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Covered bonds have been an important and fast-growing method of funding mortgages.
In simple terms, covered bonds provide a way for large lenders to raise money, which can then be lent out.
This relatively new liquidity source can translate into lower mortgage funding costs, and those savings can theoretically be passed on to consumers in the form of lower mortgage rates.
Two years ago, the government announced a new “legislative framework” for covered bonds. The goal was to increase their appeal to institutional investors and create a sounder and more regulated market. Many expected details of that framework to be unveiled in the March 29 federal budget, but that didn’t happen.
When the government finally does roll out the new covered bond regulations, the first thing analysts will look for is whether insured mortgages are allowed as collateral. That’s been the case thus far, but many predict the government will ban the practice. This would raise costs for lenders (and borrowers) but reduce the government’s risk exposure to default insurance.
Fortunately, any such cost increase would likely be modest, at least for top-rated issuers (lenders).
“Estimates of the additional cost of uninsured versus insured mortgages in covered bonds range from a low of 10 basis points to a high of 20 basis points,” said Canaccord Genuity analyst Mario Mendonca. (Source: Globe & Mail)
“Applying 20 basis points for conservatism, we estimate that the additional cost to the industry would be only $120-million or 0.7 per cent of domestic retail pretax income over the last 12 months.”
Besides the collateral questions, industry folks also want to know how CMHC will operate in its newly-announced role as administrator of the federal covered bond program.
The Finance Department says a more robust covered bond market will provide a funding source for “federally and provincially regulated mortgage lenders.” Right now, only seven of the country’s biggest lenders have the ability to issue cost-effective covered bonds.
Will CMHC’s involvement somehow improve the ability of smaller lenders to tap this important market? We’re not optimistic of that, but we’ll likely see more details of the government’s plan later this year.
Sidebar: Despite conventional mortgages being the dominant form of covered bond collateral, these securities can provide a funding method for high-ratio mortgages as well.
Last month, Desjardins issued covered bonds backed by mortgages with an average loan-to-value of 91.2%. That’s the highest LTV we recall seeing in a Canadian cover pool, which shows the growing flexibility of our covered bond market.
Rob McLister, CMT
Last modified: April 29, 2014
Sherlock Holmes might think:
1. Installing CMHC as “administrator” means the gov’t wants regular, discrete reporting on covered bonds. This implies something unsatisfactory with the status quo?
2. Not allowing insured mortgages to be used as the underlying asset means the gov’t wants the “market” to price the bonds intrinsically, without the benefit of insurance.
Therefore, my dear Watson, the gov’t is endorsing banks securitization efforts, but they’ll have to do so by giving up full claim to their “better” lower LTV mortgages.
This initiative likely has virtually no effect on the funding market.
I’m having trouble believing two things: 1) That there’s a large pool of investors out there somewhere who consider the debt of the big 5 to be “too risky” but who’d buy if the bonds were additionally backed by a pool of residential mortgage cash flows. Really? 10-20 bps is the price of the possibility of a bank blowing up absent a housing crash?
2) That there’s anyone in Ottawa with executive authority who wants to make access to mortgages cheaper and easier for Joe Sixpack right this minute. Maybe that’s the reason for this strange, inexplicable delay?
This legislation would require a constitutional amendment and will get thrown out by The Supreme Court because it is not in the national interest of the country. Our administration already tried to pass a similar law for a single securities regulator in December. It was overruled and deemed as unconstitutional.
Our administration is wasting time.
Moody’s recently named Canadian banks the safest in the world. There are always plenty of buyers for Canadian bank bonds, with or without mortgage collateral. It’s just a matter of what yield investors desire for a given level of risk.
The 10-20 bps you refer to is not the premium of covered bonds versus non-covered bonds. That premium is notably greater.
As an example, Scotiabank priced its last covered bonds at 69 bps over the government benchmark on March 15, 2012. (Source: Covered Bond Report)
A similar maturity of regular (non-covered) 5yr Scotia notes was priced at 109 bps over Canadas–a half point more. (Source: Reuters)
The 10-20 bps figure is actually the estimated premium (cost difference) of uninsured covered bonds over insured covered bonds. The market is pricing in exceptionally low odds that a housing crash will lead to bank insolvency.
It should also be noted that the covered bond policies contemplated here are long-term legislation. We have to consider the impact of such legislation in future years, not just “right this minute”…
If you’re a reader, I recommend the following. http://scc.lexum.org/en/2011/2011scc66/2011scc66.html
The short version here http://i39.tinypic.com/25k4t9d.png
It will never pass Rob, and even if it did, it would impose banks’ shareholders as subordinates.
Maybe I’m missing something but what difference does it make if insured mortgages back covered bonds? The mortgages are already insured anyway. How does selling them as covered bonds add to the government’s risk?
Well, the shareholders are always subordinate to all the debt. What covered bonds seem to do is promise the same asset to two different people — owners of current bank debt, which have a claim on all assets in the event of default (granted to them when that debt was issued, however long ago) and owners of the new covered bonds, who are being promised an exclusive claim on the mortgages in the pool. In the unlikely event of a bank failure, holders of that older general debt would sue for access to the collateral pools in a heartbeat.
In the alternative, banks’ funding costs for unsecured debt and preferred equity would go up, because it isn’t like those debtholders aren’t going to notice that they’ve been subordinated to a new class of debtholder with exclusive claims on substantial pools of on balance sheet assets. There’s no free lunch.
It’s been noted in other jurisdictions that underwriting standards for loans you’re planning on selling to investors tend to be more lax than for loans you intend to hold until maturity.
Oops, scratch that. These loans are still backed by the banks, so that reason doesn’t apply.
No free lunch indeed. If it’s not in the national interest of country, it won’t pass.
BTW, Flaherty is already whipping-up his next greatest idea to allow public pension funds to buy bank shares. Just brilliant.
Interesting. 4% of the mortgages backing RBC’s covered bonds have credit scores under 600 – i.e. subprime.
http://www.rbc.com/investorrelations/fixed_income/covered-bonds.html
Scotiabank is even more interesting.
ScotiaBank – 7.25%
CIBC – 5.45%
RBC – 3.79%
BMO – 3.01%
TD – 1.1%
Banks will have to maintain overcollateralization if home prices start heading south, which begs to question; do they mark-to-market? Replace bad mortgages with new ones?
The collateral for the bond is the loan payments, not the house itself. The way it worked in the US is that when a mortgage defaulted, it got pulled out of the pool and replaced with a good one, I believe.
OSFI is proposing banks reappraise at mortgage renewal, remember? So likely none of them are doing it now, though I’m sure every one has a gnome with a spreadsheet model of various scenarios. I bet the AVMs work better in buoyant, active markets than when there’s fewer sales, tight credit, cash buyers and many no-bid listings, but AVMs have been getting pretty slick.
“The collateral for the bond is the loan payments, not the house itself.”
That is not technically correct.
If an issuer defaults on its covered bond obligations, bondholders receive the proceeds of the mortgages in the cover pool. Those mortgages are held in trust. If a mortgagor goes in arrears, the trustee can liquidate the property for the beneficiarys’ (bond holders’) benefit.
This raises another question. Regardless of collateral valuation for bonds, in the case of HELOCs, customers who request a limit increase would require an appraisal, right? Would banks really want a paper trail of new appraisals on their assets if home prices are declining? I don’t think so.
Makes you wonder why OSFI is proposing limits on HELOCs rather then stronger underwriting standards.
I don’t know if I understand this. I thought that OSFI wanted these to be held on balance sheet. How can you list as an asset an SPV trust whose beneficiary is someone else? Just list the value of the servicing rights? What’s the offsetting liability?
In a falling market, banks won’t be falling all over each other to write more HELOCs. Few will qualify.
OSFI is certainly also proposing stiffened underwriting. Look at this stink bomb:
From now on senior management at banks “must provide a declaration to the board” that rank and file employees are obeying rules around mortgage lending, said the Superintendent of Financial Institutions.
“This [requirement] was added because we had noticed cases where board approved policies were not being followed”
http://www.blakes.com/english/view_bulletin.asp?ID=4744 covers some of the more technical aspects well, but doesn’t address the on/off balance sheet issue.