Friday, June 29, 2007

Banks Can Now Issue Covered Bonds

Financial Post, Barry Critchley, 29 June 2007

The federal financial services regulator, the Office of the Superintendent of Financial Institutions, has given the green light for financial institutions to issue covered bonds, a form of security that has been used in Europe for more than 250 years and is now enjoying a growth in popularity.

At least one big bank is already lining up to hit the market with a massive issue of the attractive securities.

After reviewing the regulatory considerations from financial institutions issuing covered bonds, OSFI "has decided at this time to limit the issuance of covered bonds."

Such bonds are in essence AAA-rated debt obligations issued by a deposit-taking institution and secured by assets, mostly mortgages of the institution or its subsidiaries.

One of the key limits is that covered bonds cannot make up more than 4% of the assets of a deposit-taking institution. Four months ago, OSFI requested financial institutions refrain from issuing covered bonds pending the outcome of its review.

In its decision, OSFI spoke of the benefits and concerns for institutions issuing covered bonds. It was impressed with the funding diversification and lower costs that flow to the issuers. But it was concerned the bonds create "a preferred class of depositors, reducing the residual level of assets available to be used to repay unsecured creditors."

The term "covered" is used because if the financial institution is unable to make interest and capital repayments on the bond, investors have access to the underlying mortgages for repayment.

The OSFI decision means the race is on to see which local financial institution will be the first to issue covered bonds.

It's understood Royal Bank of Canada, the country's largest bank, is gearing up to try and capture a piece of a large, liquid and growing market.

Total global issuance of these bonds is expected to reach ?220-billion ($313.18-billion) this year.

The talk in the market yesterday was that RBC would unveil a ?15-billion ($21.37-billion) program by year-end. In this way, the program is similar to a shelf filing in Canada.

RBC has declined comment.

Sources indicated that if RBC does unveil such a program, it will raise capital via a series of bite-size chunks, likely in the ?2-billion to ?3-billion range.

The bank is believed not to be interested in receiving euros, so it will swap proceeds into dollars. The result is that it will raise capital at an attractive rate, certainly lower than what the institution pays for its capital.

Covered bond issues differ from an offering of collateralized mortgage-backed securities. In those deals, the issuer is a stand-alone entity.

With a covered bond, the bank is the issuer --meaning the financing is "on balance sheet."

In a business dominated by German and Spanish banks, only two U.S. financial institutions, Bank of America and Washington Mutual, have raised capital using these bonds.