Feds act to legitimize covered bonds

More financial institutions are interested in covered bonds, thanks to increasing regulatory capital requirements, the need to re-establish acceptable capital levels in the short term and declining interest in securitized loans.

Governments originally issued covered bonds when political instability threatened the regime’s continued existence, triggering lenders’ demands for collateral.

Now, when new lenders aren’t prepared to lend to a financial institution solely based on the promise to pay, the institution can choose to set aside specific collateral as security for the benefit of the new lenders in priority over other creditors.

Covered bonds are debt instruments that have recourse to the issuing entity and/or to a group to which the issuing entity belongs and, upon an issuer’s default, also have recourse to a specific pool of collateral, called the “cover pool,” which is separate from the issuer’s other assets. The cover pool usually consists of high-quality assets such as public debt instruments.

Typically, covered bondholders have a preferential claim (embodied in statute in Europe) against the cover pool in the event of the issuer’s insolvency, and a pro-rata claim to the issuing institution’s other assets. The collateral remains on the bank’s balance sheet.

Conversely, in a securitization, an investor only has recourse to the assets of the special-purpose entity that issued the securities — including its cash flows. From the issuer’s perspective, covered bonds remain on the issuer’s balance sheet, whereas securitized assets are taken off.

Canadian banks have tapped into Europe’s developed covered bond market. Yet covered bondholders in Canada have no statutory claim to collateral in preference to other lenders. Their claims are based solely on a contract between them and the issuer.

Without legislation establishing the preferred position of covered bondholders in Canada, can a Federally Regulated Financial Institution (FRFI) set aside a cover pool without breaching terms applicable to other sources of capital, other contractual constraints, and deposit insurer requirements?

As promised in the 2010 budget, Finance has published a consultation paper proposing a legislative framework for FRFI-covered bonds. OSFI has limited covered bond issues by deposit-taking FRFIs to 4% of total assets; this proposed statutory regime should prompt OSFI to raise this limit.

The legislation is also important to non-deposit-taking FRFIs. It is anticipated they will sell assets to issuing FRFIs, which will aggregate the assets. The savings on funding will be split between issuing and non-issuing FRFIs.

Key aspects of the paper

The government intends to establish a legislative framework that strikes an appropriate balance between the interests of covered bondholders and those of other creditors, secured or unsecured. A new regime for covered bonds raises some key concerns:

• Should there be standardized features to assist in the development of a robust, deep and liquid market?

• Should the covered pool be segregated through the sale to a special purpose vehicle (SPV) to simplify matters in the event of default, or should the covered pool be segregated by use of registry?

• Is there an advantage to requiring all SPVs be of a specific type in the event of insolvency?

• Should we define what can be held by a collateral pool?

• Should steps be taken to encourage the use of uninsured collateral in covered pools?

• Should eligible issuers register?

• Should there be a maximum level of overcollateralization?

If an asset in a collateral pool is no longer eligible, what standards should apply to assets added to the collateral pool to meet ongoing collateral requirements, and should we limit the percentage of assets that can be added?

Once the paper becomes law, it will provide FRFIs with a new source of funding, and investors with the opportunity to invest in bonds that are safer than other FRFI debt instruments. Given the capital requirements of Basel III and the majority in Ottawa, enabling legislation should be passed in short order.