The Canadian government will prohibit the use of mortgages insured by CMHC in covered bonds issued by financial institutions under proposed legislation, a move set to radically alter the dynamics of the country’s market. The bill also seeks to strengthen investor protection.

Minister of Finance Jim Flaherty

Covered bonds issued by all Canadian issuers except Royal Bank of Canada are backed by cover pools comprising such collateral, but under a bill being released by Canada’s Department of Finance financial institutions would not be able to continue to do so if they are issuing under the proposed framework.

The proposed Act, which would implement measures included in last month’s Federal budget, establishes CMHC (the Corporation) as registrar of covered bond programmes.

A draft of the Act seen by The Covered Bond Report says that the following loans must not be held as covered bond collateral:

(a) a loan made on the security of residential property if the loan is insured by the Corporation;

(b) a loan made on the security of residential property if the loan is insured by the Canada Guaranty Mortgage Insurance Company, the Genworth Financial Mortgage Insurance Company Canada, the PMI Mortgage Insurance Company Canada or any successor to any of those companies; and

(c) a loan made on the security of residential property if the amount of the loan, together with the amount then outstanding of any mortgage or hypothecary loan having an equal or prior claim against the property, exceeds 80 per cent of the value of the property at the time of the loan.

The Covered Bond Report understands that under the proposals issuers will be able to “transition” their outstanding covered bonds into those eligible under the new legislation. However, a market participant said that it had yet to become clear what this would involve, and also whether, as an alternative, existing covered bonds with CMHC collateral could be grandfathered. He said it was also not clear whether or not issuers could decline to join the covered bond register and continue to issue covered bonds outside the framework backed by CMHC collateral.

“There needs to be more clarity,” he said.

Leef Dierks, head of covered bond strategy at Morgan Stanley, said that after a wave of Canadian issuance in the first quarter, including more than US$12bn (C$11.8bn/Eu9.07bn) in the US dollar market, the Canadian government’s move might lead to a deceleration in the pace of US dollar denominated covered bond issuance for the remainder of the year.

“The changes could see supply of Canadian covered bonds temporarily dip,” he said.

However, DBRS said in an alert that supply might not necessarily dry up straight away.

“Given that several of the banks still have insured mortgages, DBRS believes some of the Canadian banks will continue to fund using these instruments before the bill receives royal assent,” said the rating agency.

A syndicate official meanwhile forecast that outstanding Canadian covered bonds would continue to perform.

“New supply will have to wait until most issuers have restructured their programmes,” he said, “and I do have some hope that through new trade dynamics the euro market hopefully one day will see its next euro Canadian covered.”

The last Canadian euro covered bond benchmark was in 2008.

Morgan Stanley’s Dierks also said that a change in the main type of collateral for Canadian covered bonds could have implications for their distribution, given how much the quasi-sovereign backing of CMHC-insured cover pools is said to have boosted the appeal of Canadian covered bonds in the US.

“The consequent switch to non-insured mortgage loans as collateral could then see a change in demand from US investors – but make paper more appealing for European or Asian covered bond investors,” he said. “In the long run, we expect a stable issuance pattern as covered bonds have meanwhile become an important refinancing instrument for Canadian banks.”

The bill nevertheless aims to strengthen protections afforded to investors by Canadian covered bonds issued under the proposed legislation, by increasing and making more definite their delinkage from issuers. An official at a Canadian issuer noted two sections of the draft Act as being relevant in this regard:

Nothing in any law of Canada or a province relating to bankruptcy or insolvency, or any order of a court made in relation to a reorganization, arrangement or receivership involving bankruptcy or insolvency, prevents or prohibits the following actions from being taken in accordance with the provisions of contracts relating to covered bonds that are issued under a registered program:

(a) the making of any payments, including a payment to a registered issuer;

(b) the netting or setting off or compensation of obligations;

(c) any dealing with covered bond collateral, including

(i) the sale or foreclosure or, in Quebec, the surrender of covered bond collateral, and

(ii) the setting off or compensation of covered bond collateral or the application of the proceeds or value of covered bond collateral; and

(d) the termination of those contracts.

And:

Despite anything in any law of Canada or a province relating to bankruptcy or insolvency, or any order of a court made in relation to a reorganization, arrangement or receivership involving bankruptcy or insolvency, the transfer of loans or other assets to a guarantor entity – to be held as covered bond collateral – by a registered issuer, any of its affiliates or any prescribed entity

(a) is effective against every person;

(b) is not voidable or, in Quebec, annullable;

(c) is not subject to any other remedies available to creditors of the registered issuer; and

(d) does not constitute a fraudulent conveyance, unjust preference or other reviewable transaction.

CMHC will run a register of covered bond programmes and a provision of the draft Act also says:

“The Corporation may, at any time, establish conditions or restrictions applicable to registered issuers and registered programmes.”

Also under the proposed Act, the Office of the Superintendent of Financial Institutions (OSFI) will supervise CMHC, with tighter oversight of the Corporation having been announced in Finance Minister Jim Flaherty’s budget last month.

OSFI has an outstanding limit of covered bond issuance at 4% of total assets for issuers, a level that some are approaching, but this limit has not been a part of the review of Canada’s framework.