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.

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.

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:

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.

Reg AB II and Covered Bonds

Updated: 12/28/2015

The United States Securities and Exchange Commission (the “SEC”) adopted revisions to Regulation AB on August 27, 2014, after a four year process of proposals and review. Regulation AB is the rule that governs the offering disclosure and periodic reporting obligations of issuers of asset-backed securities (“ABS”).

Insofar as covered bonds are concerned, several things are clear. First, covered bonds are not included in the definition of “asset-backed security.” Item 1101 of Regulation AB provides that:

Asset-backed security means a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases.

It is clear that covered bonds are not “primarily serviced by the cash flows of a discrete pool of receivables or other financial assets.” Instead, covered bonds are senior obligations of the issuing financial institution and are expected to be repaid from the general funds of the institution. Accordingly, covered bonds should not be asset-backed securities and Regulation AB should not apply generally to covered bonds.

Second, although the Commission had proposed extending the disclosure requirements of Form SF-1 and Regulation AB to privately placed ABS, the Commission did not adopt the proposed change. The Commission stated, however, that the proposal remained outstanding.

Thus, for most issuers of covered bonds, Regulation AB II will not be applicable. Most covered bonds issued in the U.S. are issued under Rule 144A as private placements, to which Regulation AB does not currently apply. Moreover, even if the SEC were to extend Regulation AB to private placements, since covered bonds are not asset-backed securities, Regulation AB would still not apply to Rule 144A offerings of covered bonds.

For the Canadian issuers with SEC registered covered bond programs, however, there still remains the question of whether they will be required to make loan-level disclosure for the mortgage loans in their cover pools in accordance with the requirements of Regulation AB. Each of the Canadian issuers requested a no-action letter from the SEC staff to enable it to register its covered bond program. (See, e.g., the RBC no-action letter.) Each issuer stated in its letter that it would provide offering disclosure and periodic reporting in connection with its covered bond offerings consistent with the requirements of Items 1111 and 1121 of Regulation AB. These two provisions of Regulation AB have now been revised by the SEC’s amendment of Regulation AB to require disclosure of 270 data fields for each residential mortgage loan. Whether the SEC staff will extend the new loan-level disclosure requirements of revised Items 1111 and 1121 to these Canadian covered bond issuers is a question.

If the SEC decides to require the Canadian banks to disclose loan-level information for each residential mortgage loan in their cover pools in accordance with Items 1111 and 1121 of Regulation AB, this could prove troublesome. These provisions require the disclosure of information that raised concerns under U.S. consumer privacy laws. In the end, the SEC needed to obtain a letter from the Consumer Finance Protection Bureau stating that the disclosure of information as required by the SEC under Regulation AB would not result in a violation of consumer financial privacy laws. However, this protection for issuers is only protection from violation of U.S. laws. Non-U.S. issuers do not benefit from this protection if they disclose information about consumers in the issuers' home jurisdictions.

Additionally, because residential mortgage loan products are different in Canada, many of the requested fields are simply inapplicable. And the extensive disclosure required under the SEC's template would require the collection of information that Canadian banks do not currently collect in their residential mortgage business and retain in their computer systems. Modifying existing computer systems and business processes to collect and retain this information could be expensive and disruptive.

The bottom line may be that compliance with Regulation AB by foreign financial institutions is impractical. This would mean that the registered ABS market in the U.S. would be reserved for securitization of U.S. assets only.

Stay tuned.

BNS Files U.S. Prospectus

BNS initially filed its registration statement for its legislative covered bond program on Form F-3 with the SEC on May 31, 2013. That registration was declared effective on September 9, 2013. However, BNS did not file a prospectus under the registration statement with the SEC until today, August 20, 2014. In the interim, BNS filed a prospectus with the UKLA and offered covered bonds in Europe on March 26, 2014. Now, with the filing of a prospectus with the SEC, BNS is ready to offer covered bonds in the U.S.

Year to date, the U.S. covered bond market has been very quiet. Only two issuers have brought bonds to market for a total of $3 billion: Westpac Banking Corp. on May 14 and Commonwealth Bank of Australia on June 14, both privately placed offerings. So far, no registered covered bonds have been issued in the U.S. in 2014.

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.

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?

More Views on Low RMBS Issuance

In a letter to the SEC dated February 14, 2014, FINRA stated that during the fourth quarter of 2013, the issuance of mortgaged-related securities declined 33 percent compared to the same period in 2012.