Resiliency of Canadian Covered Bonds
In the current world of sharply rising interest rates and a possible recession, questions have arisen about the resiliency of the cover pools for Canadian covered bonds. Additional focus is brought to this question by the declining housing values in Canada — Vancouver and Toronto in particular have seen reported 15 to 20 per cent declines in house prices from recent peaks.
Canadian covered bonds take their strength from several factors, not the least of which is the conservative nature of property investors in Canada, combined with fairly strict underwriting standards set by OSFI. This has resulted historically in a typical annual loss rate for residential mortgage pools for most banks in basis points in the single-digit or low double-digit range.
This low loss experience is supported by the full recourse nature of Canadian mortgage loans. A mortgagor under Canadian law is personally liable for full payment of the mortgage loan if the loan is foreclosed on and liquidated at a loss. Unlike the case in many U.S. States, a Canadian property owner cannot turn over the keys to house and walk away free of the debt.
Another protection for Canadian cover pools is the monthly Asset Coverage Test that each program must pass. If the value of eligible mortgage loans in the cover pool does not exceed the outstanding amount of covered bonds by the required overcollateralization amount, the test is failed. Defaulted mortgage loans are not included in test. If the test is failed, the issuing bank is required to transfer additional, non-defaulted eligible mortgage loans to the cover pool. Thus, the cover pool is constantly refreshed with performing mortgage loans protecting the value of collateral backing the covered bonds.
More protection is provided by the requirement that an eligible mortgage loan for Canadian cover pools must have a loan to value ratio not exceeding 80%, measured each month based on an index of current property values in the location of the property. If the loan to value ratio exceeds 80% at any time, only only the portion of the loan not exceeding 80% of the value of the property is included in the cover pool for the calculation. This means that the value of the cover pool is protected from declining property values.
Moreover, the typical average loan to value ratio of mortgage loans in cover pools for Canadian covered bonds is between 50% and 60%, which provides a substantial buffer before loan amounts are reduced in the cover pool because they fail the loan to value maximum for eligibility. Statistical information on cover pools is available in the monthly report provided to investors by each of the Canadian banks.
Lastly, in addition to strong cover pools, investors in Canadian covered bonds hold exposures to banks that operate in a conservative banking environment. Canadian banks came through the financial crisis of 2008 in excellent shape and continue to be highly regarded in international capital markets. Banking regulation in Canada contributes to the conservative environment with a with a regulatory approach that prioritizes stability. The recent tightening of mortgage loan underwriting evidences this caution.
This collection of protections is what supports the perception of quasi-sovereign risk for Canadian covered bonds.
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?