Moody’s detailed what it perceives to be strengths and weaknesses of Canada’s covered bond framework in a report last week, highlighting the quality of permitted collateral as one of a dozen positives, and a lack of legal minimum OC among a few negatives that market practice mostly mitigates.

In the latest of a series of reports, the rating agency analysed the legal framework of the jurisdiction, assigning legal features a grade of strong, average or weak. These Moody’s Legal Views (MLVs) are in some cases adjusted by a Market Practice modifier (MP) to reflect contractual and non-contractual practices common among issuers.

Listed among the Canadian market’s relative strengths – which outnumber potential weaknesses identified by roughly two to one – is its permitted collateral, according to Moody’s, consisting only of first-ranking, conventional Canadian residential mortgage loans, cash collections from those loans, and securities issued or backed by the Canadian government.

The rating agency also highlighted that it is positive that under Canadian legislation loans more than three months in arrears are given no value in cover test calculations, while explicit protection is provided against both claw-back risk and moratorium risk, and a wide range of remedies is allowed for to raise liquidity in the event of an issuer default.

Among weakness cited in the report, Moody’s noted that under the Canadian framework, required overcollateralisation (OC) may be as low as 0%. However, the rating agency added that, mitigating this, market practice is for issuers to maintain minimum OC of between 3.0% and 7.5%.

Moody’s said the legal framework for cover pool management is also weak in respect of stresses and management of key risks, but that market practice is average in the management of interest rate risk, currency risk and liquidity risk.

The rating agency also noted that in the framework there is uncertainty regarding guarantors, which are SPVs, post-insolvency, but said that market practice can be considered average as replacement triggers for key counterparties are typically set at conservative levels.

The only weakness cited by Moody’s that it did not add a mitigating Market Practice modifier to was that the law requires compliance with only a nominal asset coverage test (ACT) and not a net present value (NPV) test, although it noted that the value of an NPV test is reduced by the requirement for interest rate and currency swaps.

Canada introduced its legislative covered bond framework in 2012, giving the Canada Mortgage & Housing Corporation responsibility for administering the regime. Canadian banks had previously issued on a contractual basis.

Photo: CMHC headquarters, Ottawa; Source: Robkelk/Wikimedia Commons