After months of rumour and speculation, the Government of Canada officially took action against Canada’s housing bubble on Monday.

The first change affected foreign buyers. Under a previous tax loophole, somebody who wasn’t a Canadian resident could still classify a house in Canada as their principal residence, paying no capital-gains tax when the property was sold. This loophole will be closed.

The biggest move, at least for the mortgage industry, was the change in qualifying for five-year fixed mortgages, which are, by far, the most popular choice among Canadian homeowners. Instead of qualifying at today’s ultra-low rates, buyers will instead have to qualify at the Bank of Canada posted rate, which is currently 4.64%.

And in a move many didn’t even notice, the government also announced that any conventional mortgages would no longer be eligible for bulk default insurance unless they were subject to the same rules as loans without 20% down.

Bulk insurance is important to smaller lenders because it helps bring funding costs down. If these mortgages are insured against default, they’re every bit as secure as the insurer who guarantees them.

Let’s take a closer look at how this change will affect investors, first from a big-bank perspective and then from a smaller-lender perspective.

The big banks

Some mortgage industry insiders observed that it seems like these new rules were designed by Canada’s so-called Big Five banks. They’re the big winners here.

This is because much of their funding comes from internal sources, like deposits and GICs.

Say there’s a borrower who has 50% down on a house, but they want an unconventional loan. Without the ability to bulk insure that loan, non-deposit-taking lenders don’t have many options. Sure, they can offer something, but it’s likely at a higher interest rate. A bank, meanwhile, won’t need to access the bulk insurance market. They can use their balance sheet strength fund the loan and keep it on their books.

Both Toronto-Dominion Bank (TSX:TD)(NYSE:TD) and Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) have an additional advantage. Both of these lenders already are active in the mortgage broker market and should gain market share as brokers choose these big banks for more loans.

And since the new mortgage rules completely ban bulk insurance for rental properties, banks will also benefit by snatching that business.

The smaller lenders

There’s no dancing around it. This news is not good for Canada’s non-deposit-taking lenders.

First National Financial Corp. (TSX:FN) is the largest with more than $31 billion worth of mortgages on its balance sheet. Its shares are down more than 20% since the start of the week and continue to slide. This has pushed the company’s yield up to 6.8%.

Home Capital Group Inc. (TSX:HCG), which is Canada’s largest alternative (read: subprime) mortgage lender, has also gotten whacked, falling more than 10% since the the rule changes were announced.

The big issue for these companies is funding costs. On insured loans, funding costs were very similar to Government of Canada bond rates, since these loans are insured by the government. To fund its uninsured-loan program, Home Capital offers GICs through its Oaken Financial subsidiary. These GICs pay more than 2% versus funding costs of about 1% through bonds.

Now, 1% doesn’t seem like much, but it’s an awful lot to banks that charge under 2.5% for prime mortgage customers and only 4% or 5% for subprime borrowers.

And then there’s the market shrinking. Estimates say that under these new rules, approximately 50% of prospective home buyers will no longer qualify for as much home as they want. Fewer customers plus higher funding costs is not an equation that is favourable to small lenders.

The bottom line

Slowing down Canada’s real estate market might be the best move over the long term, but it’s not going to be pleasant for small lenders. The investing thesis is pretty simple. To play this new market, go long Canada’s largest lenders and avoid the small ones that are dependent on outside financing.

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