The Covered Bond Report Issue 1
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The March 2011 edition of the Covered Bond Report focuses on the safety and potential of covered bonds in light of bail-in concerns, highlighting the evolving legislative landscape in the US and other regions. Key discussions include the regulatory challenges faced by the US Covered Bond Act of 2011, the gains seen in the UK and Australian markets, and the overall sentiment towards transparency and investor security in covered bonds. The report emphasizes the need for a stable legislative framework to support the growth of this asset class, while addressing concerns from regulators like the FDIC.
![44 The Covered Bond Report March 2011
FRANCE: OBLIGATIONS A L’HABITAT
couple of years at every conference where Michel Stubbe [head
of the market operations analysis division at the ECB] speaks
he says that we need to have a label and we need to have one
definition, so the fact that all the programmes will be covered
by one law, and be Ucits compliant, will certainly be appreciated
by them.
“It certainly helped push people along.”
Because the underlying assets remain dominated by prêts
cautionnés (guaranteed loans) rather than residential mort-
gages, the new obligations à l’habitat will not achieve Capital
Requirements Directive (CRD) compliance.
Not every issuer will be converted directly into an SFH;
Groupe BPCE will cease issuing covered bonds through GCE
Covered Bonds and Banques Populaires Covered Bonds and in-
stead issue through a new SFH, BPCE Home Loans.
Issuers, not structures, key
Whether or not French issuers will be rewarded by investors for
the introduction of the new law is another question. Some mar-
ket participants say that the conversion to obligations à l’habitat
is unlikely to have much of an impact on pricing, because struc-
tured covered bonds had been trading so well.
Stephane Bataille at Landesbank Baden-Württemberg says
that the lack of discrimination that French common law cov-
ered bonds have previously suffered is demonstrated by the nar-
rowness of spreads between covered bonds launched off BNP
Paribas’ Home Loans programme and by its société de crédit
foncier.
“The spread is between 2bp and 4bp,” he says. “So if Crédit
Agricole, for example, were to issue obligations à l’habitat now
then the advantage would be maybe 1bp-2bp.”
He argues that this is because the spreads at which covered
bonds trade are today more related to the credit of the issuer
than the underlying framework.
“It’s more credit related, more related to news-flow,” he says.
“Particularly if you are talking about strong names, you look
more at the issuer.”
He points to the way in which the relative pricing of com-
mon law and legislative covered bonds changed dramatically
between 2007 and 2010 as the financial crisis moved through
its different stages.
“Beforehand, there was a gap of perhaps 2bp between the
legal and structured issues,” he says, “so BNP Paribas and Dexia
Municipal Agency were trading at almost the same levels. Then
at the end of 2007 nobody wanted to buy structured covered
bonds and their spreads widened significantly versus obliga-
tions foncières.
“But at the end of 2008 and in 2009, this was completely re-
versed. Everyone only looked at the strength of the credit be-
cause of what happened to certain issuers. Nowadays the strong
structured covered bonds are trading well inside those of the
obligations foncières.”
Easing supply pressure
Heiko Langer, senior covered bond analyst at BNP Paribas, also
cautions against expectations that the new legislation could re-
sult in any sudden spread moves.
“I don’t anticipate prices moving too noticeably,” he says.
“These French covered bonds already trade pretty tight com-
pared with obligations foncières, and spreads are anyway very
much driven on an issuer by issuer basis, not so much structure
by structure.
“But it should make life a bit easier for the French issuers,”
he adds. “It will help the French issuers broaden their investor
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2006 2007 2008 2009 2010 2011*
French Contractual vs. Legal Jumbo Covered Bonds
French Contractual Covered Bonds French Legal Covered Bonds
Source: LBBW](https://image.slidesharecdn.com/thecoveredbondreport1-13080408430003-phpapp02-110614034348-phpapp02/85/The-Covered-Bond-Report-Issue-1-46-320.jpg)
The Covered Bond Report Issue 1
- 1. www.coveredbondreport.com March 2011 To the lifeboats! Can covered bonds offer safety after bail-in panic? Australia A whole new ball game Sterling UK gains home advantage US legislation The FDIC rears its head The Covered Bond Report THECOVEREDBONDREPORTMARCH2011WWW.COVEREDBONDREPORT.COMNUMBER1
- 2. CréditAgricoleCorporateandInvestmentBankisauthorisedbytheAutoritédeContrôlePrudentiel(ACP)andsupervisedbytheACPandtheAutoritédesMarchésFinanciers(AMF)inFrance andsubjecttolimitedregulationbytheFinancialServicesAuthority.DetailsabouttheextentofourregulationbytheFinancialServicesAuthorityareavailablefromusonrequest. We offer you our World of Solutions FIXED INCOME MARKETS Choose a bank which engages its Covered Bond expertise for the sole benefit of serving its clients. Crédit Agricole Corporate and Investment Bank continues to strengthen its global market presence in Debt Capital Markets and in Covered Bonds in particular. When it comes to Debt Capital Markets and Covered Bonds, there is no better partner for issuers than Crédit Agricole Corporate and Investment Bank. January2011 January2011January2011 January2011January2011 January2011 EUR 1,000,000,000 EUR 1,250,000,000 EUR 1,250,000,000 EUR 1,250,000,000 EUR 1,500,000,000 EUR 1,000,000,000 Joint Bookrunner Joint Bookrunner Joint Bookrunner Joint Bookrunner Joint Bookrunner Joint Bookrunner 4.25% French Obligations Foncières Due 2021 3.5% Dutch Legal Covered Bond Due 2018 3.9% French Covered Bond Due 2021 2.75% French Covered Bond Due 2015 4.125% Cédulas Hipotecarias Due 2014 4% Hypotheken Pfandbrief Due 2021 DEXIA MUNICIPAL AGENCY ABN AMRO CAISSE DE REFINANCEMENT DE L’HABITAT GCE BANCO BILBAO VIZCAYA ARGENTARIA ERSTE GROUP BANK AG EUR 1,000,000,000 Joint Bookrunner 2.75% Öffentlicher Pfandbrief Due 2016 BAYERISCHE LANDESBANK January2011February2011 January2011 EUR 1,250,000,000 EUR 1,000,000,000 EUR 1,000,000,000 Joint Bookrunner Joint Bookrunner Joint Bookrunner 5.250% Covered Bond (Italian OBG) Due 2023 4.25% French Obligations Foncières Due 2023 3.25% French Obligations Foncières Due 2016 January2011 UNICREDIT SpA SOCIETE GENERALE SCF CIF EUROMORTGAGE EUR 2,000,000,000 Joint Bookrunner 3.250% Dutch Covered Bond Due 2016 ING BANK N.V. February2011 EUR 2,250,000,000 Joint Bookrunner 2.625% French Covered Bond Due 2014 CREDIT AGRICOLE COVERED BONDS January2011
- 3. March 2011 The Covered Bond Report 1 CONTENTS FROM THE EDITOR 3 Aim high MONITOR 4 Legislation & regulation 8 Market 11 People & institutions 14 Ratings BUY-SIDE: ICMA’S CBIC 16 The voice for investors ANALYSE THIS: COVER POOL DISCLOSURE 19 Living with the data deficits Is legal or voluntary disclosure yielding the most useful information? Florian Hillenbrand, senior covered bond analyst at UniCredit, weighs the results and recommends how investors cope with a lack of transparency. 36 16 19 Cover Story BAIL-INS 36 Room for everyone? European Commission bail-in proposals have prompted senior unsecured investors to seek the security of covered bonds, raising fears of an over- reliance on the asset class among the buy and supply sides. But proponents warn that investors have nothing to fear but fear itself. By Neil Day and Maiya Keidan The Covered Bond Report
- 4. 2 The Covered Bond Report March 2011 The Covered Bond Report 22 STERLING MARKET 22 UK gains home advantage Last November the first sizeable sterling UK covered bond in four years kicked off what market participants hope could become a stable source of funding. Can UK financial institutions get better results at home? By Hardeep Dhillon COUNTRY PROFILE 28 Australia winds up for delivery After years of watching from the stands, Australia’s banks are taking a run up for issuance as early as the third quarter. The banking industry is therefore hard at work ensuring the right balance is struck between issuer and investor needs in impending legislation. But could RMBS and smaller banks be dismissed cheaply? By Neil Day OBLIGATIONS A L’HABITAT 42 France’s new model The latest fashion in Paris this spring is the obligation à l’habitat. Created by bringing France’s common law covered bonds under a legislative framework, the new instrument offers a new take on an old favourite. As such, can it command couture prices? By Neil Day LEGAL BRIEF 46 US: Today’s reality & tomorrow’s potential The US Covered Bond Act of 2011 has reignited the debate over whether legislation is necessary to seed issuance and, if so, how it should relate to the Federal Deposit Insurance Corporation. Lawton Camp and John Hwang of Allen & Overy in New York examine the proposed bill and the arguments being made against it. FULL DISCLOSURE 52 Postcards from Mainz and Washington 28 42 CONTENTS
- 5. March 2011 The Covered Bond Report 3 FROM THE EDITOR W elcome to the launch edition of The Covered Bond Report, the first maga- zine dedicated to the asset class. We launch at a critical moment in its history. After years of skirting the issue, the biggest market of them all, the US, is poised to make a decision on whether or not to put in place the foundations necessary for cov- ered bonds to thrive. This has thrown the spotlight on some of the funda- mental arguments surrounding the asset class, and never before have so many governments, regulators and inves- tors scrutinised the pros and cons of covered bonds in such depth. In Australia, interested parties are seeking to strike the right balance between issuers’ and investors’ needs after finally winning around public opinion. In the UK and elsewhere, investors new to the product are asking tough questions of issuers. And at a European level, the industry faces a battle to achieve what it considers cov- ered bonds’ rightful position to be under Basel III. An immediate focus of attention is transparency, a theme that runs through many of the articles in this issue. Among these is a column from the International Capital Market Association’s Covered Bond Investor Council, in which the buy-side’s agenda is laid out. If proponents of covered bonds are to win over scep- tics and doubters, to win over investors and regulatory authorities, they must engage them. Their opponents surely will. Few asset classes have come out of the financial crisis in such good shape as covered bonds, but being the least worst option is not enough. Neil Day, Managing Editor Aim high The Covered Bond Report www.coveredbondreport.com Editorial Managing Editor Neil Day +44 20 7263 2732 nday@coveredbondreport.com Reporter Maiya Keidan mkeidan@coveredbondreport.com Contributor Hardeep Dhillon Design & Production Creative Director: Garrett Fallon Senior Designer: Sheldon Pink Printing Wyndeham Grange Ltd Advertising Sales ads@coveredbondreport.com Subscriber Services subs@coveredbondreport.com Editorial editorial@coveredbondreport.com The Covered Bond Report is a Newtype Media publication 38a Bramshill Gardens London, UK NW5 1JH +44 20 7263 2732 www.coveredbondreport.com March 2011 To the lifeboats! Can covered bonds offer safety after bail-in panic? Australia A whole new ball game Sterling UK gains home advantage US legislation The FDIC rears its head The Covered Bond Report
- 6. 4 The Covered Bond Report March 2011 MONITOR: LEGISLATION & REGULATION The introduction into the House of Rep- resentatives of a new bill on 8 March put covered bonds firmly on the agenda in the US, as supporters and critics posi- tioned themselves for what looks set to be a tough fight to get legislation final- ised this year. Republican Congressman Scott Garrett, who has led the US covered bond push, made the opening gambit, introducing the latest iteration of proposed legislation to the House Financial Services Subcommittee on capital markets, insurance and Government Sponsored Enterprises. The bill is co-spon- sored by Democrat Carolyn Maloney. Supporters of legislation have hoped that the passage of the Dodd-Frank Act last summer would help clear the way for due consideration to be given to a covered bond bill, with Washington’s focus on GSE reform helping put it on the agenda. However, at a hearing on 11 March of the subcommittee, which Garrett chairs, it quickly became clear that the United States Covered Bond Act of 2011 (HR 940) could become bogged down in the objections of the Federal Deposit Insur- ance Corporation, which have stifled previous efforts to stimulate a US market. “We support the covered bond mar- ket,” FDIC chairman Sheila Bair had said only a week earlier, before adding a caveat that was expanded upon in the regulator’s submission to the subcom- mittee hearing: “I think it is important to get it right and we don’t want the FDIC as the implied government guarantor of covered bonds.” In its subsequent submission, the FDIC said that any legislation “must preserve the flexibility that current law provides to the FDIC in resolving failed banks” and that “any legislation that fails to preserve these important receivership authorities would make the FDIC the de facto guarantor of covered bonds and the de facto insurer of covered bonds investors”. Witnesses testifying at the hearing, aware that the issue of whether tax- payer support would be necessary for a market to develop, were quick to rebut such claims. “HR940 does not provide an explicit federal guarantee of covered bonds is- sued under the provisions of this bill,” said Bert Ely, a financial institutions and monetary policy consultant. “Fur- ther, no provision in HR 940 even sug- gests an implicit federal guarantee of covered bonds.” And Tim Skeet, board member of the International Capital Market Association, said that – contrary to claims made by fel- low witness Stephen Andrews, president and CEO of the Bank of Alameda, a com- munity bank European covered bonds did WASHINGTON FDIC unmoved by new US covered bond push “We don’t want the FDIC as the implied government guarantor” US Bank Covered Bond Capacity 3Q10 2009 2008 2007 2006 2005 Aggregate FDIC Insured Depository Institution Liabilities 11,859 11,642 12,550 11,687 10,614 9,761 Capactiy for Covered Bonds Outstanding (4% of Total Liabilities) 474 466 502 467 425 390 Fannie Mae and Freddie Mac MBS Outstanding 4,390 4,761 4,411 4,119 3,454 3,169 Covered Bond Capacity % GSE MBS Outstanding (%) 11 10 11 11 12 12 Fannie Mae and Freddie Mac Mortgage Purchases 643 1,159 915 1,110 867 906 Source: FDIC, Fannie Mae and Freddie Mac public filings, Fitch Ratings. Legislation & Regulation
- 7. Covered bonds? Aaa/AAA covered bonds backed by mortgages Average LTV of 60.5% Match-funded structure Core capital ratio of 18.5% Largest mortgage bond issuer in Europe nykredit.com/ir Figures as of 17 March 2011
- 8. 6 The Covered Bond Report March 2011 not require government support. “There are no implicit guarantees,” he said. “What there is – and we mustn’t confuse the two things – there’s explicit legislation, and there is good supervision provided by arms of the state. But that is not the same as any form of guarantees – nor do the investors factor that in.” The FDIC also claimed that legislation is unnecessary to stimulate a market, say- ing that the Best Practices and a Policy Statement on covered bonds it released in 2008 were sufficient, and pointing to issuance before this from Washington Mutual and Bank of America. But Ralph Daloisio, chair of the American Securitization Forum board of directors, contradicted this. “Without the right kind of legislation, there will be no US covered bond mar- ket,” he said. “It should be clear by now that a US covered bond market can only be seeded by a specific enabling act of legislation, which has, at its cornerstone, a dedicated legal framework for the treat- ment of covered bonds in the event the issuer becomes insolvent.” FHLBanks enter the debate Democrat Senator Charles Schumer gave the covered bond cause a fillip days later, when he said on 15 March during a Sen- ate Banking Committee hearing on hous- ing finance that he is considering intro- ducing a covered bond bill in the Senate. Schumer, who co-sponsored with Re- publican Senator Bob Corker covered bond legislation introduced into the Sen- ate in May 2010 – raised the prospect of introducing legislation when questioning Geithner – and Shaun Donovan, secre- tary of the US Department of Housing & Urban Development – in a hearing fol- lowing up on the Obama administration’s “Reforming America’s Housing Market” report to Congress. “Covered bonds work in Europe, haven’t caught on in the US because we don’t have a statutory framework that provides certainty regarding their treat- ment in the event of insolvency,” said Schumer. “There has been a bill intro- duced just recently in the House that I’m considering introducing in the Senate, by Representatives Garrett and Maloney on covered bonds.” The senator noted that Geithner had indicated a willingness to work with Congress on exploring a legislative framework for covered bonds, and asked him what he thought of the proposed bill and the FDIC’s concerns. “Yes, we would support a legislation that would help create better conditions for a covered bond market,” said the Treas- ury Secretary. “It’s important to recognise that we do have a covered bond market in the US today in the form of the Federal Home Loan Banks financing structure. It’s essentially the functional equivalent. “The questions you raise about the FDIC are very legitimate concerns – we have to work through those. Again, for this to work, you’d be putting the taxpay- er in some sense behind private inves- tors and that has its own consequences. But that’s something that we can work through and I think it can play a better role, a greater role in our system.” Geithner’s reference to the Federal Home Loan Banks system recognised criticisms made by Bank of Alameda’s Andrews and the FDIC in their com- ments to the House subcommittee hear- ing, with the FHLBanks said to be siding with the regulator and community banks to fight the introduction of legislation. Moody’s said in a report that the avail- ability of covered bonds as an alternate funding tool could reduce “the overall footprint and profitability” of FHLBanks. In a report quoted by Representative Maloney in the hearing, Fitch noted that a 4% limit on covered bond issuance rel- ative to total assets could limit issuance volumes. See Legal Brief on pages 46-51 for an explo- ration of the proposed bill and its criticisms. “We don’t have a statutory framework that provides certainty” PROGRESS? 2008: Rocket scientist Neel Kashkari (left), formerly of spacecraft manufac- turer TRW, leads covered bond push. (His time at TRW took in work on the successor to the Hubble Space Telescope.) 2011: Senator Chuck Schumer (right): “That’s why I want to get involved: it’s not rocket science. I can probably deal with it…” (Although he is campaigning for a retired shuttle to go to the Intrepid Museum in New York.) MONITOR: LEGISLATION & REGULATION
- 9. March 2011 The Covered Bond Report 7 The Reserve Bank of New Zealand has set a limit on the amount of assets allowed to be encumbered by covered bond issu- ance at 10%, with a review of the limit to be held within two years. The New Zealand central bank con- firmed its position in March, when com- menting on feedback to a consultation it had launched in January, where the plan for such a cap had been set out. “An initial limit of 10% will allow banks to develop covered bond pro- grammes, whilst providing a conserva- tive ceiling on issuance in the short term,” said RBNZ deputy governor Grant Spencer. Unlike limits set by several other reg- ulators, which base their limit on issu- ance relative to total assets or liabilities, New Zealand references the amount of assets encumbered for the benefit of cov- ered bondholders. Regulators have typically set limits on covered bond issuance because it subor- dinates the claims on a bank’s assets of senior unsecured bondholders and, most importantly, depositors. However, as overcollateralisation levels change over time, the amount of assets encumbered in favour of covered bondholders will change even if the amount of issuance remains consistent. The RBNZ said in March that there was broad agreement among respond- ents to its approach, at least for the short term, and rebuffed alternatives. “The Reserve Bank does not consider that a limit based on the face value of the bond would be appropriate as it does not address the primary prudential con- cern arising from the issuance of covered bonds, namely the encumbrance of as- sets,” it said. “The Reserve Bank recog- nises that this approach places the onus on institutions to set issuance levels that include sufficient headroom to reflect the level of risk of downgrade that is inherent in their operations. “As a result, stronger institutions may feel more comfortable issuing a higher volume of covered bonds. The Reserve Bank considers that this outcome is more appropriate than weaker institutions en- cumbering a higher proportion of assets to support the same level of issuance as more robust entities.” The central bank said that the review would consider the level of the constraint as well as “the merits of adopting a more case-by case, or sliding scale, approach to reflect the specific characteristics of the institution”. Issuance on hold Bank of New Zealand opened the New Zealand covered bond market in June 2010, shortly after the Reserve Bank had released its first guidance to recognise covered bonds. BNZ sold a a NZ$425m two tranche domestic issue, and followed this up with a Eu1bn seven year deal in November. “This inaugural euro covered bond is- sue is a very cost effective form of term funding for BNZ,” said Tim Main, BNZ treasurer. “It also increases the bank’s ac- cess to a significantly broader range of global investors.” Westpac NZ had hoped to issue its first covered bond in euros in February, a five year deal, but put plans on hold after the Christchurch earthquake and amid deteriorating market conditions. Barclays Capital, BNP Paribas, UBS and Westpac had the mandate for the subsidi- ary of Australia’s Westpac. In December a new company, ANZNB Covered Bond Trust Ltd, was established, suggesting that ANZ National Bank will be entering the market, while ASB Bank, a subsidiary of Commonwealth Bank of Australia, has indicated an interest in is- suing covered bonds. MONITOR: LEGISLATION & REGULATION NEW ZEALAND RBNZ targets encumbrance STOP PRESS UK budget promises pro-investor covered bond review The UK government announced plans for a review of the UK covered bond regime as part of its budget on 23 March. “The Government and the Financial Services Authority (FSA) will shortly publish a review of the UK’s regulatory framework for covered bonds,” said HM Treasury. “The review will consult on measures to enhance the attractiveness of UK covered bonds to investors, making it easier for banks and building societies to raise fund- ing in order to lend to households and businesses.” See news.coveredbondreport.com for updates. “It is important to get standardisation of reporting formats” page 24
- 10. 8 The Covered Bond Report March 2011 Market MONITOR: MARKET Geopolitical events totally unexpected at the turn of the year became the key driv- ers of market sentiment as the first quar- ter of 2011 drew to a close. When Fitch surveyed investors in December about the biggest challenges ahead for the covered bond market, rev- olutions in the Middle East and natural disasters in Japan were so impossible to forecast that such events barely regis- tered on investors’ radars, save possibly as part of a 4% “other” vote. Another potential challenge not cap- tured by Fitch’s detailed answers was sup- ply, as one head of covered bond origina- tion commented on The Covered Bond Report’s website. But in the first week of the year alone issuers piled into the mar- ket with 15 new benchmarks (of Eu500m or more), taking the week’s issuance to a record of more than Eu18bn. This resulted in a rather predictable turn of events, as Commerzbank analysts noted after the record week. “The market soon began showing some first signs of fatigue,” they said. “The spread targets became increasingly defensive, most new papers are now trad- ing above their issuance levels, the books have recently tended to fill up at a more sluggish pace, and the first postpone- ments of projects have taken place. “In view of these contradictory sig- nals, it is not easy to assess the funda- mental strength of the market.” It proved more resilient than could have been expected, with more than Eu43bn of benchmarks being priced by the end of January and over Eu24bn in February. Around Eu13bn during a slow- er first half of March took issuance from 1 January to 18 March above Eu80bn. Regulatory developments helped maintain the market’s momentum. While the inclusion of covered bonds in liquid- ity buffers envisaged under Basel III were a theme going into the year, a European Commission paper proposing that senior unsecured creditors be “bailed-in” when banks are bailed out catalysed fears of this outcome, leading to a flight of some issuers and investors into the secured as- set class. In the second week of March only one new benchmark was launched, a Eu1bn three and a half year Pfandbrief for Berlin-Hannoversche Hypothekenbank, with markets volatile in the wake of the earthquake, tsunami and nuclear fears in Japan and awaiting impending United Nations-sanctioned action against the Gaddafi regime in Libya. This overshadowed improved senti- ment towards southern European debt in the government markets that might oth- erwise have opened the door to further supply from the region. Spanish covered bonds had rallied since mid-January and, alongside Italian covered bonds, de- linked themselves from Portugal. An EU summit beginning the day of the Japanese natural disasters had even raised hopes that the euro-zone’s leaders might finally be ready to take decisive ac- tion to stem the region’s debt crisis. As The Covered Bond Report was being printed, the outcome of a follow-up meeting on 24-25 March was being awaited. EUROS A first quarter of shock and awe 0 50 100 150 200 250 300 350 04/01/201018/01/201001/02/201015/02/201001/03/201015/03/201029/03/201012/04/201026/04/201010/05/201024/05/201007/06/201021/06/201005/07/201019/07/201002/08/201016/08/201030/08/201013/09/201027/09/201011/10/201025/10/201008/11/201022/11/201006/12/201020/12/201003/01/201117/01/201131/01/201114/02/201128/02/201114/03/2011 Basispoints Date iBoxx spreads against asset swaps Canada France Germany Other Spain UK
- 11. March 2011 The Covered Bond Report 9 MONITOR: MARKET FRANCE CFF flies European flag Compagnie de Financement Foncier launched the only dollar benchmark for a European issuer in the year to mid-March, with a $1.5bn three year deal that took its dollar benchmark issuance to $6.3bn (Eu4.56bn) since the beginning of 2010. “Last year we issued $4.8bn in dollar benchmarks and with this transaction we now represent 20% of the existing covered bonds outstanding in the US, so we are definitely one of the key players on this market,” said Paul Dudouit, head of medium and long term funding at CFF. “We are now marketing to tier two accounts and we see more and more interest from these, which is very important in terms of diversification, not hav- ing only the big players in- volved.” However, as The Cov- ered Bond Report was go- ing to press, several issuers, mainly Nordic, were said to be preparing to access the US investor base. DOLLARS US goes loonie for Canadians Marfin Popular Bank is preparing to launch a debut covered bond off a Eu2bn programme, which would be the first public issue from Cyprus after the country’s framework was finalised in December. The Marfin group has previously issued Greek law covered bonds backed by residential mortgages through Greek subsidi- ary, Marfin Egnatia Bank. “We have experience utilising the Greek assets using the Greek law and it’s a very good opportunity for us now to use the Cypriot law,” Dimitrios Spathakis, Marfin Egnatia bank deputy head of wholesale funding, told The Covered Bond Report. “Our view is that the law is very strong and it will facilitate us in going to the market”, he added. “There is a more positive outlook towards Cypriot as compared with Greek banks.” The bank plans to have two separate programmes, one com- prising Cypriot assets and the other mainly Greek assets. It plans to enter the market with residential mortgages and grad- ually move to commercial assets and eventually to a shipping portfolio, which Spathakis acknowledges is “the most challeng- ing one of all”. The Central Bank of Cyprus, the Ministry of Finance and the Association for Cyprus Banks and all its members worked together on the project. “Now the legal and regulatory framework is in place, it is up to each individual bank to go ahead with its issuing,” said Christina Antoniou Pierides, senior officer at the Association of Cyprus Banks. Moody’s has estimated the potential of the Cypriot covered bond market as Eu4bn. Marfin Popular was downgraded from Baa2 to Baa3, on negative outlook, by the rating agency at the beginning of March. Its Greek covered bond programme is rated A3, on review for downgrade. National Bank of Canada sold its first covered bond in January and Caisse Cen- trale Desjardins was roadshowing a new programme for US investors in March, as Canadian banks picked up where they left the US dollar market last year. Dollar issuance, at just four bench- marks totalling $6bn to mid-March, was subdued compared with last year’s surge, especially when compared with the record volumes witnessed in the euro market, but Canadian issuers sold three- quarters of the new dollar supply. National Bank of Canada’s $1bn three year 144A issue was sold in late January after Bank of Montreal had returned for $1.5bn and Canadian Imperial Bank of Commerce had returned for $2bn. “People just love Canadian risk,” said a banker on Bank of Montreal’s deal, “and all the US investors are happy to add more.” NBC’s US$5bn (Eu3.75bn/C$4.94bn) global covered bond programme are backed by a Canada Mortgage & Hous- ing Corp (CMHC) insured pool of resi- dential mortgages, like all of its peers’ bar Royal Bank of Canada. Caisse Centrale Desjardins, part of Quebec’s Desjardins Group of credit unions, was marketing its new pro- gramme, also backed by a CMHC pool, in March with Royal Bank of Scotland. The Desjardins Group forms Canada’s largest credit union and would be the first such institution to enter the cov- ered bond mark from Canada. Paul Dudouit, CFF National Bank of Canada CYPRUS Marfin carries Cypriot hopes “No evidence to suggest that a legally stipulated publication obligation necessarily leads to a better result” page 19
- 12. 10 The Covered Bond Report March 2011 MONITOR: MARKET Denmark’s mortgage banks achieved bet- ter than expected yields in auctions in the first two weeks of March, despite com- ments from European Central Bank presi- dent Jean-Claude Trichet having initially threatened to push rates higher. The auctions faced high volatility be- cause of comments from Trichet suggest- ing a possible move to tighter monetary policy at the start of the month and the Japanese natural disasters. “The outright yield level increased just at the start of the auction and then we have seen this risk aversion scenario after the events of Japan,” said an analyst at Danske Bank. “It pushed down the outright yield levels at the end of the auctions.” Nykredit Realkredit was the most ac- tive, selling Dkr80bn in local currency and Eu1.6bn in euros over an 11 day period. “The positive thing was that over the 11 days of the auction the average yield tightened 10bp to swap and that’s defi- nitely more than usual,” said Nykredit first vice president Lars Mossing Madsen. “Another thing of interest was that we saw the bid-to-cover being much higher than normal during the auction.” The average bid-to-cover was 4 times, compared with 2.6 in December and 3.4 in October. Realkredit Danmark, a subsidiary of Danske Bank, had planned to issue Dkr26.6bn and Eu408m; it came close to those targets with Dkr26.4bn and Eu410m. The bank edged up to a bid-to- cover of 3.2 this month, compared with a rate of 2 in December. The Danske analyst said spreads gener- ally tightened at the auction, in euros and Danish kroner. “At the beginning of the auction they were priced around 40bp-45bp to Eonia, the one years, and they ended up being priced around 37bp,” he said. Nordea Kredit had anticipated a spread of 57bp over Eonia, according to Jacob Skinhøj, chief analyst at Nordea Kredit, but was “very happy” with spread tighten- ing during the auctions. The bank issued Eu115m and Dkr8.205bn over two days, with an aver- age bid-to-cover of 3 or 4, roughly on par with previous auctions. “I think in a world such as that we have today, with the uncertainty about Japan, investors go for safe havens and these cov- ered bonds are a safe haven and will re- main a safe haven in a situation like this,” said Skinhøj. INDEX CSI: Europe A new Covered Bond Market Sentiment index (CSI) unveiled by Crédit Agricole in February aims to provide market participants with a quantitative tool to measure confidence across the asset class. It measures investor and issuer confidence in funding conditions and investment conditions, respectively, resulting in a score on a scale from 0 to 10, with 0 being the worst and 10 the best. Like Germany’s established Ifo Business Climate Index, the CSI includes current situation and expectation components. “The ultimate goal is to get this established among issuers and investors and get as much feedback so I can actually break it down country by county,” says Crédit Agricole senior covered bond analyst Florian Eichert. “Then the main use would be for the issuer community, for example, to say: ‘OK, it doesn’t make a lot of sense to go marketing in this region.’” More than 106 investors and 19 issuers from a variety of countries participated in the January survey, released in February, which arrived at an opening level of 5.2. The latest month’s scored edged up to 5.5, but had fewer respondents, with 86 investors and 28 issuers. Investors and issuers received CSI surveys in the last week of each month and results were produced at the beginning of the following month. Eichert expects the av- erage number of participants to stabilise within the next couple months and attributes the drop in responses to European holidays in some countries when it was conducted. “I’m surely hoping to get that number up,” he says. “One hundred and six was quite nice, but I’d certainly like to get that number even higher. Eichert said his survey was greeted with an enthusiastic response, with many investors and issuers showing interest. “This is kind of what I’ve been doing all along – just trying to talk to issuers and in- vestors and trying to relay the information back and forth,” said Eichert. “I’ve just never done it in as systematic a way as the index before.” AUCTIONS Crises lower Danish yields F1 SDO DKK 3/3 4/3 7/3 8/3 9/3 11/3 14/3 15/3 16/3 17/3 2,30 2,20 2,10 2,00 1,90 1,80 DAILY YIELD (GREY) AND CUMULATIVE AVERAGE YIELD (BLUE) OVER NYKREDIT AUCTIONS
- 13. March 2011 The Covered Bond Report 11 GERMANY New analyst pairing for DZ DZ Bank is hiring Joerg Homey from Moody’s as part of a new pairing for its covered bond research, after Sebastian Sachs left the bank to head up research at Berenberg Bank. Homey was a vice president and senior analyst at Moody’s. He is set to join DZ in April to work alongside Michael Spies, who joined DZ in November and has been working as a covered bond analyst since January. Sachs, who worked at DZ from Feb- ruary 2006, left for Berenberg Bank in early March, where he will be establish- ing credit and rates research. Berenberg Bank, which claims to be Germany’s oldest private bank, is headquartered in Hamburg, but Sachs will be based in the bank’s Düsseldorf office when he joins in April. André Hovora, who previously worked alongside Sachs as a covered bond analyst, recently moved to work in the bank’s credit department. MONITOR: PEOPLE & INSTITUTIONS Scott Stengel has joined King & Spald- ing as a partner from Orrick, Herrington & Sutcliffe, while a former colleague, Howard Goldwasser, also recently moved to a new firm. Stengel is a member of the steer- ing committee of the US Covered Bond Council, which operates under the aus- pices of the Securities Industry & Fi- nancial Markets Association (Sifma). He testified in the House Financial Services Subcommittee hearing on the US Cov- ered Bond Act of 2011 on 11 March. “This was a compelling opportunity to join a first class global law firm, where I can draw on an extraordinarily deep bench of capital markets and regulatory lawyers to grow the covered bond and the general banking practices,” Stengel told The Covered Bond Report. “King & Spalding is widely recog- nized as a global leader in both finance and real estate, and our expertise there will be critical to clients as we move for- ward on covered bonds as well as GSE reform in the US.” Stengel worked at Orrick from 1997 until February. Goldwasser, who worked with Sten- gel for many years at Orrick before join- ing Allen & Overy in 2006, joined K&L Gates last month. He arrived at K&L Gates from Curtis, Mallet-Prevost, Colt & Mosle, which he had joined after leav- ing A&O in September 2009. “To me, one of the big draws at K&L Gates is that the firm has one of the mar- ket-leading housing finance practices in the US and can offer a level of expertise in that space that will position us well when the covered bond market starts up in the US,” said Goldwasser. “And it also has a very international footprint.” Goldwasser has been a member of the US Covered Bond Council and the American Securitization Forum’s covered bond sub-forum. At A&O, he worked on the first US covered bond programmes and some of the early Ca- nadian programmes. HIRES Syndicate moves Lorenz Altenburg returned to covered bond syndicate in late February, joining Nomura from Crédit Agricole. Altenburg worked in covered bond syndication for Société Générale in Paris until late 2009, before moving to sover- eign, supranational and agency trading. He left SG to join Crédit Agricole in Lon- don in a similar role in December. Meanwhile, Martin Rohland will be joining Barclays Capital’s syndi- cate desk in April. He will be joining from Landesbank Baden-Württemberg, where he was a director on the bank’s fixed income syndicate. LEGAL Orrick alumni on the move Scott Stengel: Capitol witness Sebastian Sachs: head for Berenberg “This was a compelling opportunity to join a first class global law firm” People & Institutions
- 14. 12 The Covered Bond Report March 2011 MONITOR: PEOPLE & INSTITUTIONS/RATINGS SPAIN Multi-cédulas withstand cut Fitch cut 51 classes of multi-cédulas issues on 10 March, driven by collateralisa- tion rates, but the impact of the news on the asset class was muted, even along- side a downgrade of the Kingdom of Spain from Aa1 to Aa2 on the same day by Moody’s. “As far as I can see, things are holding up in the secondary market and they haven’t really been hit too hard,” said one syndicate official. “A couple of basis points widening here and there, but nothing tragic.” An analyst added: “Spreads will be more driven by headlines on savings banks and details of mergers and not by ratings – at least not as long as they are in double-A territory.” Fitch cut 50 classes from AAAsf to AAsf and one from AAAsf to AA+sf, with the downgrades relating to 46 transactions. The actions concluded a review of the sector by Fitch. “CR (collateralisation rate) is the major driver of the downgrades,” said the rat- ing agency. “The agency’s MICH (multi-issuer cédulas hipotecarias) rating meth- odology is based on the ‘first dollar loss principle’ implying that if the weakest link in the CDO failed in a particular stress scenario, regardless of its participation in the overall transaction it would imply a default of the transaction as a whole under such rating stress. MICH transactions have traditionally comprised CH issued by multiple Spanish financial entities. “Fitch’s CR analysis includes updated cover pool market value risk assump- tions. Market value risk stems from the assumption that in the event of a CH default, the insolvency administrator may be forced to sell cover pool assets at a distressed price in order to meet payments on CHs. This is addressed by applying a refinancing spread that accounts for the cost of funding of a potential buyer plus a profit margin. Fitch has updated the components of the liquidity risk market value discount considering current market conditions and future expectations.” Tim Skeet is understood to be joining Royal Bank of Scotland, where he will work in debt capital markets. Skeet left Bank of America Merrill Lynch, where he was head of covered bond origination, in October after four years at the US bank. He has recently been work- ing as a consultant for Amias Berman. Skeet is a board member of the Inter- national Capital Market Association. He testified on behalf of the association at a House Financial Services Subcommittee hearing into US covered bond legislation in March. Prior to joining BAML he worked at ABN Amro before its European invest- ment banking operations were acquired by RBS. NETHERLANDS ABN builds with Hessels ABN Amro has hired Joop Hessels from ING as it builds out in debt capital markets. Hessels joined as a director in ABN Amro’s FIG origination team in March. Previously he worked at ING as a vice president in DCM origination, where he was responsible for coverage of Dutch and Nordic financial institutions. At ABN Amro, Hessels reports to Maurizio Atzori, head of debt capital markets origination. ANALYST CreditSuissegetsWinkler Credit Suisse is understood to have hired Sabine Winkler as a covered bond analyst. Winkler resigned from Bank of America Merrill Lynch in March. She joined Merrill Lynch in March 2007. Beforehand she worked as a cov- ered bond analyst at ABN Amro. Bank of America Merrill Lynch is un- derstood to be seeking a replacement for Winkler. UK Skeet on way to RBS Don’t forget to visit our website at www.coveredbondreport.com Tim Skeet
- 15. The Covered Bond Report Did you know that The Covered Bond Report has its own database of benchmarks? Did you know that we link directly from bond data to relevant coverage? Did you know that we include price guidance, book sizes and distribution statistics? Did you know that you can run league tables by country and currency? To register for trial access to The Covered Bond Report, visit news.coveredbondreport.com or contact Neil Day, Managing Editor, at nday@coveredbondreport.com. And don’t forget: if you are an investor in covered bonds you can qualify for free access to the website. The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.
- 16. 14 The Covered Bond Report March 2011 A request for comment from Standard & Poor’s is being awaited after the rat- ing agency in January made a last minute decision in the face of criticism to delay the application of new counterparty risk criteria to covered bonds. Until then the proposed changes had, not for the first time in S&P’s experi- ence, cast a shadow over the rating out- look for the asset class, with those fall- ing foul of the new criteria due to have been placed on CreditWatch negative the following week. “Had the initial criteria been applied to the covered bond market,” says an analyst, “we could have seen a sizeable chunk of the market being downgraded. Even covered bonds by well rated issuers would not have escaped unscathed.” Market participants had been critical of the application of the criteria to cov- ered bonds alongside structured finance transactions, but were not wholly unsym- pathetic to S&P’s covered bond team. “It seems S&P has a lot of discussions internally,” said one analyst, “covered bonds versus structured finance.” When Fitch released new covered bond counterparty criteria in mid-March mar- ket participants contrasted the actions of the two rating agencies. The introduction of Fitch’s criteria followed an exposure draft released in October 2010 and a cov- ered bond banker who had met with Fitch ahead of its final criteria, and also with S&P regarding their counterparty criteria, said that he felt Fitch had handled the changes to their criteria more carefully. “Fitch said that there would be some changes given the feedback that had been made,” he said. “They were more taking on board the feedback in terms of what we wanted to change, making some im- provements, and they seemed quite open to the ideas we presented to them. “We also got the feeling that the whole approach was more thought-through and convincing than S&P, where the changes seem to have been driven by people not close to covered bonds.” Fitch described in its release changes it had made to its proposals in light of in- dustry feedback. “Market participants generally ex- pressed their support for a separate cov- ered bond-specific counterparty criteria report that takes into account the dual- recourse and dynamic nature of covered bond programmes,” it said. “Having reviewed the feedback, the agency has made various changes and clarifications to the final counterparty criteria com- pared to the exposure draft.” When S&P in January announced that it was delaying its implementation to covered bonds of counterparty criteria for structured finance transactions, and would be reviewing the relevant criteria, it said that the new review would take into account “the dual recourse nature of covered bonds” as well as “the multiple number of counterparties that may pro- vide support to the covered bonds”. A market participant said that he ex- pected revised proposals from S&P to emerge by next month. The impact of Fitch’s counterparty criteria changes is also expected to be smaller than was feared from S&P’s. “The agency expects that application of the criteria to existing rated covered bond programmes will have an immedi- ate effect on a limited number of covered bond ratings,” it said. “Most programmes, particularly those with internal counter- parties, will only be affected if the issuer’s rating deteriorates by several notches. This is based on the expectation that is- suers, notably of programmes with ex- tended maturity for principal payments, will be able and willing to improve the liquidity protection against potential missed interest payments shortly after an issuer or account bank default.” The rating agency said that a potential mitigant issuers may choose to increase is overcollateralisation. “If this risk remained insufficiently mitigated, according to the new criteria, the affected programmes’ ratings would be tied more closely to the applicable Is- suer Default Rating (IDR) through a largely increased Discontinuity Factor (D-Factor),” added Fitch. “This may auto- matically result in downgrading covered bonds’ ratings from their current level.” MONITOR: RATINGS CRITERIA Fitch counterparties on after S&P delay “The whole approach was more thought-through and convincing” Ratings S&P loomed large
- 17. March 2011 The Covered Bond Report 15 DOWNGRADE Portuguese on watch MONITOR: RATINGS Investors are more willing than previously to consider buying non-triple-A covered bonds, according to a survey released by Fitch last month, which also highlighted a surprising flexibility among the buy-side towards innovative structures. Some 88% of investors surveyed by the rating agency in December said that they were prepared to examine non-tri- ple-A covered bonds, with 14.6% view- ing a triple-A rating as irrelevant, while 73.2% found it important but were open to non-triple-A issues. Hélène Heberlein, managing director, covered bonds, at Fitch told The Covered Bond Report she was surprised to find that “some investors are disregarding the covered bond rating and looking at the bank rating first”. However, a triple-A rating was still viewed as “very important” by 84.2% of respondents. The idea of pass-through covered bonds was also gaining acceptance, the survey found. The majority of respond- ents (52.5%) said they would consider purchasing either partial or full pass- through covered bonds. Only 38.8% re- fused to even consider non-bullet pay- back structures. Head of covered bond strategy at Deut- sche Bank, Bernd Volk, was surprised by the willingness of investors to accept pass- through covered bonds when “all existing pass-through covered bonds are on balance sheets of central banks for repo reasons”. “A pass-through structure would re- duce overcollateralisation requirements,” he said, “and hence allow higher covered bond issuance, i.e. the need for expensive unsecured funding would be reduced.” Heberlein cautioned that the diversity of investors polled must be taken into consideration when noting this result. “If you had conducted this survey primarily among insurance companies and pension funds, they would probably have said they only want hard bullets,” she said. The survey found that 43% of inves- tors were uncomfortable with the inclu- sion of residential mortgage backed as- sets in cover pools, while the remainder either viewed it as acceptable (19%), rea- sonable as long as they were compensat- ed with higher spreads (20%), or stated no opinion (18%). Eighty-two investors, all but one based in Europe, participated in Fitch’s survey. The majority of respondents, 58%, had less than Eu5bn of covered bonds under management, while 34% had between Eu5bn and Eu50bn, and the remaining 8% upwards of Eu50bn. FITCH No triple-A? No problem “A pass-through structure would reduce overcollateralisation requirements” The fate of Portuguese covered bonds has been under scrutiny after Moody’s on 15 March cut the sovereign from A1 to A3, putting ratings pressure on the country’s banks. Moody’s warned in December that if the senior unsecured long term ratings of Caixa Geral de Depósitos or Banco Espiríto Santo were downgraded by more than one notch then the mortgage covered bonds of each bank would be downgraded by one notch. However, the knock-on effects of the sovereign action on covered bond rat- ings could be limited, suggests Frank Will, head of covered bond and fre- quent borrower strategy at RBS. “We expect that the Aa2 covered bond rating of BES will be confirmed as we expect only a one notch issuer downgrade (unless the standalone rat- ing of BES is downgraded as well). “With regard to mortgage cov- ered bonds issued by Caixa Geral de Depósitos,” he added, “we expect a one notch downgrade of the Aa1 cov- ered bond rating as we view a two notch issuer downgrade as likely (unless the standalone rating of CGD is downgrad- ed by a few notches as well).” Fitch had the previous week affirmed the triple-A rating of Caixa Geral de Depósitos’ mortgage covered bonds (obrigacoes hipotecarias) and removed them from Rating Watch negative.
- 18. 16 The Covered Bond Report March 2011 BUY-SIDE: ICMA’S CBIC Transparency Investors have been asked many times by issuers, in different contexts, what their information needs are. So far there has been no unified answer to this question, but following the growth of the covered bond market there has been an increased fragmentation in the type of information provided by issuers. The CBIC has set up a transparency working group that has tried to indentify the key information that investors in cov- ered bonds need in order to make a fully informed investment decision as to covered bond issues, including their respective cov- er pools and the issuer itself. It is expected that the information required would be available on a regular basis (for example, a half yearly update) to meet investors’ trans- parency and information needs. The CBIC believes it is of vital impor- tance to improve transparency in order to increase the investor base. The objec- tive is to make it possible for investors and analysts to compare and form an independent qualified assessment of all covered bond programmes. The internationalisation of formerly domestic covered bond markets began 10 years ago and many European countries introduced new covered bond legislation or updated existing rules to be a part of this development, and to also respond to the considerable growth of mortgage lending activities in the European Union. Each different country’s covered bond laws regulate what assets are eligible to back covered bonds, minimum quality requirements for assets, and how inves- tors will be protected if the issuing bank The International Capital Mar- ket Association is one of the few trade associations with a European focus having both buy-side and sell-side representation. One of the Association’s industry groupings, created nearly two years ago — the Covered Bond Investor Council (CBIC) — serves to consider issues related to the evolution of the prod- uct in Europe and the type of infor- mation available to investors. The Council is an investor driv- en organisation, independent of issuers and the sell-side. It aims to promote the quality of the cov- ered bond product and represent the interests of European covered bond investors. The CBIC promotes greater harmonisation in the mar- ket, the transparency and simplicity of the product, and the quality of the underlying assets. Nathalie Aubry-Stacey, direc- tor of regulatory policy and market practice at ICMA and secretary of the CBIC, sets out the Council’s agenda. The voice for investors “It is of vital importance to improve transparency in order to increase the investor base”
- 19. March 2011 The Covered Bond Report 17 BUY-SIDE: ICMA’S CBIC goes bankrupt. The legislation therefore stipulates how the collateral framework must operate. It is also clear that the quality of the information available to investors re- mains uneven. Key information such as loan to value (LTV) and non-perform- ing loans (NPLs), for instance, need to be fully explained when presented to in- vestors, allowing them to assess how the calculations are being made. The CBIC is also addressing the issue of creating a level-playing field in terms of access to this information, looking at a common platform that would provide information to investors. Simplicity and quality Following governmental discussions re- garding the inclusion of loans to small and medium sized enterprises (SMEs) in covered bonds’ cover pools, the CBIC discussed the definition of a covered bond and what should be included in the cover pool. The CBIC promotes the view that cov- ered bond pools should be “clean” and should consist only of specific types of loan. The CBIC believes that SME loans do not belong in the covered bond cover pools. High quality cover pools of cov- ered bonds should only include tangible assets with a long historical track record and/or public loans. This is considered one of the essen- tial cornerstones for the future develop- ment of a sound European covered bond market. Covered bonds are best used for strong prime mortgages and some pub- lic loans. Likewise, it is important for the CBIC that covered bonds are not confused with ABS. The two asset classes attract different types of investors and by lowering the qual- ity of the cover pool and therefore blurring the distinction between the two asset class- es there is a risk that banks’ accessibility to term funding may be weakened. The CBIC will be interacting with the relevant policy- makers on this specific issue. There is another question raised by the directive amending capital require- ments for trading books and for re-secu- ritisations and the supervisory review of remuneration policies (CRD III) propos- al, as to whether ABS should be allowed in covered bonds’ cover pools at all. The proposal highlights that the exception made for the use of intra-group ABS in the cover pool could end up being per- manent as from 2013. The CBIC will also be considering this issue. The European covered bond market as a financing tool for mortgages has survived the crisis without massive pub- lic intervention and the CBIC believes that only a continued focus on uphold- ing quality will safeguard the market against any future crisis. Any dilution of the quality of the product or confusion with other fixed income products should be avoided. Engage The CBIC has been recognised by regula- tors as the voice for investors. However, the CBIC would like to take the Council further in actively engag- ing investors with an interest in covered bonds in its work, and be more active in the regulatory space. This market will continue to develop and it is essential that investors, as a group, participate in discussion on the future development of this market which is so essential for mortgage and public fi- nancing in Europe. “The CBIC would like to take the Council further in actively engaging investors” CBIC chairman Claus Tofte Nielsen (second from left) engages with (left to right) Michel Stubbe, head of monetary operations analysis division at the ECB, Deutsche Bank head of covered bond strategy Bernd Volk, HSBC global head of covered bonds Andrew Porter, and Santander’s Antonio Torío, European Covered Bond Council chairman.
- 20. The Covered Bond Report The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market. Are you a covered bond investor? Then you could be receiving free daily news bulletins from The Covered Bond Report and access to its coverage of the market as well as its proprietary database of new issues and cover pool data links. If you would like to gain complementary access to The Covered Bond Report’s website and to receive free copies of The Covered Bond Report’s magazine, contact Neil Day, Managing Editor, at nday@coveredbondreport.com or visit news.coveredbondreport.com to register*. *Investors directly linked to covered bond issuers may not qualify for this offer.
- 21. W hen Fitch recently pub- lished its covered bond investor survey, it was hardly surprising to find that “underlying collateral per- formance” was ranked second among the key covered bond spread drivers for 2011 – beaten only by “sovereign risk”. The surprising fact was that “indi- vidual issuer quality” was completely missing. However, since mortgage books usu- ally constitute a considerable share of the issuers’ balance sheets, it is quite reasonable to assume a high correlation between issuer credit quality and cover pool performance. Another aspect also weighs heavily on the importance of “underlying col- lateral performance”: numerous classi- cal ABS/MBS investors have in recent months – albeit involuntarily – shifted away from their original investment home base and explored the covered bond universe. Traditionally, invest- ing in ABS/MBS has meant keeping a close eye on the cashflow situation of the ABS/MBS collateral. The outcome of these cashflow models formed the basis of conclusions on the future valuation of the various tranches of a specific trans- action. But cashflow reporting for ABS/MBS is way beyond what is currently deemed state-of-the-art in cover pool disclosure practice among covered bond issuers; and given the rather complex situation of covered bonds as quasi-master-trust structures, it is unlikely to become stand- ard practice on a broad basis anytime soon. Here we provide an overview of what constitutes state-of-the-art in various countries with regards to homogeneity and detailed- ness of reporting. We discuss the deficits, and provide an overview of the range of opportunities given the lack of loan-by- loan data, and how these deficits can be overcome by way of secondary sources. Pfandbrief first For quite some time, the only covered bond law setting explicit standards for disclosure of cover pool metrics was the Pfandbrief Act. The relatively young Greek covered bond law, too, regulates certain disclosure to the investing pub- lic. Legislation in some other countries, such as Spain, tackles disclosure in a dif- ferent context: not vis-à-vis investors but regulators, a topic that we do not address in this context. In fact, after the introduc- tion of §28 Pfandbrief Act, the cover pool disclosure of German issuers was setting standards. However, it was, admittedly, in 2005 that the transparency regulations be- came legally binding in a format com- ANALYSE THIS: COVER POOL DISCLOSURE Living with the data deficits Is legal or voluntary disclosure yielding the most useful information? Florian Hillenbrand, senior covered bond analyst at UniCredit, weighs the results and recommends how investors cope with a lack of transparency. March 2011 The Covered Bond Report 19
- 22. 20 The Covered Bond Report March 2011 ANALYSE THIS: COVER POOL DISCLOSURE parable to today and at that time other markets (except for Germany, France and Spain) were still in a ramp-up phase: the UK and Ireland were emerging, Austria and Luxembourg were absolute niche markets, while Nordic issuers as well as Portuguese and Italian banks were still a long way from issuing. Since the introduction of the disclo- sure policy for Pfandbrief issuers in 2005, German practice has barely changed or improved. In April 2006 the Associa- tion of German Pfandbrief Banks (vdp) started an initiative to further develop practical issues, such as timeliness of publication, positioning on the issuers’ webpages, and increasing homogeneity of publication. Nevertheless, improve- ments in the form and function of the disclosures did not materialize until 2010. Most issuers currently present their historical as well as current cover pool metrics in harmonized Excel and PDF format. Furthermore, the vdp provided an internet platform where investors can easily access cover pool metrics. Strong pressure from outside the Pfandbrief market certainly accelerated the process of improving quality of disclosure. In the meantime, Pfandbrief disclo- sure is quite streamlined and the degree of detail is also quite solid. According to the Pfandbrief Act, a Pfandbrief bank shall publish on a quarterly basis the total volume of mortgage Pfandbriefe, public Pfandbriefe, ship Pfandbriefe and aircraft Pfandbriefe outstanding, as well as the corresponding cover pools in the amount of the nominal value, the net present value and the risk-adjusted net present value. In addition, issuers have to pub- lish the maturity structure of each type of Pfandbrief outstanding, as well as the fixed interest periods of the correspond- ing cover pools in pre-specified bands. Furthermore, information has to be pro- vided regarding the share of derivatives in the pool and the amounts held in the form of further or substitute collateral. Mortgage Pfandbrief issuers have to provide the distribution with the amounts assigned as cover in their nomi- nal values according to their amount in specified tranches, as well as according to the states in which the real estate collat- eral is located, and according to the pur- pose of financed properties. In-arrears figures and foreclosures, etc, must also be supplied. Issuers of public Pfandbriefe have to provide information regarding the individual states in which the bor- rowers and, in the case of a full guaran- tee, the guaranteeing bodies are based. UK raises the stakes Although the degree of detail is quite solid – as previously mentioned – there is still room for improvement. We have already mentioned the pressure on Ger- man issuers from abroad. UK covered bond issuers were the driving force with regards to cover pool disclosure, fol- lowed by US, Canadian and French issu- ers of non-obligations foncières. Without any legally binding disclosure obligation, each group of issuers managed to establish an outstandingly homogene- ous, highly detailed reporting format. Next to the conviction that in the long term openness pays off in terms of inves- tors’ trust, the high quality of the reporting was facilitated by two technical factors. Firstly, the vast majority of issuers in the aforementioned countries are experi- enced ABS/MBS issuers and are therefore usually eager to meet ABS/MBS report- ing standards. Secondly, all issuers in the respective countries or markets have recently set up covered bond IT systems and are therefore also technically capable of producing highly sophisticated data. Not only do we consider original LTV ratios as an example of sophisticated data, but also current ones and even in- dexed current LTV ratios. Also, the depth of information on the debtor provided by some issuers, such as debt-to-income ra- tios or employment status, is something that far exceeds what can be considered standard in Germany. The voluntary disclosure formats we see also show some higher standards with regards to frequency of publication. While quarterly publications can certainly a be deemed sufficient as long as the time lag is not too large, the majority of issuers out- side the German market are able and will- ing to stick to a monthly schedule. A wish list Overall, there is absolutely no evidence to suggest that a legally stipulated pub- lication obligation necessarily leads to a better result than a voluntary publica- tion. The question is rather: is there any more room for improvement and, if so, what is the direction of improvement? In order to point out fields of im- provement, one has to recognize the limitations of current disclosure formats. We identify two areas that have become increasingly important in recent years: the first is the assessment of liquidity is- sues; the second, the full comprehension of credit quality. With regards to liquidity issues, inves- tors and analysts are mostly dependent upon what is published by rating agencies, which is, however, also the result of agen- cy models rather than figures fed into own analytical models. This is one of the fields in which traditional ABS/MBS investors request more information. What would be needed in order to assess liquidity risk would indeed be classical cashflow report- ing – at least providing cash inflows and cash outflows per period. However, this is quite demanding with regards to cover pool IT. And, since in an ABS/MBS con- text we have already seen reporting like this, we do not deem cashflow reporting as unrealistic going forward. “Discussing both fields of improvement has always been wishful thinking” Florian Hillenbrand
- 23. The second aspect – comprehension of cover pool credit quality – is likely to re- main a “problem” going forward. In order to assess credit quality, it is necessary to either obtain detailed loan-by-loan data (banking confidentiality might constitute an obstacle) or in depth information about cross-effects such as covariances of the distribution of all details provided in the cover pool reporting – in layman’s terms: providing information as to how certain combinations of characteristics material- ise. Analyses of the cover pools without the knowledge of covariances is nothing but rolling dice, i.e. are higher LTV ratios (bad) associated with higher (bad) or low- er (good) debt-to-income ratios? Since in- formation would be needed for each and every combination of characteristics, the complexity becomes ridiculous. Hence, in this context, going forward we will realis- tically have to rely on secondary sources, such as Moody’s collateral score. Coping strategies Discussing both fields of improvement has always been wishful thinking. The question is rather: what is the best ap- proach for assessing cover pool quality given current limitations? As previously indicated, we believe that, given current deficits, the most proper way to assess current cover pool quality is to use secondary sources. Moody’s collateral score appears to us to be the most comprehensible figure – however, Fitch and Standard & Poor’s provide similar information. But since we are talking about covered bond investments that are usually longer dated, quality is multidimensional: it can vary over time. Hence, cover pool dis- closure documents have to be checked in combination with each investor’s in- dividual view on the future development of the asset types in the pool. This is of paramount importance since cover pools usually reflect the average business the is- suer is underwriting; a negative view on a specific type of lending in the pool also has kickbacks to the issuer itself. This brings us to the last point: changes in the cover pool must always be assessed versus the overall business strategy. As an example, investors should be alerted if a typical owner-occupied residential mort- gage lender is adding significant amounts of buy-to-let loans to its cover pool without any proper explanation. In a nutshell, we be- lieve that the com- bination of an external quality meas- urement and an analysis of cover pools with respect to both market ex- pectation and busi- ness plan-matching is the optimal strat- egy given current con- straints. ANALYSE THIS: COVER POOL DISCLOSURE “So, tell me about your cover” March 2011 The Covered Bond Report 21
- 24. 22 The Covered Bond Report March 2011 STERLING MARKET: HOME ADVANTAGESTERLING MARKET: HOME ADVANTAGE Last November the first sizeable sterling UK covered bond in four years kicked off what market participants hope could become a stable source of funding. Can UK financial institutions get better results at home? By Hardeep Dhillon Sterling gives UK home advantage
- 25. March 2011 The Covered Bond Report 23 STERLING MARKET: HOME ADVANTAGE £ 3bn of covered bonds have hit the sterling mar- ket this year in the wake of a £250m issue for Leeds Building Society in November, the first sterling covered bond benchmark in four years. The surge in supply – from Nationwide Building Society, Lloyds TSB and Abbey National Treasury Services – was long overdue in the eyes of many observers. Indeed the development of the sterling market contrasts with how the asset class has developed elsewhere. “Other jurisdictions targeted their domestic markets and then moved out after that,” says Sally Onions, partner in the covered bond and securitisation group at Allen & Overy. “It is a reverse situation in the UK, where issuers ac- cessed the euro market first and are now further accessing the sterling market.” The first sterling covered bond backed by UK assets was is- sued in December 2004, a £500m 20 year transaction off a Bank of Scotland £3bn Social Housing Covered Bond Programme. This was less than 18 months after a euro deal off the bank’s residential mortgage backed programme had opened the UK market, and was followed by a £500m five year transaction in February 2005 and a £500m 10 year in November 2006. However, the asset class failed to gain a strong foothold and become a liquid product in the UK. “We were really focussing on the best way to fund the un- derlying assets and not on development of the UK investor base for covered bonds per se,” says Robert Plehn, head of structured securitisation and covered bonds at Lloyds Banking Group. “Given UK investor familiarity with the underlying social hous- ing assets and the bank’s desire not to confuse European inves- tors with multiple covered bond programmes from the same issuer, it chose to focus on the UK investor base and only issue in sterling. “However, this clearly required a fair degree of education on the nature of the covered bond instrument. We were still at an early stage in the use of covered bonds by UK issuers and many still had not come to market with the traditional resi mortgage covered bond product that was being sold to European inves- tors. Our hopes of a development of a deeper and more liquid sterling investor base were, to a certain extent, curtailed by the credit crunch.” He cites other factors relating to the lack of the develop- ment of the UK investor base, including the fact that many UK investors were relatively full on UK bank risk and were not capable of providing for risk adjusted investments in terms of line allocations. In addition, investors were sanguine with bank risk and preferred to buy higher yielding bank capital instruments that provided a pick up to the very tightly priced covered bonds spreads. “Covered bonds were not a natural part of investors’ portfo- lios, which usually would have included equities and real estate in the risk bucket and Gilts and government securities in the non-risk bucket,” adds Tim Skeet, board member and adviser to Covered Bond Investor Council (CBIC) at the International Capital Market Association.
- 26. 24 The Covered Bond Report March 2011 STERLING MARKET: HOME ADVANTAGE Andrew Fraser, investment director for fixed income at Standard Life Investments (SLI), says that at the time of the Bank of Scotland transaction, banks still had access to relatively cheaper senior unsecured funding and the securitisation mar- kets seemed to be the banks’ choice of funding vehicle, rather than covered bonds. “Also the legislation was common law, not contractual, and this all meant that the market remained a niche pre-crisis,” he says. Only in March 2008 did the UK’s Regulated Covered Bond regime come into force. Moving goalposts The situation has since changed dramatically and there has been a shift in the attitude of portfolio managers and issuers towards covered bonds. “There is a strong premium under the Basel III guidelines for banks to get term funding and that has not been so easy to achieve over the past few years,” says Ted Lord, head of Eu- ropean covered bonds at Barclays Capital. “Some UK covered bond issuers are now more willing to pay much more along the lines of where the market is.” Cheaper costs relative to alternative funding sources and the size achievable in the market prompted Leeds Building Society to favour the sterling covered bond market, says Paul Riley, the building society’s group treasurer. He acknowledges that while funding costs have risen, launching a senior unse- cured transaction would have been uneconomical and at least 100bp wider than the covered bond issued at Gilts plus 175bp. “We took on that market leader role because it was the right trade for us,” he says. “Covered bonds have become vital to us and the backbone of our funding going forward.” Riley views the new market as being of strategic impor- tance to the UK mortgage lending sector in its ability to raise funding for advancing new mortgages, particularly if slightly tighter funding spreads are available. In addition, he believes that if lenders cannot fund at the right price in the euro market, the sterling market could offer cheaper funding, or vice versa. “Having that access to a number of markets provides an advantage to an is- suer and makes it clear to the investor community that the issuer has access to more than one mar- ket,” says Riley. This could provide a fillip to UK issuers, w h o have arguably not been given full credit for their strengths or the UK legislative framework by investors in euros. “UK investors are generally more prepared to give better credit to domestic issuers than the continental investors, par- ticularly in longer dated maturities, and that will help the over- all pricing dynamic for UK issuers,” says Skeet at ICMA. Regulatory drivers are meanwhile pushing covered bonds to play a more prominent part in a bank’s funding profile, according to SLI’s Fraser. The regulatory backdrop, in terms of bail-in and re- structuring regulations, could impose losses on senior unsecured creditors, and execution risk for bank unsecured bonds has risen. “Covered bonds seem to be exempt from any resolution re- gime so would not absorb losses at that part of the capital struc- ture,” says Fraser. “The absolute cost of issuing covered bonds relative to unsecured is obviously much lower as well for UK banks so it makes sense for them to issue in covered bond for- mat while that gap still exists.” With Basel III regulations requiring banks to term out their funding much more, using covered bonds as a financing vehicle 24 The Covered Bond Report March 2011 “It is important to get standardi- sation of reporting formats” Andrew Fraser, SLI “Covered bonds could become a cheap and permanent source of funding in the UK” Lucette Yvernault, Schroders
- 27. March 2011 The Covered Bond Report 25 STERLING MARKET: HOME ADVANTAGE allows them to more appropriately match their asset pool with their liabilities. “The sterling market will help banks maintain access to capital markets by providing another funding tool at lower cost, which is good for liquidity and general treasury operations,” adds Fraser. Mixed results Gauging pricing references in a nascent market with few com- parables has been fairly complex. “To get a rough idea of similar levels, some investors have looked at triple-A rated RMBS, some at corporate bonds, while others are attracted to the favourable spread over UK Gilts,” says Lord. The pricing rationale for Leeds Building Society was to come inside where its senior unsecured bonds and UK RMBS were trading, says Riley, but slightly above euro covered bonds to provide a new market premium. “The pricing references were well understood and it was more of a debate on the size of difference between the three instruments,” he says. Leeds priced its £250m 10 year deal at mid-swaps plus 175bp in November. Since then Nationwide Building Society’s £750m 15 year issue came at 150bp over mid-swaps in late January, Lloyds TSB’s £1.25bn 18 year at 175bp in early February, and Abbey’s £1bn 15 year at 158bp over in early March. For those UK issuers that have access to a range of funding options including securitisation, euros, or the senior unsecured markets, the sterling covered bond market may not be the most economical. “The cost differential for a bank like HSBC to issue an un- secured or a covered bond is not going to be that great, so they may prefer not to encumber assets on their balance sheet under covered bond legislation,” says Fraser. There is the potential for non-UK issuers, whether from Eu- rope or elsewhere, to tap the sterling covered bond market and target a new investor base. However, bankers say that this might not benefit European issuers that trade tightly in their own ju- risdictions if UK investors demand a higher premium for them to access the UK market. Plehn at Lloyds notes that the cross-currency swap favours European issuers in the shorter end and could offer them a pick- up to offset the higher margin potentially being demanded by UK investors. “However, demand is lacking at the short end and when you go out to 10-15 years, that swap benefit disappears,” he says. “That differential will start to come in, but it has to make sense for issuers economically. “It is an interesting diversification for non-UK issuers,” he adds, “and ultimately we expect that they will access this market.” Onions at Allen & Overy believes the sterling covered bond market will develop alongside the UK securitisation markets. “It does not seem as though one market is replacing another, as there is still a market for securitisation and it will be down to particular investor appetite which bonds they prefer,” she says. “Covered bonds offer recourse back to the issuer, which is dis- tinct from securitisation. “Meanwhile, continuing issuance of residential mortgage- backed securities under Master Trust and standalone programmes shows there is still strong demand for securitised paper.” Winning fans Interest in the sterling covered bond market is already appar- ent, as there is a ready base of investors attracted to highly rated long dated bonds in the UK. “Ratings arbitrage still exists for insurance companies and the issue of how much capital they must put aside when investing in the bond market,” Lucette Yvernault, fixed income fund manager at Schroders. “Senior unsecured bonds carry a lot of capital pen- alties for them, whereas covered bonds do not as much.” Under Solvency II insurers will have to hold less risk capital against a triple-A rated covered bond compared with a similarly or lesser-rated plain vanilla corporate bond or senior unsecured bond issued by a UK bank. “Solvency II will be a driver of demand for the UK covered bonds and the fact that many UK insurers have long term li- abilities means it makes sense to match them with these long dated assets,” says Fraser at SLI. Leeds Building Society’s Riley believes that in addition to Solvency II, the advent of a bail-in framework, which will not affect covered bonds, is another prominent factor driving inves- tor demand. “Those two factors have been a catalyst for the speed of cur- rent development in the market,” he says. “It does not seem as though one market is replacing another” Sally Onions, Allen & Overy
- 28. 26 The Covered Bond Report March 2011 STERLING MARKET: HOME ADVANTAGE Investors also point to the added security of the cover pool as a primary benefit of covered bonds. In the event of a bank encountering problems or even insolvency, investors have first claim on asset within the cover pool, in addition to a claim against the underlying issuing bank if these assets are insuffi- cient to cover losses. “The probability of default is probably much the same be- tween a covered bond and an unsecured investment in a bank,” says Fraser at LSI. “But your loss given default is going to be sub- stantially lower in a covered bond than unsecured bonds.” Investor confidence in government debt has waned, says Lord at Barclays Capital, and as spreads on covered bonds are now more attractive, the asset class is seeing greater interest from those seek- ing to invest in an ultra-safe long-term product. “Investors are considering it relatively safer to be in a cov- ered bond, an instrument that has never seen a payment prob- lem since they were created in 1769, than certain sovereign debt,” he adds. The new generation sterling covered bonds have also been finding favour with non-UK accounts, with 10% of the Leeds transaction, for example, distributed into Europe, while 20% of the Lloyds deal was non-UK, 15% going into continental Europe. Riley notes that more non-UK investors seem less wary of taking on UK housing exposure, particularly in seasoned cover pools, as the threat of a housing bubble in the UK has dissipated over the course of the last 12 months. “The housing market is subdued, but the UK has not expe- rienced significant price deterioration like we saw in Ireland,” he says. “Therefore non-UK investors are becoming more com- fortable with the cover pools, the product and the strong quality of the underlying assets.” Lord says that the share of overseas demand has the poten- tial to grow. “There are large non-UK funds with fairly reasonable ster- ling portfolios that are able to buy covered bonds but not tri- ple-A rated RMBS, and demand from central banks with large sterling reserves,” he says. As good as their last result The UK has already been recognised for having strong disclo- sure and transparency. Fraser at SLI notes that the UK is more advanced than some European countries in the reporting of collateral. While issuers report on a monthly or quarterly ba- sis in the UK, elsewhere can be published as little as on an annual basis. “It is important to get standardisation of reporting formats so that investors can continually monitor the cover pool,” says Fraser. Work by the Bank of England to increase the level of trans- parency and introduce a national template for UK covered bonds is a major step forward, says Nathalie Aubry-Stacey, di- rector of regulatory policy and market practice and secretary of the Covered Bond Investor Council at ICMA. “The UK is highly transparent and investors have access to a lot of information and data,” she says. “Having national tem- plates in all European jurisdictions will allow investors to com- pare issuance from different countries on a like-for-like basis.” Maintaining cover pool quality so it does not deteriorate over time is one major concern for investors. SLI’s Fraser, for example, stresses that although a cover pool could initially con- tain good quality residential mortgage assets, banks in the UK might have the option to replace these with other assets, such as commercial mortgages. “In that scenario, we would question the bank’s actions as the underlying commercial mortgage market has a different dynamic and the pool quality would decline,” says SLI’s Fraser. Yvernault at Schroders believes it is imperative to sub- stitute any non-performing or high loan-to value (LTV) loan with a more robust one. Substitution is superior to re- plenishment, as it does not allow the quality of the covered bond pool to be diluted over time. She adds that tightening certain regulations would make sterling covered bonds as competitive as those on the continent and also reassure for- eign investors when comparing continental products with the UK market. “Once the market fully develops, there is no reason why the sterling market should not trade on a more comparable level to the continental market,” says Yvernault. “The covered bond could become a cheap and permanent source of funding in the UK, as we have seen through the crisis with well-established covered bond programmes in Europe.” “Covered bonds have become vital to us” Paul Riley, Leeds Building Society
- 29. www.terrapinn.com/coveredbonds BOOK NOW! online www.terrapinn.com/coveredbonds | email cs.au@terrapinn.com | phone +61 2 9021 8808 | fax +61 2 9281 3950 Researched and produced by: Gi13239 Learn how to navigate the new emerging covered bond marketplace Discover innovations in the capital market that will position you at the forefront of this emerging industry. Network with potential covered bond issuers and investors Be a part of this region’s number 1 meeting place for banks, legal firms, rating agencies, institutional investors and advisories looking to grow the covered bonds market in Australia. Gain access to exclusive industry- driven content on covered bonds Gain insights from international and domestic practitioners as they educate our market in covered bonds content that is relevant to the Australian context. Funding strategy and investment opportunities for covered bond issuers and investors 22 – 23 August 2011, WatersEdge, Sydney, Australia Mark your calendar for the 22 – 23 August 2011,WatersEdge, Sydney and confirm your seat now. ww Covered Bonds World Australia 2011 is a priority for all covered bond practitioners. So what are you waiting for? Register now to become a part of the discussion on the latest industry trends and issues and expose yourself to this new and emerging market.
- 30. 28 The Covered Bond Report March 2011 COUNTRY PROFILE: AUSTRALIA
- 31. March 2011 The Covered Bond Report 29 COUNTRY PROFILE: AUSTRALIA T he Australian government’s decision in December to free Australian financial institutions from the shackles of the Australian Prudential Regulation Authority’s strict interpretation of section 13A of the Banking Act 1959 and allow ADIs to issue covered bonds represented a victory for the Australian banking industry after years of lobbying. However, its success was born out of circumstances quite different from those that prevailed when David Addis, then chair of the Australian Securitisation Forum’s prudential committee and head of structured product origination and sales at ANZ, and Brian Salter, then partner at Clayton Utz, in 2005 received the letter abridged above. “Securitisation was in its heyday back then, so you were getting very tight deals done,” says Addis, now managing di- rector at Cygnus Advisory. “But covered bonds were better in a number of ways. They tended to be bullet with a revolving structure, which regular securitisations here were not, and they also went for much tighter prices, and in much bigger volumes than the local RMBS deals. “And when you are talking billions of dollars and a few basis points, it’s actually worth quite a lot of money to everyone.” But Addis acknowledges that a new funding avenue was not essential in the same way that it had become as lobbying for covered bonds intensified post GFC – Global Financial Crisis, as it is commonly known in Australia. “It would have enabled the banks to open up a new fund- ing stream,” he says, “which would have been helpful, but there wasn’t a pressing need in the same way that obviously there has been since the securitisation market became so restricted.” With Australian mortgage lenders so reliant on the securiti- sation markets, the effects of the US sub-prime crisis changed the Australian financial landscape. “Most of the non-banks really struggled through the finan- cial crisis,” says Addis, “because a lot of them relied very heavily on securitisation and when they couldn’t, they just basically got Australia winds up for delivery 25 January 2005 Dear Messrs Addis and Salter, Covered bond holders would have first priority over assets of an ADI (authorised deposit-taking institu- tion), ahead of the ADI’s depositors. We cannot see how such arrangements can be consistent with the principle underpinning Australia’s depositor prefer- ence regime that depositors have the ability to claim on the assets of an ADI in Australia in preference to all other potential creditors… In summary, APRA believes that the issuance of cov- ered bonds would not be consistent with Australia’s depositor preference regime and it is not, as a mat- ter of principle, prepared to accept issuance of such bonds (or structures with equivalent effect) by ADIs in Australia. Yours sincerely, John F Laker 12 December 2010To secure the long-term safety and sustainability of our financial system, we will… allow all banks, credit unions and building societies to issue covered bonds to broaden access to cheaper, more stable and longer- term funding… The Hon Wayne Swan MP, deputy prime minister and treasurer After years of watching from the stands, Australia’s banks are taking a run up for issuance as early as the third quarter. The banking industry is therefore hard at work ensuring the right balance is struck between issuer and investor needs in impending legislation. But could RMBS and smaller banks be dismissed cheaply? By Neil Day
- 32. 30 The Covered Bond Report March 2011 COUNTRY PROFILE: AUSTRALIA slammed by their banks or their funders. One of them had a lot of short term extendible CP paper in the US market and it couldn’t roll it over. “Some, like Aussie Home Loans, which was one of the origi- nal securitisers, were partially bought out and supported by the banks, but a lot just stopped writing mortgages because they just couldn’t fund them. During the GFC the banks’ share of new mortgage origination went to well over 80%, and the 15%- 20% that they were not actually writing directly, they were ef- fectively funding through those non-bank originators whom they chose to support.” However, Australia’s major banks have also come under pressure. Although they remain highly, Moody’s, for example, in mid-February put the Aa1 ratings of the country’s big four – Australia & New Zealand Banking Corporation, Common- wealth Bank of Australia, National Australia Bank, and Westpac Banking Corporation – on review for downgrade. “The review will focus on the Australian banking system’s structural sensitivity to conditions in the wholesale funding mar- ket,” says Patrick Winsbury, a senior vice president at Moody’s. “The global financial crisis has underlined the speed with which shifts in investor confidence can impact bank funding, warrant- ing a review of the four major banks, for whom market funds comprise on average 43% of total liabilities.” Gail Kelly, Westpac chief executive officer, told a Senate in- quiry into the government’s banking reform package in January that covered bonds should help. “Covered bonds are valuable for us,” she said. “It’s not a pan- acea for us, but it’s an important next step to allow us to leverage our mortgages… that’s very helpful.” Meanwhile, Cameron Clyne, group CEO of National Aus- tralia Bank has welcomed the government’s move and said that covered bonds could help lower funding costs for the bank’s A$28bn of bonds it was expecting to sell this year. GFC swings the debate Speaking at a roundtable for the Deloitte Australian Mortgage Report 2011: Reforming the Agenda, Axel Boye-Moller, head of mortgages at Westpac, outlined the challenges facing the Aus- tralian mortgage industry. “What we have is a structural issue, with a limited depos- it pool unable to keep pace with growth,” says Boye-Moller. “There isn’t enough growth in deposits so we are all just fight- ing over share. Savings are not being channelled into the bank- ing system hence banks are reliant on wholesale funding, and offshore wholesale funding in particular. “Covered bonds could be part of a solution to this struc- tural issue and we would support that development. But we need to think more broadly and consider other measures to facilitate securitisation of mortgages, as well as increasing the deposit pool.” Graham Mott, financial services partner at Deloitte, says that covered bonds are a must in this context. “Given how significant their funding challenges on an annu- al basis are, covered bonds are key for our banks locally, partic- ularly the majors, to allow them to compete and raise funds on a global scale,” he says. “That’s got to be the underlying driver here, which is why the government has relented.” Addis agrees. “I expect that Treasury has been convinced that, with the securitisation market and other bond markets really being quite subdued, the performance of covered bonds was de- monstrably better than MBS or other funding through the GFC,” he says. Westpac highlighted this in its submission to a Senate in- quiry in December, ahead of the government’s announcement. “Covered bonds through the GFC provided a stable source of funding in other countries, retaining their broad investor ac- ceptance,” it said. “They have stood the test of time including a “It’s not a panacea for us, but it’s an important next step.” Gail Kelly
- 33. March 2011 The Covered Bond Report 31 COUNTRY PROFILE: AUSTRALIA significant number of economic cycles and financial crises, and as economic and financial infrastructure has evolved.” Indeed billions in government guaranteed bank issues ben- efiting from such support begin come up for redemption from next year and offering ADIs an alternative funding option that might appeal to a similar investor base has been cited as an- other reason for the government’s decision. And as if these factors were not enough, some observers ar- gue that the launch in June 2010 of the first covered bond in New Zealand, by National Australia Bank parent Bank of New Zealand, was the final straw. “That was a big help,” says one market participant. “It just made the Australian position even stranger. It wasn’t just Eu- rope having covered bonds, it wasn’t just the US and elsewhere, it was now New Zealand. “The four major banks in New Zealand are subsidiaries of the four major banks in Australia, so it made a mockery of the fact that these same groups were doing it in New Zealand and yet not at home.” Boundaries expanded While a change to the Banking Act will allow ADIs to add cov- ered bonds to their funding options, the government will not give Australian banks free rein to issue covered bonds. “The Treasury will also consult on the appropriate level of cap to be placed on covered bond issuance for individual insti- tutions, for example 5% of an issuer’s total Australian assets,” it said. “This will ensure a substantial buffer of assets to cover depositor claims, making it extremely unlikely that a levy under the Financial Claims Scheme would ever be needed.” As The Covered Bond Report was going to press, a draft law for Parliament to consider was imminent, but market partici- pants have expressed confidence that the paper will double the 5% limit to 10% , a level settled on by the Reserve Bank of New Zealand in March. “The 5% level was quite swiftly and successfully explained as totally inadequate,” says one, “and it looks like being 10%.” According to calculations by Deloitte’s Mott, were banks across the board to take full advantage of a 10% limit, issuance could reach around A$180bn, which is more than twice the out- standing volume of Australian RMBS. “Certainly that would be the sort of capacity that the balance sheets would support,” he says. While the number is impressive, questions remain. “Initially the government was thinking only a 5% issuance limit relative to assets, but it seems there is an acknowledgement that it needs to be higher in order to make individual issuance the broader market for Australian covered bonds a meaningful and worthwhile,” says Alex Sell chief operating officer of the Australian Securitisation Forum. “That should perhaps mean that the percentage goes higher but with a secondary limit re- garding liability mix whereby if you’re very highly dependent on retail deposits you will be able to issue less than if you are less exposed. We understand that APRA has been calling for something along those lines, and this resembles the FSA’s ap- proach in terms of looking at overall asset encumbrance relative to liability mix.” Meanwhile, Fergus Blackstock, head of Australian debt capi- tal markets at UBS, says that the 10% limit takes into considera- tions the requirements of a variety of players in the market. “It’s clearly within the comfort limits of the rating agencies and it would make it efficient for some of the smaller issuers who have got smaller balance sheets,” he says. Investors drive law change The minimum that the government needs to do to trigger cov- ered bond issuance is amend the relevant section of the Bank- ing Act, which reads: “If an ADI becomes unable to meet its obligations or suspends payment, the assets of the ADI in Aus- tralia are to be available to meet that ADI’s deposit liabilities in Australia in priority to all other liabilities of the ADI.” However, while this de minimus approach might have been sufficient in 2005, when markets were roaring and UK banks were prospering from a similar position to price covered bonds just a few basis points back from products based on prescriptive laws, such as Pfandbriefe, the banking industry is now expect- ing something more thorough. “The government has already committed itself to amending the Banking Act to permit covered bonds by removing the ab- solute depositor preference provision that has been there since 1959,” says Sell, “which you might think means that structured and legislative would then be possible. But the government has indicated that it doesn’t wish to see structured covered bonds coming about.” While this might previously have disappointed some banks, all are said to be moving towards a position where they con- sider a more comprehensive framework to carry benefits for the industry. “The push locally has been that we need a legislative frame- work rather simply progressing with a structured solution,” says Mott at Deloitte. “And mainly that’s to demonstrate to the global investor community that Australia has the rigour of a legislative framework to support its covered bonds. “The people that we are listening to the most, which is the right answer, is now the investor community in our positioning of covered bonds.” Louise McCoach, a partner at Clayton Utz, echoes this. “The current iteration of the policy certainly takes into account more of the buy- side perspective.” Louise McCoach
- 34. 32 The Covered Bond Report March 2011 COUNTRY PROFILE: AUSTRALIA “Certainly the first consultative document tabled by Treas- ury was very much looking at a de minimus regime, which con- templated some legislation, but not a regulated regime like the Regulated Covered Bonds in the UK,” she says. “The industry was very quick to point out that the consultation process prob- ably needed to listen a bit harder to what investors had to say, especially offshore investors that are not used to investing in an unregulated market. “Some of that feedback has been taken on board by Treasury and the current iteration of the policy certainly takes into ac- count more of the buyside perspective, actually factoring in the possibility of regulated elements, although elements that do not seem particularly onerous.” Sell at the ASF says that one thing this means is that legisla- tion must produce a homogenous product. “Issuers want to ensure that when an investor in London or Oslo picks up an Australian covered bond they don’t need to worry too much about heterogeneity between Aussie deals,” he says. “We want them to be able to say: ‘Right, I know that if this is a legislative, regulated Australian covered bond, then it will contain these features, so I therefore need to just focus on pric- ing, the detail of the collateral, and the issuer itself. It’s about trying to make the investors’ job easier to lower any potential obstacles to investment.’ “And also making the product as similar as possible to what they are used to as possible, while making sure that the Austral- ians are best of breed and can take the best bits from the various products in Europe.” Keeping APRA in check However, he stresses that the framework must retain flexibility and McCoach says that such an approach could yield benefits for issuers and investors. “We don’t know necessarily how investors are going to react, so the sort of structure that the industry has been putting for- ward is a flexible structure where, yes, we pass some legislation to implement the necessary framework to allow an Australian covered bond market to develop, and allow for regulations to be passed in the future to enable issuers to be flexible enough to meet needs and to tweak their structures depending on investor feedback,” she says. “So if anything needed to be done to make the model more regulated, that could be achieved through reg- ulation that would be subordinate to legislation, and would be much easier to enact and pass.” The imminent legislative proposal is expected to set down various parameters for Australian covered bonds that will reso- nate to differing degrees with issuers and investors in different parts of Europe. In structure, they will resemble the model pio- neered in the UK. “They’re going down an SPV route for the structure, rather than an integrated model as a lot of continental European is- suers have,” says Alex Chernishev, senior associate in Clayton Utz’s securitisation team. “The SPV route just requires less ma- jor surgery in terms of our banking legislation.” After some suggestions that APRA might act as cover pool monitor, the role is now considered more likely to be taken up by auditors or trustees, with conflicts of interest potentially arising were the regulator responsible for depositor protection to take on the covered bond function. The Treasury is also understood to be moving towards set- ting eligibility criteria for covered bonds, which was not in initial plans, and laying down how banks would be registered and regulated under the regime, and who by. Alongside APRA among Australia’s financial authorities is the Australian Securi- ties & Investments Commission (ASIC). Sell says that issuers are keen to ensure that as well as limits on their activities, there are limits on the regulator’s discretion- ary powers under the legislation. “Legislation or regulation should deliver as little supervi- sory discretion as possible. We want certainty with respect to overcollateralisation, minimum and maximum levels, so that an investor knows that APRA can only direct a bank to stop maintaining a particular level of OC at a given level, rather than APRA having the discretion to say stop whenever it feels it needs to. “That’s designed to give investors certainty and predictabil- ity about where APRA’s rights of intervention start and stop.” He says that the second reason is for the benefit of not just issuers, but also investors. “We want certainty with respect to overcollateralisation, minimum and maximum levels, so that an investor knows that “Most of the non-banks really struggled through the financial crisis.” David Addis
- 35. March 2011 The Covered Bond Report 33 COUNTRY PROFILE: AUSTRALIA APRA can only direct a bank to stop maintaining a particular level of OC at a given level, rather than APRA having the dis- cretion to say stop whenever they like. “That’s designed to give investors certainty and predictabil- ity about where APRA’s rights of intervention start and stop.” CIBC calms nerves When announcing its plans in December, the Treasury cited a recent example of successful covered bond issuance in Aus- tralia – albeit from an overseas issuer. The deal in question was a A$750m three year issue from Canadian Imperial Bank of Commerce in October, and it was the first covered bond sold into Australia since before the GFC, when Dexia Municipal Agency tapped the market in July 2007. And after CIBC’s issue, Bank of Nova Scotia raised A$1bn. While covered bonds might be in their infancy in Australia, Wojtek Niebrzydowski, vice president, treasury, at CIBC, notes that Australia has a mature fixed income market, with Kanga- roo issuance last year totalling around A$30bn. “Ultimately it’s not going to provide the same volumes that the US can now and that, theoretically, the euro could, but it has become a very important secondary market for us,” he says. However, ahead of CIBC’s second issue, fears that de- mand for covered bonds – from overseas issuers as well as forthcoming Australian issuance – could be stymied were raised when APRA disappointed the market once again, by stating that under its initial implementation of the Basel III framework no securities would be eligible as liquidity buffer Level 2 assets – the category the Basel Committee had en- couragingly placed them in. The announcement did not come as a complete surprise, and not only because of APRA’s historical aversion to cov- ered bonds. Market participants adjudged APRA’s decision that covered bonds are not yet sufficiently liquid as fair, and hold out the hope that a review promised by the regulator will let covered bonds in around the time Basel III is imple- mented in 2015. “I would see APRA coming to the party in the future regard- ing Level 2 assets,” says Deloitte’s Mott, “and that will also support this as a funding mechanism through the pricing and liquidity that it delivers. However, the industry needs to prove up the li- quidity before APRA responds favourably to their position.” Market participants also point out that covered bonds could still be used in liquidity buffers, since they could become eligi- ble for the Reserve Bank of Australia’s ordinary Open Market Operations and then its new committed secured liquidity fa- cility. This is a means by which Australian banks can generate prudential liquidity to meet the LCR ratio, under an option af- forded certain countries under Basel III where there is a lack of Level 1 and Level 2 assets. Their worries were nevertheless eased by the success of a follow-up transaction by CIBC in early March – although not without some nerves being suffered along the way, as a Kan- garoo issue in the sovereign, supranational and agency sector – also excluded from LCR ratios – was put on hold. CIBC went ahead with a A$700m deal through leads CBA, CIBC, HSBC and UBS and some three-quarters of the covered bond was sold to banks, the majority in Australia. Niebrzydowski says that this was similar to bank participation in the issuer’s first Aussie dol- lar covered bond. “We had hoped that this would be the case, but we weren’t certain,” he says. “If it had come prior to the APRA announce- ment, it would have been less challenging, coming after our de- but and one of our Canadian competitors. “Once the announcement came out, we spent a fair amount of time going back and forth looking at whether the market would still be there, and whether we should still go for a five year or instead a three and a half year that would take it up to “I would see APRA coming to the party in the future regarding Level 2 assets.” Graham Mott
- 36. 34 The Covered Bond Report March 2011 COUNTRY PROFILE: AUSTRALIA before the January 2015 Basel III imple- mentation. But ultimately we came to the conclusion that a five should still work and it did.” The five year issue was priced at 74bp over mid-swaps, while its three year de- but came at 48bp over. The new issue’s spread was well inside levels at which banks had been raising senior unsecured debt in Australian dollars. Barclays Bank sold a three year in mid-February at 140bp over and Westpac a four year in early February at 110bp over, for example. RMBS on the back foot? More pertinent than comparisons with senior unsecured lev- els, however, could be the relative pricing of covered bonds versus RMBS. While there is confidence that an Australian product akin to European covered bonds will find buyers who value the structure among an established investor base, there have been some questions as to how much interest the asset class might garner among Australian investors more used to securitisation. “There was a lot of speculation about this, because the inves- tor base has been more used to RMBS, which is a higher spread product,” says Blackstock at UBS. “However, our experience with both CIBC and Bank of Nova Scotia was that there are plenty of investors who have a strong appetite for the product and like the liquidity and the bullet nature. “So there is proven demand for both.” Justin Mineef, senior vice president, corporate finance secu- ritisation at CBA, says that he expects the covered bond inves- tor base in Australia to be comparable to that for RMBS. “The investors will be those that we would ordinarily see in an RMBS book,” he says, “and also that would be both real mon- ey managers as well as financial institutions, which has always been a blend in RMBS books. It’s another product, so there’ll be a different price point, but it’ll be going to pretty much the same investor base that we’ve got.” Rob Verlander, head of corporate finance securitisation at CBA, says that key to what kind of spread investors are willing to accept will be liquidity considerations. “They’ll look at covered bonds versus RMBS not only in terms of credit, but in terms of liquidity,” he says, “and given the sort of environment we’re in, they’re likely to put more weight on the notion of liquidity than credit. They’re already working the triple-A credit in RMBS – with the performance of that product in this marketplace having been almost perfect – so you are not dealing with any repu- tation issues in this market. So then it boils down to issues of liquidity and it’s quite clear that the double-A bank unse- cured market, for example, is perceived as more liquid than the triple-A RMBS market. “Investors may well consider that they will get more liquidity out of covered bonds than RMBS, more akin to double-A bank paper, and be willing to pay for that. It then would be an issue of how much they are going to pay.” But others remain cautious. “It’s difficult to say with certainty until we see the markets side by side, but what you can say is that in Australia there isn’t much of a rates investor base,” says one market participant. “So investors are pri- marily credit investors, be they senior unsecured, bank debt, or RMBS credit investors. “The major investor pool will be the global rates investor. Of course, there is the caveat that the distinction between rates and credit investors has become blurred, more by rates inves- tors moving towards credit.” Some bankers point out that cross-currency swaps today would make Australian dollar issuance more attractive for the country’s banks were they to issue now, although the situation could change by the time their programmes are up and running. The other side of the coin is what the covered bond alterna- tive will mean for issuers’ desire to sell RMBS. Although the major banks have recently returned to RMBS, their enthusiasm for the market has been dampened as the levels achievable have been unattractive versus where they can issue senior unsecured debt against their double-A ratings – with the aforementioned caveat that they are on review for downgrade. “RMBS has sort of gone out of fashion for the major banks – albeit Westpac did do A$1bn the other day – and the rea- son is primarily because the price doesn’t stack up. If you’ve got double-A ratings, why would you be issuing RMBS? “That said,” he adds, “RMBS have come in from about 160bp to 100bp while senior unsecured have blown out from around 80bp to as wide as 160bp. Also, they may like the funding di- versification.” However, APRA’s harsh treatment of RMBS under APS 120, where market participants say it is hard to convince the regula- tor that “significant risk transfer” has occurred, is said to be a further obstacle for securitisation in the competition with cov- ered bonds. Mutuals seek redress While the major banks are seen as shoe-ins for covered bond issuance, the case is not considered so clear for smaller ADIs. Indeed some have raised concerns about the introduction of covered bonds in Australia. Abacus, which represents Australian mutuals, said in No- vember in its submission to the Senate inquiry into competition within the banking sector that it strongly rejected the notion that covered bonds are pro-competitive. “There is little doubt that the major banks will be able to source additional lower cost funding through covered bonds, however it is unlikely that many smaller regional banks, credit unions or building societies would be able to access funding through such an instrument,” it said. “Furthermore, the promise that the issue of covered bonds will have flow on effects for other Issuance could reach around A$180bn, which is more than twice the outstanding volume of Australian RMBS.
- 37. March 2011 The Covered Bond Report 35 COUNTRY PROFILE: AUSTRALIA lenders because of reduced competition in other funding markets seems to be il- lusory. “It seems unlikely to Abacus that a major bank will let go of one source of funds simply because it has found another source of funds. A more likely proposition is that the additional funds will be used to strengthen the position of those banks that issue covered bonds, to the detriment of other participants in the market.” Abacus said that if covered bonds are allowed – and it said that it was not philosophically against them – credit unions and building societies should receive corresponding support. Initially, the government planned to outline a pooling or ag- gregation model or joint issuance, to ensure that smaller issu- ers could also benefit, but difficulties in achieving a workable model are understood to have held back this ambition. “The lobbying has really decoupled the pooled arrangement from the direct issuance, which has allowed the direct issuance to continue through the legislative process and hopefully un- encumbered allow our ADIs to issue direct to the market,” says one observer. “The reason for decoupling the pooling is because of the complexity that’s involved, just the general structuring to make that happen. “I still see that you probably need some government inter- vention somewhere to make that a more simple process for eve- ryone to enjoy the benefits of covered bonds.” Jennifer Wu, vice president and senior analyst at Moody’s, says that cultural differences explain some of the difficulties of creating a workable aggregation model in Australia. “Unlike some of the European models where the smaller banks are actually quite open with each other, in Australia the credit unions, the smaller mutuals, are more conservative and protective of their own business,” she says. “So finding a struc- ture whereby the smaller ADIs, mostly in single-A or Baa range, can actually be competitive with covered bonds by achieving a triple-A rating would probably require some governmental supervision. “The government will therefore have to consider how much they want to be involved.” The government and smaller banks are therefore focusing on other meas- ures that could help them, and the package of measures that covered bonds were part of in December con- tained some moves in this regard. But some bankers suggest that smaller institutions could by- pass any attempts at aggregation and access the covered bond directly on a standalone basis. They point to the success of smaller issuers with non-triple-A rated covered bonds access- ing the market in Europe. “There is merit in lower rated institutions considering the market,” says CBA’s Mineef, “even if they may be constrained by their rating, by duration and outright volume. If you are a lower rated institution, there’s probably more merit in that than possibly the aggregated model, which is interesting but may not come together in a practical way, at least in the first instance. “There is clearly a benefit for the majors of going and issuing triple-A paper in larger volume here or offshore, but the other guys can pursue a non-triple-A covered bond market with the investor base locally. If investors understand the financial insti- tution and may be a current buyer of their RMBS programme, then they may well look at it in covered bond format.” And Verlander says that they may be boosted by a lack of competing supply. “The Australian market has very little by way of credit product,” he says. “That’s particularly evident in the corpo- rate market, but there isn’t a lot of credit product overall. So to the extent that you can actually do double-A covered bonds and offer a reasonable spread, you are probably going to attract a reasonable level of interest, even if they are tight relative to RMBS.” 5.0% 10.0% 15.0% Combined capitals -5.0% 0.0% Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Combined ‘Rest of State’ Source: RP Data–Rismark Rolling annual change in house values, Capitals v Rest of State RP Data-Rismark Home Value Index, Seasonally-Adjusted Results, Houses “Plenty of investors have a strong appetite for the product and like the liquidity and the bullet nature.” Fergus Blackstock
- 38. 36 The Covered Bond Report March 2011 COVER STORY: BAIL-INS
- 39. March 2011 The Covered Bond Report 37 COVER STORY: BAIL-INS H appy New Year? Not for the senior unsecured market. Issuers and investors were barely back from their seasonal holidays on 6 January when the European Commission delivered a nasty shock. Expanding upon proposals released in October setting out the Commission’s proposed framework for crisis management in the financial sector, the EC launched a consultation that put more flesh on exactly what “fair burden sharing” might mean for bank creditors. “The possible options set out in this consultation would con- stitute a significant step for the EU in delivering the commitment made at the G20 summit in June 2010, by ensuring that authori- ties across the EU have the powers and tools to restructure or resolve (the process to allow for the managed failure of the finan- cial institution) all types of financial institution in crisis, without taxpayers ultimately bearing the burden,” said the Commission. It said that this “might include possible mechanisms to write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses”. Commenting on the detail of the proposals, Fitch analysts spelt out very clearly what this will involve. “Under this framework, ‘bail-in’ debt would be viewed as a form of hybrid capital and be rated accordingly,” was the rating agency’s verdict. Fitch said that the EC had gone a step further in January than in its October proposal. “Rather than pursuing the notion that all banks be potentially subject to a resolution regime, the Commission suggests that some institutions may be ‘too large, complex or interconnected’ to be put into a resolution regime and may have to be dealt with on a going concern basis through the deployment of contractual ‘bail-in’ debt,” said the rating agency. “‘Bail-in’ and resolution are, therefore, in the first instance mutually exclusive alternatives.Room for everyone?European Commission bail-in proposals have prompted senior unsecured investors to seek the security of covered bonds, raising fears of an over-reliance on the asset class among the buy and supply sides. But proponents warn that investors have nothing to fear but fear itself. By Neil Day and Maiya Keidan “Although the activation of the ‘bail-in’ trigger might be at the behest of the regulators, this is nevertheless a contractual mecha- nism for dealing with a failing bank, akin to hybrid capital.” And not only would senior unsecured debt be subject to being bailed in; any bail-in would also be subject to the whims of regulators. Georg Grodzki, head of credit research at Legal & Gen- eral Investment Management, summed up investors’ fears at a Landesbank Baden-Württemberg covered bond conference in early February. Whilst he stressed that taxpayers’ money should not bail out failing banks and their debt holders, he was not im- pressed with the threat posed to senior debt by the wide rang- ing discretionary power afforded to regulators in the proposed bail-in legislation.
- 40. 38 The Covered Bond Report March 2011 COVER STORY: BAIL-INS “We don’t really want to second guess what individual nation- al regulators may do with that discretionary power”, he said. ”We are worried that a more aggressive regulator could be tempted to bail in senior debt because it is more convenient than to put a bank into administration and let creditors work out a solution according to their contractual rights and the insolvency laws. “Senior debtholders would be at risk of losing money be- cause of regulators moving the goalposts for a bank’s capital requirements. This additional risk would have to be compen- sated for through higher credit spreads. The access to wholesale markets and the funding costs for banks would also become more volatile.” Although the proposals envisage the grandfathering of out- standing senior unsecured paper and implementation is not expected until at least 2014, the effect on sentiment towards senior unsecured debt was immediate, with issuance stymied. Schadenfreude? Covered bonds, meanwhile, were enjoying a record start to the year, with more than Eu18bn of benchmark euro issuance in the first week alone. From almost the very first issues of the year there were fears that, as on many occasions in the past, the market was heading for a fall, with the asset class set to be its own worst enemy with oversupply souring market conditions. Yet the market proved resilient and more than Eu80bn of euro benchmark issuance had been digested by mid-March, as demand proved able to match supply, with investors defecting from the senior unsecured market into covered bonds. “What I can see at this very moment, already, is that a lot of guys from the senior side are calling me up, wanting teachings on covered bonds and are seriously thinking of switching – at least some of their money – into covered bonds,” said Crédit Agricole analyst Florian Eichert in early February. “I don’t know whether those guys have actually started shift- ing their holdings, but at least they’re asking a whole lot more questions than they were in the past and they have been active in primary market deals like a recent UniCredit OBG.” Royal Bank of Scotland analyst Frank Will said that he, too, had noticed a significant shift from senior unsecured to covered bonds. “People are scared on the senior unsecured side” he said. “People are looking for alternatives now.” What seems clear now is that the EC’s plan played into long- er term trends prevalent in the markets. “What you can see and feel in the market is that the investor base is growing, that we have had new investors coming into the market since January,” says Heiko Langer, senior covered bond analyst at BNP Paribas. “Whether that is mainly due to this spe- cific EC paper or is a trend that had started already at the end of last year and is now accelerating, that is difficult to say. “But clearly the bail-in theme, which was already around before that paper, has significantly changed the demand side.” And Langer believes that the shift is far from over. “There are a good deal of investors out there who are still in the research phase and looking at the product but haven’t started buying yet, and others that have been buying covered bonds for a long time and are considering buying more,” he says. “They are switching out of senior, or just running off sen- ior unsecured exposures as they mature and replace the incom- ing cash with covered bonds. “They are looking at other secured instruments as well,” he adds. “We must not forget that covered bonds are not the only secured instruments out there and there is a chance that the revival that we have seen so far in securitisation could develop further because people might have a preference for security and if the question is bail-in-able senior or securitised, maybe some people will say, I’ll rather have the securitised debt.” Richard Kemmish, head of covered bond origination at Credit Suisse, echoes this. “All the bail-in proposals are doing is accelerating a trend that has been happening for a long time,” he says, “and that is the trend for more people to realise that they really need secu- rity in some form, whether it be for credit or regulatory reasons. People were increasingly nervous about bank credit given eve- rything that has happened, and covered bonds looked increas- ingly attractive. “Brussels and to some extent the ECB had exacerbated that trend by making the incentives to own covered bonds more significant. Then suddenly they’ve massively accelerated the trend by formalising the uncertainty about senior unsecured bonds with the resolution regime proposals. Formalising that uncertainty means that a huge number of people have looked to “The line of covered as the new senior is quite a catchy phrase” Heiko Langer, BNP Paribas
- 41. March 2011 The Covered Bond Report 39 COVER STORY: BAIL-INS reallocate large chunks of their portfolio from senior unsecured into covered.” And observers point out that while securitisation could yet compete in offering investors security, it does not benefit from the regulatory support afforded covered bonds under the Basel III proposals, where the asset class will be eligible for liquidity buffers, in Europe at least. Ever vigilant As has been the financial markets’ wont since market partici- pants failed to notice the impending crisis before it struck in 2007, attention quickly turned to seeking out the next potential problem in the market. Not surprisingly, given their dramati- cally higher profile, covered bonds came into the firing line. Posting on M&G’s “Bond Vigilantes” blog in the midst of the record-breaking start to the year, Matthew Russell, a fixed in- come manager at M&G at the investment firm, was one investor to warn against the burgeoning asset class, describing “covered bonds as the only option for bank funding”. “A preponderance of covered bonds is clearly not good news for senior debt holders,” he wrote, “because in the event of a bank liquidation you are further away from the top of the capi- tal structure and therefore have a claim over fewer assets than you would have traditionally had. It will be interesting to see how the covered bond market develops and what happens to spreads – what will dominate? Demand or supply? “This Titanic issuance of covered bonds is more than mov- ing the proverbial deck chairs around to fund the banks. In fact senior and subordinated bond holders are being rearranged further from the safety of government and legal lifeboats.” Russell was not alone in his opinion, as some of his peers became concerned and the argument was relayed by the Finan- cial Times and other established financial markets publications warning of the dangers of banks becoming over-reliant on cov- ered bonds. “I think this was overplayed, the fear of people that banks will shift dramatically towards covered bond issuance and stop issuing senior,” says BNP Paribas’ Langer. “The line of covered as the new senior is quite a catchy phrase and lent itself well to being a headline on all kinds of reports, includ- ing research reports. While there is some truth in it, one has to be realistic. “One has to look at who the issuers are, what their issuing potential is, and what their balance sheet structure is. A lot of the new banks that have entered the market in the last three to four years are quite diversified universal banks that have a lot of assets on their balance sheets that are not eligible as collateral for covered bonds.” Jan King, covered bond analyst at Landesbank Baden-Würt- temberg, points out that even those issuers for whom covered bonds constitute a major funding source will have to retain ac- cess to senior unsecured debt. “The question is how overcollateralisation will be funded going forward,” he said, “because senior unsecured is probably becoming more unattractive for investors or at least it should become more expensive. There is in the end still some remain- ing funding that is needed on an unsecured basis and I think that’s the challenge going forward.” An uncommon curse In early March Fitch published an extensive research report ex- amining what proportion of banks’ funding came from covered bonds and found that their use was “modest” – even if the rat- ing agency said that it was not passing judgement on what the impact of issuance was on senior creditors. The rating agency said that only in extreme scenarios would covered bonds become “more of a curse than a choice”. “There is an argument that a potential spiralling effect exists, whereby growing covered bond funding could gradually crowd out appetite for senior unsecured debt,” said Fitch. “Certainly, increased issuance of secured funding in a troubled bank may become more a curse than a choice for treasurers seeking inves- tors for unsecured issues. “Apart from such extreme cases, the risk of covered bond funding reaching a level that acts as a deterrent to potential senior unsecured debt investors is still small for the majority of issuing banks.” While acknowledging the structural subordination covered bonds cause, Fitch highlighted their positives. “It makes sense that covered bonds are exempted from bail-ins” Ralf Grossmann, Société Générale
- 42. 40 The Covered Bond Report March 2011 COVER STORY: BAIL-INS “The increase in covered bonds funding is compounded by the over-proportional increase in the size of the cover pool assets, which collateralise the bonds,” said the rating agency. “Issuers now provide larger overcollateralisation than in the past to pro- tect investors against credit and market value risks. This reduces the assets available to enable repayment of unsecured debt and depositors in the event of an issuer default. Furthermore, covered bonds are not the only form of secured funding encumbering as- sets on banks’ balance sheets. There is also an increased use of collateral for central bank funding and market repo activity. “However, Fitch notes that access to alternative, low-cost fund- ing sources and especially long-term ones is beneficial to a bank’s creditworthiness and, by extension, to its unsecured creditors.” Credit Suisse’s Kemmish says that it is important that this side of the argument is heard and that too great a focus on loss given default and recovery rates is a danger. “It is an erroneous but common belief that asset encumbrance becomes a vicious circle,” he says, “the more covered bonds you issue, the more difficult it is to issue senior unsecured debt. The reasoning being that is when the bank goes bust you’ve got all these German investors in front of you in the queue for the assets. And who’s going to buy what is effectively subordinated debt? “That is an overstated problem, but it is something that every single regulator in the Anglo-Saxon world – unlike almost eve- rybody in continental Europe – is concerned about. And that is going to send a negative signal about conflicts of interests within regulators, suggesting that when something goes wrong they may try to claw back some of the assets for the unsecured creditors.” Indeed, with the notable hold-out of a few regulators around the world solely focused on depositor protection (notably the Federal Deposit Insurance Corporation in the US), the tide among governments and financial authorities has turned firmly in favour of covered bonds. The nuclear option The apparently irresistible momentum driving the covered bond market could, however, rapidly disappear were covered bonds ever to be subject to bail-ins themselves. Although Pfandbriefe are explicitly exempted from German bank restructuring legislation passed last year, covered bonds are not mentioned in the EC’s proposal. The newly elected Irish government has already raised the unexpected spectre of bail- ing in senior unsecured creditors and popular opinion in Ice- land has swayed its president into taking decisions that appear to ignore conventional financial wisdom. However, few market participants are willing to even con- sider this scenario. “In the documents we have seen, and the EC one in particular, it is not written that covered bonds should be bailed in, whereas it explicitly mentions senior unsecured, or non-secured debt,” says Ralf Grossmann, head of covered bond origination at Société Générale. “And it makes sense that covered bonds are exempted from bail-ins, because why establish a legal framework that gives them an exemption from general insolvency legislation – which covered bond laws in France, Germany and Spain, for example, do – and then basically declare this null and void by bailing them in? “It really doesn’t make sense.” However, he suggests that in countries where covered bonds are not specifically exempted from bankruptcy proceedings, is- suers and the authorities might want to take the opportunity afforded by implementation of any new bail-in regime to make the asset class’s privileged position explicit. Credit Suisse’s Kemmish says that he is more concerned about this possibility being feared than such a scenario ever coming to pass. “I think it’s very real that people might think that covered bonds could be bailed in,” he says, “but, no, I don’t think it could ever happen. Every regulator understands that they are there to protect covered bond holders, even if they know that the guy sitting in the office next to them is trying to protect the unse- cured depositors. “It would never come to the case where a government would make a covered bond default by taking assets away from a pool. That would cause huge systemic damage.” Grossmann agrees. “In the Irish case, there could indeed be a solution where the senior unsecured debt will be bailed in,” he says, “but would they go so far as to bail in the covered bonds as well? “Which would mean that they could forget about covered bonds for the future, right?” “It is an erroneous but common belief that asset encumbrance becomes a vicious circle” Richard Kemmish, Credit Suisse
- 43. The Covered Bond Report The Covered Bond Report is the first magazine dedicated to the asset class. If you are an investor or issuer with an interest in covered bonds, then your subscription to The Covered Bond Report’s magazine is free. To ensure that you receive every copy of The Covered Bond Report, please send an e-mail to Neil Day, Managing Editor, at nday@coveredbondreport.com. Alternatively you can enter your details while registering for our website at news.coveredbondreport.com – and access to our online offering is completely free to qualifying investors. www.coveredbondreport.com March 2011 To the lifeboats! Can covered bonds offer safety after bail-in panic? Australia A whole new ball game Sterling UK gains home advantage US legislation The FDIC rears its head The Covered Bond Report The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.
- 44. 42 The Covered Bond Report March 2011 FRANCE: OBLIGATIONS A L’HABITAT
- 45. March 2011 The Covered Bond Report 43 FRANCE: OBLIGATIONS A L’HABITAT T he publication of a decree in the Journal Offi- ciel de la République Française on 25 February marked the end of a legislative process aimed at transforming French common law or structured covered bonds into legislative covered bonds, newly created obligations à l’habitat. In parallel, enhancements to France’s obligations foncières have been enacted. The move paved the way for French issuers to apply to the Autorité de contrôle prudential (ACP) for licences for their is- suers to become sociétés de financement a l’habitat (SFHs). As The Covered Bond Report was going to press, the ACP was due to hold its monthly meeting at the end of March and was expected to approve existing issuers’ applications. Initially, the French authorities and market participants had considered bringing France’s common law covered bonds un- der a single framework with its existing obligations foncières. However, the two asset classes will remain distinct, albeit shar- ing many features, particularly given the updates to the obliga- tions foncières framework. “The SFH legal framework is very similar to the current contractual framework,” says Nadine Fedon, general manager of Crédit Agricole Covered Bonds and global head of fund- ing, Crédit Agricole. “It adds real security for bondholders as most of the provisions defined contractually are now written in the law. “With this modification of the legal framework for French covered bonds, SCF and SFH have both been made more sound by the law,” she adds. “There is an obligation to adhere to 2% overcollateralisation and to have enough liquidity at all times to ensure any payment in the next 180 days. These two require- ments have been added to the SCF law and will apply to the SFH framework accordingly.” An element of the existing obligations foncières framework that it will now share with obligations a l’habitat is a contrôleur spécifique, or specific controller. But aside from this, and the application for a licence, there is little that issuers need to do to adapt to the new framework, according to Boudewijn Dierick, flow ABS and covered bonds structuring at BNP Paribas. “The original aim on the government’s part was to increase harmonisation in the asset class, so that they could have eve- rything covered under one law,” he says, “and then also from the issuers’ point of view to make them Ucits compliant, which requires a law. “But on the other hand, the structures worked very well, so we didn’t want to make major changes to them.” The project’s aims segued into developments at a European level. When the European Central Bank announced its Eu60bn covered bond purchase programme in May 2009 it had to deal with the question of whether or not non-Ucits compliant cov- ered bonds – mainly French structured covered bonds – should be included. Ultimately it allowed the purchase of covered bonds that were Ucits compliant or were “offering similar safe- guards”. The ECB has since banged the drum for greater harmonisa- tion of European covered bonds, campaigning for a “label” that could be applied to the asset class to maintain standards and make life easier for investors. “As well as the desire for harmonisation from the French government side, you also had this theme from the central banks, the ECB,” says one market participant. “Over the past France’s new model The latest fashion in Paris this spring is the obligation à l’habitat. Created by bringing France’s common law covered bonds under a legislative frame- work, the new instrument offers a new take on an old favourite. As such, can it command couture prices? By Neil Day “The structures worked very well, so we didn’t want to make major changes to them”
- 46. 44 The Covered Bond Report March 2011 FRANCE: OBLIGATIONS A L’HABITAT couple of years at every conference where Michel Stubbe [head of the market operations analysis division at the ECB] speaks he says that we need to have a label and we need to have one definition, so the fact that all the programmes will be covered by one law, and be Ucits compliant, will certainly be appreciated by them. “It certainly helped push people along.” Because the underlying assets remain dominated by prêts cautionnés (guaranteed loans) rather than residential mort- gages, the new obligations à l’habitat will not achieve Capital Requirements Directive (CRD) compliance. Not every issuer will be converted directly into an SFH; Groupe BPCE will cease issuing covered bonds through GCE Covered Bonds and Banques Populaires Covered Bonds and in- stead issue through a new SFH, BPCE Home Loans. Issuers, not structures, key Whether or not French issuers will be rewarded by investors for the introduction of the new law is another question. Some mar- ket participants say that the conversion to obligations à l’habitat is unlikely to have much of an impact on pricing, because struc- tured covered bonds had been trading so well. Stephane Bataille at Landesbank Baden-Württemberg says that the lack of discrimination that French common law cov- ered bonds have previously suffered is demonstrated by the nar- rowness of spreads between covered bonds launched off BNP Paribas’ Home Loans programme and by its société de crédit foncier. “The spread is between 2bp and 4bp,” he says. “So if Crédit Agricole, for example, were to issue obligations à l’habitat now then the advantage would be maybe 1bp-2bp.” He argues that this is because the spreads at which covered bonds trade are today more related to the credit of the issuer than the underlying framework. “It’s more credit related, more related to news-flow,” he says. “Particularly if you are talking about strong names, you look more at the issuer.” He points to the way in which the relative pricing of com- mon law and legislative covered bonds changed dramatically between 2007 and 2010 as the financial crisis moved through its different stages. “Beforehand, there was a gap of perhaps 2bp between the legal and structured issues,” he says, “so BNP Paribas and Dexia Municipal Agency were trading at almost the same levels. Then at the end of 2007 nobody wanted to buy structured covered bonds and their spreads widened significantly versus obliga- tions foncières. “But at the end of 2008 and in 2009, this was completely re- versed. Everyone only looked at the strength of the credit be- cause of what happened to certain issuers. Nowadays the strong structured covered bonds are trading well inside those of the obligations foncières.” Easing supply pressure Heiko Langer, senior covered bond analyst at BNP Paribas, also cautions against expectations that the new legislation could re- sult in any sudden spread moves. “I don’t anticipate prices moving too noticeably,” he says. “These French covered bonds already trade pretty tight com- pared with obligations foncières, and spreads are anyway very much driven on an issuer by issuer basis, not so much structure by structure. “But it should make life a bit easier for the French issuers,” he adds. “It will help the French issuers broaden their investor -20.0 0.0 20.0 40.0 60.0 80.0 100.0 2006 2007 2008 2009 2010 2011* French Contractual vs. Legal Jumbo Covered Bonds French Contractual Covered Bonds French Legal Covered Bonds Source: LBBW
- 47. March 2011 The Covered Bond Report 45 FRANCE: OBLIGATIONS A L’HABITAT bases and, to be honest, that will be quite welcome. “As everybody knows, there has been a lot of supply out of France and there’s probably more to come.” French issuers have been by far the most active in 2011, selling more than Eu20bn of benchmark covered bonds in the year to mid-March, equivalent to almost a quarter of total euro benchmark issuance. Around-two thirds of this French issu- ance has been from those issuers that will now be issuing obli- gations à l’habitat. But some market participants are sceptical that there are ar- eas for France’s newly legislative covered bonds to reach. “The French have been hoping that they could place more with certain investors,” says one covered bond banker, “but we do not expect that to be the case. If you look at who has been buying these covered bonds in the past, it is the typical covered bond investor base. “Their distribution is already very broad and to my knowl- edge there are not any investors who do not participate.” Indeed he says that when he looked at distribution figures for the two types of French covered bonds, he found that big banks and funds had been buying more structured covered bonds than legislative covered bonds out of France. But Langer says that feedback from investors suggests that the new law will help issuers broaden their investor bases. “There are still quite a lot of investors out there who would like to diversify into other covered bonds, including French covered bonds, but they are uncomfortable with buy- ing covered bonds where there is no underlying legal frame- work,” he says. “I would say this is particularly true for non- European investors. “But I have had discussions with lots of German investors who want to diversify away from Pfandbriefe for line reasons, and some of the smaller ones haven’t yet bought French covered bonds so far because of the lack of a legal framework. I there- fore think it will have an impact on the investor base and allow the French banks to grow more.” Market participants are also hopeful that the new law will clarify for investors France’s covered bond market. This also takes in a third strain, namely the issuance of Caisse de Refi- nancement de l’Habitat under its own legislation, which raise some Eu3.7bn in the first three months of the year. “Until now, it has been difficult for foreign investors to un- derstand the situation,” says Géraldine Lamarque, head of fund- ing, financial communication and market at Crédit Immobilier de France and CIF Euromortgage, “there having been three kinds of covered bonds with two legal frameworks and a variety of contractual programmes. Having three true legal bases now increases the readability of the French covered bond segment at a pan-European level. “This is a very positive signal for a community of investors looking for clarity, transparency and regulation, and will in- crease the overall investor base for French covered bonds. The bigger this base is, the better it is for all French players.” For more on the new instrument, please see a Crédit Agricole roundtable involving key issuers and investors – “The emergence of Obligations à l’Habitat in the evolving French home loan refi- nancing market” – on The Covered Bond Report website. “Particularly if you are talking about strong names, you look more at the issuer.” -20 0 20 40 60 80 100 France Covered Legal France Covered Structured Source: iBoxx, Crédit Agricole CIB iBoxx France Covered Legal vs iBoxx France Structured 2011 2012 2014 2015 2016 2017 2018 2019 20202013 Assetswapspreads
- 48. 46 The Covered Bond Report March 2011 LEGAL BRIEF: THE US DEBATE 1. What is a covered bond? Covered bonds are bonds that are issued by credit institutions as senior unsecured debt. The bonds are “covered” by a dynamic pool of ring fenced assets (the cover pool), usually commer- cial or residential mortgage loans, and/or public sector assets. Legally and economically, the cover pool is isolated from the general assets of the credit institution, and upon the insolvency of the credit institution the covered bondholders have a prefer- ential claim on the proceeds of the cover pool. This dual recourse for investors (to both the general assets of the issuer, and the proceeds of the cover pool upon issuer insolvency) enables covered bonds to be issued with a higher rating than the standard senior, unsecured debt of the issuer. In contrast to a securitisation structure, the cover pool assets remain on the issuer’s balance sheet, and the sponsoring bank retains the related credit and prepayment risk. In contrast to se- cured debt, after the insolvency of the issuer, the covered bond holders continue to be paid from the proceeds of the cover pool and the covered bonds remain outstanding until their original scheduled maturity. 2. The existing US landscape The covered bond market is well developed in Europe; however, the absence of a specific legal framework for covered bonds in the United States (which gave rise to investor concerns about the treatment of covered bonds upon the insolvency of the sponsoring credit institution) has stifled the development of the product in the US. While the US-issued covered bond market has stalled, a significant majority of the largest Canadian banks and financial institutions have established covered bond pro- grammes. In 2010 and the first quarter of 2011, European and Canadian banks have issued more than $35bn of covered bonds into the US through the 144A market, demonstrating a strong demand for the product among US investors. For US issurers, investors were concerned about how the Federal Deposit Insurance Corporation (FDIC) would treat the covered bonds upon the occurrence of a receivership or conser- vatorship with respect to the issuing bank. The FDIC has stated, that if an insured depository institution (IDI) becomes subject to a FDIC conservatorship or receivership it currently has three options with respect to the IDI’s covered bonds: (i) Affirm: The FDIC can cause the IDI to continue to perform under the original terms of the covered bond programme. The FDIC may then transfer the covered bond programme and the cover pool to a new financial institution. (ii) Repudiate: The covered bonds become immediately due and payable, and the FDIC determines the fair market value of the cover pool and pays the covered bond holders the lesser of (1) the outstanding principal amount of the bonds plus interest accrued to the date of appointment of the FDIC and (2) an amount equal to the fair market value of the cover pool. (iii) Repudiate: The covered bonds become immediately due and payable, and the FDIC allows the covered bond hold- ers to exercise self-help remedies with respect to the cover pool resulting in the liquidation of the cover pool and the covered bond holders receiving the amount equal to the lesser of (1) the outstanding principal amount of the bonds plus interest accrued to the date of appointment of the FDIC and (2) the proceeds from the liquidation of the cover pool. Any action with respect to the cover pool is subject to an automatic stay of 45 or 90 days following the appointment of the FDIC to the conservatorship or receivership, respectively (the “automatic stay”). The options available to the FDIC as described above and the automatic stay provide the FDIC with a significant amount of flexibility when dealing with the covered bond programmes of insolvent IDIs. This flex- ibility leads to uncertainty for covered bond holders. Issuers of covered bonds have been subject to the additional costs of maintaining the liquidity that would be needed to make pay- ments on the covered bonds during these periods after the appointment of the FDIC. US: Today’s reality & tomorrow’s potential The US Covered Bond Act of 2011 has reignited the debate over whether legislation is necessary to seed issuance and, if so, how it should relate to the Federal Deposit Insurance Corporation. Lawton Camp and John Hwang of Allen & Overy in New York examine the proposed bill and the arguments being made against it.
- 49. March 2011 The Covered Bond Report 47 LEGAL BRIEF: THE US DEBATE As an indication of (at least limited) support for the devel- opment of a covered bond market in the US, on 15 July 2008, the FDIC issued its Final Policy Statement, which set out when the FDIC will grant expedited access to pledged covered bond collateral (i.e. when the automatic stay will be reduced to 10 days). The right to damages in the case of an insolvency of the covered bond issuer was limited under the Policy Statement to the par value of the covered bonds plus interest accrued to the date the FDIC is appointed conservator or receiver. The Policy Statement also required the cover pool to be liquidated using commercially reasonable and expeditious methods taking into account existing market conditions. Liquidating the cover pool expeditiously after a major bank failure exposes the covered bond holders to significant pricing risk with respect to the cov- er pool. Finally, the FDIC restricted the eligible assets to limited categories of residential mortgages or AAA rated mortgage- backed securities. On 28 July 2008, the US Department of the Treasury published a document setting out certain Best Practices in respect of US covered bonds. The Best Practices were intended to complement the Policy Statement and, like the Policy Statement, were seen as a signal of approval and support for the development of the US covered bond market. The Treasury indicated that the Best Practices were intended to help standardize US covered bonds and included an express note that the Treasury fully expected the structures, collateral and other key terms of US covered bonds to evolve with the growth of the market in the US. The Best Practices include provisions with respect to cover pool assets, overcollateralisation, substitution, asset coverage testing and monitoring and issuance limitations. To date, only two covered bond programmes have been set up by US credit institutions: Washington Mutual in 2006, and Bank of America, NA in 2007. Both of these programmes at- tempted to use structural solutions to emulate European cov- ered bond programmes that are, for the most part, issued under specific statutory regimes. In addition, both programmes were created prior to the Policy Statement from the FDIC and the Best Practices guidance from Treasury. Despite initial indica- tions of interest, other US credit institutions have not followed in setting up covered bond programmes of their own, due in large part to the regulatory uncertainties mentioned above, as well as the recent general economic climate. 3. US covered bond act of 2011 On 4 March 2011, US Representatives Scott Garrett (R-NJ) and Carolyn Maloney (D-NY) reintroduced a proposed federal cov- ered bond framework into the US House of Representatives by way of a bill (HR 290) entitled the “United States Covered Bond Act of 2011”. 3.1 Key Features of the Act (a) A statutory regime for covered bonds The Act provides for the establishment of covered bond pro- grammes by eligible issuers secured by a covered pool consist- ing of a single class of eligible assets or substitute assets. Each covered bond programme must be approved by the applicable covered bond regulator. The Treasury Secretary will establish a covered bond regulatory oversight programme through which covered bond programmes will be evaluated, including providing for additional regulation relating to eligible assets and any estate created consistent with maximising the value of the cover pool. (b) Covered bond regulator The Act defines the covered bond regulator as (i) the Office of the Comptroller of the Currency (OCC) in the case of a nation- al bank, a district bank or an insured federal branch of a foreign bank; (ii) the FDIC in the case of an insured non-member bank, including an insured state branch of a foreign bank; (iii) the Board of Governors of the Federal Reserve System in the case of a state member bank; (iv) the Office of Thrift Supervision (which in July 2011 will change to either the OCC or the FDIC as a result of the Dodd-Frank Wall Street Reform & Consumer Protection Act) in the case of an insured federal or state savings association; or (v) the Secretary of the Treasury in the case of an eligible issuer that is not regulated by a federal banking agency. (c) Eligible issuers The Act defines an eligible issuer as any insured depository institution, bank holding company, savings and loan holding company, non-bank financial company approved as an eligible issuer by the applicable covered bond regulator, any subsidiary of any of the foregoing and any issuer sponsored by one or more eligible issuers for the sole purpose of issuing covered bonds. The inclusion of a provision that allows “any issuer sponsored by one or more eligible issuers” to be an eligible issuer effec- tively enables smaller banks to join together and issue covered bonds from a single sponsored issuer (similar to the covered bond programmes of SpareBank 1 Boligkreditt AS in Norway and Caisse Central DesJardins du Quebec in Canada). (d) Covered bonds definition The Act defines covered bonds as recourse debt obligations of eligible issuers that: (i) have a maturity of not less than one year; (ii) are secured by a perfected security interest in or other lien on a cover pool that is owned directly or indirectly by the issuer of the obligation; (iii) are issued under a covered bond programme that has been approved by the applicable covered bond regulator; (iv) are identified in a register of covered bonds that is main- tained by the Secretary; and (v) do not constitute deposits (as defined in the Federal De- posit Insurance Act). (e) Cover pool assets Each cover pool must be made up of assets from a single eligible asset class, which include the following: (i) certain identified residential mortgages; (ii) home equity loans; (iii) commercial mortgages;
- 50. 48 The Covered Bond Report March 2011 LEGAL BRIEF: THE US DEBATE (iv) public sector debt issued by a State, municipality or other governmental authority or guaranteed by the full faith and credit of the US Government; (v) auto loans or leases; (vi) student loans; (vii) credit or charge card receivables; (viii)small business loans; and (ix) other assets classes designated by the Secretary; Provided that (i) the relevant loan is not delinquent for more than 60 consecutive days, and (ii) the asset is not subject to a prior pledge. The cover pool may also consist of substitute assets which may include: (i) cash; (ii) direct obligations of the US government or guaranteed by the full faith and credit of the US government; (iii) direct obligations of a US govern- ment corporation or US government sponsored enterprise (a GSE) of the highest credit quality (not to exceed 20% of the cover pool); (iv) overnight investment in federal funds; and (v) other substitute assets designated by the Secretary; and may contain ancillary assets (such as interest rate or currency swaps, credit enhancement and other liquidity ar- rangements). The list of eligible asset classes in the Act is broader than the types of assets that are traditionally used to back covered bonds (usually residential mortgages and certain public sector assets). It remains to be seen whether there will be appetite (on behalf of either issuers or investors) for covered bonds backed by, for example, auto loans, but the flexibility that allows issuers to have multiple covered bond programmes each backed by a different eligible asset class is encouraging for potential future growth of the market. (f) Minimum overcollateralisation requirement The Secretary will establish minimum overcollateralisation re- quirements for each eligible asset class designed to ensure that sufficient eligible assets are available to pay interest and principal on the covered bonds when due, based on credit, collection and interest rate risk. The assets in the cover pool will be required to meet the minimum overcollateralisation requirements at all times. Failure to meet the minimum requirements is a default for purposes of Section 4 (Resolution Upon Default or Insolvency), paragraph (a) (Uncured Default Defined) of the Act. That an overcollateralisation level is mandated by the Act alleviates concerns in existing US structured covered bonds is- sued by institutions subject to FDIC supervision that, upon the appointment of the FDIC as conservator or receiver with re- spect to a covered bond issuer, investors would lose their rights to any overcollateralisation in the cover pool. However, as dis- cussed further in Section 4(a) below, concerns have already been raised as to whether the overcollateralisation provisions are sufficiently broad to truly protect investors in the case of issuer insolvency. (g) Asset coverage test To ensure that the assets in the cover pool satisfy the minimum overcollateralisation requirements at all times, the cover pool will be required to satisfy an asset coverage test. The asset cov- erage test will be required to be carried out on a monthly basis by the issuer and the results are required to be disclosed to the applicable covered bond regulator, the Secretary and the inden- ture trustee, along with all covered bond holders. In addition, the issuer will be required to appoint an inde- pendent third party to act as asset monitor with respect to the cover pool, with responsibility for verifying on at least an an- nual basis whether the cover pool satisfies the asset coverage test. Likewise, the asset monitor’s findings must be disclosed to the applicable covered bond regulator, the Secretary, the inden- ture trustee and the covered bond holders. While a failure to satisfy the asset coverage test does not prejudice the eligibility of the covered bonds under the Act, failure to satisfy the asset coverage test after the cure period specified in the transaction documents will constitute an event of default with respect to the programme. (h) Default and Insolvency Perhaps the most significant provisions of the Act relate to the protections that are introduced for covered bond holders fol- lowing an event of default or insolvency event with respect to the issuer. As noted above, there were regulatory concerns in existing US covered bond structures surrounding the rights of covered bond holders to the cover pool following, in particular, the appointment of the FDIC as receiver or conservator of the issuer. The Act introduces measures to relieve these concerns in three main scenarios, set out below. (i) Upon the occurrence of an event of default with respect to a covered bond that occurs prior to the issuer entering into conservatorship, receivership or analogous proceeding, a separate estate is created by automatic operation of law (the John Hwang
- 51. March 2011 The Covered Bond Report 49 LEGAL BRIEF: THE US DEBATE “separate estate”). The covered bond regulator will act as or appoint a trustee. The separate estate consists of the cover pool (including ancillary assets, and the Act-mandated overcollateralisation), and is created free of any claim of the issuer or its conservator or receiver. The separate estate is fully liable for all claims of covered bond holders under the covered bonds. The covered bond holders retain a claim against the issuer for any amounts remaining outstanding on the covered bonds following full distribution of all the assets of the separate estate. In addition, the issuer (or its re- ceiver or conservator) has a claim against the separate estate for any residual amounts remaining following satisfaction in full of amounts owing to the covered bond holders. In an attempt to ensure that there are no disruptions to cashflows on the covered bonds following an issuer default, the issuer may be required to continue servicing the cover pool for 120 days after the creation of the separate estate, in return for a “fair-market-value fee”. The covered bond regu- lator, as trustee of the separate estate, may then appoint a servicer or administrator to service and realise on the cover pool on an ongoing basis, including by way of liquidating the cover pool assets, in order that the separate estate con- tinues to make scheduled interest and principal payments on the covered bonds. This provision would allow the servicer or administra- tor to pursue private market alternatives that meet certain conditions set out in the Act in the event of a lack of li- quidity caused by a timing mismatch between the assets and the covered bond liabilities (i.e. in situations where the amortisation profiles of the cover pool assets and the cov- ered bonds do not match exactly). This is in contrast to the inclusion in a prior draft of the Act of a committed govern- ment liquidity facility that would have given the separate estate access to a secured financing facility with the Federal Reserve Bank, allowing it to raise any funds needed to make payments on the covered bonds without it having to sell as- sets in the cover pool under potentially unfavorable market conditions. (ii) If the FDIC is appointed as conservator or receiver with respect to the issuer prior to the occurrence of another event of default on the covered bonds, the Act confers to the FDIC the right, for a period of 180 days following its appointment, to transfer the cover pool (and the relevant covered bonds and other related obligations) to another en- tity that is an eligible issuer under the Act that meets all of the conditions and requirements in the related transaction documents. Crucially, the Act also provides that during the 180 day period described above, the FDIC will meet all obliga- tions (monetary and non-monetary) of the issuer under the covered bonds and the related transaction documents and shall fully and timely cure all defaults by the issuer until the transfer of the cover pool to an eligible issuer as described above, or delivery by the FDIC of written notice of its elec- tion to cease further performance under the covered bond programme. This gives covered bond holders much greater certainty than in the previous position set out in the Policy Statement by the FDIC, which could potentially lead them to incur losses on their investments as a result of the FDIC’s appointment, notwithstanding the existence of the claim against the cover pool. (iii)If either (A) a conservator, receiver or analogous entity other than the FDIC is appointed with respect to the issuer be- fore the occurrence of an event of default or (B) the FDIC is appointed as conservator or receiver with respect to the issuer but no transfer is completed within the 180 day period described in (ii) above, the FDIC delivers written notice of its election to cease further performance under the covered bond programme or fails to fully and timely satisfy the mon- etary and nonmonetary obligations or timely cure all defaults of the issuer under the covered bond programme, a separate estate is again created by automatic operation of law. The operative provisions with respect to the separate estate are identical to those described in paragraph (i) above. (i) Securities law considerations Covered bonds that are offered and sold to the public by a bank (or bank subsidiary) are to be exempt from federal securities laws, but will be subject to any applicable securities regulations of such issuer’s primary federal regulator as well as antifraud rules. No such exemption is created for covered bonds that are of- fered and sold to the public by any other non-bank issuer that are not otherwise exempt from federal securities laws. 4. Comment and concerns (a) Criticism of the Act from the FDIC (i) The FDIC wants covered bonds to be treated in the same way as other secured debt. Lawton Camp
- 52. 50 The Covered Bond Report March 2011 LEGAL BRIEF: THE US DEBATE As described in the section The Existing US Land- scape, the FDIC currently has the option to determine the fair market value of the cover pool or liquidate the cover pool and obtain immediate access to any overcollateralisa- tion. Under the Act, if the FDIC does not transfer the cov- ered bonds and related cover pool, the FDIC retains a re- sidual interest in the separate estate. The residual value of the cover pool is therefore not “lost for all other creditors of the failed bank” as suggested by the FDIC, but rather converted into a residual interest that can be certificated and sold to third parties. The holder of the residual in- terest is entitled to the remaining value of the cover pool after the covered bonds have been paid in full at their ma- turity. It is inaccurate to suggest that the residual inter- est would be entirely illiquid. In fact, the pool of investors who can invest in certificated residual interest certificates may be greater than the number of investors who can di- rectly purchase and hold the eligible assets. The FDIC cor- rectly points out that the Act provide covered bond hold- ers with greater rights with respect to the cover pool than they would have if they were simply secured creditors. The question is whether these additional rights create sig- nificant additional burdens on the FDIC and the deposit insurance fund (DIF) and whether those burdens, if any, are outweighed by the benefits of covered bond financing. (ii) The FDIC wants control over the liquidation or transfer of the cover pool. The FDIC’s desire to be able to use all of its available op- tions with respect to the transfer or liquidation of the cover pool is understandable in light of the FDIC’s mandate to use “least costly” method to resolve any insolvency of an ADI and to protect the DIF. However, the optionality provided to the FDIC creates uncertainty for covered bond holders that increase the costs of issuance. Currently, the FDIC has up to 90 days to decide what to do with the covered bond programme and the related cover pool. During this time, they are not required to make any payments to cov- ered bond holders, and if the FDIC chooses to liquidate the pool, interest will not accrue on the covered bonds from the time the FDIC is appointed. Under the Act, the FDIC can take up to 180 days to decide whether to transfer or repudi- ate the cover bond programme, however, during this time, the FDIC must continue to pay all amounts owed under the covered bond programme as they become due. The FDIC argues that any time limit imposed on the FDIC results in the FDIC being the de facto guarantor of covered bonds. (iii)The FDIC believes that the Act will primarily benefit the large financial institutions. The Act allows smaller banks to join together to create a single issuer of covered bonds. As previously described, similar structures currently exist in Canada and Norway as well as other jurisdictions. (iv)The FDIC believes that the legislation fails to recognise that US banks already have access to a covered bond market and that covered bonds were successfully issued prior to 2008. What the FDIC does not acknowledge is that no US en- tities have issued covered bonds since 2007, while Canadian and European issuers have sold billions of dollars of cov- ered bonds to US investors. Further, given the uncertainty relating to the automatic stay and the liquidation of the cover pool, US covered bond programmes were forced to include contingent payment swaps and guaranteed invest- ment contracts that, given the changes in market conditions and regulation, may be extremely expensive or unavailable in the future. (b) Will the Act protect overcollateralisation in excess of the prescribed minimum? While the Act requires that the covered bond regulator must determine a minimum overcollateralisation level for each as- set class, there is no express protection given to overcollater- alisation in excess of that minimum: the asset coverage test language, for example, requires that the assets in the cover pool satisfy the minimum overcollateralisation requirements set by the covered bond regulator. If the issuer commits addi- tional overcollateralisation to the cover pool as a result of, for example, investor demand or to meet rating agency criteria, it is not clear whether such excess overcollateralisation would form part of the separate estate (or be transferred to another issuer) upon the insolvency of the issuer. There is no guar- antee at this stage that the excess could not be clawed back by the FDIC or other relevant bankruptcy official appointed with respect to the issuer, and form part of the issuer’s gen- eral insolvency estate rather than being ring-fenced in favor of covered bond holders. Standard & Poor’s (S&P) began a consultation process that led to the publication on 16 December 2009 of its “Re- vised Methodology And Assumptions For Assessing Asset- Liability Mismatch Risk In Covered Bonds”. These set out a number of aspects of covered bond legislation that S&P con- siders are particularly relevant in assessing refinancing risk, including specifically whether there are any limits to over- collateralisation levels. If there is any question as to whether excess overcollateralisation above the Act-mandated mini- mum will be available to covered bond holders on the default of the issuer, this will negatively affect S&P’s rating analysis of US covered bonds. In its comment piece on a prior draft of the Act entitled “US Covered Bond Overhaul Would Be Credit Positive Overall,” Moody’s expressed concern that the draft provisions in relation to calculation of the minimum overcollateralisation level to be set by the covered bond regulator (which specifically excludes liquidity risk associated with the relevant asset class) could re- sult in the overcollateralisation level being set artificially low. As investors (and presumably although not specifically dis- cussed by Moody’s the rating agencies) may well require ad- ditional overcollateralisation in the cover pool to mitigate the liquidity risk discussed above, particularly as a result of the re- moval from the Act of the committed liquidity facility provided by the Federal Reserve Bank that was proposed in a prior draft of the Act.
- 53. March 2011 The Covered Bond Report 51 LEGAL BRIEF: THE US DEBATE (c) Liquidity: (i) How will scheduled bond payments be met after an issuer default? As discussed above, a prior draft previously proposed by Rep Garrett included a committed government lend- ing facility that would be accessible to any separate es- tate following an issuer default. This would have allowed the separate estate to raise financing to make scheduled covered bond payments without forcing a fire-sale of the assets at potentially distressed prices or under unfavora- ble market conditions, which could leave covered bond holders without full payment on their investments. The inclusion of such a government lending facility would have been a significant difference between the Act and similar covered bond legislation in Europe, but one that was welcomed at the time that prior draft of the Act was introduced by both potential investors and the rat- ing agencies. However, political pressure seems to have led to the removal of the proposed facility from the Act to avoid the appearance that the covered bonds had the benefit of an implicit government guarantee. The current proposal in the Act requires the servicer or administrator of the separate estate to “pursue private market alternatives” in order to raise funds that will enable it to make scheduled payments on the covered bonds where there is a mismatch between the timing of receipt of payments on the assets and due payments on the covered bonds. This refinancing risk is a feature of covered bond pro- grammes in almost all jurisdictions, and has, since the start of the credit crisis, received increased attention from inves- tors and the rating agencies alike. (ii) How do the rating agencies approach liquidity risk? The credit ratings assigned to covered bonds by the ma- jor rating agencies may be capped if there are asset-liability mismatches that are not addressed structurally. The rating agencies generally evaluate the likelihood that the liquid- ity risks and liquidation risks created by an asset-liability mismatch will result in an interruption in the payment of amounts when due on the covered bonds as a result of an is- suer default. The asset-liability mismatch results in a liquid- ity risk due to the fact the amount and timing of payments produced by the cover pool may vary from the amount and timing of payments due on the covered bonds. A liquidation risk exists because a portion of the cover pool may need to be liquidated under stressed conditions to meet the asset- liability mismatch while still maintaining enough collateral to service the remaining debt. In evaluating the liquidity risks and liquidation risks, the rating agencies consider the jurisdiction of the covered bond issuer (and the applica- ble legislative framework, if any), the refinancing options available to the covered bond programme and the timing and availability of those refinancing options relative to the liquidity and credit enhancement available in the covered bond programme. (iii) What structural solutions are used to mitigate liquidity risk? Although refinancing risk has been the subject of in- creased scrutiny as a result of the recent financial turmoil, it is not in itself a new concern. Covered bond programmes in Europe and Canada in particular have used various struc- tural features in an attempt to mitigate the risk, including but not limited to those discussed below. (A) Extendable maturities (so-called “soft bullet” covered bonds): soft bullet covered bonds provide for the extension of the maturity date of the covered bonds by a specified period following the default of the issuer. This al- lows additional time for assets to be sold to finance repay- ments and so avoids assets being sold at distressed or fire- sale prices in order to meet repayment obligations that arise shortly following default. (B) Pre-maturity tests: a pre-maturity test looks at the issuer’s rating at a specified date prior to the maturity of any series of covered bonds (usually six to 12 months). If the issuer does not meet the specified rating threshold, it will be required to post cash to the deal or to begin liquidating assets immediately following the failed pre-maturity test in order to raise the required redemption funds. (C) Minimum liquidity requirement: for example, the German covered bond legislation requires issuers to test potential liquidity shortfalls on an ongoing basis over the next 180 days. If there is a projected liquidity shortfall, it is compensated for by adding additional liquid assets. 5. Conclusions In the FDIC’s Statement of the Federal Deposit Insurance Cor- poration on Legislative Proposals to Create a Covered Bond Market in the United States, dated 11 March 2011, the FDIC states that it has “long worked with the financial industry to es- tablish a sound foundation for a vibrant covered bond market”. However, no US originated covered bonds have been issued since 2007 and the FDIC’s Policy Statement did not result in the establishment of a single new US covered bond programme. However, since 2007, at least seven Canadian covered bond programmes have been created. Further, during this time Eu- ropean and Canadian issuers of have sold billions of dollars of non-US covered bonds to US investors. European and Canadian covered bond issuers have proven that there is robust demand for covered bonds among US inves- tors. For US covered bonds to be competitive, the legal frame- work must be more robust and outcomes must be more certain. The introduction of the Act forms a very positive step for the potential US covered bond market in that it addresses the insol- vency and liquidity concerns related to current US covered bond programmes. The Act has received initial indications of support from politicians across the political spectrum and from the issuer and investor communities alike. It is hoped that by this time next year, articles will be written not about the introduction or possi- bility of US covered bond legislation, but instead about the rules to be promulgated under the Act.
- 54. 52 The Covered Bond Report March 2011 FULL DISCLOSURE Postcards from the LBBW European Covered Bond Forum, Mainz, where the great and the good of the covered bond market gathered in February. At a gala dinner (bottom left), a surprise guest revealed a new bail-out plan: turn twenty euro notes into fifties. Washington & Mainz The West Wing, starring (L-R): Chris Russell, legislative director, Rep Scott Garrett, ECBC head Luca Bertalot, and Bert Ely, FDIC-watcher.
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