Covered bonds from north of the border are changing, and could be making a comeback here.
Canadian covered bonds have been on “hiatus” pending the development of dedicated legislation, but the potential for U.S. investment is promising if you consider that about 80% of Canadian covered bonds issued were U.S.-dollar denominated prior to the introduction of a legal framework, Fitch senior director Vanessa Purwin said.
However, “What’s going to come back is going to look a lot different than what’s been issued because it’s uninsured paper,” noted Fitch senior director Suzanne Mistretta.
But given that “there has been a ton of demand for RBC’s paper, and that’s uninsured,” there does seem to be potential for interest, especially given that the Royal Bank of Canada’s bonds did have their way paved into this market by a Securities and Exchange Commission no-action letter.
That being said, “There are some concerns with the housing market in Canada,” Mistretta noted. “It’s overvalued, but it is hard to say by how much.”
Fitch plans to be the first ratings agency to shed some light on this and at press time had a Canadian home price model pending, the two Fitch analysts said.
“Our estimates are slightly more conservative” than others, Mistretta said, noting that her sense of consensus is that just some areas like Toronto are overvalued because of excessive construction, but Fitch’s estimates that do not adjust for nominal declines over time paint a better picture than the real price projections others have released.
“I think the economy is slowing down and we may see a home price correction soon,” she said.
However, she added that “it’s very hard to tell with Canada because they haven’t had a stress” like the one the U.S. market experienced.
“They don’t have an underwriting problem like we did,” said Mistretta, noting that the banks do not play in the subprime market or have risk-based pricing, and the nonbank subprime market Canada has is relatively small.
“They did play a little with the products,” she said, noting that there was adjustment to the amortization terms, and the variable-rate mortgages in the market allow payments to remain unchanged while allocations to principal and interest change upon rate adjustments. “But you don’t have piggybacks or silent seconds like you had in the U.S.” and there is no mortgage interest deductibility, Mistretta said.
Nevertheless, Canadian homeowners have become “highly levered, and I think that’s what has everyone nervous,” she said.
Investors may take some comfort in that Canadian loans are shorter-term—renewing every five years—and have recourse, although there is some speculation that the government could waive recourse in the event of a crisis, given the precedent set by U.S. government modification and refinancing programs that give mortgage borrowers a break.
But that’s “yet to be tested,” she noted.
Whether the U.S. might ever develop its own legal framework for covered bonds remains a question.
“It depends on how amenable the FDIC is,” Purwin said, noting that while Canada has addressed the question of how access to the cover pool might be affected in a bankruptcy, the U.S. has not resolved this.
