The date for the draft has not been confirmed but it is should be released with the budget. However, last May the Department of Finance questioned whether the new legislation should encourage the use of uninsured collateral.
CMHC is close to its C$600bn mortgage insurance limit, Fitch warned in a report this week, but it added that Canada’s parliament has regularly raised the cap in the past. However, a further increase would go against finance minister James Flaherty’s recent moves to curb mortgage lending.
A ban on insured mortgages could weaken demand from the US buyer base, which is attracted by the CMHC guarantee. However, the proposed domestic framework would open Canadian covered bonds to European investors eager for top quality paper from a strong jurisdiction.
George Lazarevski, credit analyst at Bank of Montreal, said it was highly probable that Canadian banks would not be permitted to use insured mortgages as collateral for future covered bond transactions under the proposed law.
“There’s been a lot of discussion about the possibility that banks will be unable to bulk insure mortgages to the same extent, because the limit on how much insurance CMHC can provide may not be increased,” said Lazarevski. It was also highly probable that insured mortgages would not be eligible as collateral for covered bond programmes, he said.
“Covered bond pools in other jurisdictions don’t have this feature, and Canadian banks already have the Canada Mortgage Bond programme as a federally sponsored form of funding,” he said.
Over the long term, he added, the use of uninsured mortgages should help reduce the reliance on government-backed mortgage insurance and improve the liquidity of uninsured mortgages.
The Canadian Deposit Insurance Corp would prefer the use of uninsured mortgages in collateral pools, he said, rather than the more liquid CMHC-insured mortgages, because of the structural subordination covered bonds impose on depositors.
Devil in the detail
By limiting eligible collateral to uninsured mortgages, the new law would require banks to change their programme documentation, or set up new programmes.
Fitch said eligibility requirements could theoretically be amended without bondholder consent if the security trustee and bond trustee believed the changes did not hit investors’ interests.
However, the rating agency doubted that trustees would sanction the change because using uninsured loans as collateral “would greatly increase bondholders’ exposure to credit risk on the underlying assets”.
Lazarevski said existing covered bonds backed by CMHC mortgages would probably be grandfathered, though the advantage to Canadian banks of issuing covered bonds would decrease, and so would overall issuance.
The perceived government guarantee is a big factor for US investors deciding to buy Canadian paper, said an analyst at a rating agency. “The issuers are strong double-A rated banks, but the perceived government backing is important and if this level of protection is removed it will definitely impact pricing.”
Of the seven Canadian issuers only Royal Bank of Canada issues bonds backed by uninsured mortgages. RBC’s US dollar covered bonds trade 10bp-15bp back of equivalent bonds with CMHC insured collateral.
The consultation paper also raised the possibility of setting a 10% limit on over-collateralisation, which, in conjunction with a potential ban on insured mortgages, could have ratings implications.
“Even if OC is capped at 10% for bonds backed by uninsured mortgages the programmes would probably still retain triple-A ratings from DBRS,” the analyst said. “But there could be downgrades from other rating agencies.”
However, Standard & Poor’s on Wednesday affirmed its triple-A rating of RBC’s covered bond programme, which has OC of 7.4%.
Investor friendly framework
Though it may remove some protection from the underlying collateral, domestic legislation should broaden the investor base for Canadian covered bonds by allowing buyers that require a domestic framework to participate. Even if backed by uninsured mortgages, the country’s banks should find willing buyers at a time when stability and quality are in high demand. One syndicate banker also suggested that investors would find relative value decisions between Canadian covered bonds and those of strong European jurisdictions easier without government backed insurance.
“A lot of buyers view them as a kind of quasi-agency product, and so if you’re comparing Nordic and Canadian covered bonds you are not comparing the same product from two different regions,” he said. “It would make switching in and out of Canadian covered bonds easier and with domestic legislation the pricing impact of removing the CMHC guarantee might not be that great.”
Grandfathered paper would become increasingly rare, and Lazarevski said this could explain tightening of up to 20bp in recent Bank of Montreal and Scotiabank US dollar covered bonds.
But whether Canadian covered bonds are backed by insured or uninsured mortgages, appetite is unlikely to diminish.
“Canadian mortgage default rates have been 2bp-3bp on average,” said Lazarevski. “Canadian banks are some of the highest quality banks in the world, and there would still be demand for Canadian covered bonds backed by uninsured mortgages.”