Yearly Archives: 2020

Covered Bonds – Flight to Quality

Posted on by

Critical Liquidity Source in Times of Stress

In the past ten days, covered bonds have shown their value in a crisis for the Canadian banks. They have issued covered bonds in Europe at least seven times in that last ten days. When senior debt and ABS is difficult to bring to market, covered bonds have a ready investor base. Covered bonds represent a flight to quality when markets are difficult. The Canadians have been so successful that they have irritated European funding officials. See the story in Global Capital.

Canadian banks survived the last financial crisis in better condition than perhaps any other OECD banking system. And the Canadian banking system, although relatively small, remains one of the preeminent banking systems in the world. The six major Canadian banks dominate the banking market in Canada. They are quite conservative. They tend to follow each other and particularly the traditional leader, Royal Bank of Canada. Compared, for example to the banking system in the United States, the Canadian banks have had remarkably few crises. It is a close-knit community and a comfortably profitable business in Canada.

When the crisis created by the coronavirus COVID-19 began to envelope the Western world, the Canadian banks moved quickly to shore up their liquidity. An important tool for accomplishing this has been covered bonds. In uncertain times, investors tend to seek sovereign paper in a flight to quality. Covered bonds provide an attractive alternative to sovereign paper. Covered bonds have a similar risk profile to sovereign bonds but generally provide better yields.

Why did the banks choose Europe to issue their bonds? Because of favorable currency swap costs. And the market proved quite receptive. Even though there were at times two or three Canadian banks in the market at same time, they all managed to issue benchmark-size offerings at favorable rates. There was clearly an investor hunger for safe assets with a decent yield and the Canadians met that need quickly. They were in and out of the market before their European competitors had even contemplated challenging the market turmoil.

And although the Canadians deserve credit for moving quickly, the moral of the story is really the value of covered bonds in stressful times. As it did during the financial crisis, the covered bond market continues to be open and available to provide critical liquidity when other finding sources are spotty or not available at all. And just to note, this is a funding tool that U.S. banks do not have access to.

Sub-Prime Mortgage Loans

Posted on by



 

A New Narrative

A lot of ink has been spilled assigning liability for the financial crisis to sub-prime mortgage loans.The role of sub-prime mortgage loans was so prominent that it has been called the ‘sub-prime crisis’. But a recent study by the New York Federal Reserve Bank shows how wrong this conclusion is.

In a paper published on Liberty Street Economics, “Did the Subprime Borrowers Drive the Housing Boom?”, (https://libertystreeteconomics.newyorkfed.org/2020/02/did-subprime-borrowers-drive-the-housing-boom.html) the authors demonstrate quite clearly, for example, that inflated appraisals were not concentrated in sub-prime mortgages.

They also demonstrate that the boom in house prices and sub-prime mortgage loans occurred in different places (see the maps below). They show a clear negative correlation between house price appreciation and the sub-prime share of home purchase mortgages.

As the authors say, “Our analysis contributes to a ‘new narrative‘ that rapid U.S. house price appreciation during the 2000s was mainly driven by prime borrowers. Hence, policy prescriptions intended to limit access to credit for marginal borrowers may be insufficient by themselves to prevent a future housing boom.”

Reg AB II — BNS SEC Filing Expires

Posted on by

BNS SEC Filing Expires

On September 9, 2016, the SEC registration statement of Bank of Nova Scotia for its covered bonds expired without renewal.*  This was followed by the pricing on September 13, 2016, of a $1.5 billion offering of five year covered bonds by BNS in a 144A private placement.  Apparently BNS, like BMO, has abandoned the SEC registered format for its covered bonds. 

On inquiry, BNS stated that …….  This action now leaves Royal Bank of Canada as the sole Canadian bank with an SEC registered covered bond program.* 

The RBC program was inaugurated in September 2012 to much acclaim.  While RBC has not publicly stated what action it will take regarding the loan-level disclosure requirements imposed under Regulation AB starting in November 2016, the response of BMO and BNS suggest that there may be no further issuances of SEC registered covered bonds after November.  This will certainly be a disappointment to investors and will increase the funding costs of the banks.

Reg AB II — BMO Abandons SEC Filing

Posted on by

BMO Abandons SEC Filing

On December 16, 2015, Bank of Montreal quietly withdrew its SEC registration statement for covered bonds.  The registration statement became effective on November 8, 2013.   The registration statement was originally filed in July 2013.   Prior to the filing, BMO had obtained a no-action letter from the SEC staff to permit the Guarantor to register its Guarantee on the same shelf registration statement as the bond to be issued by the bank. 

On inquiry, BMO reports that there were a number of reasons for their withdrawal of the registrations statement.  One of the reasons for the withdrawal was the prospect of needing to comply with the loan-level disclosure requirements of Regulation AB beginning in November 2016.   That compliance requirement arose from the conditions imposed on BMO by the no-action letter.   BMO cited the uncertainty of its ability under Canadian law to provide the information required and the significant cost of altering its systems nationwide to collect the information.

This is the first of the three Canadian banks with SEC registration statements to react publicly to the new loan-level disclosure requirements imposed by the SEC.   (See Regulation AB II and Canadian Covered Bonds– the end of SEC registered covered bonds?).   This action suggests that the other two banks, Bank of Nova Scotia and Royal bank of Canada, may cease issuing SEC registered covered bonds by the November 2016 date.   Neither of the two banks, however, has publicly stated its intent in this regard.

EU Covered Bond Framework

Posted on by

EU Covered Bond Framework

December 2019 saw the enactment in European Union of a Covered Bond Framework consisting of a Covered Bond Directive and a Covered Bond Regulation to harmonize covered bond legislation across the Member States of the EU. Member States are required to adopt and publish laws, rules and regulations by July 8, 2021 necessary to comply with the Directive, which shall be effective not later than July 8, 2022. Covered bonds compliant with the Covered Bond Directive are treated preferentially under the Capital Requirements Directive (as amended by the Covered Bond Regulation) and may qualify for credit quality step 1 under the Liquidity Coverage Requirement Regulation. Covered bonds are defined under the Directive to be covered bonds issued by credit institutions subject to the Capital Requirements Directive. Accordingly, covered bonds issued by Canadian or Australian or other third-country issuers of covered bond will not qualify for preferential treatment under the Capital Requirements and will therefore be less attractive to investors that are EU credit institutions than covered bonds issued by EU credit institutions. This disadvantage is addressed under the Directive by a requirement that “[t]he Commission should therefore, in close cooperation with EBA, assess the need and relevance for an equivalence regime to be introduced for third-country issuers of, and investors in, covered bonds”. And that “[t]he Commission should, no more than two years after the date from which Member States are to apply the provisions of national law transposing this Directive, submit a report thereon to the European Parliament and to the Council, together with a legislative proposal, if appropriate.” The report of the Commission on the need for an equivalence regime therefore needs to be delivered to the European Parliament no later than July 8, 2024. There is no basis to predict when equivalence legislation, if any, might be adopted. The bottom line is that third-country issuers from Canada, Australia and other jurisdictions are likely to be at a disadvantage until at least 2025.

U.S. Legislation in 2020

Posted on by

U.S. Legislation in 2020

Where are we with U.S. legislation for covered bonds starting 2020?

First, we are in a highly contentious and partisan presidential election year. A few days ago CNN reported that there was a tie for the most admired person in the United States: Donald Trump and Barak Obama. The division is deep and wide.

Second, the possibility for bi-partisan legislation is not high, but there has been some bi-partisan legislation, even during the impeachment hearings in the House. For example, the amended North America Free Trade Agreement was passed. So there is some possibility of passage of legislation, as there always is even in an election year.

Third, it is unlikely that covered bond legislation will be separated from GSE reform, because GSE reform will inevitably examine housing finance and the role of the government in housing finance. Until that is settled it probably makes little sense to initiate a new form of housing finance in the form of covered bonds.

It seems very unlikely that covered bonds would not be a viable form of housing finance in a post-GSE reform world, but why put the cart before the horse.

That leaves us with the question of the prospects for GSE reform in 2020. The GSEs have now been in conservatorship for more than 10 years. The current situation of the GSEs is obviously acceptable to many sectors. Nevertheless, there remains a desire to resolve the situation and clean up this unfinished business.

In June 2018, the President of the United States released a reform and reorganization plan entitled “Delivering Government Solutions in the 21st Century.” This plan includes a proposal to convert Fannie Mae and Freddie Mac into private sector entities, to provide an express government guarantee of mortgage loans to Fannie, Freddie and other qualifying entities, and to restructure financial support for low and moderate income family mortgage loans into the Department of Housing and Urban Development.

In March 2019, the President issued a Presidential Memorandum directing the Secretary of the Treasury to develop a plan to reform housing finance. In September 2019, the Department of the Treasury issued The Treasury Housing Reform Plan. While the Plan provides many specifics for the resolution of the conservatorship of Fannie Mae and Freddie Mac, much of the Plan is dependent on enabling legislation, the prospects for which appear rather bleak in this strained political environment. As part of the plan, the Federal Housing Finance Agency, as Conservator of Fannie and Freddie, exercised its administrative power in the fall of 2019 to permit the GSEs to retain their profits and begin rebuilding their capital as an initial step to resolving the conservatorships. This step increases the pressure on Democrats in Congress to agree to a resolution of Fannie and Freddie.

In 2020, we may see additional administrative action from FHFA that will increase pressure on the Democrats to come to the table on GSE reform. Democrats will be reluctant however to agree to any significantly undesirable changes to the GSEs while there exists a fair prospect for taking over the White House this year and taking more control of GSE reform. Accordingly, we are most likely waiting until 2021 to see any real movement in GSE reform.