OPEN ACCESS: How Canada’s covered bond framework will impact the market

Author: | Published: 15 May 2012
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Canadian Parliament proposed legislation on March 29 that would create a statutory framework for investment in covered bonds, and enable previously-restricted international investors to purchase shares in the collateralised pools. But excess demand and a flurry of bank exits could follow.

Canadian covered bonds are currently issued on a contractual basis, in which a bank sells assets into a covered bonds pool. This is owned by a special purpose vehicle that guarantees the bank-issued bonds.

But regulated financial institutions are not allowed to issue covered bonds greater than four percent of regulated assets, limiting growth in the market.

The new framework would incur greater costs for banks issuing the product.

Issuers would be required to register with the Canada Mortgage and Housing Corporation (CMHC), for example. And while the CMHC will not be setting overcollateralization limits, issuers will have to disclose to the registrar the minimum and maximum ratio of total covered bonds in relation to the total assets backing the bonds.

Banks who choose to register as a covered bond issuer, despite the cost of uninsured collateral, would also have to unwind any other bond issuing programs in accordance with the Bill.

The outstanding amount of insured mortgages is not to breach $600 billion as required by the National Housing Act (NHA). The CMHC is close to hitting that ceiling. And it is expected that some will drop out of the market if insured mortgages - the primary asset in covered bond pools - are restricted from use as collateral in accordance with the law.

“The amount of CMHC insurance currently stands over $560 billion,” Torys partner Michael Feldman said. “CMHC is quickly running out of room.”

It is unclear if non-insured mortgages will be able to fill the void. According to a consultation paper released by Canada’s Department of Finance last year, using uninsured mortgages as collateral can, in the longer term, reduce reliance on government-backed mortgage insurance and also improve the liquidity of uninsured mortgages.

But James Lisson, counsel at Fasken Martineau said that in instances of higher stress, uninsured mortgages would be more exposed than insured mortgages. “Covered bonds will be more expensive to issue as a result, and a higher cost of funding for the Canadian banks,” he said.

Feldman said the limits on the CMHC mortgage insurance and ability to fund the NHA mortgage-backed securities program would start to lead to an increase in mortgage interest rates. “I think that’s what the government wants to see happen,” he said.

“[Collateral] would be uninsured residential mortgages,” he said. “Whether banks continue to have a covered bond programme is debatable.”

While others predicted that as covered bonds and other insurance backed mortgage financing become more limited, the Canadian market could see the return of reverse mortgage backed securities.

International investors have previously not purchased contractually issued covered bonds because of regulatory restrictions in their jurisdiction or hesitance over a market without legislative structure.

“In Canada there is this refinancing risk in the mortgage market which Canadian institutions are very comfortable with,” Feldman said. “International investors look at that as higher default risk, but in practice you have one of the lowest mortgage default rates.”

Covered bond issuances totaled roughly $60 billion compared to the $170 billion of outstanding Canada mortgage bonds in 2010, and insured mortgages can still be securitised through Canada’s National Housing Act Mortgage-Backed Securities (NHA MBS) program.