Covered bonds are debt instruments that are generally issued by
financial institutions and secured by a cover pool of high-quality
assets held by a special purpose vehicle (SPV) which guarantees
repayment of the covered bonds if the issuer defaults on the bond
payments. Covered bonds are common internationally and have also
become a significant funding source for Canadian banks, with all
the Schedule I banks establishing a covered bond program and
issuing one or more series under such program. To date, total
issuances of covered bonds by Canadian financial institutions
exceed $30 billion.
At this time, there is no legislative framework governing the
issuance of covered bonds in Canada, and each of the current
Canadian programs has been established under a contractual
framework. This non-legislative, contractual approach suffers from
two drawbacks: i) it makes the Canadian covered bond market less
robust compared to those jurisdictions in which a legislative
framework exists, as it reduces the ability of Canadian financial
institutions to diversify their funding sources since many
investors are restricted from purchasing covered bonds for which no
legislative framework exists; and ii) the assurance by an issuer of
repayment in the event of default is not as robust as if that
assurance is enshrined in legislation.
The Federal Department of Finance (the Government) has issued a
consultation paper regarding a proposed
legislative framework for covered bonds in Canada. Some of the key
elements are as follows:
Insolvency Protection - The Government
proposes the legislative framework clarify that in the event of
issuer insolvency, the covered bondholders have priority of claim
over the assets held by the SPV. The Government also proposes to
protect the priority of service providers in the event of the
insolvency of the SPV. While the current programs have been
structured in a manner that is meant to ensure such priorities, the
certainty afforded by a statutory regime is desirable to many of
the participants in the programs.
Permitted Assets - The Government proposes
that the legislative framework will only permit loans made on the
security of a residential property located in Canada to be included
in the cover pool, unlike in other jurisdictions in which a broad
range of assets may form the collateral for covered bonds. To date,
all Canadian covered bond programs include only Canadian
residential mortgages in their collateral pool.
Permitted Issuers - The Government proposes
that the legislative framework be available to federally regulated
financial institutions (FRFI) only. Non-FRFIs would be able to
benefit from the framework by selling eligible assets to
Overcollateralization - Overcollateralization
is the amount by which the value of cover pool assets is required
to exceed the value of the covered bonds issued. A higher level of
overcollateralization serves as a credit-enhancement for the
covered bonds, but diminishes the amount of assets available to
other creditors and depositors of the issuer. Under current
Canadian practice, issuers generally set the maximum
overcollateralization at 10 percent. The Government proposes that
the legislative framework standardize current Canadian practice and
set a maximum level of overcollateralization.
What happens to existing issuances? - The
Government proposes that, subject to the approval of the proposed
covered bond registrar, existing covered bonds programs could
become registered programs if the issuer becomes a registered
issuer and the program otherwise complies with the
Rick Fullerton's practice covers many areas
of banking, finance and securities law, with an emphasis on
securitization and structured finance, corporate finance and
financial institutions work.
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.
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