‘Relax restrictions’ on covered bonds, say C.D. Howe experts

The federal government should make it easier to access covered bonds to mitigate the risk to taxpayers from “excessive borrowing,” a memo from the C.D. Howe Institute says.

If you’ve never heard of covered bonds, here’s a quick primer: not guaranteed by the government, these bonds are “high-quality debt instruments issued and fully-backed by banks, and are covered by uninsured mortgage loans (i.e., loan-to-value ratios below 80%),” say senior policy analyst Jeremy Kronick and researcher Nikki Hui from the C.D. Howe Institute.

They prepared the memo for Jeremy Rudin, who heads the Office of the Superintendent of Financial Institutions (OSFI). The memo discusses covered bonds as an alternative to “taxpayer-backed mortgage insurance,” which may be linked to “excessive borrowing” under rising housing costs, and which leaves taxpayers on the hook if loans go bad.

Kronick and Hui suggest that OSFI “relax restrictions” on covered bonds to mitigate the risk to taxpayers of such borrowing.

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“This vehicle for financing would help develop Canada’s private-label residential mortgage-backed securities market,” the memo says.

The writers add that major banks “have continually increased their use of covered bonds as a source of funding. [Ten] percent of Canada’s residential mortgages are now funded by covered bonds.”

A potential issue, however, is banks are limited in how many covered bonds they can use. Currently, the memo says, “covered bonds cannot exceed 4% of a financial institution’s total assets.” While “banks have not yet been constrained by the limit,” the experts predict that “new OSFI stress test requiring all buyers to prove they can afford a 2% increase in interest rates is likely to change that.”

The demand for covered bonds may rise and create issues, say Kronick and Hui.

Read the full memo.

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