Covered Bonds Explained – Ask a Vancouver Mortgage Broker

Covered Bonds Explained

Chances are, unless you work in something related to finance or the housing industry, you’ve probably never heard of “covered bonds”. Though I’m sure you’d be happy to hear that they indirectly help provide homeowners (including yourself) with low mortgage rates. They also help give mortgage borrowers additional options.

We will delve into a little bit of the history behind the covered bond market in Canada, to see how covered bonds play a role in the everyday life of lenders and borrowers.

Covered bonds: what are they and where do they come from?

Financial institutions issue covered bonds. These bonds are backed by both, the good credit of the institution, and a large amount of collateral (such as mortgages). They make offering low mortgage rates on the part of banks a little bit easier.

Covered bonds aren’t necessarily new to the real estate financing industry. They were first used in Europe in 1769. But as of today, Denmark is the most prolific issuer of such covered bonds; it issued about $200 billion worth of them in the prior year. Germany also issues a substantially large amount of covered bonds.

Despite their popularity abroad, it was only 4 years ago when covered bonds made their way to Canada. But since then, they’ve been sold like crazy by large financial institutions. Investors like covered bonds because they offer a superior return when compared to similar investments, and are also considered very safe. Consult your trusted mortgage broker in Vancouver for a more detailed explanation of covered bonds and how they help provide you with the best mortgage rates in BC.

According to an expert on the subject at a large bank, there is an “opportunity for substantial growth” within the covered bond market. They would grow even faster and potentially be even more important in the absence of regulation restraining their proliferation.

Why are covered bonds important?

The reason lenders like covered bonds is because they are a comparatively inexpensive source of funds for mortgages. And the cheaper a bank can borrow funds, the more easily it can offer low mortgage rates.

Another advantage is that covered bonds can be issued at any time during the year, as opposed to CMB’s which can only be issued according to a schedule mandated by the CMHC.

They can also be issued in vast quantities. Large banks are allowed to issue substantially more covered bonds on a yearly basis then CMBs. A few large banks are permitted to issue up to $20 billion worth of such covered bonds on a yearly basis.

Covered bonds, as an extra source of funding, allow financial institutions to lower their funding costs. Hypothetically, Cheap funding should be able to be passed on to borrowers in the form of low mortgage rates.

But before we speak too soon…

Stunted growth appears on the horizon for covered bonds in Canada. This is because the OSFI puts a cap on the total amount that any single financial institution is allowed to issue. Currently, the cap stands at 4% of the financial institution’s assets. Even though it reportedly has $353.7 billion in assets, CIBC is already nearing its limit for covered bonds. Consultant an honest mortgage broker for more information on what effect this might have on you.

This 4% limit also makes things difficult for smaller financial institutions. Their comparatively lower levels of assets makes issuing covered bonds not nearly as cost-effective. Credit ratings also make things much more difficult for smaller financial institutions engaged in real estate financing.

Bare in mind that the 4% limit imposed by the OSFI is essentially arbitrary. Australia, which has a very similar banking environment to Canada has decided on a covered bond cap of 8%.

The theoretical risk (and the reason to establish a low percent limit) is that many homeowners default at the same time. In such a situation, financial institutions might be unable to cover their losses.

Due to lingering fears from the recently passed credit crisis, it’s probable that the OSFI will not change its cap in the near future

But then again, the stable balance sheets of Canada’s financial institutions makes a potential catastrophe very unlikely. A little more slack for banks from the OSFI probably wouldn’t hurt.  If you’d like to learn more about this topic, we recommend contacting your Vancouver mortgage broker.