Author Archives: JRM

Videos

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These are videos from recent covered bond conferences and other events that relate to Canadian or U.S.$ covered bonds.


European Covered Bond Directive • Euromoney

Covered bonds and securitisations are easily confused • Euromoney

TCB Roadshow 2022 | The implications of growth: Canadian covered bonds in 2022 and beyond

Mayer Brown Webinar • 2020
Covered Bonds Update in the United States
Jerry Marlatt and Laura Drumm

US $ covered bonds – back again • Euromoney 2019

Equal treatment for non-EU covered bonds? What’s needed? • Euromoney 2018

Euromoney/ECBC Covered Bond Congress 2018, 13 September 2018 • Munich
Concerns about the Covered Bond Directive.

Euromoney/ECBC Covered Bond Congress 2018, 13 September 2018 • Munich
Outlook for the Canadian covered bond market and prospects for the U.S. market

Euromoney/ECBC Covered Bond Congress 2018, 13 September 2018 • Munich
Impact of MREL and TLAC on covered bond issuance.

Euromoney/ECBC North America Covered Bond Forum, 19 April 2018 • Vancouver
Keynote Address by Sandra Johnson, FHFA

Euromoney/ECBC North America Covered Bond Forum, 19 April 2018 • Vancouver
Interview with Sandra Johnson, FHFA

Euromoney/ECBC North America Covered Bond Forum, 19 April 2018 • Vancouver
Interview with Jerry Marlatt on “What Hope for America”.

Congressman Jeb Hensarling On Covered Bonds • 2010

Congressman Scott Garrett On Covered Bonds • 2010

Garrett Introduces Covered Bonds Amendment • 2010




Resiliency of Canadian Covered Bonds

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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.

Stellar Year for Canadian Covered Bonds

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A Smashing Year for the Canadians

2022 was a remarkable year for Canadian covered bond issuers. The Canadians issued 68 series of covered bonds in 2022 for an equivalent total of C$100,515 million, more than doubling the 30 offerings of 2021. There were 58 offerings in 2020, but 25 of those were retained offerings for repo with the central bank, so don’t count as public offerings.

In 2021, the Canadians were 20 per cent of the global market in covered bond issuance. While the final numbers for 2022 are not yet available, with 68 offerings it is likely that the Canadian banks have not slipped from that position.

In 2022, the Canadians issued in six different currencies: USD, A$, C$, CHF, £, and €. Euro was the most popular currency, with 29 offerings for €32,368 million, followed by the USD with 14 offerings for $24,705 million. RBC was the most active issuer with 18 offerings, followed by BNS with 14 offerings.

Some of the motivation for issuance likely was replacing funding obtained at the beginning of the pandemic from the Canadian central bank in 2020, when about C$90,000 million of covered bonds was taken to the central bank by the Canadian banks. Most of those loans from the central bank were two-year loans.

The elevated Canadian covered bond issuance was also responsible in large part for the largest U.S. dollar covered bond issuance since 2012. With a total U.S. dollar covered bond issuance of $32,500 million in 20 offerings in 2022, the Canadian banks accounted for $24,705 million in 14 offerings, well above their typical 50% of the market.

In 2023, Canadian banks have 43 series of covered bonds maturing, 16 of which are in euros and 13 in Canadian dollars. Of the maturing Canadian dollar series, ten of the series, representing C$33,500 million, were retained covered bonds transferred by repo to the central bank. With so many series maturing next year, it likely that 2023 is going to be another very active year for Canadian banks in covered bonds.

1Q22 – A Blistering Pace in 1st Quarter

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A Blistering Pace in 1Q22

It was a notable first quarter for Canadian covered bond issuers: 19 issuances across dollars, sterling and euros [see the table below].  All six of the major Canadian banks issued bonds.  On a Canadian dollar equivalence basis, the banks issued C$38.7 billion. Continuing a trend set last year, the Canadians represented 20% of covered bond offerings for the quarter — punching well above their weight. This activity is probably partly attributable to the heavy retained issuance by the banks at the start of the pandemic in March and April 2020, when nearly C$90 billion was taken to the central bank for funding. This was the inaugural covered bond repo program by the central bank. Issuance limits were temporarily increased at the time to support the central bank program and provide enhanced liquidity to the banks. Most of those covered bonds had two year maturities and are running off this year.
Pricing Issuer Series Cur. (mm) Coupon Maturity Tenor Spread Type
2022-03-30 National Bank of Canada CBL18 $ 1250 2.900 2027-04-06 5yr +65 144A
2022-03-29 Bank of Montreal CBL28 € 1750 1.000 2027-04-05 5yr +8 Reg S
2022-03-17 Toronto-Dominion Bank CBL34 € 2500 0.864 2027-03-24 5yr +11 Reg S
2022-03-17 Royal Bank of Canada CB69 € 150 1.296 2037-03-24 15yr +15 Reg S
2022-03-17 Royal Bank of Canada CB70 $ 1500 2.600 2027-03-24 5yr +65 144A
2022-03-15 Royal Bank of Canada CB68 € 2000 0.625 2026-03-25 4yr +9 Reg S
2022-03-08 Bank of Nova Scotia CBL42 € 2000 0.450 2026-03-16 5yr +10 Reg S
2022-03-03 CIBC CBL40 $ 100 SOFR+45 2025-03-10 3yr +45 144A
2022-03-03 CIBC CBL39 € 2500 0.375 2026-03-10 4yr +6 Reg S
2022-03-02 Bank of Nova Scotia CBL41 $ 2250 2.170 2027-03-09 5yr +58 144A
2022-03-02 Bank of Montreal CBL27 £ 600 SONIA+40 2027-03-09 5yr +40 Reg S
2022-02-02 Bank of Nova Scotia CBL36-2 € 100 0.623 2041-10-15 20yr +16 Reg S
2022-02-01 FCDQ CBL14 € 750 0.250 2027-02-08 5yr +5 Reg S
2022-01-20 National Bank of Canada CBL17 € 1000 0.125 2027-01-27 5yr +5 Reg S
2022-01-19 Bank of Montreal CBL26 € 2750 0.125 2027-01-26 5yr +6 Reg S
2022-01-18 Royal Bank of Canada CB67 € 2000 0.125 2027-01-25 5.25yr +6 Reg S
2022-01-17 Bank of Nova Scotia CBL39 £ 1300 SONIA+100 2026-01-26 4yr +28 Reg S
2022-01-17 Bank of Nova Scotia CBL40 € 1250 0.375 2030-03-26 8yr +10 Reg S
2022-01-11 CIBC CBL38 $ 2500 1.846 2027-01-19 5yr +48 144A/Reg S

Covered Bonds – Flight to Quality

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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

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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.”

EU Covered Bond Framework

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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

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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.

U.S. Housing Overview

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U.S. Housing Overview

The continued conservatorship of Fannie Mae and Freddie Mac exposes taxpayers to continued risk. &nbsp The failure to address the GSEs and release them from the conservatorship evidences a significant failure of political will.

This chart from the latest monthly report from the Housing Finance Policy Center at the Urban Institute provides a fine summary of the government dominance of U.S. residential housing finance.   This imbalance with private sector financing is imposing significant risk on the GSEs and therefore on the government and taxpayers without analysis or justification.   There should be a fundamental analysis of the government’s housing policy and how much risk needs to be taken by the taxpayers in order to achieve the government’s goals.