Most homeowners don’t know what a “covered bond” is. But they’d probably be happy to hear that covered bonds help lower mortgage rates (indirectly) and provide borrowers with more options.
In the story that follows, we take a brief look at the growing Canadian covered bond market and what it means to everyday borrowers and lenders.
So, What is a Covered Bond?
Covered bonds are basically bonds that are issued by a financial institution (FI) and backed by two things:
A) That institution’s good credit
B) A big pool of collateral (such as mortgages)
Covered bonds have existed in Europe since 1769. Denmark is the biggest issuer of mortgage-backed covered bonds, having sold some $200 billion of them last year. In Germany, as much as one quarter of its mortgages are funded by covered bonds.
Despite their international prominence, covered bonds arrived on Canadian shores only four short years ago. Since then, our biggest FIs have been selling them like hotcakes. Investors eat them up because covered bonds are considered ultra-safe and pay a better return than comparable investments.
We had a good chat about covered bonds recently with a capital markets expert at a major bank. He asserts that covered bonds have an “opportunity for substantial growth” and will become an increasingly important source of mortgage funding.
“Notwithstanding regulatory and supply constraints,” he said they could become even more important overall than Canada Mortgage Bonds (CMBs). (Many smaller lenders rely on CMBs to fund their mortgages.)
Why Do They Matter?
Covered bonds provide giant lenders with a relatively cheap source of mortgage funds. A trader source quotes covered bonds as just 30-40 basis points more expensive than CMBs, as measured by their respective spreads over government bond yields.
Other things being equal, the cheaper a lender’s funding costs, the more competitive its mortgage rates—over the long run.
There are also two other helpful characteristics of covered bonds:
Lenders can issue them whenever they want (CMBs on the other hand are issued on a relatively set schedule by CMHC…e.g., quarterly.)
FIs are able to issue covered bonds in large quantities (Conversely, if a lender wants to fund 5-year mortgages through the CMB, CMHC currently limits them to roughly $1.6 billion a year +/-, according to sources. The big banks therefore max out on their CMB allocations in short order. With covered bonds, however, some of the big boys can fund up to $20 billion worth, or more, each year.)
Having covered bonds as an extra source of funds means that FIs can:
Lower their cost of funding (which can theoretically be passed down to consumers)
Allocate more capital to uninsured/non-prime lending (which provides more options to people who don’t qualify for traditional mortgages)
Reduce their reliance on government-backed mortgage insurance. (This was a point raised by the Finance Department in its 2010 review of the covered bond market.)
Stunted Growth Ahead
As beneficial as they are, Canadian Banks may eventually be unable to sell enough covered bonds. That’s because OSFI, Canada’s banking regulator, caps the amount that any one FI can issue.
That cap equals 4% of an institution’s assets. One bank (CIBC) has already started approaching that limit despite $353.7 billion in assets.
The 4% cap also makes it tough for littler banks. Their smaller asset bases mean they can’t issue enough covered bonds to make them cost effective. There’s a significant fixed cost to create and market covered bonds. One lender’s treasurer tells us you need to issue at least $500 million worth to make them economical.
Albeit, the bigger hurdle for small lenders is their credit ratings, which are generally low or nil for issuance purposes. That makes it almost impossible for most lenders to directly fund mortgages with covered bonds.
Incidentally, that 4% cap is largely an arbitrary number. Some countries have significantly higher caps. Australia, which has a somewhat analogous banking market to Canada, has a cap that its regulators set at 8%.
The biggest theoretical risk to increasing this cap is that mortgage borrowers default en masse. In that case, the danger is that an FI can’t recoup its losses. In turn, it could then need to drain its capital to make good on its obligations to covered bond investors.
Given the destruction wrought by the credit crisis, some expect OSFI to remain conservative on this cap. In addition, most banks are reasonably well-capitalized already, so there’s no tremendous urgency to raise it.
It is this very conservatism that has built a strong foundation under Canada’s banks. So, it’s tough to slight regulators for being cautious.
At the same time, it’s always prudent to plan ahead. At some point, more access to covered bonds will be necessary, with consumers being the net beneficiary of that liquidity.
Given the rock-solid balance sheets of Canadian FIs and the quality of the underlying mortgage collateral, many agree that OSFI can safely give banks more leash when it comes to covered bond issuance.