Impact of Canadian Covered Bond Legislation
- CMHC is required to establish and maintain a registry of covered bond Issuers and programs.
- Collateral in the cover pool is limited to Canadian residential mortgage loans, securities issued by the Government of Canada and such other assets as may be prescribed by regulation.
- Mortgage loans insured by CMHC or other mortgage insurers may not be included in the cover pool.
- Statutory insolvency protections will apply for registered covered bond programs.
- Canadian banks will at some future date be prohibited from issuing non-registered covered bonds.
Requirements Imposed by the CMHC Registered Covered Bond Programs Guide
- Existing Canadian covered bonds program structures are largely codified.
- Compulsory disclosure obligations apply, including mandatory new valuation calculations.
- Ratings triggers will be relied upon to determine an Issuer's obligations to replace the account bank and swap counterparty as well as to collateralize contingent swaps on a mark-to-market basis.
- No caps are set on an Issuer's aggregate amount of issuance but OSFI's cap remains in place at 4% of the Issuer's aggregate assets.
Canadian banks and other federally incorporated financial institutions may now begin applying for registration of covered bond programs under Canada's new legislative covered bond regime pursuant to federal legislation enacted in June 2012 and new guidelines for covered bond programs issued in December 2012.
The legislative framework now set out in the National Housing Act (Canada) (the NHA) mandates the establishment by the Canada Mortgage and Housing Corporation (CMHC) of a covered bond registry and provides statutory protections for bondholders' interests in cover pools backing registered covered bond programs. These protections will provide further reassurance to investors in AAA-rated covered bonds that the cover pool assets that are sold by the financial institution issuing covered bonds (the Issuer) to the Issuer's special purpose vehicle that guarantees the registered covered bonds (the Guarantor) will be available to satisfy the Guarantor's covered bond guarantee following an insolvency of the Issuer.
Registration of covered bond programs requires the Issuer to complete a comprehensive application process established by CMHC and described in the covered bond program guide issued by CMHC on December 17, 2012 (the Guide). The Guide also imposes numerous requirements on covered bond programs that in large part codify the provisions set out in existing contractual (non-legislative) covered bond program documents but also introduces many important new requirements.
Prior to the introduction of the legislative covered bond regime, six Canadian banks and one provincial co-operative credit society established contractual (non-legislative) covered bond programs since 2008 which formed an increasingly important aspect of these institutions' funding platform for residential mortgage loan originations. Most or all of these banks are expected to establish new covered bond programs that satisfy the legislative requirements and the requirements of the Guide. Provincial co-operative credit societies will also be permitted to participate in the federal registry (and thereby provide bondholders the resulting statutory insolvency protections) at a future date to be determined by ministerial order.
ESTABLISHMENT OF A LEGAL FRAMEWORK FOR COVERED BONDS
The statutory covered bond framework was implemented as part of the Jobs, Growth and Long-term Prosperity Act (Canada) by way of an amendment to the NHA. Under the amended NHA, CMHC is mandated to establish a registry containing the names of institutions that have applied for registration and met the registration requirements, including giving the CMHC an undertaking that following its initial program registration, the Issuer will not issue any covered bonds except under a registered program. Once an Issuer is registered, it may apply for registration of its covered bond program (or, potentially, different programs) by providing the information required by the NHA and the Guide and any other information which CMHC considers necessary for the purposes of considering the application. The registry will be accessible to the public through the Internet but most registration information is submitted to the CMHC on a confidential basis.
The Minister of Finance is empowered to make regulations to carry out the purposes of the provisions of the covered bonds regime but it appears that no regulations will be adopted at this time. Instead, CMHC's Guide provides a comprehensive set of requirements that must be satisfied in order for an issuer and its covered bond program(s) to qualify for registration. Under the amended NHA, CMHC is empowered to establish conditions and restrictions applicable to registered issuers and registered programs.
MANDATORY DISCLOSURE OBLIGATIONS
In addition to requiring detailed prospectus-level disclosure be provided to CMHC regarding a proposed covered bond program as part of the registration process, Issuers are required under the Guide to provide to all investors and potential investors all material information in respect of the Issuer, the program and the relevant covered bonds upon establishment of a program, the issuance of bonds and thereafter on a continuous basis such that the investors can make informed investment decisions in respect of buying, selling or holding the bonds. This obligation applies even in respect of private placements though the disclosure may only need to be made to investors and potential investors.
Furthermore, if covered bonds are offered to the public in any jurisdiction, then a prospectus containing full, true and plain disclosure of all material facts concerning the bonds and the program must be publicly disclosed and the Issuer must maintain a public website with copies of all material contracts and monthly reports concerning the program (including in respect of privately placed covered bonds).
In addition, a new monthly reporting obligation will apply which requires Issuers to compare the current Canadian-dollar equivalent of the trading value of outstanding covered bonds to the calculated value of the cover pool reflecting a discounting of future payment obligations under mortgage loans, subject to capping mortgage loan values at 80% of market value (as adjusted in accordance with indexation methodologies that Issuers will be required to adopt).
Annual compliance certificates are also required to be generated by cover pool monitors reflecting detailed agreed-upon procedures and diligence requirements and these certificates must be posted to the Issuer's covered bond investor website.
ELIGIBILITY FOR REGISTRATION AS A COVERED BOND ISSUER
Mortgage lenders that are "federal financial institutions", as defined in section 2 of the Bank Act (i.e., banks, trust companies, loan companies, co-operative credit associations and insurance companies which in each case are federally incorporated)may apply for registration as "registered issuers" and provincial co-operative credit societies will also be permitted to apply for registration in the future. As noted above, to be qualified for registration as an Issuer, applicants will be required to give an undertaking to not issue any unregistered covered bonds once the Issuer has an approved registered program.
ELIGIBLE COVER POOL ASSETS: SUBSTITUTE ASSETS AND THE INELIGIBILITY OF INSURED MORTGAGES
Covered bond assets to be included in the pool of collateral securing the covered bonds are restricted to (i) residential mortgages on properties located in Canada and consisting of not more than four residential units, (ii) any prescribed assets (currently, no assets have been prescribed), and (iii) securities issued by the Government of Canada (Government Debt) and any other prescribed assets (collectively with Government Debt, Substitute Assets) subject to a cap on the value of such Substitute Assets at 10% of the total value of all of the assets held in the cover pool unless otherwise provided in the future by regulation. The Guide also clarifies that proceeds (cash) derived from eligible loans in the cover pool may be held in the cover pool and the Guide also expands the class of permitted Substitute Assets to include repos of Government Debt approved by CMHC and proceeds (cash) derived from Government Debt and such repos, subject to the value of such Substitute Assets (including proceeds thereof) not exceeding 10% of the total value of all assets in the cover pool.
The NHA imposes a general prohibition on the inclusion of mortgage loans that are insured by CMHC or any other specified insurance company from the pool of cover assets. The policy objective underlying this prohibition has been stated to be the reduction of reliance on government-backed mortgage insurance and the improvement of the liquidity of uninsured mortgages. The prohibition effects a fundamental change to the Canadian covered bond market given that the loans and/or mortgage bonds comprising the cover pool of six of the seven covered bond programs currently existing in Canada are made up exclusively of CMHC-insured collateral.
The NHAalso prohibits loans to be included in the cover pool if the loan-to-value ratio at the time of loan origination exceeded 80% (with the amount of the loan measured together with the amount then outstanding of any mortgage or hypothecary loan having an equal or prior claim against the property). However, banks that originate mortgages above an 80% LTV ratio are required to obtain mortgage insurance as a condition of extending the loan and accordingly such loans will generally already be prohibited from inclusion in the cover pool due to the existence of such mortgage insurance.
BANKRUPTCY AND INSOLVENCY PROTECTIONS AFFORDED TO COVERED BONDHOLDERS
The statutory protections afforded to investors in covered bonds is the primary impetus for seeking covered bond legislation in Canada. In particular, the NHA now provides that no stays or court orders in relation to any insolvency proceeding may prevent or prohibit actions taken in accordance with the contractual provisions of a registered program relating to the making of any payments (including payments to the Issuer), the netting or setting off (or compensation) of obligations, any dealing with covered bond collateral, or the termination of program contracts.
Furthermore, the transfers of loans and other assets to the bankruptcy-remote Guarantor under a registered program are made effective against every person, are not voidable, are not subject to other remedies available to creditors of the registered issuers and do not constitute a fraudulent conveyance, unjust preference or other reviewable transaction.
The Guide also tightens certain documentation and monitoring obligations, including by specifying requirements in respect of agreed-upon procedures to be conducted annually by an auditor in respect of the cover pool, as well as requirements to review and provide opinions in respect of powers of attorney and other documents relevant to the enforcement of bondholders' interests in the cover pool. In addition, powers of attorney and certain other key documentation and information must be delivered to a custodian to hold on behalf of the Guarantor.
ENFORCEMENT POWERS OF CMHC
CMHC has no direct prudential or regulatory authority over covered bond issuers except in respect of their covered bond programs and CMHC may not impose penalties or fines in respect of any failure to adhere to its Guide. However, CMHC is empowered to withhold registration if its requirements are not met or, upon notice, to suspend the right of a registered issuer to issue further registered covered bonds, which will also serve to revoke the statutory bankruptcy and insolvency protections for any covered bonds issued during the period of suspension. Outstanding covered bonds will continue to benefit from the legislative protections regardless of any such suspension.
APPLICATION FEES AND ONGOING FEES
CMHC is authorized by the NHA to determine the amounts of application fees and other fees to be paid by Issuers. In the Guide, CMHC has set C$700,000 as the fee to establish and launch a registered covered bond program in 2013 (inclusive of annual fees for 2013). The Guide does not indicate what annual fees may apply on an ongoing basis after 2013.
PROVISIONS NOT YET IN FORCE
The prohibitions against the issuance of covered bonds outside of the new legislative covered bond regime by Canadian banks and other federal financial institutions will come into force on such day or days as may be fixed by ministerial order.
The amendment to the NHA that enables provincial co-operative credit societies to apply for registration as registered issuers will also only come into force pursuant to a ministerial order.