Since March 2022, the Bank of Canada has been periodically increasing the country’s key interest rate. Seven interest rate hikes later the overnight rate is now at a staggering 4.25%, a dramatic increase from the beginning of the year. For many Canadians, this has caused adverse changes to their mortgage payments. Mortgagors with variable-rate mortgages who make fixed monthly payments of interest and principal have been most significantly impacted by the increasing interest rates as this has caused many variable mortgages to activate the “trigger rate” and, for some, the “trigger point.”
As interest rates increase in Canada, the principal portion of a fixed payment under a variable-rate mortgage decreases and the portion consisting of, and allocable to, interest increases. When the entirety of the fixed payment covers only the interest on the mortgage, the “trigger rate” has been activated, meaning the mortgagor is no longer paying off the principal with their payments. The net effect of this is that the mortgage is not being paid off or paid down in the same way as was conceived when the mortgage was originated. The Bank of Canada has reported that approximately 50% of variable-rate mortgages with fixed payments have activated the trigger rate specified by their mortgage contract. Although reaching the trigger rate may not increase a mortgagor’s monthly payments, they would be at risk of reaching the “trigger point,” which occurs when the outstanding balance on the mortgage exceeds the principal (i.e. the original mortgage amount initially received). This can occur where the fixed payments no longer cover all of the interest owing and as such, unpaid interest is added to the principal amount owing. When a mortgage loan reaches the ‘trigger point,’ the mortgage can be said to be ‘under water’ and lenders and mortgagors need to try to resolve the issue, commonly by lump sum or increased monthly payments – such remedies can increase the risk of default for mortgagors. Many recall images of American mortgagors abandoning their homes during the 2008 credit crisis when the market value of their homes in a softening real estate market was less than the principal amount owing under their mortgage loans. Can similar situations be anticipated again, and will Canadian mortgagors and lenders face similar situations?
In combination with increased interest rates, inflation has risen significantly which increases the risk of mortgage default. Simply stated, the increased cost of living associated with higher inflation combined with the increased mortgage payments associated with reaching mortgage loan triggers is putting serious pressure on the ability of many mortgagors to meet their ongoing commitments. This paints a familiar picture, as seen during the 2008 financial crisis, where lenders were hastily loaning funds to homeowners in the United States who presented a high risk of default. Among other things, this had a detrimental impact on mortgage-backed securities (“MBS”) in the United States, which were tied to the U.S. real estate market, as mass mortgage defaults rendered MBS of little or deteriorating value. MBS represent securities backed by a portfolio of mortgage loans. Experiences in the mortgage loan market and pressures on mortgagors can impact the performance of MBS. MBS, a type of fixed-income security, derive value from the ability of mortgagors to pay the principal and interest on their mortgages. MBS are asset-backed investments that represent ownership of a pool of mortgages and which receive a portion of the monthly principal and interest payments arising from the pooled mortgages. MBS also helps lenders deploy a greater number of mortgages because pooling and selling mortgage receivables to a diverse group of investors immediately frees up capital to continue lending to additional mortgagors rather than waiting years for such loans to mature.
Although there is an increased risk of mortgage defaults as a result of recent inflation and interest rate hikes in Canada, those MBS in Canada that form part of the National Housing Act Mortgage Backed Securities (“NHAMBS”) benefit from payment guarantees. In Canada, absent government changes and focusing only on those MBS that benefit from the Federal Government NHAMBS program rules (which represents the vast bulk of the Canadian MBS market), the market for and quality of MBS may not be impacted due to the guarantee of such securities by the Canadian Mortgage and Housing Corporation (“CMHC”), a federal crown corporation backed by the Canadian government. To support the intended low-risk nature of MBS, the mortgages which make up MBS and are eligible for, and included within, the NHAMBS are insured by CMHC, meaning that even if such mortgages are defaulted upon, the lenders (or issuers, to be precise) will be repaid. The principal and interest paid on an MBS in Canada are also guaranteed by CMHC, so there is essentially a lower risk that the principal and interest will not be paid if held to maturity. As a result of the insurance and guarantee provided by CMHC, a Canadian MBS that is covered by and included as NHAMBS would most likely not be affected by mortgage defaults. Of course, increasing guarantee payments under defaulting NHAMBS by CMHC (essentially, our Federal Government) does increase the costs and exposure of our Federal Government to mortgage losses.
In general, many mortgages have reached the trigger point as interest rates have increased. To remedy this situation, lenders are taking different measures to hold off defaults and assist mortgagors who cannot manage growing mortgage payments. Some lenders are providing emergency loan modification options which will allow mortgagors experiencing significant financial hardship to extend their amortization periods to a maximum of 40 years leading to a significant reduction in the amount of each mortgage payment. The impact of increased monthly mortgage payments on Canadians as a consequence of the increased interest rates will be an important and continuing theme in 2023.
Miller Thomson’s Structured Finance and Securitization group will continue to examine the effect of increased mortgage costs on the payment and performance history of MBS and the experience of lenders and mortgagors.