Covered bonds have long been a source of cost-efficient and secure financing for lenders. A staple of European financing for nearly 200 years, covered bonds first made their way onto the Canadian banking scene in 2007. Since then, Canadian covered bonds have helped to lower mortgage rates (indirectly) and have provided borrowers with additional financing options. So just what are these bonds and why are some economists calling them the next hottest mortgage products? Read on to find out!
What is a Covered Bond?
To put it simply, covered bonds are bonds issued by a financial institution. What sets them apart from other bonds is that they’re backed by three layers of collateral:
- The institution’s good credit
- A pool of mortgages
- The taxpayers (through the Canadian Mortgage and Housing Corporation)
It’s this collateral that has investors and bankers chomping at the bit. Since these bonds are nearly always backstopped by the taxpayers through CMHC insurance, they’re considered an ultra-safe and ultra-smart investment. Plus they offer a better return than comparable investments.
How They Work
Since covered bonds are backed by a boatload of debt that’s considered “bankruptcy remote” (this means that in the event the issuer is unable to meet its obligations the collateral becomes the property of the investor), they provide unparalleled protection – both to the bank and the investor. To put it simply, if the bank hits a rough patch, holders of covered bonds would potentially get their money back even before the bank depositors.
The interest in Canadian covered bonds has increased exponentially since they were first introduced some five years ago. Last year, financial institutes sold a staggering $24.7-billion in covered bonds. That’s an increase of more than $7-billion from 2011.
What They Have To Do With Your Mortgage
Covered bonds are every banker’s best friend because they provide large lenders with a relatively cheap source of mortgage funds. What’s more, unlike Canadian Mortgage Bonds (CMBs), covered bonds can be issued whenever the bank wants. The big banks are also able to issue covered bonds in extremely large quantities. While CMB’s are limited to roughly $1.6-billion annually, some of the bigger Canadian financial institutions can fund upwards of $20-billion in covered bonds.
One of the biggest benefits of covered bonds is that they can act as an extra source of funds, allowing financial institutions to lower their cost of funding and pass savings onto consumers. Many banks also use the funds to allocate capital to uninsured/non-prime lending, which provides more options to homebuyers who are unable to qualify for traditional mortgages. Finally, covered bonds have made it easier for financial institutions to reduce their reliance on government-backed mortgage insurance.
But There’s a Catch
There’s a limit to how far Canadian covered bonds can grow. Currently, the Office of the Superintendent of Financial Institutions (OSFI) caps the amount of covered bonds that any one bank can issue. This cap is firmly set at just 4% of an institutions assets. Not surprisingly, this makes it difficult for smaller banks to issue enough covered bonds to make them cost effective. Since covered bonds are partially calculated by a financial institution’s credit rating, this also causes issuance problems for smaller organizations, which in turn makes it almost impossible for these lenders to directly fund mortgages through covered bonds.
Many in the financial world are pushing the OSFI to increase the cap on covered bonds in order to improve the market. Theoretically, this could be done without a lot of fallout – Australia, who’s banking market is similar to Canada’s, currently boasts an 8% ceiling on their covered bonds. But, given the current nature of the economy, and Canada’s foundation of financial conservatism, there appears to be little need for an immediate increase.
Still, the option isn’t entirely off the table. At some point, more access to covered bonds will become prudent, with consumers enjoying the bulk of the liquidity.