Two Toronto-based mortgage lenders, Xceed Mort-gage Co. and Home Equity Income Trust, have each announced their intention to apply to the federal minister of finance for approval to operate a federally chartered Schedule 1 bank.

Both firms are looking to tap into the deposit brokerage network and avail themselves of a reliable source of funding, now that other sources of funding have become too costly or dried up altogether.

“It’s an indication that the securitization market isn’t coming back,” says Jim Murphy, president and CEO of the Canadian Association of Accredited Mortgage Professionals, “at least not in the size and scope that it had in the past.”

In March, Xceed, an originator of insured residential Canadian mortgages, announced that it would be seeking bank status, with the aim of becoming operational as a bank in the first quarter of 2010. Xceed says it has been in discussions with the Office of the Superintendent of Financial Institutions regarding its intention and is optimistic it will get the go-ahead — although OSFI has made no assurances.

In February, Home Equity announced its intention to seek a bank charter for its operating subsidiary, Canadian Home Income Plan Corp., through which it provides reverse mortgages to Canadian seniors. Should it receive all necessary approvals, Home Equity will begin operating its bank subsidiary, which will be known as HomEquity Bank in English and Banque HomEquity in French, in the third quarter of this year. (Home Equity plans to convert itself into a corporation from a trust prior to its CHIP subsidiary becoming a bank.)

Although the two firms’ business models are quite different, they each have had to contend with the challenge of finding sources of reliable, affordable funding since the capital markets seized up in the autumn of 2007. That, along with other key motivating factors, led each to the decision to apply for bank status.

“Becoming a bank, a deposit-taking institution, really gives us a significant diversification of our funding sources,” says Ivan Wahl, chairman and CEO of Xceed. “The deposit-broker market has long been considered a far more stable, more diversified market [than other sources of funding].”

To win business, Xceed plans to offer deposit brokers innovative compensation systems and incentives. “The same skill set that works with mortgage brokers,” Wahl says, “will help us compete successfully in the deposit brokerage market. We understand intimately how [mortgage and deposit] brokers think. The big chartered banks often don’t have the mentality to deal with commissioned salespeople. They’re more effective dealing with employees in a branch network.”

Xceed has undergone enormous changes since the freezing up of the asset-backed commercial paper market, in which it raised a significant amount of funding, in August 2007. After waiting for six months in the hopes the credit markets would improve, Xceed decided in early 2008 to get out of the alternative mortgage business and operate solely as a provider of traditional mortgages.

It also downsized significantly, cutting its staff to 40 employees from 150 employees.

“We have had to be an adaptive company,” Wahl says, “because the environment has changed so dramatically.”

Today, Xceed sells much of its $2.1-billion portfolio of mortgages into the Canadian mortgage bond market. The firm also enjoys good residual interest cash flows on its existing mortgages and can tap into a $350-million credit facility from Germany-based Deutsche Bank AG.

Xceed posted net income of $3.3 million in its first quarter ended Jan. 31, vs $1.5 million during the same period a year earlier. The firm reported a $12-million net loss for the fiscal year ended Oct. 31, 2008, its second straight year of losses. Its share price also traded down, in the 70¢-80¢ a share range in March, from a high of $10.20 a share in February 2006.

Xceed received good news in January, when the restructuring deal for ABCP was approved, allowing the firm to book a one-time payment of $4.8 million for the retroactive adjustment in funding costs and a further $900,000 in residual interest.

Wahl believes there’s still a great opportunity in providing uninsured traditional and non-traditional mortgages to Canadians who otherwise would find it difficult to obtain a mortgage from the big banks. Xceed could provide these mortgages in the future, after its possible transformation into a bank.

“That’s the market we’re ultimately going after,” Wahl says. “It’s a market we believe can be very profitably underwritten and the spreads are there for making it a reasonably profitable venture.”

@page_break@For Home Equity, converting into a bank would allow the firm to diversify its sources of funding and increase the number of reverse mortgage it can originate, says Gary Krikler, senior vice president and chief financial officer. “There is a very deep and liquid source of funds in the deposit market,” he says, “and that will help us continue to grow this business.”

The transformation into a bank will also allow Home Equity to benefit from the efficiency of being federally regulated, Krikler adds.

A reverse mortgage, which is available exclusively to those at least 60 years old, allows a homeowner to borrow against the value of his or her home. As of Dec. 31, 2008, CHIP had a portfolio of approximately 7,000 reverse mortgages, valued at $814 million, on residential properties worth $2.3 billion.

The demand for reverse mortgages is growing, Krikler says, particularly as seniors have to deal with lower interest rates on fixed-income products and the effects of battered equities portfolios.

In March, OSFI issued a draft advisory on the capital treatment of reverse mortgages, which gives the regulator a framework by which to determine the amount of capital a bank is required to hold against its holdings of reverse mortgages. The publication of the draft advisory, Krikler says, is an encouraging sign from OSFI in terms of Home Equity’s application to become a bank.

Although Home Equity has been challenged by the drying up of credit markets, Krikler says it gained access to relatively low-cost medium-term debt before the credit crunch hit. Still, Home Equity has said that until it begins operating as a bank, it will take steps to preserve cash, including reducing the average mortgage amount for new customers. The firm expects this will temporarily reduce originations.

“We haven’t taken any drastic steps and our business model hasn’t changed,” Krikler says. “We’ve been careful to have sufficient cash sources to take us through the process of becoming a bank.”

Home Equity posted net income of $29.5 million in the fiscal year ended Dec. 31, 2008, up from $1.6 million in 2007. Its unit price traded at less than $4 in March, after trading as high as $14.20 in October 2006. IE