On April 26, 2012, the federal government introduced the Jobs, Growth and Long-Term Prosperity Act, the legislation to implement the March 29, 2012 federal budget. Buried in this legislation (over 420 pages!) are significant changes to both the Canada Mortgage and Housing Corporation (CMHC) and the law in respect of Canadian covered bonds that will have direct and material effects on our mortgage and securitization markets. Industry participants who initially asked for covered bond legislation must surely be regretting it.
CMHC is now (finally) under adult supervision. As a federal Crown corporation with over $540 billion of outstanding guarantees on Canadian housing (an amount equal to the entire Canadian federal debt), CMHC will now report to the Office of the Superintendent of Financial Institutions, instead of the Minister responsible for Human Resources and Skills Development Canada (believe it or not!). With CMHC approaching its current statutory guarantee cap of $600 billion (which has been raised 4 times in 8 years), something had to give.
However, the legislation does much more. It amends the National Housing Act to provide for a legislative covered bond framework, and prohibits federally regulated institutions (banks, trust companies and insurers) from issuing covered bonds outside this framework. In particular, these amendments generally provide for:
- a covered bond registry to be established and maintained by CMHC that will identify registered issuers and registered programs
- eligible covered bond collateral is restricted to uninsured loans made on the security of residential property located in Canada (but not more than four residential units)
- insured mortgage loans (by any of CMHC, Canada Guaranty, Genworth or PMI) are not eligible covered bond collateral
- loans having an LTV ratio in excess of 80% are not eligible covered bond collateral
- statutory protection for the enforcement of covered bond contracts and covered bond collateral in the event of a registered issuer's bankruptcy or insolvency
What does it all mean? The single most important feature of this legislation, by a country mile, is the exclusion of CMHC insured mortgages from future Canadian covered bond pools. Most Canadian banks use CMHC insured mortgages exclusively in their cover pools to effectively provide a sovereign guarantee on their bonds, thus reducing their cost of funds. This easy route to a relatively cheap funding source is now gone. If Canadian banks continue to issue covered bonds under the new framework, spreads will inevitably widen. Bondholders under new covered bond issuances will now be taking increased credit risk. Apart from pricing changes, issuing banks can also expect their credit and underwriting policies and procedures to come under somewhat closer scrutiny by bond purchasers.
For issuing banks, it is "back to the covered bond drawing board". Money is fungible and the comparative cost of issuing covered bonds as a funding source will be reviewed, given the likelihood of wider spreads. Programs will have to be re-established (probably from scratch) to accommodate the new framework (resulting in "Canadian covered bonds 2.0"). The investor base may also change. Without the implicit sovereign guarantee, investments in new Canadian covered bonds will be based on much different considerations than in the past. Covered bonds will still provide attractive credit enhancement and should remain a cheaper source of funds than bank deposit notes, but will clearly cost more than before. For those banks that decide to revamp their programs, the rewards will likely be longer term. Building an international brand in the covered bond market based on the uninsured (but much deeper) Canadian mortgage market will take time and cost more in the short term, but should pay off in the end as it preserves an important alternative source of capital.
For the Canadian housing market and mortgage borrowers, the legislation is definitely bad news. Borrowing costs will rise as bank lenders will pay more for the funds used to provide these mortgages. As banks (and their bondholders) assume more of the credit risk (and losses) in these programs (and with CMHC approaching its own statutory guarantee limit), mortgage underwriting by the banks should become stricter and more selective (whether they acknowledge it or not). If so, fewer borrowers will qualify for the best priced loans and more borrowers on the fringes will be pushed out of the banks' market.
The winners? Clearly not the banks. Arguably Canadian taxpayers, who are ultimately on the hook of CMHC's mortgage guarantee program (and 90% of the private insurers' guarantee obligations as well). But close runner-ups may be the Canadian private mortgage lenders (who are not federally regulated) and the Canadian securitization market. The funding advantage of Canadian banks in the mortgage market has eroded somewhat with these changes. It's still not an even playing field but it is closer now than it was. With a larger potential market and higher spreads, these private lenders will need to raise capital somewhere and the (now dormant) private rmbs securitization market is a logical consideration. While it is still very early, this legislation should create more opportunities for growth and profit in these areas than we've seen in some time.
As a post-script, while the new covered bond legislative framework itself might be considered a theoretical positive, from an issuer perspective any substantive benefits are highly debatable. The existing Canadian covered bond structures work well, and there is no evidence that this new framework will actually perform "as advertised" and increase the size of the existing investor base and, as a result, bring in spreads. Who are these potential investors who have been waiting patiently on the sidelines for these legislative changes in order to invest in Canadian covered bonds? Our guess is that they don't actually exist. From our perspective, this new legislative framework appears to provide a lot more regulation for no real benefit. From an issuer's and investor's perspective today, the entire exercise looks like a real step backward.
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