The federal government has finally cracked down on covered bonds – and rightfully so.
Under new legislation put forward in the House of Commons, covered bonds can no longer include mortgages insured by Canada Mortgage and Housing Corp., or by private companies such as Genworth Financial or PMI Mortgage Insurance Co.
The rule changes mean that federally guaranteed mortgage insurance, paid for by homeowners, can no longer be used to get Canada’s financial institutions a cheaper cost of funding.
Here’s how they saved money before. Covered bonds are securities issued by major financial institutions, in which the sellers package a bunch of mortgages on their balance sheet. These assets are often insured by CMHC, which means the resulting covered bonds are implicitly guaranteed by the government.
The odd thing, however, is that this insurance is paid for by the homeowner. So the individual pays for it, the federal government guarantees it, and the financial institution benefits with little or no cost.
The new rule change was widely expected, and the banks have been proactive because they assumed it was coming. Over the past few months, they issued a flurry of covered bond offerings to raise cash on the back of as many insured mortgages off their books as possible.
However, the additional costs that the banks will have to pay in the form of more expensive funding may not be that high. As we pointed out last week, Canaccord Genuity analyst Mario Mendonca ran the numbers and estimated that “the additional cost of uninsured versus insured mortgages in covered bonds range from a low of 10 basis points to a high of 20 basis points.” Using the more conservative number, “the additional cost to the industry would be only $120-million or 0.7 per cent of domestic retail pretax income over the last 12 months.”
Covered bonds have exploded in Canada since Royal Bank of Canada first experimented with the structure a few years back. Before that, the securities were mostly confined to Europe.
**Editor's note: A previous version of this post said mortgages packaged into covered bonds are taken off balance sheet. This only happens for typical securitizations. Mortgages in the cover pool remain on the balance sheet, and institutions must hold capital against them.