Standard & Poor’s expects Canada’s planned covered bond legislation to reinforce the country’s existing contractual framework, even if it sees outstanding programmes being wound down upon a prohibition of CMHC collateral. Fitch, meanwhile, issued a correction to its initial opinion on the bill, now saying that OC caps will only need to be reported to CMHC.

Covered bond and Canada Mortgage & Housing Corporation elements of the bill were discussed by the parliamentary Standing Committee on Finance yesterday (Wednesday), according to Cathy McLeod, Conservative MP and Parliamentary Secretary to the Minister of National Revenue, who sits on the committee.

In a report published on Tuesday, S&P noted that included in the bill – which it expects to be complemented by regulations adopted by the Minister of Finance – are measures aimed at supporting the true sale of covered bond collateral and existing provisions and mechanisms outlined under a covered bond programme’s contractual obligations following a covered bond issuer’s default.

However, the rating agency said that, with insured mortgages not being eligible assets under the proposed legislation and issuers prohibited from issuing outside the new framework, there will probably be a gradual wind-down of some existing programmes, unless grandfathering is allowed.

“As no further covered bond issuance would be allowed out of unregistered programmes we would expect that existing covered bond issuers of unregistered programmes may set up new legislation-enabled covered bond programmes,” said S&P.

A lack of further issuance from unregistered programmes would result in a gradual decrease in the remaining maturity of outstanding covered bonds, which S&P said could lead to an assessment of increased asset-liability mismatch (ALMM) risk. Under S&P’s methodology this would lower the number of notches of uplift possible between an issuer’s rating and its covered bonds, and the rating agency noted that with “high” ALMM risk banks rated at least A+ could achieve AAA covered bonds ratings and those with “low” scores would need to be rated at least A- to hit its top rating. Greater ALMM risk could also result in more credit enhancement being necessary to be commensurate with a bank’s maximum achievable covered bond rating.

The rating agency said that the shift from insured to uninsured collateral could also result in higher credit enhancement levels.

“This is because we believe that potential credit losses to covered bond collateral pools are likely to be higher if there are no insured mortgage assets as underlying collateral,” said S&P. “Additionally, if the guarantor has to sell this uninsured collateral to meet a programme’s asset-liability mismatches, we believe that uninsured mortgages will have a higher cost of liquidity versus insured mortgages.

“This is reflected through higher target asset spread assumptions for uninsured collateral under step 4 of our ALMM criteria.”

S&P noted that the bill does not include a maximum overcollateralisation level for covered bond programmes, something that had been discussed in a Department of Finance consultation paper.

Fitch last Thursday (10 May) corrected its view on this, having on 30 April said that the bill included a 10% OC ceiling that could have capped covered bond ratings.

“Positively, the new bill does not contain an OC limit for protection against credit and liquidity risks associated with the underlying collateral in a post-issuer default scenario,” said Fitch in its updated opinion. “While this concept was part of the initial consultation paper published by the Dept. of Finance Canada in May 2011, Fitch confirmed with Canadian authorities that there is no OC cap imposed by the legislation.

“Rather, as part of their application for their registration with CMHC, Canadian issuers of regulated covered bonds will need to declare the minimum and maximum ratio (Asset Percentage or AP) of total covered bonds vs total cover pool as set under their programme documents. Thus, OC caps under registered programmes only need to be reported to CMHC.”

Fitch said it expects OC levels for uninsured mortgage cover pools to be higher than for insured pools to offset the increased credit risk and refinancing cost of the underlying assets.

“While uninsured loans generally exhibit lower default risk than insured mortgages, on account of significant amounts of home equity (at least 20%), the pools would incur higher losses in a stressed market given their exposure to declines in house prices due to the lack of CMHC insurance,” said the rating agency. “In addition, the cost of bridging maturity mismatches for programmes backed by uninsured assets is likely to be higher than for their insured counterparts, the assets of which are eligible for Canada Mortgage Bonds, which benefit from strong market bid.”

While Fitch, like S&P, said it expects contractual programmes to be wound down, it said that “because mortgage insurance will remain in effect for existing programmes, ratings on existing covered bonds will not be affected”.