A consultation paper on Canadian covered bond legislation released last Wednesday would be credit positive, but has a drawback, said Moody’s yesterday (Monday), namely that it calls for a 10% maximum overcollateralisation level. The rating agency also noted that the proposed legislation would not apply to all issuers.

Imposing a maximum level would jeopardize an issuer’s ability to support its covered bonds if its credit strength deteriorates, said Moody’s.

“This, in turn, would increase the credit linkage between the issuer and the covered bonds,” said the rating agency. “For example, we would be unlikely to rate covered bonds issued by a Canadian bank rated A3 without more than 10% overcollateralisation.”

The consultation paper noted that Canada issuers have generally set the maximum overcollateralisation at 10%.

“A higher level of overcollateralisation serves as a credit-enhancement for the covered bond, but diminishes the amount of assets available to other creditors and depositors of the issuer,” said the Department of Finance.

Moody’s was nevertheless encouraging about the paper, reflecting positively on most other aspects of the proposal, including cover pool segregation and transparency. The mere enactment of a legislative framework, said the rating agency, would mean that Canada’s covered bond investors are better protected in the event of issuer default.

Better transparency is also called for in the consultation, which requires third party audits of cover pools. The consultation paper said the audit will compare mortgage data files with underlying mortgage documents, and inspect mortgage records for borrower details, among other measures.

Moody’s noted that the legislation would only apply to federally regulated financial institutions, including the six largest Canadian banks, and not to other institutions such as Caisse Centrale Desjardins du Quebec.