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.