Canada finally gets the go-head to issue covered bonds

(July 2007) Just when you thought you knew everything there was to know about North America’s financial markets, along comes a brand new product that could have lasting effects on Canada’s financial industry.

In late June the Office of the Superintendent of Financial Institutions gave the go-ahead for Canadian banks to start issuing covered bonds — an instrument similar to mortgage back securities — and already people are excited about this new investment opportunity.

“Why wouldn’t you buy it?” asks Harry Koza, a senior market analyst for Thompson Financial. “It’s a no brainer for investors.”

A covered bond is a senior debt instrument that is secured by a covering pool for mortgage loans. But, instead of packaging up loans and selling them off, the banks keep them on their books. Covered bonds typically carry an AAA rating, which means the risk level is low and funding is cheaper than other types of investment.

“You’re buying a triple-A, which is the same credit as the government of Canada, at an extra spread,” he explains.

Covered bonds are also useful for diversification. When a Canadian bank eventually does issue the asset, it will likely look to the European market for their first offering, as it is by far the most developed market. This will give institutions exposure to new, eager investors.

“If Canadian banks come into the European covered bond market they will be warmly welcomed,” says Armin Peter, head of covered business and syndicate at UBS.

Two U.S. banks have already been warmly received in the European market — Washington Mutual and Bank of America. Washington Mutual’s euro-denominated covered bond offering had about 20 billion orders, the most ever.

“Whenever there is a new name coming to market from a new country, Europeans welcome that,” says Peter. “Washington Mutual’s issuance just confirmed all the hype and excitement within the market now that North American borrowers are looking at these products.”

Issuing in Europe first makes a lot of sense; the covered bond market is the sixth largest bond market in the world, with more than $2.5 trillion worth of bonds outstanding. It’s also one of the most mature, dating back to 18th century Germany, where, according to Koza, farmers used their land as collateral to keep their operations running.

With such a storied history, Canadian institutions can tap into a developed market and make money right off that bat. “It’s huge over there. They can’t get enough of them,” says Koza. “You can do a billion dollar deal with no problems. You can probably do it at a cheaper spread than you can do it here too.”

Eventually, Canadians will set up a home-grown market, but for now they’ll have to follow Europe’s lead if they want to cash in. “At some point North American borrowers are going to say, how about this, how about that?” says Peter. “But right now they’re still doing it the European way.”

Clearly, the investment community is excited. Andrea Montanari, UBS’s director in charge of covered bond structuring, says that from a “purely structural perspective there are not many downsides to covered bonds. That’s why it’s been so hugely successful across the centuries.”

But there are problems with this instrument, which is why it has taken OSFI so long to give it the green light. The main concern is that this product creates two classes of depositors, because banks, in the event of a collapse, are required to pay off the covered bondholders first, leaving a reduced pool of assets for the average depositor.

“Creating two classes of depositors flies in the face of the basic principles of bank regulation,” says Koza. “If a bank takes all their assets and issues covered bonds and then becomes insolvent, what assets are left to secure the bank?”

To protect depositors, OSFI’s put limits on the value of covered bonds a financial institution can sell. In a June 27 letter addressed to all deposit taking institutions, the government body says a DTI cannot issue more than 4% of its total assets in covered bonds.

“We took a cautious approach,” says Gilbert Ménard, OSFI’s managing director, capital division. “We’re trying to balance concerns with some of the benefits.”

While 4% might seem like a low number, that cap is not without precedent. The Financial Services Authority, the U.K.’s uber-regulator, put the same restrictions in place in 2004, only to move it to 20% once the market matured.

Ménard will not give a timeline, but he is not ruling out a change in the asset limit. “We’ll assess more deeply the concerns and benefits and see how it develops and we’ll take it from there,” he says.

According to Montanari, the cap should not affect interest in Canadian covered bonds. He says it is “a reasonable number” and he expects OSFI to eventually alter that restriction.

Though OSFI might not want to get overly ambitious, Montanari adds that some jurisdictions have allowed issuance limits to rise as high as 60% without having any negative results.

It’s still too early to tell which Canadian bank will be first out of the gate to issue covered bonds, but most experts think it will be RBC. Ménard’s not saying, but he admits that some institutions have expressed a desire to jump into the market. “We’ve had some queries not only from institutions, but also from some market players in Europe.”

When Canadians do start issuing covered bonds, the question will then become what to do with all the money that’s made? Koza says the Germans have used the bond offerings to finance government infrastructure, and he thinks Canada should follow suit.

“It’s a good, cheap way to get this kind of stuff done,” he says. “It’ll also help consumers because banks will need longer assets, encouraging them to make 10 or 20 year [term] mortgages.”

But until someone takes the initiative to get into the market and answer that question, OSFI is forced to stay cautiously optimistic about the future of the covered bond. “We still need to know more about the market,” says Ménard. “We don’t know the structures Canadian banks might use or the types of assets they’ll use. We shouldn’t iron out every possible aspect of this without anything in front of us domestically.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(07/18/07)

Bryan Borzykowski