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Harry Koza's Weekly Column

Delving into covered bonds


Harry Koza


14:33 EST Thursday, Jul 05, 2007



 It was only last February that the Office of the Superintendent of Financial Institutions (OSFI) said in an advisory that it expected "Canadian deposit-taking institutions to refrain from issuing covered bonds until regulatory and policy concerns have been resolved." Yeah, right, I thought, that'll likely happen the day after bank mergers are finally allowed.


But just last week, OSFI announced that it had concluded its initial review of the concept, and would now allow the issuance of covered bonds by domestic deposit-taking institutions (DTIs), subject to a few limiting conditions, namely that total covered bond issuance must be limited to 4 per cent of the DTI's total assets, that total assets for purposes of the limit will be equal to the numerator of the DTI's asset-to-capital multiple, and that the DTI would amend its pledging policies to take specific account of these instruments.


Wow, that was easy! By now, of course, you are likely thinking, what the heck is a covered bond anyway, and why should I care?


Covered bonds are the latest thing in the bond world, but they are also a very old idea, which dates back to the Austrian succession wars of the 1700s, when farmers got the loans necessary to keep running their farms during the troubles by using agricultural land as collateral. Essentially, a covered bond is a debt instrument secured by a covering pool of mortgage loans - or, as is the case in some European countries, public-sector debt and even loans on ships - as collateral to which the covered bond investors have a preferential claim in the event of a default. They're actually a lot like mortgage-backed securities (MBS), except that the underlying assets stay on the issuing bank's balance sheet rather than being assigned to a trust that issues the MBS.


Since those 18-century agricultural loans, there have been a pile of the things issued in Germany, where they are known as Pfandbriefe, of which there are ?1.1 trillion ($1.6-trillion) worth outstanding. The Pfandbriefe is the largest homogenous asset class in the European market and the sixth largest bond market in the world. In all of Europe, there were ?1.8-trillion worth of covered bonds outstanding at the end of 2005. And they are spreading.


There have already been a couple of Canadian dollar Maple covered bonds issued in Canada by foreign institutions. And while Australia's regulators banned the things a year or so back, many (20) European countries already permit covered bonds or are in the process of enacting regulatory frameworks to allow them. In the United States, Washington Mutual became the first covered bond issuer last fall, with a euro-denominated offering, and Bank of America recently became the first to issue a domestic U.S. dollar deal.


Both issuers and investors love covered bonds, though regulators have some concerns. Covered bonds are senior debt for issuing institutions, and so they rank equally with deposits. But bank regulations are designed to ensure that depositors come first in the event that any bank becomes insolvent, and covered bonds, with their extra layer of security, seem to create a class of depositors that ranks ahead of other depositors, which reduces the available assets securing those other depositors and their ultimate backstop, the Canada Deposit Insurance Corporation. So regulators need to get the rules right before they can allow the things to be issued.


Issuers love covered bonds because they let them borrow cheap, long-dated funds in big size. At the long end of the curve, due to the extra collateral covering these bonds, they are cheaper to issue than conventional senior bank debt. So issuers mostly use their senior debt programs to finance in the under-five-year part of the curve, and issue covered bonds at the longer end. Banks get funding diversification and save money. Plus, the mortgage collateral stays on the bank's balance sheet, which gives a bank more flexibility in dealing with its retail customers - it's hard to change the terms on your mortgage when it's been securitized and sold to someone else.


Investors love the things because, since covered bonds are liabilities of the issuing bank with a whack of extra collateral, they get essentially the same credit quality as government debt (triple-A), with some extra yield. Plus, the issues are generally large enough so that they are liquid and can be actively traded. Canadian banks will now have access to the vast and liquid European covered bond market, where Pfandbriefe, Cedulas (Spain), obligations fonci?res (France) and other variants are already hugely popular.


The upshot of all this for Joe Canuck will be that this new financing flexibility for the domestic banks will lead to increased financing flexibility for their customers too, in the form of longer-term mortgages, lower rates and general customer-friendliness. Plus, if our governments ever manage to get their heads out of their fundaments on the subject of privately-financed infrastructure, covered bonds might be a good way to help finance the long overdue renewal of Canada's crumbling infrastructure.




Harry Koza,


Sr. Market Analyst,


Thomson Financial,


36 Green Meadow Crescent


Richmond Hill, Ontario,


L4E 3W7









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