Canada’s Department of Finance has published a consultation paper (the Paper) [http://www.fin.gc.ca/activty/consult/cb-os-eng.asp] which sets out a proposed legislative framework for covered bonds for federally regulated financial institutions (FRFIs) in fulfillment of a promise made by Minister of Finance Jim Flaherty in the Government of Canada’s March 2010 Budget.

BACKGROUND

The recent upheavals in global markets have increased the cost of raising capital for financial institutions around the world, especially for those whose credit ratings and/or reputations have fallen. Increasing regulatory capital requirements over the next several years, the need to re-establish acceptable capital levels in the short term and declining interest in securitize loans have prompted an increasing interest in “covered bonds”.

While many may not be familiar with these instruments, they have a long history. They were originally issued by governments where the regime’s continued existence, and therefore ability to tax and pay was in question, triggering lenders’ demands for specific hard assets as collateral. In more recent times, where new lenders have not been prepared to lend to a financial institution based on the promise to pay and share pro rata with other lenders in the event of a default, the institution has chosen or has been forced to set aside specific collateral as security for the benefit of the new lenders in priority over other lenders and creditors.  

Covered bonds are debt instruments that have recourse either to the issuing entity or to an affiliated group to which the issuing entity belongs, or both, and, upon an issuer’s default, also have recourse to a pool of collateral, called the “cover pool”, separate from the issuer’s other assets. The cover pool usually consists of high quality assets (e.g. residential-mortgage backed securities or public debt instruments).

Typically, covered bondholders have a privileged or preferential claim (embodied in statute in various European jurisdictions) against the cover pool in the event of the issuer’s insolvency and a pro-rata claim with respect of other assets of the issuer. The collateral remains on the issuer’s balance sheet. In contrast, in a securitization, an investor only has recourse to the special purpose entity that issues the securities and to that issuer’s assets, which include the asset pool and its cash flows. From the issuer’s perspective, covered bonds remain on the issuer’s balance sheet, whereas securitized assets are off balance sheet.

In Europe, there is a fully developed covered bond market which Canadian banks have accessed. Given the extra security of the cover pool, Canadian banks have been able to obtain funding at lower rates. Unlike the case in certain European jurisdictions, currently there is no legislative framework in Canada which establishes a statutory claim for covered bondholders to the cover pool in preference to the interests of other lenders, such as depositors. The claim of covered bondholders is based on contract. Without legislation establishing the preferred position in Canada, it continues to be necessary to consider whether a FRFI can set aside a cover pool without breaching the terms and conditions applicable to other sources of capital, other contractual constraints and requirements of any applicable deposit insurer.  

KEY ASPECTS OF THE PAPER

The Government’s intention is to establish a legislative framework that strikes an appropriate balance between the interests of covered bondholders and other creditors, whether secured or unsecured. The establishment of a new regime for covered bonds raises a number of key issues, concerns and questions. The Government is seeking input with regard to a number of fundamental questions including:

  1. Should there be certain standardized features to assist in the development of a robust, deep and liquid market?  
  2. Should the coverer pool be segregated through the sale to a special purpose vehicle (SPV) to simplify matters in the event of default, or should the covered pool be segregated by use of a registry?  
  3. Is there an advantage of requiring all SPVs be of a specific type in the event of an insolvency?  
  4. Should there be a list of eligible assets or prohibited assets that can be held by a cover pool?  
  5. Should steps be taken to encourage the use of uninsured collateral (such as uninsured residential mortgages) in cover pools?  
  6. Should eligible issuers have to “register” prior to issuance of covered bonds?  
  7. Should there be a maximum level of overcollateralization?  
  8. If an asset in a cover pool is no longer eligible, what standards should apply to assets added to the cover pool to meet applicable on-going collateral requirements, and should there be a limit to percentage of assets that can be added?

NEXT STEPS

While OSFI has limited covered bond issues by deposit taking FRFIs to 4% of total assets, it is anticipated that the implementation of a statutory regime will allow this limit to be raised. The legislation is important to non-deposit taking FRFIs as it is anticipated that they will sell assets to issuing FRFIs who will aggregate assets in cover pools and the savings on funding will be split in some manner between issuing and non-issuing FRFIs.  

The comment period on the Paper ends on June 10th. The importance of responding to the request for comments cannot be overstated as once the legislative structure is formally proposed, significant modification will be more difficult.