The Ripple Effect of Mortgage-Backed Securities

Fear prefers a certain means of transportation as it spreads like a brushfire. It is obvious to any Canadian following the financial media that the fear of what is happening in the subprime lending market south of the border has most definitely spilled over into the Canadian financial landscape.

Things got to the point where the country’s five major banks have developed a need to calm investors and citizens by stating how much, if at all, they’ve been exposed to the troubled sector. More importantly, people wanted to know if Canadian banks have the money for a bailout. Without this information, investors took their frustration out on financial stocks, all of which lost significant ground in the past few trading sessions.

According to Royal Bank of Canada, its exposure to the subprime market is minimal. This statement may be calming to some investors, but it’s rather unusual, since it’s not common for a bank to disclose its books to the public. Moreover, Royal Bank was joined by Firm Capital Mortgage Investment Trust, which also said it has virtually no exposure.

Unfortunately, not all players can claim the same. Earlier this week, Coventree Capital Group Inc. announced the company’s mortgage-backed commercial paper came due, but there were no buyers in sight. Mortgage-backed securities are really a number of individual mortgages packaged together as investments and sold to investors with preset expiry dates. When they come due, they are rolled over as good sources of fixed debt income. However, when those mortgages are under a default cloud, buyers flee with their cash as fast and as far as possible come rollover time. This is precisely what is happening to Coventree Capital.

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Judging by the trading activity in the sector, trusts that are run by Canada’s five major banks seem okay about their mortgage-backed securities. But Coventree Capital is not run by a major bank. It is not even supported or funded by one. Poor little Coventree is independent, and it is now approaching a hole the size of CDN$100.0 billion. At the same time, Coventree’s other activities can squeeze a maximum of CDN$30.0 billion. The Street is not likely to jump at a 70:30 default-versus-credit ratio, now is it?

So, what else is left for lenders like Coventree to do? Not much, really. There are two alternatives: the company can either try to find itself a bank with a bigger purse, or it can fold. As far as I can tell, no one is rushing to bail out an independent. The pockets of firms like Coventree were never deep to begin with. And, at this point in time, not many banks are willing to throw away more good money to go after the bad.

Case in point is the Caisse de dépòt et placement du Quebec, one of Canada’s largest buyers of mortgage-backed securities. Last week, Caisse said that it is done pumping money into the sector. This is not even the bailout money, rather actual liquidity money that is being pulled out.

Unfortunately for underwriters in the subprime sector, things are going from bad to worse, even in Canada, a country where subprime lending never really took off. At this point, fear dominates the credit landscape. Investors — institutional or individual — appear very much afraid of buying debt of any kind, but particularly debt connected with any kinds of mortgages.

This could mean that if you are about to look for a car loan, new mortgage, line of credit, or consolidation loan, you might be scrutinized even more and have even more difficulty finding a lender than before. Things are bound to get tough; not just on a personal level, but also in your portfolios. In fact, I have a feeling that the ripple effect created by the credit market collapse in the U.S. is going to have long and far-reaching tentacles.