Why raising the cap on covered bonds would be good for Canadian homebuyers: Financial Post Op-Ed

By Finn Poschmann

Few Canadians may have heard of them, yet covered bonds, an important bank funding mechanism, have taken a place near the heart of the financial system. How big a place that should be, and how close to the heart, will be a question for whoever forms the next government in Ottawa – and this will matter to housing finance.

Covered bonds have been around for centuries – capital markets folk are mostly well used to German pfandbrief, and they made sporadic appearances in the U.S. in the 19th Century. But they are pretty new to Canada.

What makes covered bonds special is their belt-plus-suspenders approach to credit quality. The bonds typically are backed by decent assets, low loan-to-value ratio mortgages in the Canadian case. These bonds are overcollateralized: the underlying mortgages’ face value exceeds the amount of the bond issue.

The bonds are issued only by major banks, and the issuing bank’s full faith and credit stands behind them. If the issuing bank should go belly up, title to the underlying mortgage assets flows to a guarantor, a separately capitalized triple-A rated special purpose vehicle that holds the mortgages on behalf of the issuing bank.

This allows banks to generate a cheap funding stream for mortgage lending, which is good for their shareholders and for borrowers. Even better, this low-cost funding is accessible without going to the taxpayer, via the Canada Mortgage and Housing Corporation, for insurance and securitization guarantees.

Indeed, federal law now bars insured mortgages from covered bond pools. The government has been consistent in saying, since 2012, that taxpayers should take a shrinking role in housing finance, and the no-insured-mortgages rule is part of that.

And, given that the government has also raised the price and pinched the supply of mortgage insurance and securitization guarantees, banks generally would not mind issuing more covered bonds.

They are, however, nearing a cap on issuance that the Office of the Superintendent of Financial Institutions imposes. Covered bonds can amount to no more than 4 per cent of a bank’s assets.

The reason for the cap, which is very low compared to the rest of the global bond marketplace, is what happens in the case of a bank’s bankruptcy.

Title to the key mortgage assets flow to the guarantor: They are bankruptcy-remote, and so are out of reach of creditors during a windup, and creditors pointedly include the deposit insurer.

Canadian banks currently have just over $100 billion in covered bonds outstanding, and regulatory room to issue perhaps $70 billion more. Doubling the cap, say, to 8 per cent of assets, would create an extra $170 billion in issuance capacity.

So raising the cap on covered bond issuance, which seems not just practical but an attractive idea for safely lubricating housing finances, could pose problems for the Canada Deposit Insurance Corporation. The CDIC must stand ready to compensate depositors, and the bigger the share of assets that is bankruptcy-remote, the smaller the pool of assets available for them to seize, hence the higher the premium they must charge for insurance coverage.

Clearly this matters only in the event of the failure of a major Canadian bank, and many of us may regard this as inconceivable. A deposit insurer like CDIC cannot afford to think that way, and would take careful note of the failures and windups of major banks in the past decade in Scotland, the U.K., the U.S., Germany, Spain … and, and, and.

Now, CDIC assesses premiums according to the amount of insured deposits that customers park with deposit-taking institutions; the premiums are therefore a tax on deposit-taking or deposit-making activity. Taxing depositors more, to make life easier for borrowers and lenders, does not sound terribly appealing.

To make it more palatable, my thinking is that we lift a page from the Dodd-Frank banking reform act in the U.S. Dodd-Frank required the U.S.’ federal deposit insurer to change its assessment base from deposits to total assets less regulatory capital.

That makes deposit insurance less a tax on deposit-making or -taking, and more a tax on size, complexity, or leverage. The Americans did this because they wanted to harass the large banks in favour of the smaller, and community banks, for whom the business of deposit-taking was more of their business.

My rationale for making the same change in Canada is quite different: a quid pro quo for access to enhanced covered bond issuance capacity.

To recap, raising the regulatory cap on bond issuance would be good for homebuyers, banks and their shareholders. As things stand, it wouldn’t be so good for depositors if, owing to the change in bond issuance rules, CDIC saw a need to raise deposit insurance premiums.

However, a risk-based deposit insurance premium system, which collected premiums from banks depending on the amount of their risky assets, rather than the deposits they happen to take, could better balance the risks, costs and benefits of changes in the bond market.

I see a decent trade-off in this, which would make mortgage markets work better for the benefit of all Canadians. How the next government responds is the outstanding question.

Published in the Financial Post on September 2, 2015

Finn Poschmann, formerly vice president, policy analysis at the C.D. Howe Institute, is president and CEO at the Atlantic Provinces Economic Council.