Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Structured Finance & Derivatives, May 2011
The Department of Finance (Finance) has followed through as promised in the last federal budget to propose a legislative framework for covered bonds. The proposal is accompanied by a series of consultation questions and an invitation for public comment.
The major elements of the proposed framework include the following:
- formally recognizing the priority rights of bondholders to cover pool assets in the event of an issuer's insolvency
- limiting participation in the program to banks and other federally regulated financial institutions
- limiting cover pool assets to residential mortgage loans and qualifying substitute assets
- prescribing certain terms and conditions for eligible covered bond programs in order to standardize transaction formats and balance the protections of bondholders against terms that could adversely affect an issuer's depositors
- establishing a regulatory format for overseeing covered bond issuances and establishing disclosure standards based on current Canadian practice
Covered Bonds in Canada
Since 2007, covered bonds have become a significant funding source for Canadian banks with more than C$30-billion in covered bonds currently outstanding under programs established by the six leading banks and one Quebec central credit union.
Covered bonds are debt instruments issued by a financial institution and secured by a pool of high-quality assets. As with senior debt issuances, the issuing financial institution pays interest and principal on the bond. Unlike senior unsecured bank debt, a covered bond is also backed by a segregated pool of high-quality assets. If the issuer defaults on bond payments, the covered bondholders continue to be paid from the pool of cover assets. The cover pools for existing Canadian programs consist of loans made on the security of Canadian residential real estate, including CMHC-insured mortgages, conventional (uninsured) mortgages and CMHC-insured home equity lines of credit.
Covered bonds are given "AAA" credit ratings (and issuers enjoy the accompanying low rate of interest) because the cover assets are segregated from the issuing bank and owned by a bankruptcy-remote special-purpose vehicle (SPV) that guarantees the bonds. In the event of an issuer default, in addition to the unsecured senior claim against the defaulting issuer, the cover pool assets are available for the benefit of covered bondholders to the exclusion of other creditors of the defaulting issuer.
Unlike in many European countries where covered bond markets are more developed, there is currently no legislative framework for covered bonds in Canada. Covered bonds can only be issued by Canadian financial institutions under a contractual framework without the benefit of specific legislative bondholder protections.
The contractual method for defining the terms of the covered bonds and related investor protections has two main drawbacks that motivate a legislative response. First, it is advantageous to have a clear legislative path for investors to know that cover pool assets will be available for their benefit in the event of an issuer insolvency. Second, demand for covered bonds issued by Canada's financial institutions would be bolstered by legislative protections since some international investors are restricted from purchasing covered bonds that are not issued under a legislative framework.
Basis for Finance's Proposal
Finance's proposal generally recognizes and endorses that issuers of covered bonds should be guided by market discipline rather than burdensome regulatory constraints. In that regard, Finance identifies three policy objectives:
- the promotion of financial-sector stability;
- the creation of high standards consistent with international
- the establishment of a regulatory body to be charged with overseeing each program which adopts the legislative framework (the registrar).
As part of the consultation process, the government invites comment on a variety of questions regarding the nature, breadth and scope of the legislative framework.
The Proposed Framework
The following are key elements of the proposed legislative framework:
Eligible Institutions. The benefits of the framework would be directly available only to federally regulated financial institutions (FRFIs). Non-FRFIs would only be able to benefit from the framework by selling eligible assets to FRFIs. To become eligible, an FRFI would need to register as an eligible issuer. One open question is whether the framework ought to permit registered issuers to also maintain unregistered covered bonds programs that operate outside the framework. For eligible issuers with existing covered bonds programs, it is proposed that, subject to approval of the registrar, those programs could become registered programs if the issuer becomes a registered issuer and the covered bond program otherwise complies with the legislation.
Asset Segregation. The proposal requires an immediate asset segregation of the underlying asset pool through a legal sale to an SPV. In contrast, some countries with covered bond legislation do not require cover assets to be sold to an SPV but instead the assets are owned by the financial institution and the legal separation of assets for the benefit of bondholders is provided for by legislation. The latter approach could lower the initial costs of creating a cover pool but might increase uncertainty if the issuer defaults and would not reflect the current Canadian program structures (or the structure used in the United Kingdom, on which the Canadian programs are based).
Protection in the Event of an Issuer Insolvency. Investors in covered bonds need assurances that if the issuer defaults, the assets in the cover pool will be available to service the covered bonds, and will not be subject to an insolvency stay affecting the issuer. Although the current contractual framework can provide satisfactory protections, the proposal would clarify the insolvency process, including to provide that covered bondholders would have priority over the assets held by the SPV in the event of an issuer insolvency. Covered bond service providers would also benefit from these protections.
Eligible Assets. The proposal would limit the eligibility of underlying assets to loans made on the security of a residential property located in Canada. In a few countries, such as Germany, issuers have issued covered bonds backed by other assets, such as public-sector loans, ship loans, or aircraft loans. Finance indicates that expanding the scope of permitted assets beyond residential mortgages would increase the complexity of the proposed framework with little benefit to financial institutions and so no extension of asset categories is proposed.
Finance also asks whether covered bond legislation should encourage the use of conventional (uninsured) mortgages in cover pools in order to reduce reliance on government-backed mortgage insurance and also to improve the liquidity of uninsured mortgages. Six of the existing seven Canadian covered bond programs have cover pools consisting of residential mortgages or home equity lines of credit which are insured by Canada Mortgage and Housing Corporation and investors and rating agencies attach significant weight to the fact that a government guarantee ultimately backs the mortgage assets held in these cover pools. It will be interesting to see if the policy objectives which may underlie Finance's question come into greater focus as the proposal advances.
Standardized Terms. The proposal would standardize a number of commonly used terms and conditions based on current Canadian practice, including:
- Asset Values for Coverage Purposes. The proposal would
standardize the approach used to value covered assets and prescribe
how often the related coverage tests must be conducted. It appears
that the approach would reflect current Canadian practice by
applying monthly a predetermined valuation formula to reflect
factors such as available insurance and the arrears status of the
- Overcollateralization. The proposal suggests
setting a maximum level of overcollateralization in the cover pool
- Terms of Demand Loans. Each issuer lends its
SPV the cash required to purchase the cover pool assets from the
issuer. The issuer has the right to demand repayment from the SPV
of a portion of this loan in an amount equal to the
overcollateralization which is not currently required under the
program agreements – this callable portion of the loan is
the "demand loan". Finance has identified a regulatory
concern that allowing for excess assets to be retained by an SPV
following an issuer default could increase risks faced by the
issuer's ordinary depositors. The proposal would have demand
loans be deemed to be called if and when the issuer defaults and
the amount to be repaid would be the larger of the value of the
demand loan as calculated on the day the issuer becomes insolvent
and as calculated on the day the loan is repaid. This could
potentially limit the assets available in the cover pool at the
time payment is required under the SPV's guarantee.
- Dynamic Asset Replacement. Existing programs typically allow issuers to add new assets to the SPV in order to continue to meet the applicable asset coverage test at all times that covered bonds are outstanding. In case the issuer does not have sufficient eligible mortgage loan assets to sell to the SPV, it will generally be permitted to cover a shortfall by allowing the SPV to hold government securities or other high-quality substitute assets. The proposal would set out minimum standards for substitute assets and set a maximum percentage of substitute assets.
Back-Up Swaps and Services Providers. The proposal would specifically allow issuers to act as swap counterparties and service providers, despite the risk of disruption if the issuer defaults and a replacement is needed. To mitigate the replacement risk, the issuer would be required, upon the occurrence of a trigger event, to engage back-up swap providers and/or back-up service providers. Credit ratings downgrades below specified ratings levels would provide one possible trigger event. However, Finance has asked for comment on the possibility of including non-ratings-based triggers for this purpose, recognizing the general shift away from reliance on ratings for regulatory purposes.
Disclosure. The framework would establish minimum standards for reporting and disclosure and may prescribe standardized formats and the means to make the disclosure publicly available (e.g., on the registrar's website). The commentary suggests that these provisions would essentially formalize the already high level of disclosure common in Canadian covered bond transactions. Key disclosures would include issuer and program ratings, events of default, results of the asset coverage tests and asset tests and asset information (e.g., arrears rates, remaining terms and loan-to-value ratios), as well as information regarding the administrative service providers and the back-up providers. In addition, the proposal calls for annual audits and public disclosure of any deficiencies. It is noteworthy that the recent proposal by provincial securities regulators to specifically regulate "securitized products" carves out covered bonds from the new regulatory requirements, and so covered bonds may continue to be distributed in Canada under the ordinary private placement exemptions without being subject to any additional provincial securities disclosure requirements or other limitations.
Role and Responsibilities of the
Finance continues to consider what roles and responsibilities would be appropriate for the registrar as the overseer of the covered bonds framework. Based on the commentary, it appears that Finance is leaning toward a less intrusive role for the registrar, seemingly favouring a regime based on market standards and transparency. It is proposed that the role of the registrar would be limited to certifying that covered bond programs meet specified requirements and that the issuers are providing appropriate disclosure to the market. By contrast, in some European states, the registrar is involved in various aspects of the market, including examining proposed issuances, certifying compliance, supervising the SPV and the issuer, and in the event of issuer insolvency, acting as the administrator of the SPV.
As a related matter, Finance is considering whether the registrar ought to be an existing financial-sector regulatory body, which would have technical expertise and knowledge of the financial sector and relationships with financial institutions, or another government body that is familiar with financial markets operations but has no existing financial-sector regulatory or oversight responsibilities. Finance is also considering the merits of assigning the registrar role to a private-sector entity or a new self-regulatory organization. Public input is requested on this point.
Finally, consideration is being given to the nature and extent of the registrar's enforcement powers. Finance has indicated that, at the minimum, the registrar should be able to suspend an eligible issuer from issuing additional covered bonds, and that additional sanctioning powers may also be necessary. Importantly, the proposal clarifies that outstanding covered bonds issued under a legislative covered bond program would continue to benefit from the legislative framework regardless of any issuer contravention.
The Consultation Process
Comments on the proposal may be submitted to Finance by June 10, 2011 and will be kept confidential.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.