OSFI to Reconsider 4% Limit?

According to reports in The Cover and The Covered Bond Report, Canada is considering whether to increase the 4% limit imposed on covered bond issuance. This limit was imposed by the Office of the Superintendent of Financial Institutions (OSFI) at the inception of covered bond issuance by Canadian banks in 2007 and remains unchanged today. While the limit is the most stringent currently applied in the covered bond world, Canadian banks have nevertheless been active issuers of covered bonds as can be seen by the table below.

US$ EUR GBP CHF A$ C$
Issued (mm)*71,60044,0374,3752,0757,4504900
Outstanding (mm)*39,60038,6134,3751,4005,1003,300

Source: www.us-covered-bonds.com/cdn_issue_details
* As of January 28, 2016.

The current 4% limit is measured as the Canadian dollar equivalent amount of covered bonds outstanding divided by total assets. The table below shows the covered bond issuance capacity remaining for each Canadian covered bond issuer as of December 2015.

BMO BNS CCDQ* CIBC NBC RBC TD TOTAL
Total Assets (mm)**641,881856,4971,318463,309216,0901,074,208862,5324,115,835
Maximum Amount (mm)26,10033,6007,40018,2008,30043,50042,400179,700
Outstanding Amount (mm)11,60022,2005,40010,7007,30031,30020,900109,400
Used Capacity44.3%66.0%73.1%*59.0%87.8%71.6%60.9%60.9%
Remaining Amount (mm)14,50011,4002,0007,5001,00012,40021,50070,300

Source: CMHC, Covered Bond Business Supplement, September 2015.
*Note that CCDQ is subject to a different limit, which is set by Autorité des marchés financiers at EUR 5.0 billion.
** As of October 31, 2015.

In most major covered bond issuing jurisdictions there are no limits on the issuance of covered bonds. Some jurisdictions, such as the United Kingdom and the Netherlands adopted issuance limits at the inception of their covered bond issuance, but have subsequently removed fixed limits. In both jurisdictions today the issuance limit is determined on a case-by-case basis by financial authorities based on the condition of the issuer. A few jurisdictions still retain a fixed limit: Australia at 8%, Greece at 20% and New Zealand at 10%. No other country has a limit as stringent as that of Canada. See, ECBC, European Covered Bond Fact Book, 1.4 Factors Affecting Asset Encumbrance (2014) at pages 54-55.

That all other issuers of covered bonds have the benefit of more accommodating regulation of covered bond issuance limits and Canadian covered bond programs have grown for nearly ten years without evidencing any problems, suggests that OSFI may be willing to increase its 4% limit. The 4% limit increasingly appears overly restrictive.

Even under the existing tight limits on issuance, CMHC reports that covered bonds have become increasingly important as a source of funding for residential mortgage loans for Canadian banks. Covered bonds have grown from funding 5% of residential mortgage loans in early 2013 to nearly 8% by mid-2015.

With the growing use of covered bonds as a funding source for supporting mortgage loan origination, it is not surprising to see that OSFI is considering changing the current 4% limit. If OSFI were to change to limit for issuance of covered bonds to 6% or 8% or 10%, the maximum capacity of each of the issuing banks would be as follows:

BMO BNS CCDQ* CIBC NBC RBC TD TOTAL
6% limit (mm)38,51351,38911,00027,79912,96564,45251,752246,950
8% limit (mm)51,35068,52014,80037,06517,28785,93769,003329,267
10% limit (mm)64,18885,65018,50046,33021,609107,42186,253411,583

*This assumes that the limit set by Autorité des marchés financiers is increased comparably.

If OSFI were to raise the limit for covered bond issuance to 10% of total assets, that would create the potential for an additional C$320,683,000,000 of covered bonds outstanding based on current outstandings.

Moody’s expects lower predictability of government support for Canadian banks; changes banking system outlook to negative

On July 8, Moody’s followed up on its June 11 announcement regarding risk related to a “bail-in” regime in Canada with an announcement of the change to “outlook negative” in Global Credit Research.  Additionally, Moody’s notes that “high household indebtedness and elevated housing prices remain key risks to banking system stability in Canada”.  Further, Moody’s states that “growth sought by the banks has led them to diversify into riskier businesses and geographies which dilute their strong domestic credit profiles and represent a growing risk to the Canadian system's stability”.

Moody’s: Canadian Banks on Outlook Negative

On June 11, 2014, Moody's Investors Service changed the outlook of the seven largest Canadian banks from stable to negative and confirmed each of their long-term ratings.  Moody's stated that the action was taken in response to previously announced plans of the Canadian government to implement a "bail-in" regime for Canada.  In Moody's view, the balance of risks for senior debt holders and uninsured depositors of Canadian banks "has shifted to the downside."

This rating action by Moddy's has not affected the rating of any outstanding covered bonds issued by the banks.  The current long-term ratings of the banks by Moody's range from Aa3 to Aa1.

Another View on Canadian Housing

The Financial Times reports that “Pimco goes bearish on Canada” (Pimco goes bearish on Canada, FT, p. 16, March 3, 2014).  The article reported that the Pimco Total Return Fund had reduced its holdings of Canadian debt by about 50% due to its concerns about housing prices in Canada.  Pimco is reported to be expecting a decline in housing activity and prices this year due to tightening of mortgage credit and an increase in loan rates.  The decline in prices is expected to be as much as 30% over the next two to five years, so a gradual decline over several years rather than an abrupt market fall.  Other reports express a concern about the high levels of consumer indebtedness in Canada and the rapid rise in housing prices.

More on Canadian Housing Prices

The Wall Street Journal reports in its February 19, 2014 paper that the campaign to prevent a housing bubble is gaining traction. They report that many observers think the market is drastically overpriced and may be subject to t sharp correction. The article reports that housing prices have doubled since 2002 and rose 9.5% in January compared to January 2013. A chart shows average house prices in Vancouver at more than C$800,000 and in Toronto at more than C$500,000. House prices are reported to be 50% above those in the U.S. And the construction industry is reported to represent twice the percentage of the gross domestic product in Canada as in the U.S.

As noted elsewhere, however, this is not a repeat of the subprime mortgage debacle we had in the U.S. Canadian residential mortgage loans have much lower loan-to-value (LTV) ratios and are full recourse, so the borrower is unable to just turn over the keys and avoid the debt. But these comparative numbers would suggest that Canadian consumers are carrying high levels of housing related indebtedness. Small wonder that Canadian consumers are reported to have debt to asset ratios close to those of U.S. homeowners prior to the crisis. And most of that asset value is from overpriced houses. A sharp correction in housing prices would hit consumers hard.

See also, Is there a housing bubble in Canada?