benefits as it could enhance liquidity and market functioning in the GoC bond market.

The government could generally seek to replicate the structure of CMB issuance, attempting to match the term of NHA MBS purchases, which would materially increase supply in 5- and 10-year issuances. One issue with this option is that the GoC does not plan to issue FRNs.

If instead the government were to distribute this additional issuance across its whole range of sectors, the increased issuance would be considered as part of government's annual DMS. This would likely result in a more balanced increase in issuance across all sectors and would likely be more "efficient" for the government's portfolio as a whole. It would also allow the government to improve liquidity and market functioning by using the additional issuance to bolster those sectors most in demand from investors. However, this approach would not match the term of NHA MBS acquisitions.

Adjustments to the Government's Debt Management Strategy (DMS)

• Please provide views on the best way for the government to incorporate this additional issuance into its DMS.
• Is it preferable for the government to mirror existing CMB issuance or distribute issuance across sectors?
• If the government were to spread $40 billion of issuance across the range of issuance sectors, how would it be best distributed?
• What are the implications of using a mirrored structure without FRNs?
• Please provide views on the impacts of increased borrowings on liquidity and market functioning for GoC debt.
• Should the government open new benchmarks in existing sectors in order to accommodate this increase in issuance? In which sectors?
• Should the government reorganize maturity dates in the context of opening new benchmarks?

Funding Cost for Mortgage Lenders

Currently, the funding cost provided to mortgage lenders through the CMB program is linked to the yield on CMB issuance, which is a transparent, market-driven rate. In the absence of CMBs, a new methodology will be needed to determine the funding cost provided to mortgage lenders. How to determine the new funding cost will be a crucial element in ensuring the program continues to function effectively and continues to meet the government's objectives with respect to the NHA MBS program, including the provision of stable financing for mortgage lenders in line with market rates, and the promotion of competition in the Canadian mortgage market by ensuring small and medium sized lenders maintain similar levels of participation in the sale of NHA MBS.

• Is the government considering the correct objectives referenced above with respect to the funding cost for mortgage lenders?
• What are your views on the three objectives' potential interconnectedness?

With respect to determining the new funding cost, the government is considering conducting regular NHA MBS purchases with pricing set as a spread to the GoC yield curve, with the opportunity to reset the spread at regular intervals to ensure the price remains roughly in line with market rates. This would seem to provide pricing stability or predictability for mortgage lenders. However, as market conditions change, the spread may need to be reset at regular intervals to help ensure that the program reflects current market conditions.

• Please assess the pros and cons of this model and how it would align with the government's objectives.
• Are there any other pricing models that should be considered?

Should the government decide to proceed with CMB consolidation using a set spread to the GoC curve, the spread could be calibrated with reference to a basket of liquid securities (e.g., GoC, provincial bonds, etc.) that are closely correlated with CMBs. This basket would be designed to reflect a 'theoretical CMB' and would aim to maintain current funding costs for mortgage lenders and support predictable price movements. Using a basket to reflect the broader market in calibrating the spread could reduce the need for more frequent spread adjustments than pricing based solely on the GoC yield curve.

• What data points should be included in the construction of a basket for the all-in pricing of a theoretical CMB?
• What steps can the government take to ensure transparency in the rate offered by the theoretical CMB approach?

Next Steps

Following these consultations, the government will take time to assess all the feedback received. The government may choose to publish a summary of these consultations, as well as some or all of the written responses received. The comments received will be used to guide policy decisions on the proposal to consolidate CMBs within the regular GoC borrowing program. As announced in Budget 2023, the government intends to provide an update on this matter in the fall of 2023.