Download - The Covered Bond Report Issue 3
www.coveredbondreport.com July 2011
Fall of the sovereign
Will covered bonds rise amid the ruin?
CRD IVEverything to play for
CanadaRules and legislates
ICMAAnti-whispering campaign
The CoveredBond Report
Covered bonds?
Highly rated covered bonds backed by mortgages
Average LTV of 60.5%
Match-funded structure
Core capital ratio of 18.6%
Largest mortgage bond issuer in Europe
nykredit.com/ir
Figures as of 17 March 2011
July 2011 The Covered Bond Report 1
CONTENTS
FROM THE EDITOR
3 It’s all in the timing
MONITOR
5 Legislation & regulation
11 Ratings
15 Market
20 People
22
5
15
Cover StorySOVEREIGNS VERSUS COVERED
22 Fall of the sovereign
Sue Rust reports.
The CoveredBond Report
2 The Covered Bond Report July 2011
The CoveredBond Report
30
CRD IV: GAME ON
30 Everything to play for
Neil Day
CANADIAN MOMENTUM
36 Canada rules and legislates
Maiya Keidan
ANALYSE THIS: SOLVENCY II
42 It’s the end of the world as they know it
FULL DISCLOSURE
49 From fairway to oche
36
42
CONTENTS
FROM THE EDITOR
July 2011 The Covered Bond Report 3
Would the European Commission’s
CRD IV proposals have been more
definite in a less uncertain world?
Merely publishing a timely
and relevant magazine is fraught
enough without the fate of the
euro-zone changing on a daily basis. Producing an inter-
national framework that will see the financial system safely
through its ups and Lehmans is asking for trouble at any
time — even more so when a euro-zone sovereign is on the
verge of defaulting.
Small wonder that the EC passed on most of the big
decisions, leaving the European Banking Authority to
carry the can. Would Commissioner Barnier really have
stood up and declared sovereign debt to be the nec plus ultra of liquid assets a day before haircuts for Greek
bondholders were revealed?
That said, leaked drafts of the EC proposals seen by
The Covered Bond Report suggest that the decision to
leave open a final definition of liquid assets was not taken
at the last minute. However, this should only give en-
couragement to covered bond supporters, some of whom
have already taken heart from being offered a second op-
portunity to lobby for better treatment.
What the Commission did lay down, though, was a
tough wish-list for the EBA to use when examining which
asset classes are fit for liquidity buffers. To name but three: a
proven record of price stability; maximum bid/ask spreads;
and transparent pricing and post-trade information.
While the list of criteria is welcome in that it gives
everyone a clearer idea of what needs to be done to win
over the EBA, satisfying them will be no easy task. Is the
covered bond industry up to the challenge?
Four years have now passed since the onset of the
crisis and in many of these areas little progress has been
made. Less time remains until implementation in 2015,
let alone until the EBA reports back to the Commission.
The clock is ticking.
It’s all in the timing
The CoveredBond Reportwww.coveredbondreport.com
EditorialManaging Editor Neil Day
+44 20 7415 [email protected]
Deputy Editor Sue [email protected]
Reporter Maiya [email protected]
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www.coveredbondreport.com July 2011
Fall of the sovereign
Will covered bonds rise amid the ruin?
CRD IVEverything to play for
CanadaRules and legislates
ICMAAnti-whispering campaign
The CoveredBond Report
The CoveredBond 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 [email protected]. 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.
July 2011 The Covered Bond Report 5
MONITOR: LEGISLATION & REGULATION
Stark and potentially unbridgeable di-
visions between the FDIC and covered
bond proponents led by Republican Con-
gressman Scott Garrett were laid bare as
the House Financial Services Committee
passed the United States Covered Bonds
Act of 2011 on 22 June.
Garrett complained of a breakdown in
communications with the regulator while
former HFSC chairman Democrat Bar-
ney Frank tried to introduce two amend-
ments at the behest of the FDIC that the
Republican said would render the bill
ineff ective.
And although FDIC chairman Sheila
Bair’s term of offi ce ended in July, cov-
ered bond supporters already fear that
her expected successor, Martin Gruen-
berg, will adopt a similar stance and
place obstacles in the way of the develop-
ment of a US market.
Garrett’s bill — co-sponsored by
Democrat Carolyn Maloney — was ulti-
mately passed by a comfortable 44 votes
to seven, but the potential pitfalls facing
the proposed legislation on its way to
being signed into law were laid bare by
votes on Frank’s amendments. Although
Garrett warned that “you would no long-
er have a covered bond marketplace” if
the amendments were passed, they were
only narrowly defeated, each by 28 ayes
to 26 nays.
Frank’s amendments would have giv-
en the FDIC more far-reaching powers
than those envisaged in Garrett’s legisla-
tion. Frank said that his fi rst amendment
had been draft ed in close co-operation
with the FDIC, which he said was con-
cerned not with the concept of covered
bonds, but the extent to which it and the
Deposit Insurance Fund are protected.
The amendments would have al-
lowed the FDIC to repudiate covered
bonds following a bank default and
would have capped maximum overcol-
lateralisation levels and after the hearing
Moody’s backed up Garrett by saying
that “both would have hurt the develop-
ment of the market”.
“Th e repudiation power in the re-
jected amendment was better for inves-
tors than the FDIC’s current repudiation
power because the amendment required
the FDIC to pay off investors in full rather
than up to the market value of the cover
pool,” said the rating agency. “However,
the amendment would have exposed in-
vestors to an early pay-off , which existing
covered bond investors do not want.
“Furthermore, a cap on the amount
of overcollateralisation would reduce the
resiliency of covered bonds, preventing
issuers from adding collateral to main-
tain the credit strength of the covered
bonds if the issuer deteriorates.”
Concerns addressed ‘time and time again’
Garrett pointed out that an earlier ver-
sion of the bill that had contained less
protection for the FDIC had been passed
by the committee last year under the
chairmanship of Barney Frank with bi-
partisan support, including that of Frank.
Garrett went on to say that he noted
that Frank had enjoyed “a positive work-
ing relationship and dialogue with the
FDIC”, before saying:
“Would that it be the case that we had
continued to have that relationship with
the FDIC as well. I thought we had it for a
long period of time and members on the
other side of the aisle, their staff knows
that we engaged in numerous hours of
staff to staff discussions on various por-
tions of the bill, but I will point out that
that for some reason or another, despite
those ongoing discussions that we were
able to continue to have on a member to
member and staff to staff member level
here in the House, the FDIC, for what-
ever reason, decided to stop responding
to our staff ’s e-mails.
“So as of last week those aspects of
discussions that we would want to have
with the FDIC came to an abrupt halt.
We were sending over e-mails as to what
UNITED STATES
FDIC fi ght ahead after bill passes
Will Martin Gruenberg take over Sheila Bair’s position?
“The FDIC decided to stop responding to our staff’s e-mails”
Legislation & Regulation
6 The Covered Bond Report July 2011
MONITOR: LEGISLATION & REGULATION
we thought we could do to improve the
bill to make changes to address their
concerns, and those ended at that point
in time.”
Garrett went on to say that while he
was pleased that member to member dis-
cussions could continue, he could not sup-
port Frank’s amendment because of what
he said it would lead to: “Th ere would not
be any investors interested in the market-
place were this amendment to pass.”
He said that Frank’s amendments
would introduce too much uncertainty
into the instruments, such that investors
would either not be interested in them or
only at a price that would not make them
viable. He went on to point out several
ways in which the diff erent versions of
bills he has introduced had progressively
included more and more concessions
to the FDIC over more than two years,
“time and time again”.
HFSC chairman, Republican Spen-
cer Bachus, also said that the com-
mittee had “tried very hard to accom-
modate the FDIC”, which had, he said,
only the day before indicated that it
had three problems with the bill that
were being addressed.
Reconciliation impossible?Frank responded by acknowledging that
there was a clear diff erence of opinion
between the FDIC and those pushing for
covered bonds. He said that those sup-
porting the bill had “overestimated” the
extent to which agreement with the FDIC
had been reached.
Two amendments that offered con-
cessions to the FDIC were nevertheless
approved.
One, from Democrat Carolyn
Maloney, co-sponsor of the bill, extends
from 180 days to one year the period the
FDIC has to fi nd an institution to take
over a covered bond programme in the
event it is appointed conservator or re-
ceiver of a failed issuer.
Maloney said that the FDIC support-
ed the amendment, which she said was
designed to give the regulator as much
fl exibility as possible and to protect the
Deposit Insurance Fund. Th e FDIC had
argued that it is more diffi cult to sell off
a covered bond programme than other
banks’ assets and products, particularly if
a number of institutions are failing.
An amendment allowing a covered
bond issuer’s regulator to place a cap on
covered bond issuance relative to total
assets was approved. Th is was introduced
by Republican John Campbell, who had
expressed disapproval of the bill in a sub-
committee markup in May but ultimately
voted in favour of the bill. He said that
the possibility of including a number had
been discussed, but that this would be left
to regulators rather than legislated for.
Th e FDIC has previously set a 4% limit.
The end of Bair’s term as chairman
had held out the prospect of a change in
the FDIC’s position, but there have al-
ready been signs that acting chairman
Martin Gruenberg will adopt a similar
position to his predecessor. DBRS, for
example, suggested this might be the
case in mid-July when discussing lob-
bying of the FDIC to relinquish its first
right to cover pool assets in the event of
an issuer default.
“Vice chairman of the FDIC Martin
Gruenberg, who some believe will be
President Obama’s choice to succeed
Chairman Bair, recently reiterated a
variation of this position stating that in
the event of a bank failure, the FDIC,
and not investors, should have first
rights to any excess collateral included
in a covered-bond offering,” said the
rating agency.
Th ere are also fears that time could be
running out for legislation to be passed
in this Congress. While the HFSC vote
and Republican control should smooth
the bill’s passage through the House of
Representatives, observers are less cer-
tain about the Senate.
“Th e length of the remaining legisla-
tive calendar has become a serious con-
sideration, particularly for Senate ac-
tion,” said Jerry Marlatt, senior of counsel
at Morrison Foerster. “Th e Senate has not
previously considered a covered bond
bill and, accordingly, there is much to be
done for the Senate staff to be prepared
to take informed positions on a bill. Per-
haps the most important factor in mov-
ing a bill quickly through the Senate will
be who sponsors the bill.
“As previously reported, Senator
Charles Schumer (D-NY), who is a key
senator on the Senate Banking Com-
mittee, has said that he would consider
introducing a covered bond statute.
Sponsorship by Senator Schumer would
greatly enhance the prospects for the bill
moving quickly.”
“The legislative calendar has
become a serious consideration”
Barney Frank: supporters of bill overestimated any agreement with FDIC
July 2011 The Covered Bond Report 7
AUSTRIA
Forum discusses steps to uniform lawMoves towards harmonising Austria’s covered bonds under a single law were discussed at the first conference of the Österreichisches Pfandbrief und Cov-ered Bond Forum at the end of May.
According to DZ Bank covered bond analyst Michael Spies, representatives of the Austrian central bank (Oesterrei-chische Nationalbank) and the finance ministry said that the harmonisation of laws governing Austrian covered bonds would be on their agenda.
Martin Schweitzer, speaking on be-half of the Österreichisches Pfandbrief und Covered Bond Forum, told The Covered Bond Report that a single cov-ered bond law was not imminent but
would be the ultimate outcome of work to improve the Austrian framework.
“We are heading towards one law,” he said. “But before that there will definitely be intermediary steps to further harmo-nise the existing ‘two-plus’ frameworks.
“There will be harmonisation in terms of transparency, in terms of fur-ther quality improvements.”
Austrian covered bonds are either Pfandbriefe issued under the Mortgage Banking Act, which in 2005 brought together the old Mortgage Banking Act and the Pfandbrief Law, or Fundi-erte Bankschuldverschreibungen. Er-ste Group Bank and UniCredit Bank Austria, for example, issue under the
Mortgage Banking Act, while Kommu-nalkredit Austria and Bawag PSK issue Fundierte Bankschuldverschreibungen.
The Österreichisches Pfandbrief und Covered Bond Forum was launched in January by Austria’s leading covered bond issuers, representing Bawag PSK, Erste Group, Kommunalkredit Austria, Österreichische Volksbanken, Raiffeisen Bankengruppe, UniCredit Bank Austria, and Hypoverband.
Schweitzer said that the forum would not only be working on legisla-tive changes.
“It’s about transparency in the market, speaking with one voice, and being vis-ible on the European stage,” he said.
MONITOR: LEGISLATION & REGULATION
The prospect of standalone covered bond
issuance from South Korean banks has
increased following the release of covered
bond guidelines by the country’s regula-
tors in late June.
The Financial Services Commission
(FSC) and Financial Supervisory Service
(FSS) described the guidelines as part of
measures to implement “Comprehensive
Measures on Household Debt”.
“The guidelines are intended to pro-
vide a framework for covered bond issu-
ances, diversifying banks’ financing in-
struments and encouraging banks to offer
more long term and fixed rate mortgage
loans instead of short term and floating
rate ones,” said the FSC and the FSS.
The “best practice guidelines” run to a
mere two pages, but contain rules on key
features of issuance — see box.
Issuers permitted under the guidelines
include banks, agricultural and fishery
co-operatives, the Korean Development
Bank, Export-Import Bank of Korea, In-
dustrial Bank of Korea, and securitisation
vehicles under the Act on Asset-Backed
Securitization.
The cover pool may comprise: first
priority mortgage loans with maximum
secured amounts of 120% or more of the
actual loan amount, a 70% loan-to-value
cap, and no delinquencies in excess of 60
days; cash; ABS backed by such mortgage
loans or cash; mortgage backed bonds is-
sued by Korea Housing Finance Corpora-
tion (KHFC); and mortgage backed secu-
rities issued by KHFC.
“After monitoring the issuances of cov-
ered bonds in the future, we will have fur-
ther discussions on whether to come up
with legally binding regulations on cov-
ered bond issuances,” said the regulators.
Jerome Cheng, vice president, senior
credit officer at Moody’s, told The Covered
Bond Report that the establishment of a
covered bond framework has been under
discussion for quite some time.
“Market participants have been lobby-
ing government to enact a law or publish
guidelines,” he said. “From market par-
ticipants’ perspective, having guidelines
will allow originators to structure covered
bonds with a higher degree of certainty.
“The guidelines, which we have not yet
assessed, should give additional comfort
to investors.”
Previously only one Korean bank has
issued a covered bond on a standalone
basis — Kookmin Bank, with a $1bn is-
sue in 2009. State-run KHFC sold a sec-
ond international covered bond issue — a
$500m five year — on 18 July, but its issu-
ance is under an act governing the insti-
tution and the bond is backed by pooled
collateral from its member banks.
SOUTH KOREA
Korean rules raise solo supply hopesKey features of Korea’s guidelines:
or greater
of total liabilities
“Covered bonds could be observed trading through government bonds” page 24
8 The Covered Bond Report July 2011
MONITOR: LEGISLATION & REGULATION
ECBC DATA
Issuance rises, ECB share fallsThe volume of covered bonds outstand-ing rose to Eu2.5tr in 2010, according to data published by the European Cov-ered Bond Council, as their funding role gained in prominence.
In 2009 outstanding covered bond volumes were Eu2.4tr. Last year Eu606.7bn of new covered bonds were issued, versus Eu529.8bn in 2009.
Denmark had the highest total issu-ance last year, at Eu148.6bn, followed by Germany (Eu87bn) and Sweden (Eu80bn).
Mortgage backed covered bonds’ share of the total increased, with public sector covered bonds standing at only 24% of issuance in 2010, down from 29% in 2009 and 58% back in 2003.
The ratio of mortgage backed covered bonds outstanding relative to outstanding mortgage loans increased in all countries aside from the UK and Germany, where the ratio remained the same — although in Germany, and some other countries, mortgage backed covered bond volumes
do not accurately reflect the amounts backed by residential mortgages.
Landesbank Baden-Württemberg analysts compared mortgage backed covered bond volumes with mortgage lending volumes and ABS issuance. They found that even in countries where se-curitisation has been increasingly used, such as Italy and Portugal, covered bond funding has increased its share of hous-ing finance. In the UK the share of RMBS has fallen over the last two years, while covered bonds have held steady.
They also looked at volumes in the two asset classes relative to their use as European Central Bank collateral and found that fewer than 18% of eligible covered bonds are being used for refi-nancing via the Eurosystem — less than in 2009 and compared with 38% of available ABS.
“In other words, considerably more covered bonds were placed in the mar-ket or not acquired with the immediate intention of using them as collateral,” they said.
The Association of Swedish Covered Bond
Issuers (ASCB) and the Pfandbrief & Cov-
ered Bond Forum Austria have welcomed
an ICMA Covered Bond Investor Council
transparency initiative in responses to a
consultation on the proposed standards,
but several national groupings have said
they need more time to consider them.
Responses to the consultation were due
by 30 June and a spokesperson for the CBIC
said that the consultation had in general
been received quite positively. The Euro-
pean Covered Bond Council — also speak-
ing for some national associations — and
European Central Bank are understood to
be among those parties that contributed to
the consultation by the deadline.
However, the Austrian association
(Österreichisches Pfandbrief und Cov-
ered Bond Forum), which got back to the
CBIC, said that it would need a couple
more weeks to agree a common Austrian
position, and other national associations
were not in a position to respond by the
deadline. The Italian Banking Associa-
tion (ABI) was due to meet to prepare a
response as The Covered Bond Report
was going to press, said an official at the
association. The Covered Bond Report
understands that the Association of Ger-
man Pfandbrief Banks (vdp) had not yet
formally submitted a response.
Sweden’s ASCB said in a submission
dated 27 June that it welcomed the CBIC
initiative and would recommend its mem-
bers have common cover pool information
set up “largely in line with your proposal”.
The association disagreed on several
points it said were of a more “technical na-
ture”. For example, the ASCB took issue with
a suggestion that issuers should have to pro-
duce margin calculations, saying that these
were not always available or appropriate. It
also said that it did not see why breaking out
covered bond funding into bearer and regis-
tered formats was necessary.
The Swedes noted that some data fields
suggested by the CBIC were not relevant
in their case as most Swedish issuers are
specialised mortgage entities that do not
conduct other business.
TRANSPARENCY
First CBIC responses favourable
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
2004 2005 2006 2007 2008 2009 20100.0%
4.0%
8.0%
12.0%
16.0%
20.0%
24.0%
28.0%
32.0%
total eliible collateral (€bn) eligible covered bonds (€bn)covered bonds used as a % of eligible cb (rhs)
Volume of assets considered eligible and the share of deposited covered bonds in the total eligible volume of covered bonds (rhs)
Sources: ECB, LBBW Credit Research
July 2011 The Covered Bond Report 9
MONITOR: LEGISLATION UK
The Investment Management Asso-
ciation believes UK Regulated Covered
Bonds lack “the very high degree of
certainty” that should be expected of a
regulated product, and that the frame-
work needs more significant changes
than those being proposed in a review.
In its response to a consultation on
proposals announced in April by HM
Treasury and the Financial Services Au-
thority, which ended on 1 July, the IMA
said that it was unfortunate that, as be-
fore the UK framework’s introduction
in 2008, it was not pre-consulted on re-
form proposals.
“Th is is unfortunate since it would ap-
pear that an assumption has been made
that the regime needs little change, where-
as we would argue that it might benefi t
from more signifi cant change,” said Jane
Lowe, the IMA’s director of markets.
The association outlined several con-
cerns relating to the transparency and
structure of UK RCBs, and urged HM
Treasury to tackle these, even if such re-
form was not envisaged in the timetable
for the review of the framework.
“For investors, the RCB regime is
lacking the very high degree of certainty
that should be expected of a regulated
product,” said the IMA. “For issuers, the
regime runs the risk that over time it
will fail to attract long term stable inves-
tors into the product.
“If the impact of bank resolution and
bail-in extends also to the RCB regime,
this is likely to lead to a gradual with-
drawal of long term investors from bank
funding, leaving banks with a different
and probably less stable investor base.”
Some market participants had sug-
gested that such bail-in questions might
have been sufficiently addressed when
the review was announced. However,
the IMA said that the introduction of
bail-ins of senior debt might affect the
RCB regime and that to maintain inves-
tor confidence the RCB should be clear-
ly carved out of bail-in requirements.
“This is particularly important as
in contrast to many EU RCB regimes,
a UK RCB is a senior unsecured bond
and only becomes ‘secured’ by way of a
guarantee on ‘default’,” said the associa-
tion. “In a special resolution situation,
this means that the guarantee may not
be triggered under the relevant contract
because the issuer is not deemed to be
in default.”
Investor data demands confl ictThe IMA said that covered bonds have
been increasingly taken up by its mem-
bers in the past year but that they have
not found the documentation “user-
friendly”.
“Key information is frequently bur-
ied deep within detailed prospectuses
(400+ pages is not unusual),” said the
IMA. “Whilst they are able to manage
this, we question why it should be nec-
essary for a regulated product.”
The association argues in favour of
disclosure of loan level data in line with
Bank of England requirements.
“This is a much needed measure to
improve investor confidence and trans-
parency for Regulated Covered Bonds,”
it said.
However, the Covered Bond Investor
Council said in a response to the con-
sultation that loan-by-loan disclosure
of cover pool assets, as required by the
Bank of England, “would contaminate
the reputation of high quality the cov-
ered bonds product has in the market”.
Asset backed securitisation (ABS)
products and covered bonds need to
be distinguished, it said, in particular
with respect to the level of information
required.
“Covered bond pools need to be
monitored by investors but maybe not
nearly as frequently as ABS pools as
long as the pool is fairly elitist from
its creation onwards and substitution
mechanisms are in place,” said the coun-
cil, which has called for aggregated data
it believes would be more useful. The
dynamic nature of cover pools makes
regular loan-level disclosure superflu-
ous, it added.
Th e level of transparency that inves-
tors should be provided with was the
only point of contention raised in the
CBIC’s submission, with the council say-
ing that it is “generally positive” toward
the changes proposed by the review.
RCB REVIEW
IMA cites weaknesses in UK consultationJane Lowe: “It might benefi t
from more signifi cant change.”
“Key information is frequently buried”
“Sovereign investors are more vulnerable to potential haircuts” page 25
10 The Covered Bond Report July 2011
MONITOR: LEGISLATION & REGULATION
Recent amendments to Spain’s legal
framework for mortgage loans weaken
creditors’ recourse to low income borrow-
ers, but preserves full recourse mecha-
nisms in the Spanish market, according to
Fitch and Moody’s.
Spain’s parliament passed a resolu-
tion, Royal Decree 8/2011, on 30 June
that, among other changes, increases the
threshold of defaulted borrower income
that is ring-fenced from a claiming credi-
tor. The new law became effective on 7
July, and was put forward by the ruling So-
cialist party, the main opposition People’s
Party and Catalan group Convergencia i
Union, demonstrating widespread sup-
port for the move.
Alvaro Gil, director, covered bonds at
Fitch, said that a motivation behind ini-
tiatives to end or modify full recourse was
the large number of legal cases for repos-
sessions since 2008. There have also been
recent protests in support of borrowers
facing repossession.
According to statistics from the Span-
ish judicial system cited by Moody’s, the
number of foreclosures reached 93,000 in
2010, up 260% from 2007 levels. Fitch said
that legal cases for repossessions since
2008 totalled 240,000.
Under Spanish law mortgage borrow-
ers remain personally liable for their debt
after foreclosure, instead of being able, as
is the case in some countries, to discharge
that debt in bankruptcy.
“Full recourse to current and future as-
sets and income of the obligor is system-
atically used by banks to ensure full re-
covery on defaulted mortgages when the
foreclosed property value at auction does
not cover the outstanding debt,” said Car-
los Masip, director, RMBS at Fitch.
The rating agency said that although
newly approved changes to Spain’s mort-
gage loan framework may reduce the
strength of full recourse from a cashflow
perspective, in particular for low income
borrowers in negative equity situations,
it continues to consider the Spanish debt
market as one featuring full recourse.
“Fitch recognises that there are many
disincentives that a sensible borrower will
consider before defaulting on its mortgage
loan to take advantage of the newly-ap-
proved measures,” it said.
Such disincentives include the alterna-
tive costs of occupancy such as property
rental or the potential loss of fiscal ben-
efits, according to Fitch.
“The full recourse mechanism over
borrower’s existing and future assets per-
sists by law, and would disqualify default-
ed borrowers from owning other assets or
from generating additional income in the
future,” it said.
In Fitch’s view the new law could trig-
ger a tightening effect on mortgage under-
writing policies, in particular with regards
to loan-to-value ratios for low income
borrowers.
Moody’s said that the revised frame-
work introduces three main changes. A
first involves raising the threshold that full
recourse to a defaulted borrower’s exist-
ing and future income is applicable to, a
change that Moody’s described as “cur-
tailing the rights of creditors to attach the
wages of borrowers who default on their
mortgage loans”.
But it said that this measure will have
a negligible impact on the Spanish RMBS
market because most of a mortgage loan’s
recovery stems from the effective sale of
a property, and not from the personal li-
ability remaining against a mortgage bor-
rower if the foreclosure process ends with
any debt outstanding.
The new framework also raises the
minimum percentage of the property
value – from 50% to 60% – at which a
bank can repossess a mortgaged property
if the foreclosure process ends with no
offers. Carlos Terre, director, structured
credit at Fitch, said this will shift poten-
tial losses from the obligors’ side to the
banks’ side, but that the rating agency
considers the effect on recovery assump-
tions to be neutral.
Moody’s highlighted a third amend-
ment, which reduces the amount that a
party has to deposit upfront to participate
at a property auction.
“Lowering the liquidity require-
ment may attract more bidders; the third
amendment may thus be considered cred-
it-positive, so long as it forms an incentive
for third parties to bid at mortgage auc-
tions,” said Moody’s.
SPAIN
Full recourse withstands populist move
Source: Plataforma Afectados por la Hipoteca
“Incentives to repay are still in force”
July 2011 The Covered Bond Report 11
SOLVENCY II
Covered to keep shine despite low returns
MONITOR: RATINGS
Bayerische Landesbank put on hold a
new covered bond issue on 6 July in re-
sponse to Moody’s that morning plac-
ing its Pfandbrief ratings on review for
downgrade alongside those of three oth-
er public sector banks.
“Since announcing a 10 year Jumbo
Öff entliche Pfandbriefe transaction yes-
terday, BayernLB has achieved a strong
momentum in the shadow order book
process,” the issuer said in a statement.
“However, the issuer has decided to delay
marketing the transaction following the
Moody’s announcement this morning.
“BayernLB would like to express their
thanks to those investors who have al-
ready shown their support. Th e decision
was taken in the interest of protecting
BayernLB’s investor base.”
Crédit Agricole, Credit Suisse, Deut-
sche Bank and Royal Bank of Scotland
had the mandate for the transaction and
a syndicate offi cial at one of the leads said
that preparations for the transaction had
gone very well, and that the decision to not
proceed was taken solely on the basis of
Moody’s action, which he described as “ab-
solutely unprecedented” and “ridiculous”.
“We had a good IoI book and were
ready to go,” he said.
BayernLB’s mortgage and public sec-
tor covered bonds are rated triple-A by
Moody’s, but the ratings were placed on
review for possible downgrade alongside
those of Pfandbriefe issued by HSH Nor-
dbank, WestLB, and Deutsche Kredit-
bank, aft er Moody’s placed the respective
issuer ratings on review for downgrade
the previous week.
A covered bond analyst described
Moody’s action with respect to BayernLB’s
public sector Pfandbriefe as a sign of the
rating agency’s willingness “to go the edge”
given that the rating of the public sector
covered bonds could sustain a three notch
issuer downgrade before being cut, accord-
ing to the rating agency’s methodology.
MOODY’S
‘Unprecedented’ move blocks BayernLB deal
BayernLB: “Had a good IoI book and was ready to go.”
Full implementation in 2013 of Sol-
vency II rules in their latest iteration
could lower the appeal of covered bonds
on the basis of their capital-adjusted
returns and thereby render them more
expensive to issue, according to Fitch.
However, the rating agency said in a
June report that the security the asset
class off ers means they will remain at-
tractive to insurers.
Th is dynamic would be one among
many — such as a shift from long term
to shorter term debt, and an increase in
the attractiveness of higher rated corpo-
rate debt and government bonds — that
would occur as a result of insurers, the
largest investor group in Europe, mak-
ing signifi cant changes to their asset
portfolios to optimise their capital posi-
tions, according to Fitch.
In a summary introducing the re-
port, the rating agency said that an in-
crease in the attractiveness of covered
bonds would be one of the main eff ects
of insurers adjusting their asset portfo-
lios to optimise capital positions.
However, in a section dedicated to
covered bonds the rating agency said
that although triple-A rated covered
bonds have a lower capital charge than
other corporates, “the charge is rela-
tively punitive compared with the risk
and returns currently available, making
them less attractive than other bonds on
a pure return-on-capital basis under the
(credit) spread module” (see chart).
With banks under pressure to in-
crease funding, a reduction in demand
could increase covered bond pricing,
the report added.
However, Fitch ended its assessment
of the impact on covered bonds on a
positive note, saying that the asset class
is likely to remain attractive to insurers
because of their “very safe nature”.
Comparison of Bond Returns under Solvency II (Taking into account cost of capital)
Issuer (Dated) Duration Rating Category Standalone capital charge* –standard formula (%)
Spread overswap (bps)
Return onequity (%)
Tesco (2014) 2.5 ‘A’ 3.5% (2* , 1.4%) 50 14.0
BAA (2041) 14 ‘A’ 19.6% (14*, 1.4%) 200 10.2
Deutsche Bank covered bond (2018) 6 ‘AAA’ 3.6% (6*, 0.6%) 10 7.8
* assuming duration matching using swaps. Source: Bloomberg, Fitch
Ratings
12 The Covered Bond Report July 2011
MONITOR: RATINGS
A revised approach to Danish covered
bonds from Moody’s resulting in nega-
tive rating actions has raised tensions
with Danish issuers, leading to Realkredit
Danmark terminating its collaboration
with the rating agency and others seeking
ways to escape the rating pressure.
Moody’s on 10 June increased the refi -
nancing margins and lowered the Timely
Payment Indicator (TPI) from “very
high” to “high” for the covered bonds
of fi ve Danish issuers, citing increased
refi nancing risk due to a material rise in
adjustable-rate mortgage (ARM) loans,
and reduced systemic support and cred-
itworthiness.
Among measures taken by Danish
mortgage banks in response to Moody’s
move was Realkredit Danmark’s decision
to drop the rating agency.
“Realkredit Danmark has discussed
the fundamentals of the matter with
Moody’s in order to understand the ra-
tionale behind its rating model, but has
concluded that the parties disagree about
the fundamentals,” it said on 23 June.
Moody’s went on to cut three Danish
mortgage credit institutions’ issuer rat-
ings on 1 July and lowered covered bonds
issued out of BRFkredit Capital Centre E
from Aa1 to Aa2.
However, with the Danish commu-
nity increasingly vocal in its criticism
of the rating agency, Moody’s put out a
special comment on the Danish covered
bond system in which its strengths were
highlighted.
“Despite weakening issuer credit
strength and our assessment of increased
refi nancing risk, the position of Den-
mark as having one of the strongest cov-
ered bond frameworks in Europe has not
changed,” said Moody’s, adding that the
new refi nancing margins are the lowest
in Europe and that the TPIs are among
the highest in Europe.
Moody’s methodological revisions
coincide with increased scrutiny of
Denmark’s mortgage financing system
by the country’s central bank, which has
highlighted a reduction in refinancing
risk linked to ARM loans and a reduc-
tion in risks surrounding continuous
loan-to-value requirements as ways in
which financial stability needs to be
strengthened.
Th ese recommendations and Moody’s
changes were among “future business
conditions” cited by Nykredit Realkredit
in an announcement from 21 June setting
out a fi ve point operational plan. Th is in-
cludes funding ARM loans with bonds is-
sued out of a special capital centre so that
these “may be given an independent, and
possibly lower, rating leading to lower
overcollateralisation requirements as a
result of Moody’s announcement”.
Surprised and confusedRealkredit Danmark will also establish a
new capital centre for the fi nancing of its
ARM loans, but in contrast to Nykredit
decided not to continue its collaboration
with Moody’s.
“Th e decision was taken because
Moody’s, as a result of its model calcula-
tions, demanded that Realkredit Danmark
provide an additional excess cover of
Dkr32.5bn (Eu4.36bn) if it wanted to keep
its current AAA rating,” said the issuer.
Realkredit Danmark said that it is in the
position to provide excess cover through
the issuance of junior covered bonds or
through a loan from its parent, Danske
Bank, but Moody’s on 14 July placed on re-
view for downgrade covered bonds issued
out of the issuer’s Capital Centre S because
the collateral had not yet been added.
Other rating agencies could gain from
the fall-out, with Realkredit Danmark
potentially turning from Moody’s to
Fitch — Standard & Poor’s already rates
its covered bonds AAA.
BRFkredit is in talks with S&P about
rating its capital centres aft er saying that
it was “surprised and unable to under-
stand” Moody’s actions. Th e move was
announced on 6 July as one of a pack-
age of measures from BRFkredit, which
Moody’s cut to Baa3 on 1 July.
Th e bank said that it will keep Moody’s
as a “co-operation partner” and establish
a new capital centre (H) that will prima-
rily refi nance ARM loans, in line with
Nykredit Realkredit’s and Realkredit
Danmark’s plans.
Th e issuer had made a commitment
in the documentation of covered bonds
issued out of capital centre E to maintain
a Aa1 rating by injecting capital if nec-
essary, but BRFkredit said that Moody’s
methodology made achieving such a rat-
ing impossible.
DENMARK
Danes up in arms amid Moody’s fall-out
Moody’s offi ces in New York
“The parties disagree about the
fundamentals”
July 2011 The Covered Bond Report 13
MONITOR: RATINGS
COUNTERPARTY CRITERIA
S&P hears warnings about proposals’ effectStandard & Poor’s proposals for assess-ing counterparty risk in covered bonds would have a disproportionate effect on ratings compared with asset-liability mismatch (ALMM) risk, issuers and in-vestors have told the rating agency.
They consider counterparty risk to be mainly an issuer risk, with investors pleased at the prospect of increased trans-parency about derivative counterparty risks in programmes, said S&P in an interim re-port published on 7 June.
However, the rating agency said that the majority of investors and issuers ap-peared to view counterparty risk as sec-ondary to an issuer’s ability to pay its covered bond obligations.
“Most investors and issuers consid-ered that counterparty risk, if assessed using the 2011 request for comment as
currently proposed, would have a dis-proportionate effect on covered bond ratings compared with asset-liability mismatch risk, as assessed using the ‘2009 ALMM criteria’,” said S&P.
DZ Bank analyst Jörg Homey drew at-tention to S&P disclosing that many issuers would consider the move to cap covered bond ratings by reference to the rating agency’s new counterparty criteria as — in Homey’s words — an “over-reaction”.
S&P said it will respond to feedback “by changing the criteria if we deem it necessary, by explaining the original pro-posals more clearly to remove ambiguity, or by leaving the proposals unchanged”.
Homey said that programmes where the issuer acts as a counterparty will be hit particularly hard.
“The decisive question in this case
is probably going to be whether S&P is satisfi ed by the precautions taken to replace the bank as counterparty for its own cover assets in the event of a downgrade,” he said.
Increased issuance of covered bonds and
renewed repo activity raise asset encum-
brance issues, according to Fitch, but the
rating agency sees the trend easing, even
if bank funding costs remain elevated.
Regulatory reforms, increased risk aver-
sion and other measures pushing the asset
class to the fore have led to greater use of
covered bonds, said the rating agency in a
report in June, adding that the increased
take-up of the asset class will hit a peak.
“Fitch believes that the limited supply
of high quality cover pool assets and na-
tional regulatory limits, if properly mon-
itored and enforced, serve as checks to
the use of covered bonds, allaying some
investor concerns over high issuance vol-
umes in recent months,” it said.
Th e rating agency said that a high de-
pendence on secured funding could con-
strain ratings and that an over-reliance
on this type of fi nancing could encumber
most assets on the company’s balance
sheet, reducing overall fi nancial fl exibility.
“In addition, a high concentration of
secured fi nancing increases the risk that
unsecured creditors could be adversely af-
fected as secured creditors may have prior-
ity claims to higher-quality assets,” it said.
“If the industry shift s to a signifi cantly
higher level of secured funding versus his-
torical levels, Issuer Default Ratings (IDRs)
could come under pressure and unsecured
debt ratings could fall below the IDR due to
lower recovery expectations.”
Fitch nevertheless noted the benefi ts
covered bonds can carry for issuers from
a ratings perspective.
“Most global trading banks did not
have a covered bond programme prior
to the crisis, but many have established
such programmes in the past two years,”
it said. “As such, the use of covered bonds
by these banks remains limited, but rep-
resents a funding source off ering poten-
tial diversifi cation and maturity exten-
sion benefi ts. Th is potential has yet to be
fully tapped by these banks.”
FITCH
Encumbrance a concern, but checks exist
Jörg Homey: Rating cap seen as “over-reaction”
New Issuance in Debt Markets (Euro Zone) Excludes issues <USD50mCovered bonds (not retained) Covered bonds (retained) Senior unsecured debt(USDbn)
700600500400300200100
0
Source: Dealogic, Fitch
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
“You look at the debt-to-GDP ratio in Canada, it’s very impressive indeed” page 39
14 The Covered Bond Report July 2011
MONITOR: RATINGS
Moody’s made good on a commitment
to deliver more timely covered bond
data by skipping Q4 2010 and moving
straight from Q3 2010 to Q1 2011 with
its latest quarterly monitoring report,
released on 11 July.
The rating agency said that it has been
focusing on producing more up to date
information since its last overview, which
was released in April.
“The delay between the publication
date of this report and the date the in-
formation relates to [up to 31 March] has
halved since the last monitoring report
was published,” said Moody’s. “Going
forward, Moody’s aims to produce this
report within three months of the date
the information relates to.
“The production of timely data has
also extended to the production of
the performance overviews, which are
published for every covered bond pro-
gramme included in this report. Moody’s
aims to publish all performance over-
views within six weeks from the date the
required information is received from
the covered bond issuer.”
Since the end of the last quarter
Moody’s has revised its assumptions
with regard to Danish covered bonds
and taken action in relation to several
programmes from the country. Data on
Danish covered bond programmes in the
overview was therefore incomplete, with
the rating agency referring to recent re-
leases. (See separate article for coverage
of Moody’s Danish actions.)
Among the largest changes in aggre-
gate country data given by Moody’s were
figures relating to Portuguese covered
bond programmes, even though the data
relates to a period before the rating agen-
cy cut Portugal to junk on 5 July.
The biggest fall in average surplus
overcollateralisation for a country was
in Portugal, where the figure fell from
18% to 5%. All Portuguese covered bond
programmes were cut by two or three
notches in between the ends of Q3 2010
and Q1 2011.
Three tiers for investorsThe rating agency also launched a re-
search service in June packaging its
covered bond research with analyses of
sponsor banks and related sovereigns.
“We’ve tried to complement the cov-
ered bond research by adding in sovereign
research as well as the issuing banks’ re-
search,” said Arlene Kearns, senior product
strategies in Moody’s structured finance
group. “The feedback that we’ve gotten
from the marketplace is that they look at
the sovereign first, the issuer next, and the
programme third — not necessarily in that
prescriptive order, but those are the three
tiers that they look to do analysis on, and
their focus depends on the situation.
“For example, if an investor has ex-
posure to a covered bond programme in
Canada, the focus of their credit monitor-
ing right now may just be on the issuing
bank, versus Spain where their current
focus may be on the sovereign, the bank,
and the cover pool detail.”
Kearns said that the launch of the serv-
ice also reflects developments in the cov-
ered bond market and its investor base.
“There’s an overwhelming sense that
US investors are interested in the space,
but they represent credit investors much
more than rates investors, like the tradi-
tional buyer-base,” she said. “This is all
the way from your typical high grade
credit investor to your hedge funds that
are looking at more high risk exposure.
“Their expectations are definitely differ-
ent from the traditional rates investor. They
are looking for cover pool information and
detail and looking to do that deep dive.”
MOODY’S
Timelier quarterly report presages latest trendsAverage cover pool losses by country: mortgage backed covered bonds
Average cover pool losses by country: public sector backed covered bonds
3% 4%7%
5%11%
3% 4% 5%
16%
5% 5% 4%
11% 9%12%
16%
29%
15%
9%
27%
21%
10%
15%
8%
0%5%
10%15%20%25%30%35%
Collateral risk Market risk
3% 3% 3%
7%
3%
7%
19%
11% 9%
24%
7%
18%
0%
5%
10%
15%
20%
25%
30%
Austria France Ireland Italy Germany Spain
Collateral risk Market risk
Finlan
d
Fran
ce
Germ
any
Italy
Irelan
d
Nether
lands
Norway
Portu
gal
Spain
Swed
en
United
King
dom
United
King
dom
(non-
bulle
t)
Source: Moody’s
“They represent credit investors
much more than rates investors”
July 2011 The Covered Bond Report 15
MONITOR: MARKET
Syndicate bankers are awaiting the details
of prospective ICMA best practice guide-
lines to see if primary market practices
will have to change in ways that could in-
crease execution risk for covered bonds,
resulting in issuers having to pay higher
new issue premiums.
Th e International Capital Market Asso-
ciation (ICMA) is working toward a set of
best practice guidelines aimed at increas-
ing transparency in new issues, through
changes to the way in which information
is communicated at various stages of the
new issue process. Any such guidelines
could aff ect the practice of price whisper-
ing, with the release of updates on order
book sizes also under scrutiny.
Banks’ eff orts to get in line with the
impending guidelines have already had an
impact on the primary market.
When Landesbank Baden-Württem-
berg sold a debut benchmark mortgage
Pfandbrief on 4 July, a Eu500m six year
deal, leads Natixis, LBBW, Royal Bank
of Scotland and UniCredit launched the
deal without having gone out with a price
whisper, despite market conditions being
fragile, if stable.
Jörg Huber, head of funding and investor
relations, treasury at LBBW, said that initial
feedback was positive, but non-committal in
the absence of a pricing indication.
“Unfortunately there was recently an
ICMA announcement recommending not
to use price whispers,” he told Th e Cov-
ered Bond Report, “which makes it quite
diffi cult to fi nd the right clearing level.
“Th is meant that we couldn’t inform
the sales teams what our initial pricing
ideas were to get relevant feedback, so
it took a bit longer to establish what the
right level was.”
Th is was deemed to be represented
by the 18bp-19bp over mid-swaps range,
with the leads taking indications of inter-
est at that level and order books growing
quickly once they were offi cially opened,
according to Huber. Th e deal was ulti-
mately priced at 18bp over on the back of
a Eu750m order book.
“We hit it spot-on, but the proce-
dure could have been smoother,” he said.
“Th ese kinds of guidelines are harming
the proper evaluation process, but we had
to deal with that.”
Go the extra mileRuari Ewing, director, primary markets,
market practice and regulatory policy at
the International Capital Market Associa-
tion (ICMA), told Th e Covered Bond Re-
port that the association had in October
2010 added an explanatory memorandum
on pre-sounding, bookbuilding and allo-
cations to its handbook, and that several
roundtables with investors had been con-
ducted over the past couple of years, most
recently in May.
“Banks are now continuing their dis-
cussions internally, with some already
starting to draw conclusions and move
ahead with new practices,” he said.
One practice being scrutinised is that
of price whispers, which Ewing character-
ised as an interim step aft er pre-sounding
but before bookbuilding has begun on the
basis of offi cial guidance. He said that the
practice of price whispers had emerged in
response to the fi nancial and sovereign
debt crises.
“In an easy market you can go straight
to guidance, but in volatile markets you’re
dealing with a completely diff erent kettle
of fi sh,” he said.
Although price whispers can be shared
with many market participants, some are
arguing that the information needs to be
communicated to a larger audience, ac-
cording to Ewing.
“Th e aim is to go out much wider with
a whisper than before,” he said. “With in-
creasing volatility there is a feeling that it is
important to go the extra mile. Under the
old system you could always miss a hand-
ful of accounts, and this new approach is
trying to wrap up that residual end.”
In practice this means that banks are
looking at ways to modify their commu-
nication to better reach transactions’ tar-
get audiences, said Ewing, which could
involve sending information as they have
been doing but also potentially dissemi-
nating it by way of news-feeds, among
other options.
Th e Covered Bond Report under-
stands that ICMA has been seeking to
release a formal publication that would
most likely be in the form of an addition
to the association’s primary market hand-
book. However, it is not clear how detailed
or prescriptive this might be.
Broadbrush adoptionAlthough fi nal guidelines have not been
drawn up, syndicate offi cials said that
market participants have already been im-
plementing what one banker described as
“broadbrush” changes to new issue prac-
ICMA
Anti-whispering campaign ‘counterproductive’
Jörg Huber: “These kinds of guidelines are harming the proper
evaluation process.”
Market
16 The Covered Bond Report July 2011
MONITOR: MARKET
tices in line with where discussions have
been heading.
Syndicate bankers described ICMA’s
position as aiming to ensure that everyone
who could be involved in a transaction has
access to public information, with inves-
tors pushing to do away with whispers and
other practices that could involve them
being made privy to inside information
and/or wall-crossed. ICMA explains wall-
crossing as being sounded for a potential
transaction on the basis of information
that may amount to inside information
and that could make investors subject to
legal restrictions, such as restrictions on
trading in related securities.
A syndicate offi cial said that one out-
come of discussions taking place could be
that the term “whisper” is no longer used,
partly on account of its connotations of
secrecy.
Terminology is not likely to be the
only feature of primary market activity
set to change, however, with a syndicate
banker saying that the ideas under dis-
cussion will also change the dynamics of
pre-sounding.
“Pre-sounding will be on a more public
basis,” he said. “Th e process will be slightly
diff erent, designed to make it more trans-
parent.”
Another syndicate offi cial said that IC-
MA’s guidelines had left him unimpressed
because of the increased execution risk
they would involve for borrowers. Inves-
tors, on the other hand, deemed infor-
mation such as price whispers and order
book updates to be relevant.
Th e guidelines were “slightly confusing
and counterproductive”, said the syndicate
offi cial.
Th e debate in part echoes that that took
place in the covered bond market last year
when the Covered Bond Investor Council
(CBIC) in January 2010 called for an end
to the practice of building shadow order
books based on price whispers.
A leading covered bond investor told
Th e Covered Bond Report that his posi-
tion remained unchanged today and that
he is still dissatisfi ed with what he called
pre-sounding. It was unfair for only a
handful of investors to be given prelimi-
nary pricing thoughts, while others only
belatedly received this information and
had little time to place orders given short
bookbuilding periods, he said.
While issuers are eager to avoid execu-
tion risk, the portfolio manager said that
he did not consider there to be any stigma
attached to not completing a deal or hav-
ing to widen pricing, and that this could in
any case also happen if a new issue project
had been pre-sounded.
He urged a return to traditional deal
execution methods, citing high issuance
volumes this year and the lack of failed
transactions
“Th e crisis mode for covered bonds
doesn’t make sense,” he said.
Less fear of failure?Making it more diffi cult to arrive at the ap-
propriate initial guidance for a transaction
by prohibiting discreet discussions with a
small number of key investors would in-
crease execution risk or the risk of an issu-
er fi nding itself in a position where it has
to pull a deal. Th is could result in issuers
having to pay higher new issue premiums
to reduce such risks.
But some bankers questioned whether,
or the degree to which, any new measures
would aff ect new issues, saying that price
whispers already spread quickly and wide-
ly, perhaps reaching more market partici-
pants and journalists than was intended.
“To all intents and purposes, how
many deals have been out where you
haven’t heard a price whisper?” asked one
syndicate offi cial. “A cynic would argue
that if it is not in writing then it is easier to
more elegantly step back or adjust levels,
but I’m not 100% convinced by that.
“When it’s announced, it’s announced.”
Others said that those pulling deals
could in future be less stigmatised for
doing so. One syndicate banker said that
market participants’ judgements of pulled
deals had already eased over the past three
years, and that such occurrences were less
conversational.
He identifi ed the return of retention
deals as a possible outcome of any new
guidelines on the communication of up-
dates on order book sizes — something
that bankers said is also being debated. Th e
Covered Bond Report understands that
lead manager and trading orders being in-
cluded in order books that may otherwise
not be fully covered is a focus of scrutiny.
Th e syndicate offi cial said that a po-
tential clampdown on including lead
manager orders in order book sizes and/
or potentially requiring such orders to be
identifi ed separately could lead to the re-
turn of retention deals because such rules
would make it more diffi cult for banks to
give the impressions that deals are being
successfully handled in pot format.
“The crisis mode for covered bonds
doesn’t make sense.”
Ruari Ewing: “The aim is to go out much wider with a whisper.”
July 2011 The Covered Bond Report 17
MONITOR: MARKET
Moving into the second half of the year
after an increasingly fraught first six
months, covered bond analysts were con-
sidering the prospect that covered bond
issuance might not meet the projections
they made at the turn of the year.
“Everything is stuck on the topic of
the euro-zone,” says Bernd Volk, head of
covered bond research at Deutsche Bank.
“The covered bond market will continue
on a slower pace even though a resolu-
tion is found for Greece, also due to pre-
funding and the declining funding needs
of numerous issuers.”
Deutsche Bank had estimated
Eu250bn in euro benchmark issuance for
the year, a number Volk now considers
impossible.
“Due to all this rating action and
market concern I think the market will
be happy if we do another Eu60bn and
hit Eu200bn, but I think everyone will
probably struggle with market issuance,”
he says.
“France will be crucial in reaching
Eu200bn,” he adds, “which is the best we
can hope for. If they issue a lot, we’ll have
a lot more volume.”
French issuers sold some Eu37bn of
benchmarks, including taps, in the first
half of the year.
Danske Bank had forecast Eu226bn
in gross supply for 2011, and some 62%
of that volume was issued in the first
six months of 2011. By comparison,
Eu185bn hit the market in 2010, accord-
ing to the Danish bank.
“There’s still a lot of uncertainty be-
cause market access is very much linked
to the sovereign debt crisis,” says Chris-
tian Riemann-Andersen, senior analyst
at Danske. “If they don’t come up with
a sustainable solution for Greece, who
knows what will happen?
“But if they do, we might even see
more issuance than we have forecast,
driven by the peripheral countries.”
Covered bond analysts say that sup-
ply in different currencies could affect
what should be expected from each ju-
risdiction.
“The UK is a little bit behind what we
had expected,” says Riemann-Andersen,
“but we stick to the forecast as most UK
banks have large refinancing needs.
“The joker that could take euro sup-
ply lower than projected is of course di-
versification into US dollars or British
pounds.”
UK banks issued some Eu10bn in
the first of the year in euros, according
to Danske, when the bank had forecast
Eu22bn for the year.
Florian Hillenbrand, senior credit
analyst at UniCredit, attributed the UK
shortfall to a greater trend towards US
dollars.
“There is one respect that weighs
heavy on euro issuance,” he says. “That’s
the US. What we see right now is in
countries where they have to swap their
issuance back into their home currency
(the UK, Norway, and Denmark), we
have seen active US dollar issuance.
“This is something that will poten-
tially drag euro issuers toward the dollar
market.”
New Zealand and Australia are con-
sidered minor players, with market par-
ticipants undecided as to whether Aus-
tralian issuers will even come to market
this year.
“For Australia, we have a cautious
estimate of Eu2bn, but there also might
be nothing if the upcoming law gets de-
layed” says Danske’s Riemann-Andersen.
Other jurisdictions have meanwhile
surprised to the upside.
“Italy has done pretty well as they
benefitted from the relief in the sovereign
market earlier this year,” adds Riemann-
Andersen.
Italian banks sold some Eu14bn of
benchmark euro covered bonds, com-
pared with Eu20bn forecast by Danske.
UniCredit’s Hillenbrand foresees
heavy issuance in September.
“Last year we had Eu27bn in in Sep-
tember,” he says. “I would be quite sur-
prised to see anything less than this
number after we saw record issuance in
September through March.”
SUPPLY
Wildcards undermine H2 forecasts
0
10
20
30
40
50
60
German
y
Franc
e
Irelan
d
Luxe
mbour
g
Spain
UK
Austr
ia
Finlan
d Ita
ly
The N
etherl
ands
US
Swed
en
Portu
gal
Canad
a
Norway
Denmar
k
Greece
Switz
erlan
d
New Z
ealan
d
2010 2011 ytd 2011e
UniCredit H2 supply forecasts
Source: UniCredit Research
Diversification into dollars or pounds
“the joker”
“The legislation is being perceived positively by investors” page 40
18 The Covered Bond Report July 2011
MONITOR: MARKET
Westpac NZ fi nally came to the market
with its fi rst covered bond in early June
aft er postponing its plans in February,
but hopes of further supply from New
Zealand were dashed when ANZ Nation-
al postponed a debut, euro denominated
deal on 22 June.
In February Westpac NZ had cited
poor market conditions and an earth-
quake in New Zealand when delaying its
inaugural covered bond. But at its second
attempt, Westpac NZ’s leads — Barclays
Capital, BNP Paribas and UBS — built a
book of Eu1.3bn for the Eu1bn fi ve year
issue and priced it at 75bp over mid-
swaps on 9 June.
A Bank of New Zealand seven year
was the only other New Zealand covered
bond outstanding in euros and a syndi-
cate offi cial at one of Westpac NZ’s leads
said that this was trading in the low 70s
mid over swaps. BNZ issued its Eu1bn
seven year at 62bp over mid-swaps last
November.
A syndicate offi cial away from the
leads suggested pricing was more real-
istic than when Westpac NZ had previ-
ously approached the market.
“Th at was aft er the Christchurch
earthquake, but I don’t think they really
had a trade then,” he says.
Bankers said that they were somewhat
surprised at the level Westpac NZ needed
to pay given its qualities, and struggled to
explain why the New Zealand banks did
not trade tighter.
“Th e bank is relatively small,” suggest-
ed one, “even if it’s part of a bigger group,
and the fact that it is non-ECB collateral
doesn’t help.”
Th e New Zealand sector faced further
challenges in June when ANZ National
postponed a new issue project until aft er
the summer in light of rapidly deteriorat-
ing market conditions aft er having gone
on a roadshow for a debut covered bond.
A syndicate banker familiar with the
New Zealand bank’s plans said that feed-
back from the roadshow had been “quite
strong” but that as a well funded issuer
ANZ felt it did not need to rush to launch
a deal in such uncertain markets.
Aussie cheer for BNZ, DnB NorBNZ found conditions closer to home
more conducive, selling a debut, A$700m
(Eu512m) fi ve year covered bond at 88bp
over swaps on 7 June via HSBC, RBC and
RBS. Th is was larger than the A$500m
originally targeted, with oversubscrip-
tion also allowing pricing at the tight end
of the guidance of 88bp-90bp.
Comparing this with Westpac NZ’s
euro benchmark launched two days later,
a banker away from the two deals said
that BNZ’s level translated to around
30bp over Euribor, meaning that it had
saved about 45bp versus where Westpac
NZ had funded in euros.
DnB Nor Boligkreditt also found suc-
cess in Aussie dollars, becoming the fi rst
European issuer to sell a covered bond
in the currency since the onset of the fi -
nancial crisis when it sold a A$600m fi ve
year at 85bp over mid-swaps on 8 June
via ANZ, Deutsche Bank and HSBC.
“Th e target was to print a deal like
this, with a A$500m minimum size,”
Th or Tellefsen, senior vice president and
head of long term funding at DnB Nor,
told Th e Covered Bond Report. “For us
it’s all about investor diversifi cation.”
He said that the pricing was more or
less in line with what DnB Nor could
achieve in the US dollar covered bond
market or in euros. Th e proceeds of the
Australian dollar issue were swapped to
dollar Libor at 61bp — DnB Nor issued
a fi ve year dollar benchmark at the end
of March at 66bp over that was trading in
the high 50s.
AUSTRALIA/NEW ZEALAND
Westpac NZ on, but ANZ off, as Kiwis travel
Westpac NZ rescue helicopter
DnB Nor, Oslo
July 2011 The Covered Bond Report 19
MONITOR: MARKET
Issuers found the euro primary market in-
creasingly challenging through June and
the fi rst half of July, as investors retreated
fi rst to only names from core jurisdictions
and then onto the sidelines completely.
Greece proved to be a major wrecking
ball as the market awaited Greek prime
minister George Papandreou’s attempt to
withstand a vote of confi dence on 19 June
by reshuffl ing his cabinet and then pushing
through a new austerity package on 29 June.
A relief rally on the back of the success-
ful initiatives allowed Eu1bn plus of cov-
ered bond funding to be raised by Caisse
de Refi nancement de l’Habitat and BNP
Paribas Home Loans SFH, but the diffi -
culty of tapping into even such issuance
windows was demonstrated when Fin-
land’s OP Mortgage Bank struggled to get
a Eu1bn seven year away at the same time.
But worse was to come as fears of con-
tagion spread. Aft er Landesbank Baden-
Württemberg and CM-CIC Home Loan
SFH sold benchmarks in the fi rst full
week of July, benchmark euro issuance
came to a standstill.
“It’s a very quiet, very political mar-
ket,” said Christoph Alenfeld, syndicate
offi cial at DZ Bank. “It’s really turned
sour lately, and given the political situa-
tion, no one is really surprised by this.”
June had started well for Italian banks,
with UniCredit and Credito Emiliano
selling benchmarks — the latter its debut
covered bond. But the country took a hit
on 24 June when Moody’s placed covered
bond programmes of fi ve Italian fi nan-
cial institutions on review for possible
downgrade — the republic’s Aa2 rating
had been put on review a week earlier —
dashing the hopes of compatriots queu-
ing to issue.
However, Italy’s travails in the covered
bond market were minor in comparison
with Spain’s. Only one Spanish issuer ap-
proached the market and it found the
environment unwelcoming: a Eu1bn fi ve
year issue for Santander backed by public
sector collateral was widely criticised as
poorly timed and aggressively priced.
“Just because one day the indices are
trading better, it doesn’t mean that inves-
tors are going to wake up and decide that,
just having sold Spain, they are going to
start buying again,” said a syndicate offi -
cial away from the leads. “I wouldn’t have
recommended going ahead unless I want-
ed to be left with Eu100m on my book.”
However, some market participants
said that the overall performance of the
asset class in the face of tough economic
conditions had shown it in a positive light.
“Th e covered bond market has shown
a great amount of resilience to the situ-
ation in southern Europe,” said Per Høg
Jensen, vice president, DCM origination
at Danske Bank. “It’s a good testimony
to the market that deals still are getting
done in the covered space.”
He cited as an example a Eu500m fi ve
year mortgage Pfandbrief from newcom-
er ING-DiBa, which had been warmly re-
ceived on 22 June, with the order books
more than twice subscribed in spite of
what some market participants consid-
ered tight pricing.
EUROS
Issuers steer clear of Greek wrecking ball
Prime minister George Papandreou: survived two tests
0
100
200
300
400
500
600
700
800
900
11-rpA11-naJ01-tcO01-luJ
bp
iBoxx € France Covered Structured iBoxx € Netherlands Covered iBoxx € Portugal CoverediBoxx € Spain Covered iBoxx € UK Covered iBoxx € France Covered LegaliBoxx € Hypothekenpfandbriefe iBoxx € Ireland Covered iBoxx € Norway CoverediBoxx € Oeffentliche Pfandbriefe iBoxx € Sweden Covered iBoxx € Italy Covered
Spread performance by sector
Source: UniCredit Research
“OC ceiling could negatively impact investor confi dence” page 41
20 The Covered Bond Report July 2011
MONITOR: PEOPLE & INSTITUTIONS
LBBW
Rath heads for Commerz
Former UBS credit trader Michael Rudd
has joined RBC Capital Markets as a
director of its fi xed income platform in
New York.
Rudd will work closely with Catherine
Chere, a credit trader in London. RBC
said this will better enable it to provide
clients with the ability to trade covered
bonds and Yankee banks.
In January RBC hired Ben Colice as
head of covered bonds origination from
Barclays Capital.
“Currently, we have the right number
of people in place given the size of the
market,” Mike Meyer, head of US credit,
RBC Capital Markets, told Th e Covered
Bond Report, “and we’ll be in a good
place to add more people if needed. We’re
positioned well to grow the business.
“We think the market is going to
continue to grow in Canada and Europe
and though there are still some ques-
tions around US and Australian markets,
we are optimistic about growth there as
well.”
Th ere has been ample US dollar cov-
ered bond issuance out of Canada, added
Meyer.
“If US legislation passes, we would be
in a very good place,” he said.
RBC
Rudd hired on US hopes
Michael Rudd: latest RBC hire
Denis Rath: from covered to senior
People & Institutions
“If US legislation passes, we would be in a very good place”
Denis Rath is leaving Landesbank Baden-Württemberg to join Commerz-bank’s DCM syndicate team as a vice president in London.
Rath is on gardening leave and will be joining Commerzbank by the beginning of 2012. He had been working at LBBW for fi ve years, most recently as debt capital markets syn-dicate manager sharing responsibility
for covered bonds.Earlier this year Martin Rohland
joined Barclays Capital’s syndicate af-ter having left LBBW, while a year ago head of syndicate Vincent Hoarau went to Crédit Agricole.
At Commerzbank, Rath will be fo-cused on senior unsecured bonds. He will report to Hugh Carter in London and Joachim Heppe in Frankfurt.
Don’t forget to visit our website at:
www.coveredbondreport.com
July 2011 The Covered Bond Report 21
MONITOR: PEOPLE & INSTITUTIONS
Landesbank Baden-Württemberg has
appointed long-serving analyst Alexan-
dra Hauser to its covered bond team to
replace Jan King, who is due to leave the
bank this autumn, while Ralf Burmeister
is also departing.
Burmeister, who was head of covered
bonds and fi nancials research at LBBW,
is understood to have lined up a posi-
tion at German asset manager DWS In-
vestments. Currently on paternity leave,
joined LBBW in 2000 and became head
of the covered bond and fi nancials re-
search team in November 2007.
King is set to join Royal Bank of
Scotland in London, with one of the UK
bank’s previous covered bond analysts,
Sophia Kwon, having moved internally to
work in debt capital markets. King joined
LBBW in 2006.
LBBW’s Hauser began working as a
senior credit analyst on covered bonds at
the beginning of this July, and will share
responsibility for the bank’s covered
bond research with Christian Enger, also
senior credit analyst at the bank.
Before moving to her new role Hauser
worked for 12 years as an equities analyst,
most recently as manager of LBBW’s engi-
neering and industrial equities team. She
joined LBBW in 1994, and aft er completing
a training programme worked in the bank’s
controlling department for four years.
Her focus was on strategic bank man-
agement, dealing with issues concerning
asset and liability management in the
context of refi nancing requirements, in-
cluding in relation to specifi c products
such as Pfandbriefe, Hauser told Th e
Covered Bond Report.
ANALYSTS
LBBW brings in Hauser
Alexandra Hauser: credit switch
NBIM
New role for NielsenClaus Tofte Nielsen, chairman of the Covered Bond Investor Council, has taken on the role of head of position management, allocation strategies, at Norges Bank Investment Man-agement.
Nielsen was until recently senior portfolio manager at NBIM, which manages Norway’s oil fund, the Gov-ernment Pension Fund Global, but is now heading the allocation strategies department.
The department is responsible for the overall risk positioning of the fund, overlay positions establish-ing total fund exposures, as well as management of dedicated portfolios in chosen market segments. Nielsen’s appointment comes after a series of top level organisational changes, in March and April.
TRADING
Poli leaves BAMLNicolas Poli has left Bank of America
Merrill Lynch, where he was a director
and worked on the sovereign, supra-
national and agency and covered bond
trading desk.
He joined Merrill Lynch in mid-2008
from Calyon. Th e Covered Bond Report
understands that Poli will be re-emerg-
ing in a similar role at a leading covered
bond house aft er his departure in June.
Meanwhile, Crédit Agricole has hired
Matej Chytil from National Bank of Slo-
vakia to work as a covered bond trader.
BARCLAYS
Harju joins from S&PJussi Harju joined Barclays Capital in May
from Standard & Poor’s, where he was re-
sponsible for rating UK, Scandinavian and
Dutch covered bond programmes.
As European Strategy analyst, he and
Fritz Engelhard, German head of strategy,
are primarily responsible for Barclays’ cov-
ered bond research, while Michaela Seimen
works on SSA and covered bond research.
Harju’s hire follows the departure of
Leef Dierks, who left Barclays’ research
team last year to join Morgan Stanley as
head of covered bond and SSA strategy.
STRUCTURING
Credit Suisse hires BNP Paribas’ Peacocke Hamish Peakcocke is understood to be joining Credit Suisse from BNP Paribas.
Peacocke worked in covered bond structuring at BNP Paribas and is expected
to fi ll a similar role when he joins Credit Suisse.
Arjan Verbeek heads flow ABS and covered bond structuring at BNP Paribas.
The French bank ranks top of the covered bond league table for benchmark cov-
ered bonds in all currencies.
July 2011 The Covered Bond Report 23
COVER STORY: SOVEREIGNS VERSUS COVERED
I f secondary market trends are anything to go by, cov-
ered bonds issued out of countries such as Ireland,
Greece and Portugal have been deemed less risky than
their respective sovereign debt as they have become
engulfed by the euro-zone crisis.
“Covered bonds trading in line or inside respective sover-
eign levels can be considered a feature of the so-called ‘periph-
eral economies’ and as a crisis signal,” says Leef Dierks, head
of covered bond and SSA strategy at Morgan Stanley. “It shows
that covered bonds are viewed as equal to or better than sover-
eign debt in risk terms.”
Dierks noted back in April that in all European economies
that experienced funding difficulties and/or were subject to
support measures from the European Union and International
Monetary Fund — Ireland and Greece, at the time — covered
bonds could be observed trading through government bonds.
This was before Portugal also received a Eu78bn bailout package
from the EU and the IMF agreed at the beginning of May, but
Dierks observed that already the average correlation between
swap spread movements of Portuguese government bonds and
those of the country’s mortgage covered bonds (obrigações
hipotecarias) had also started to decline.
The development of such a relationship can make sense,
say investors.
Roger Doig, senior credit analyst at Schroders, points to the
example of McDonald’s at one point in 2010 trading tighter
than the US sovereign, and says that covered bonds could also
be candidates for such behaviour.
“You would need a cover pool with extremely strong operat-
ing rules, where government bonds cannot serve as alternative
collateral and where there are very strict limits on factors such
as loan-to-value ratios,” he says. “Ultimately a triple-A rating
stems not from recourse to the sponsor bank but from confi-
dence in the management of the cover pool and low to no cor-
relation between the collateral and the sovereign situation.”
The importance of good quality, non-public sector assets as
collateral was also highlighted by a large covered bond investor.
“Take the Greek situation, where it now seems that there
will be some type of voluntary rollover,” he says. “The prob-
lems there have not been caused by the mortgage market but
by an inefficient public sector and uncompetitive economy, so
you could argue that this is a case where covered bonds should
come out better than government debt.”
Although such an argument would be more difficult to make
with respect to Ireland, he adds, given that many of the coun-
try’s problems are linked to the housing market.
Vincent Cooper, financials analyst at hedge fund BlueMoun-
tain Capital Management, says that in a distressed sovereign
scenario covered bonds issued out of a country can justifiably
trade through the sovereign, the key reason being covered
bondholders’ recourse to a pool of collateral.
“To the extent that you are comfortable with the underpinning
legal framework, the recourse does provide significant enhance-
ment to the security of your investment,” he says. “We are seeing
examples of that in the sovereign space where sovereign investors
are more vulnerable to potential haircuts without any real claim to
assets and also face the likelihood that there will be a number of
preferred creditors ranking ahead of them, such as the IMF.”
BlueMountain, for one, has taken a more active interest in
covered bonds partly on account of recent price movements in
the market resulting from sovereign developments in the pe-
riphery, according to Cooper.
“With the weakness in peripheral Europe we have seen some
pretty distressed prices in parts of the covered bond market,
Fall of the sovereignThe theory is simple: sovereign debt is the risk free asset class; covered
bonds appeal to those looking for safety but extra yield. But today investors are faced with the possibility of an EU state defaulting. Which asset class
will prove to have been the least risky should doomsday arrive?Sue Rust reports.
24 The Covered Bond Report July 2011
COVER STORY: SOVEREIGNS VERSUS COVERED
which have provided good opportunities for us,” he says. “Cov-
ered bonds in places like Ireland, Portugal and Spain are trading
at yields that are similarly interesting to those on subordinated
bank debt.”
Technical and fundamental doubtsHowever, although Greek, Irish, and Portuguese covered bonds
have been trading inside levels on their sovereign’s debt, this
relationship has yet to manifest itself in the primary market and
the large investor says that this renders it less meaningful.
“People say it does not matter as long you don’t have a pri-
mary issue price tighter than the sovereign,” he says, “but we
will not see this because it would kill a bank from Ireland or
Portugal to issue at this kind of levels.”
And Heiko Langer, senior covered bond analyst at BNP Pari-
bas, says there are limits on the extent to which covered bond
spreads can decouple from sovereign spreads.
“There are some investors out there who value the fact
that they have tangible collateral as opposed to just a promise
from a sovereign to pay back their debt based on tax income,”
he says. “But if you are realistic, most institutional investors
need a country allowance to also hold covered bonds from
that country.
“So if they are not allowed to pick up Irish exposure they will
not be allowed to buy more Irish covered bonds, and people
may also oft en sell government bonds before covered bonds or
what is more easy to sell, especially in distressed times.”
Greater liquidity in the government bond market than in the
covered bond market can also help explain why some covered
bonds have been trading tighter than their sovereigns, he adds,
with covered bond spreads reacting more sluggishly than those
for government bonds.
“I am aware of some Portuguese covered bonds continuously
trading through their sovereign,” he says, “but not necessarily
because there are so many people out there taking a view that
they are better off holding covered bonds from Portugal than
the sovereign debt.
“Th ere are a lot of technical reasons that can lead to that type
of behaviour.”
And Schroders’ Doig argues that despite it being possible
that covered bonds will trade through sovereigns — because of
the lack of correlation between a mortgage pool and the “idi-
osyncratic” problems facing the sovereign — there are factors
working against this.
“Banks are typically large holders of government bonds, and
to the extent that cover pool assets are correlated to a bank’s un-
secured rating you will get a feed-through: worsening sovereign
Leef Dierks: “Covered bonds could be observedtrading through government bonds”
Ass
et s
wap
spr
ead
(bp)
-400
-300
-200
-100
0
100
200
Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11
Italy Spain Portugal Ireland
Spread between sovereigns and covered bonds (iBoxx aggregates)
Source: Markit, Morgan Stanley
July 2011 The Covered Bond Report 25
COVER STORY: SOVEREIGNS VERSUS COVERED
spreads can drive out senior unsecured spread, which can take
secured spreads wider,” he says.
An investor would also need to believe that the country’s
mortgage market could prosper when the sovereign is in trou-
ble or defaults, adds Doig.
“Th e weakness in the country’s economy probably mitigates
against a housing market doing well because of the intercon-
nectedness of it all,” he says.
Can bail-ins be escaped?As European policymakers strive to avert a Greek default that
could trigger a Lehman Brothers-style meltdown and to con-
tain a wider sovereign debt crisis, their eff orts have focussed on
involving the private sector in a restructuring of the country’s
maturing debt. One high profi le proposal was that originated
by the French banking federation, which foresaw the country’s
banks voluntarily rolling over a portion of maturing Greek
bonds into new government bonds, the idea being that other
fi nancial institutions would also take part.
However, contrary to the initiative’s aims, Fitch and Stand-
ard & Poor’s reacted to the rollover plan by announcing that
they would consider such an initiative to constitute a default,
and at the time Th e Covered Bond Report went to press Eu-
ropean leaders were searching for a new strategy as part of a
second bailout plan for Greece.
Tim Skeet, managing director, fi nancial institutions group at
Royal Bank of Scotland, says that the impact on covered bonds
of a restructuring or default is hard to gauge, with challenges on
multiple levels. Investors’ decisions should therefore be taken
on the basis of a “big picture” view.
“On paper, if there is a restructuring of sovereign debt the
status of covered bonds should not be directly impacted,” he
says, “but from a credit perspective they are bound to get hit.
“You will want to buy or hold such covered bonds on credit
fundamentals because you will be exposed to credit events and
rating risk. Th eoretically the credit of covered bonds should
hold up, but in practice that is very unclear.”
Covered bonds’ exemption from bail-in discussions surround-
ing sovereign and senior unsecured debt is also pertinent to the
assessment of sovereign and covered bond risk, according to Skeet.
“If covered bonds are not bail-inable then you should be able
to get your money back when it is due regardless of what is hap-
pening to the sponsor bank or the sovereign,” he says. “By defi -
nition you are talking about covered bonds being the most sen-
ior of all debt categories in a country, but they are not risk-free.
“If there is a super meltdown bringing down the banks and
the economy, including the payment systems, mortgage bor-
rowers will not have the means of servicing their debt so over-
collateralisation levels will be insuffi cient and possibly irrele-
vant — where are you going to get your money from?” he adds.
Fitch sets out roadmapMuch depends on the nature of any further deterioration of
Greece’s debt problems and how this is managed, say market
participants.
-700
-600
-500
-400
-300
-200
-100
0
100
200
Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11
Ass
et s
wap
spr
ead
(bp)
3.375% BES Feb 2015 - 4.200% PGB Oct 2016 3.875% CGD Dec 2016 - 4.200% PGB Oct 2016 3.375% BCP Oct 2016 - 4.200% PGB Oct 2016 3.250% BPI Jan 2016 - 4.200% PGB Oct 2016
Spread between Portugal and Portuguese covered bonds
Source: Morgan Stanley
Vincent Cooper: “Sovereign investors are more vulnerable to potential haircuts”
26 The Covered Bond Report July 2011
COVER STORY: SOVEREIGNS VERSUS COVERED
In a statement setting out the rating implications for struc-
tured fi nance securities and covered bonds of a restructuring or
rollover of Greek debt, Fitch said that for a covered bond rating
to exceed the issuer default rating of the relevant euro-zone sov-
ereign the rating agency must expect that the country’s fi nancial
payment system will continue to operate, without interruption,
at all times throughout the lives of the transactions and their
underlying pools of assets.
“It is possible that a country’s payment system will continue
to operate throughout a period in which the debt obligations
of the sovereign and even individual fi nancial institutions un-
dergo some form of restructuring, particularly if such events
are anticipated and overseen in an orderly manner by external
parties such as the International Monetary Fund,” it added.
Cashflows in securitisations could therefore be maintained
and payments made as required despite the potential techni-
cal insolvency and liquidity problems that could be created
for banks as a result of some form of restructuring or default,
it believes.
Skeet says that references to problems such as the uninter-
rupted operation of a fi nancial payment system illustrate that
for technical reasons the “super-seniority” of covered bond-
holders may not matter.
In contrast to securitisations, said Fitch, covered bond rat-
ings would continue to be tied to the ratings of their issuers,
which the agency would be likely to cut in the event of a further
downgrade of the Greek sovereign.
Th e impact on the issuer ratings would take into account
whether the restructuring or rollover event “is accompanied by
fi rm commitments from the European authorities for general
bank re-capitalisation and re-fi nancing, as well as its anticipat-
ed eff ects on the individual banks,” said Fitch.
And while market participants emphasise the value of cov-
ered bondholders’ claims on collateral, the performance of
those assets is anything but certain in the context of a sovereign
under stress, as Fitch highlights in the case of Greece.
“Th e implementation of more severe austerity measures, de-
clining economic output and ongoing political tension all have
the potential to reduce the ability and/or willingness of bor-
rowers to make payments on their loans and have a detrimental
eff ect on asset prices,” it said.
Negative feedback loopsWhether or not it will all boil down to the assets in cover pools
depends on the extent to which issuing fi nancial institutions,
domestic and international, can survive a sovereign debt crisis,
a debt restructuring, or, ultimately, a default.
In a research note exploring ways to bring Greece back to
solvency Barclays Capital economists described the impact sov-
ereign fears have had on domestic fi nancial institutions, espe-
cially their funding costs.
“Profi tability is a key concern, as margins are further
squeezed,” they said. “Deposit wars are still ongoing in Spain
and are becoming a threat in Italy as well. More generally, el-
evated sovereign spreads add pressure on fi nancial and nonfi -
nancial corporates, putting downward pressure on credit supply
and investment decisions, thereby creating a negative feedback
loop into the economy.”
A report published by the Bank for International Settle-
ment’s Committee on the Global Financial System (CGFS) in
July described the causality between sovereign risk and the cost
and composition of bank funding.
“Higher sovereign risk since late 2009 has pushed up the cost
and adversely aff ected the composition of some euro area banks’
funding, with the extent of the impact broadly in line with the
deterioration in the creditworthiness of the home sovereign,”
it said. “Banks in Greece, Ireland and Portugal have found it
diffi cult to raise wholesale debt and deposits, and have become
reliant on central bank liquidity.
“Th e increase in the cost of wholesale funding has spilled
over to banks located in other European countries, although to
a much lesser extent.”
As Th e Covered Bond Report was going to press the euro-
zone crisis had reached Italy’s doorstep. Analysts at Landesbank
Baden-Württemberg noted that a key cause for concern was
how intertwined are the sovereign and its banks, also citing the
CGFS report.
“The Bank for International Settlements offered some
ideas as to why rising credit risks at state level also impact
negatively on the funding situation of the banks in question,”
they said. “The BIS makes out in particular four transmission
channels, above all impending writedowns on banks’ sover-
eign debt portfolios.
Roger Doig: “Weakness in a country’s economy probably mitigates against the housing market doing well”
July 2011 The Covered Bond Report 27
COVER STORY: SOVEREIGNS VERSUS COVERED
“Especially in developed countries, banks typically have
high exposures to their home state according to the BIS. For
example, the exposure of Italian banks to the Italian state repre-
sents nearly 70% of the banks’ capital.”
Standard & Poor’s has said that the magnitude of the im-
pact on Greek banks of any restructuring of the sovereign’s debt
would largely depend on the amount of debt aff ected and the
terms and conditions of a restructuring.
Greek banks’ capital bases could be affected by any such
restructuring, it said, adding that the effect would vary ac-
cording to whether the potential restructuring involves:
principal haircuts; a lengthening of debt maturities by ex-
tending the maturities of existing debt or by exchanging ex-
isting bonds for longer term new debt; or altering the level
of the coupon on any new bonds offered in exchange relative
to the original debt. The impact would also depend on any
forbearance in its recognition.
“As a result, scenarios for Greek banks in the event of a po-
tential Greek government debt restructuring range from being
able to operate with capital levels above minimum regulatory
limits, for example, if the government debt restructuring af-
fects only part of the government debt, to potentially facing
insolvency in the more negative scenarios affecting the whole
of rated banks’ large portfolios of Greek government debt,”
said S&P.
Euro exit caveatSchroders’ Doig says that with regard to Greece the intercon-
nectedness of its debt burden, and the state of its economy
and its banks means that trade ideas promoting Greek covered
bonds are not appealing.
“A few people on the sell-side have pushed Greek covered
bonds on the basis that the country’s housing market is not
what has caused the problems,” he says, “but Greece has gone
far enough that that is no longer compelling.
“Th ere is material enough a risk there — if the country
leaves the euro you lose value on the cover pool assets and
clearly there are also many problems with the sponsor banks
given that they hold a lot of Greek debt and are losing deposi-
tors due to sovereign worries.”
And while similar arguments made about Portuguese cov-
ered bonds are worth listening to, adds Doig, there is a risk
that the Portuguese sovereign will go in a similar direction
as Greece.
“We see the logic of that argument, but whether it is a risk
worth taking I am not sure,” he says. “If you felt that a sovereign
was going to be in trouble that would raise signifi cant uncer-
tainty about the value of your collateral.”
Other investors and analysts contrast a well-managed restruc-
turing or selective default with the altogether more worrying out-
come of Greece or another country leaving the euro-zone.
Such a move has been contemplated in some commentaries
on the sovereign debt crisis, but is deemed unlikely and a fate
that European policymakers are desperate to avoid. Nonethe-
less, market participants brought up the hypothetical case for
discussion, pointing to the uncertainty this would create, not
least because the underlying mortgages would be repaid in a
new, local currency while the covered bonds remained denomi-
nated in euros.
ECB collateral or junk?Short of the doomsday scenario of default, market participants
have been analysing the likelihood of covered bonds following
sovereigns over another threshold: that from investment grade
to junk. Covered bonds must have at least one investment grade
rating to retain eligibility for ECB repo operations — although
there is speculation that the ECB could waive the requirement
were this to happen.
As sovereigns have been stripped of their investment grade
ratings, the way in which rating agencies view the transmission
of sovereign risk to banks and, in turn, from issuers to covered
bonds has been key in this regard.
Greek covered bond programmes, for example, were down-
graded to junk by Moody’s in June, with their eligibility for repo
with the European Central Bank hinging on Fitch continuing to
rate them investment grade. It looked set to do so, with Fitch on
15 July cutting programmes of four Greek banks to BBB- and
indicating that restructurings of covered bonds embarked upon
by the issuers would stave off a cut to junk.
A four notch cut of Portugal to junk status by Moody’s at the
beginning of July, meanwhile, was considered likely to lead to
downgrades of Portuguese covered bonds because of the link-
age under Moody’s methodology between a sovereign’s ratings
Jane Soldera: “As the sovereign’s creditworthiness weakens so does that of the banking system”
28 The Covered Bond Report July 2011
COVER STORY: SOVEREIGNS VERSUS COVERED
and that of its banks, and the relationship between banks’ rat-
ings and those of their covered bonds, said analysts.
“Even taking into account Portugal currently having only
a negative outlook compared to the review for downgrade of
Greece in June 2010, the new Portuguese sovereign rating of
Ba2 (compared to Ba1 of Greece in June 2010) is a tough new
reference for covered bonds,” said Bernd Volk, head of covered
bond research at Deutsche Bank.
Morgan Stanley’s Dierks highlighted the possibility of junk
status for Portuguese covered bonds.
“In light of the ongoing rating migration, we caution that
it will only be a matter of time before further downgrades, in
some cases potentially to the sub-investment grade, might oc-
cur,” he said.
Jane Soldera, senior credit officer at Moody’s, says that
if banks are being downgraded in lockstep with cuts of the
sovereign rating, covered bonds would be affected under the
rating agency’s expected loss modelling. This determines ex-
pected loss as a function of an issuer’s probability of default
and the stressed losses on cover pool assets following an is-
suer default.
“We might also lower the Timely Payment Indicator (TPI)
to refl ect our view of a lower likelihood of timely payments fol-
lowing an issuer default,” she says. “Th is would cap the covered
bond rating relative to the bank rating.”
Th e most important factor infl uencing the TPIs would be
Moody’s view on refi nancing risk in the environment where the
sovereign credit is weak.
“Our concern would be that as the sovereign’s creditwor-
thiness weakens so does that of the banking system, with the
sovereign being less able to provide support (directly or in-
directly) for covered bonds where the issuing bank has got
into trouble,” says Soldera. “Mitigants of refinancing risk such
as government intervention would be seen as increasingly
threatened as the sovereign becomes weaker.”
The continued importance of ratings for investors not-
withstanding, many market participants have bemoaned
what they see as overly mechanical rating actions. RBS’s
Skeet says that investors need to look through the technical-
ity of rating decisions.
“Many rating triggers are somewhat artifi cial,” he says.
“Downgrades happen but does it really mean bonds are less
likely to perform?
“Th e expansion of the investor base, as credit and ABS buy-
ers have become involved, means that covered bonds are being
looked at on fundamental grounds,” he adds. “To not do so is
the day before yesterday’s strategy.”
Germany prepares to take the strain as the sovereign debt crisis reaches Italy — as interpreted by German cartoonist Horsch, fi rst published in LBBW’s Covered Bonds Weekly
Tim Skeet: “Downgrades happen but does it really mean bonds are less likely to perform?”
The CoveredBond ReportThe 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 [email protected] or visit news.coveredbondreport.com to register*.
*Investors directly linked to covered bond issuers may not qualify for this offer.
July 2011 The Covered Bond Report 31
CRD IV: GAME ON
“Anyone who was hoping that the European
Commission’s new draft would provide
a clear definition of the status of covered
bonds in the calculation of banks’ liquidity
cover ratios must now be disappointed. The
debate will now be carried forward to the next round.”
Indeed.
Heading into the summer recess, Brussels-watchers, lobby-
ists, and basically anyone with an interest in the covered bond
market had been awaiting the European Commission’s propos-
als for the fourth iteration of the Capital Requirements Direc-
tive to see if and how it might deviate from the Basel III frame-
work set out by the Basel Committee for Banking Supervision.
Not only had observers been trying to second guess how the
Bank for International Settlement body’s plan would be trans-
posed into the European Union, but even the date of the EC’s
announcement was the subject of speculation.
But when, on 20 July, Commissioner Michel Barnier finally
delivered the CRD IV proposal, it did little to bring the frenzy
of speculation to an end. DZ Bank analysts’ reaction to the pro-
posals, quoted above, summed up how the draft failed to offer
any conclusion to the debate.
The disappointment was all the stronger given how impor-
tant CRD IV is to the fate of covered bonds.
A key objective for covered bond market supporters — and
others who believe they should have a greater role in financial
stability — has been for the asset class to be granted better treat-
ment in Liquidity Coverage Ratios than that envisaged by the
Basel Committee.
Under the Basel III framework it proposed in December, cov-
ered bonds are considered Level II assets in LCRs. This means
that, alongside high quality non-financial corporate bonds, they
can comprise up to 40% of liquidity buffers that banks will have
to hold, and will be subject to haircuts of at least 15%.
While this should prove supportive of covered bonds, some of
those lobbying for better treatment would like to see them eligi-
ble as Level I assets, which include principally government bonds
free from such limits or haircuts. A group of countries, led by
Denmark and Germany but including several other jurisdictions,
last year put forward a proposal whereby covered bonds meeting
certain strict criteria would be granted Level I status.
EBA terms of referenceRather than deliver a verdict on what assets should qualify for
Level I or Level II status, the EC’s CRD IV proposal pushed
back any such decision, instead leaving the responsibility to the
European Banking Authority. The regulator is due to report its
findings after an analysis of potentially eligible assets by the end
of 2013, in time for implementation in 2015.
Cognisant of the focus on covered bonds’ role in liquidity buff-
ers, the EC specifically addressed the fate of the asset class in a set of
Frequently Asked Questions released alongside the CRD IV draft.
“For the LCR, a particular focus of the observation period
will be set on the definition of liquid assets,” said the Commis-
sion. “EBA will test different criteria for measuring how liquid
securities are under stressed market conditions.
“This will prepare the ground for a decision before 2015 that
will ultimately determine the eligibility criteria for the two tiers
of the liquidity buffer.”
Although the EBA is left to report thus, the criteria it must
use when deciding how liquid securities are were specified by
the Commission — see table on Article 481.
The Basel Committee’s Level I and II assets are meanwhile
transposed into transferable assets of “high” or “extremely high”
Everything to play forThe European Commission’s CRD IV draft has left open as many questions
as it answered. A deferral of the definition of assets eligible for liquidity buffers means that lobbying is set to continue. But should covered bond supporters really be encouraged by the lack of news? Neil Day reports.
The criteria upon which the EBA is to base its decision, listed in Article 481, are:
of Annex VI
32 The Covered Bond Report July 2011
CRD IV: GAME ON
liquidity and credit quality, as per the Commission’s list of as-
sets that will comprise liquidity buff ers (in Article 404):
these deposits can be withdrawn in times of stress;
credit quality;
the central government of a Member State or a third country
if the institution incurs a liquidity risk in that Member State
or third country that it covers by holding those liquid assets;
Until the EBA gives its verdict on which assets can be clas-
sifi ed as being of high or extremely high liquidity and credit
quality, “competent authorities” are to provide guidance based
on these criteria to fi nancial institutions, which will decide
themselves what qualifi es.
While the EC draft off ered no more clarity as to whether or not
covered bonds might win better treatment than that proposed
by the Basel Committee, those that had been most vigorously
lobbying for changes have taken heart from the proposals.
Th e Association of Danish Mortgage Banks (Realkreditrå-
det) welcomed the Commission’s paper, saying that it holds out
the possibility of their covered bonds being treated on a par
with their government bonds.
“Th e European Commission has taken heed of one of the
crucial Danish arguments in favour of the Danish mortgage
system,” said Jan Knøsgaard, deputy director general of the as-
sociation. “Th e Commission recognises the fact that diff erences
exist between the covered bonds of diff erent countries.
“It is very encouraging that the coming liquidity rules will be
expanded with a set of quality criteria.”
Commissioner Barnier had stressed in his announcement of
the proposals that while it was important for the EC to respect
the Basel Committee’s framework, it should take into account
European “specifi cities”. Th e Commission also stressed that the
observation period should be used to the fullest possible extent.
Moody’s — with whom the Danish mortgage industry has re-
cently been arguing — echoed the Danes’ positive spin on the draft .
“Th e proposal is credit positive for Danish fi nancial insti-
tutions, which hold large portfolios of covered bonds because
it eases the fulfi llment of liquidity requirements in a country
where other top-tier assets such as sovereign bonds are not
plentiful,” said Moody’s vice president and senior credit offi cer
Oscar Heemskerk in a report. “At the same time, covered bonds
ensure that liquidity buff ers consist of high quality assets.”
Th e Association of German Pfandbrief Banks (vdp) also
found succour in the proposals.
“Th e vdp believes that progress has also been made in terms
of recognizing Pfandbriefe as highly liquid investment instru-
ments for the liquidity buff er, which all banks will in future be
required to maintain,” it said. “Th us, in the Association’s opin-
ion, it can no longer be ruled out that, according to the crite-
ria still to be developed by the European Banking Authority,
Pfandbriefe may also be included in the highest possible cat-
egory for securities.”
However, other market participants believe that there is lit-
tle chance of any meaningful change from Basel III. Florian
Hillenbrand, senior credit analyst at UniCredit, says that while
there are diff erences of opinion as to whether or not covered
bonds might yet gain better treatment, he does not see that hap-
Michel Barnier: “We take into account the specifi cities of the European banking sector”
EBA offi ce: “Fate of covered bonds in European Banking Authority’s hands”
July 2011 The Covered Bond Report 33
CRD IV: GAME ON
pening — even if he does not believe this is justifi ed.
“From my perspective, I rather see covered bonds being put
at a signifi cant disadvantage compared with what we had be-
fore,” he says, “because they get worse treatment in compari-
son to assets that are defi nitely more risky, less liquid and more
volatile.
“Most covered bonds have been more liquid and more stable
than Greek or Portuguese government debt, but they are put in
a worse position — in particular with regards to the Liquidity
Cover Ratio.”
Just as covered bond supporters have been aspiring to equal
status with government bonds, proponents of securitisation
have been hoping that certain asset backed securities — notably
high quality residential mortgage backed securities — might be
deemed fi t for liquidity buff ers. A key argument in favour of
this has been that their credit quality — unlike that of covered
bonds — is not linked to issuers, i.e. banks — with all other
fi nancial institutions debt excluded from LCRs.
Th e lack of fi nality in the EC’s draft was also considered pos-
itive by those advocating this position.
“Th e observation and parallel running periods must be fully
utilised before long lasting and wide reaching operational issues
are settled,” said the British Bankers’ Association. “We support
the Commission’s decision to introduce the liquidity coverage
ratio as a reporting standard to allow the industry time to work
with the Basel Committee and to identify which assets should
qualify for the buff er where, in particular, we believe good qual-
ity retail mortgage backed securities should stand alongside
covered bonds.”
Outgoing Basel Committee chairman and Dutch central
bank governor Nout Wellink had, in April, raised the prospect
of MBS being included in the LCR.
“As you probably know, MBS securities are not recognised
in the LCR buff er,” said Wellink. “Increased transparency and
market liquidity, for instance through market quotation, would
increase the likelihood that MBS securities would be recog-
nised as liquid assets.”
While the securitisation market has an initiative dubbed
Prime Collateral Securities aimed at enhancing the sector in a
way that would gain it better regulatory treatment, the covered
bond industry has been engaged in a “labelling” initiative, led
by the European Covered Bond Council and supported by the
European Central Bank. Market participants say that any “la-
bel” that results from this could become a term of reference for
the European Banking Authority when it delivers its response
to the Commission at the end of 2013.
Whatever the precise state of play with regard to liquidity buff -
ers, the vdp could claim a late goal in one of the few areas where
a defi nitive answer to the future of covered bonds was given by
the EC draft . Th e German association welcomed a move to as-
sign for the fi rst time covered bond risk weightings on the basis
of their ratings.
Under Basel II, covered bonds’ risk weightings were as-
signed based on the creditworthiness of issuers (under Option
2) or their sovereign (Option 1). Under Basel III’s standardised
(rather than internal ratings based or IRB) approach, if the CRD
IV draft remains unchanged, covered bond ratings will deter-
mine the risk weighting — although they will still be one step
removed, with the credit quality step referred to in the draft .
Covered bonds with credit quality step 1 will have a 10% risk
weighting, step 2 and 3 20%, step 4 and 5 50%, and step 6 100%.
According to DZ’s analysts, there is no universally accepted
defi nition as to how ratings of Fitch, Moody’s and Standard &
Poor’s map onto the diff erent credit quality steps, and the EBA is
charged with coming up with an assignment structure. But were
the EBA to rule in line with Germany’s BaFin, for example, the
mapping would be as per the accompanying table (see next page). Th e change will halve the amount of capital that fi nancial in-
stitutions using the standardised approach will have to hold for
many covered bonds. DZ analysts use mortgage covered bonds
ratings from Fitch and Moody’s (at the time of writing) mean
that the covered bonds would be 10% risk weighted under Basel
III, whereas if the risk weighting were based on the rating of
the bank’s senior unsecured bonds or Portugal’s triple-B ratings
from Fitch and S&P (with the second best rating decisive), they
would be 20% risk weighted — or 50% were it to be based on
Moody’s Ba2 rating of Portugal.
Some observers have played down the importance of the
change in risk weighting, given that bigger players will be using
the IRB approach, but DZ’s analysts said that the move is still
relevant.
“Even if the new standard approach rules will not aff ect
many large and mid-size banks that apply the advanced ap-
proach,” they said, “we believe that the new regulations could
tend to lighten the capital requirements of many smaller banks
that follow the standard approach on effi ciency grounds.”
Jan Bettink: leverage ratio “would be bad news for the public sector”
34 The Covered Bond Report July 2011
CRD IV: GAME ON
And even those that played down the impact of the change
have been encouraged by it.
“In our view, while covered bonds are not a delinked prod-
uct, the new risk weighting rules confi rm that the EU remains
supportive for covered bonds,” says Bernd Volk, head of cov-
ered bond research at Deutsche Bank.
We can’t wait!According to the vdp, the change to how covered bond weight-
ings are calculated was made late in the draft ing process and
followed an intervention by the German delegation. Bettink
said that the move was “an important sign of the institutional
support in Europe for the Pfandbrief ”.
Th e association said that in principle it welcomed the draft
directive.
“Th e passages of the Brussels draft directive that are relevant
to the Pfandbrief largely take the special safety of Pfandbriefe
and other covered bonds into consideration,” said Jan Bettink,
president of the vdp.
But the vdp called for continued lobbying from German
representatives in Brussels, in particular on the proposed in-
troduction of a leverage ratio from 2018. It said that if this is
introduced as a mandatory supervisory ratio, Pfandbrief banks’
“traditionally conservative cover loan business”, particularly
low margin public sector lending, would be jeopardised.
“At the same time, this would be bad news for the public sec-
tor, because German Pfandbrief banks play a major role in the
fi nancing, above all, of German local authorities,” said Bettink.
Th e vdp has called for the leverage ratio to be introduced
purely as an observation metric and some analysts have sup-
ported it in this regard.
“Th e — in our view completely inconsistent — leverage ratio
will be subject to an ‘extensive monitoring procedure’ before
decisions on the implementation are made,” says UniCredit’s
Hillenbrand. “We regard this as rather positive since we believe
that the non risk adjusted nature of the leverage ratio stands in
stark contrast to everything that has been tried or achieved in
order to stabilize banks in the past.
“In fact, the leverage ratio would represent a de-stabilising
factor. Hence, the ‘extensive monitoring procedure’ leaves at
least a slight chance that the leverage ratio will not come into
force.”
Hillenbrand also highlights how implementation of the Net
Stable Funding Ratio is up in the air.
“For the NSFR, the Commission will analyse how such a
structural requirement plays out across the EU banking sector,
notably as regards its ability to provide long term funding to
support the real economy,” he says.
Th e news that implementation will not take place until 2018
at the earliest was welcomed by the Danes.
“Th e future of adjustable rate mortgage loans is still uncer-
tain,” said Realkreditrådet’s Knøsgaard. “Th e uncertainty has
already depressed the sentiment among homeowners and in-
vestors, which is not good at all.
“On the bright side, however, we are pleased to note that no
devastating rule will be introduced right away. It is crucial that
the current proposal is changed.”
With such rhetoric echoing the language used ahead of the
release of the CRD IV draft , market participants can surely look
forward to at least another couple of years of lobbying. Indeed
the release of CRD IV has left open at least as many questions as
it answered — and some debates have hardly even been touched
upon yet.
“Will there be a distinction between jumbo covered bonds and
other covered bonds?” asked DZ’s analysts. “We can’t wait!”
MAPPING OF RATING GRADES TO REGULATORY CREDIT QUALITY STEPS
1 Aaa to Aa3 10%
2 A1 to A3 20%
3 Baa1 to Baa3 20%
4 Ba1 to Ba3 50%
5 B1 to B3 50%
6 Caa1 and below CCC+ and below 100%
Bernd Volk: “The EU remains supportive for covered bonds”
The CoveredBond 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.
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www.coveredbondreport.com March 2011
To the lifeboats!
Can covered bonds offer safetyafter bail-in panic?
AustraliaA whole new ball game
SterlingUK gains home advantage
US legislationThe FDIC rears its head
The CoveredBond Report
The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.
July 2011 The Covered Bond Report 37
CANADA: RULES
While Canadian issuers have not accessed
the euro market since September 2008,
they have found the US dollar market
highly receptive to their trades in the
past 18 months. In 2010 they raised some
$14bn in the 144A market after Canadian Imperial Bank of Com-
merce reopened the US market to covered bonds that January,
and four issuers have collectively raised $5.5bn this year.
In the first month of the year Canada’s big five banks were
joined in the covered bond market by National Bank of Can-
ada. It inaugurated a $5bn programme with a $1bn three year
benchmark through Barclays Capital, Citi, Morgan Stanley and
National Bank Financial.
Quebec’s Caisse Centrale Desjardins launched its first cov-
ered bond in March, a $1bn five year via Barclays Capital,
HSBC, Morgan Stanley and RBS. The issue was the first from
Canada’s credit union sector and other such institutions are ex-
ploring the possibility of establishing programmes.
Some 64% of Canadian covered bonds outstanding are now
denominated in US dollars.
“American investors are generally much more comfortable
with Canada than pick-a-name-out-of-Europe,” says Wojtek Nie-
brzydowski, vice president, treasury at CIBC. “That’s partially
a function of geographic proximity combined with economic
proximity (the North American Free Trade Agreement, for ex-
ample), and a continuous lack of bad news out of the jurisdiction.
“If you are in the US, chances are you’d be much more exposed
to the news from Canada than the news from Belgium, right?”
Canada is, for all intents and purposes, “golden” right now,
says Niebrzydowski.
“In relative terms as compared to other jurisdictions, all
Canadian banks came effectively unscathed through the near
end of the world,” he said. “If people were to have concerns
about the fiscal viability of the Canadian federal government
we would be facing much bigger problems globally.
“So, now you have a combination of a strong sovereign with
a reasonably strong banking system.”
Canada’s banking system has been ranked the world’s sound-
est by the World Economic Forum in its last three annual sur-
veys. And covered bond market participants hold the country’s
covered bonds in similarly high regard.
“You look at the debt-to-GDP ratio in Canada,” says Derry
Hubbard, head of FIG syndicate at BNP Paribas, “it’s very im-
pressive indeed.
“The other major component of that in terms of the recent cri-
sis is that there was no failure in the banking sector, so you genu-
inely had a picture of very strong balance sheets from very well run
banks — banks that went into the crisis with very high ratings and
also came out of the crisis and still have very strong ratings.”
Hubbard says that Canada is one of those key jurisdictions
to be involved in.
“It’s just a very positive cocktail of factors where you have, in
the face of a worsening general backdrop in terms of the general
picture,” he says, “a very clear diamond on the horizon.
“If you look at where spreads were across the board, but in
particular with a view to Canada, anyone who participated in
these deals, going back a couple years, did very well. Spreads
have been very stable and performed well.”
CMHC ensures US welcomeA DCM banker says a lot of US banks are involved in Canadian
covered bond deals with the CMHC guarantee.
“It’s also been a great way to start the US market,” she says.
“Investors, especially in the US, really value the CMHC backed
mortgages in these cover pools.
“US investors really give the Canadians credit for this fact.”
Canadian cover pools — with the exception of Royal Bank of
Canada’s — consist entirely of Canadian residential mortgages
that are insured by Canada Mortgage & Housing Corporation
(CMHC). Under the Bank Act, banks have to have insurance on
mortgages that have a loan-to-value ratio (LTV) over a certain
level, which the customer pays for. In addition, issuers can pur-
chase bulk insurance.
“What this means in essence is that the cover pool has the
The US has become a second home for Canada’s banks as, buoyed by CMHC-insured collateral, they have crossed the border to sell increasing volumes of covered bonds. Planned legislation could help their cause in Europe — although there are concerns that it could prove too inflexible.
Maiya Keidan reports.
Canada rules and legislates
38 The Covered Bond Report July 2011
CANADA: RULES
full backing of the Canadian government,” says Cathy Cran-
ston, senior vice president, financial strategy at BMO, an is-
suer whose programme is backed solely by mortgages insured
by CMHC.
Jerry Marriott, managing director, Canadian structured
fi nance at DBRS commends the Canadian covered bond pro-
grammes for utilising the insured residential mortgages in their
cover pools — while acknowledging that RBC faces no disad-
vantages in its use of uninsured mortgages given the quality of
the mortgages in that bank’s portfolio.
“Th e other Canadian banks had decided to use CMHC in-
sured mortgages in their cover pools fi rstly, because they have
a lot of insured mortgages in their portfolios, and secondly, be-
cause it removed any uncertainty regarding credit quality for
investors due to the Canadian government guarantee of CMHC
insurance,” says Marriott. “We certainly don’t see that there’s
any disadvantage in terms of RBC having non-insured mort-
gages which are conventional mortgages that generally have
extremely high quality.”
As well as in US dollars, Canadian issuers have blazed a trail
in other currencies, notably the Australian dollar. CIBC reo-
pened the Australian dollar market for covered bonds in Oc-
tober 2010, with a A$750m three year and has since returned
alongside Bank of Nova Scotia this year as Australian banks are
preparing to issue covered bonds for the fi rst time under an
upcoming legislative framework.
Euro drought to end?Th ough Canadian euro issuance came to a halt in September
2008 due to an unattractive cross currency basis, a near fl at basis
swap from euros into dollars recently is said by bankers to have
increased the likelihood of a Canadian issuer accessing the euro
market for the fi rst time since the collapse of Lehman Brothers.
“Th e basis swap is in their favour right now,” said a covered
bond banker in early July, “so yes, I think they’re watching the
market. I think if we see a drop of 4bp-5bp more in their favour,
then they will look at accessing the market.
“Th e question is whether this would be the best time for
them to issue given that they haven’t been in the market for
some time.”
Hubbard at BNP Paribas says the basis swap had been very
discouraging.
“I think that it has kept a lot of these issuers away,” he says,
“much to the disappointment of European investors.
“One thing you need to realise is that when euro based issu-
ers have been issuing in US dollars and bringing those dollars
back into euros they have picked up a very signifi cant spread in
the cross-currency basis, and this factor has kept a lot of issuers
that have natural dollar needs in the dollar market and away
from the euro.”
Euro denominated issues amount to 18% (Eu9.8bn) of total
outstanding Canadian covered bonds. Th ere are three Cana-
dian euro denominated covered bonds outstanding.
Canadian covered bonds have been priced tighter than those
from other, European jurisdictions in US dollars, but this is the
reverse of the situation that has prevailed when Canadians have
issued in euros, where Canada’s banks have always had to pay
a premium over core European covered bonds in the primary
market. Th is, alongside the unfavourable basis swap, has been
cited as a factor for the lack of euro issuance from Canadians.
Market participants say that they could not be sure of what
impact pending Canadian covered bond legislation could have
on Canadian ventures into the euro market.
“It’s diffi cult to say whether the proposed legislation has any
eff ect on the European markets,” says Niebrzydowski at CIBC.
Issuance by year
-
2
4
6
8
10
12
14
16
18
20
2007 2008 2009 2010 2011
C$(bn)
BMO BMO BMO
BNS
BNSNBC
RBCRBC
RBC
RBC
TD
CIBC
CIBC
CIBC
CIBC
RBC
CCDQ
Source: CIBC
Wojtek Niebrzydowski: “All Canadian banks came effectively unscathed through the near end of the world”
July 2011 The Covered Bond Report 39
CANADA: RULES
“I think we probably won’t know until there is actually a Cana-
dian issue in euros.”
Covered win in re-electionTh e Canadian Department of Finance released a consultation
paper on plans to introduce a legislative covered bond frame-
work on 11 May. Th is followed the 2 May re-election of Con-
servative prime minister Stephen Harper, who was voted in
with a majority, as opposed to his previous minority, which had
fi rst announced plans to work towards Canadian covered bond
legislation back in March 2010.
Th ough some market participants have questioned whether
legislation is even necessary for a jurisdiction with the strengths
of Canada, the paper was mainly greeted with enthusiasm.
“We’re very supportive of the legislation,” says Cranston at
BMO. “We’ve been working as an industry to get that moving
for a while, and we think it will provide greater clarity and cer-
tainty for investors.
“Th e issue is not that we felt it was necessary — as we have a
structural and legal system in Canada that we felt didn’t require
legislation — but there are a lot of investors that are precluded
from investing in covered bonds that aren’t underneath a legis-
lative framework.”
Andrew Fleming, senior partner at Norton Rose, welcomes
the step.
“I would say we are very encouraged by the tone of the con-
sultation paper and by the fact we have a majority government
in Canada, so that makes it even more achievable in terms of
getting legislation in the near term,” he says.
Aaron Palmer, a partner at Blake, Cassels & Graydon, was
also encouraged by the government’s move.
“Canada’s adoption of a legislative framework for covered
bonds will be a welcome development for issuers and investors
alike,” he said. “Strengthening and clarifying investor rights in
covered assets upon an issuer’s insolvency should bring Cana-
da’s position into line with other countries that have adopted
legislative frameworks.”
Palmer said he found interesting the proposed scope of eligi-
bility criteria for covered assets and issuers.
“Cover pools for legislative covered bonds would be lim-
ited to residential mortgages, unlike the recent US proposal
that would open up the US covered bond market to other as-
set classes, like autos, credit cards, and student loans,” he said.
“[Th e Department of] Finance suggests that the more modest
the scope of permitted assets will simplify the process and per-
mit a more rapid implementation of a legislative regime.”
OC medicine hard to swallowAlthough market participants were keen on the launch of the
consultation paper, elements of the document were greeted
with some concern.
One potentially worrying proposal is a maximum overcol-
lateralisation level called for by the paper. Th e prevailing Ca-
nadian practice is for issuers to set a maximum overcollater-
alisation of 11%, although this is described in documentation
not in terms of overcollateralisation, but as a contractual mini-
mum asset percentage of 90%. Th is is contractual and can be
amended by the issuer, but the consultation document proposes
codifying it at 10%. Th e Department of Finance proposed that
this maximum be included in the legislation because it believes
the rights of covered bond holders must be balanced with those
of other creditors and depositors.
S&P OVERVIEW OF PROPOSALS UNDER THE CONSULTATION PAPERAsset segregation Legal sale to a special purpose entity (SPE)
Eligible assets Residential mortgage loans for properties located in Canada
Asset valuation The introduction of a standardised approach to value the assets in the cover pool, and standard-ised testing
Eligible issuers Federally regulated fi nancial institutions (FRFIs) — although non-FRFIs would be permitted to sell assets to FRFIs in order to benefi t from the framework
Overcollateralisation A standardised maximum level of overcollater-alisation
Demand loan Defi ned as the excess overcollateralisation above the required overcollateralisation to pass the asset coverage test. The issuer may call the de-mand loan at any time, and the loan may have to be called based on certain triggers
Disclosure Minimum disclosure standards to be defi ned
Role of covered bond registrar
To be defi ned
Source: Standard & Poor’s
Derry Hubbard: “You look at the debt-to-GDP ratio in Canada, it’s very impressive indeed”
40 The Covered Bond Report July 2011
CANADA: RULES
Despite most Canadian programmes having overcollater-
alisation levels nowhere near the proposed 10% ceiling — with
most programmes sitting at around 5%, according to BMO’s
Cranston — market participants from banks, rating agencies
and law fi rms see negative consequences of the limit.
“It’s not ideal to have a limit on the overcollateralisation —
not that you want to get near or above 10%,” she says. “Th e issue
is that the OC limit is unique to Canada, so that’s never good.”
Rating agencies S&P, Fitch and DBRS have all raised con-
cerns about this limit preventing issuers from mitigating against
potential risks in their covered bonds in the future.
S&P says a key feature of a covered bond is a dynamic cover
pool and that a static overcollateralisation level may not be suf-
fi cient to protect against future risks.
“Th e consultation paper proposes codifying a maximum
level of overcollateralisation,” said the rating agency in research
on the Canadian consultation paper. “Th is would in our view
enshrine in law the current status quo, would remove an ele-
ment of fl exibility, and could constrain issuers from managing
their covered bond programmes.”
Hélène Heberlein, managing director and head of Fitch’s
covered bonds group, says that this could constrain the ratings
that Canadian programmes can achieve.
“It may preclude high ratings on some covered bonds if the
OC supporting a given rate exceeds 10%,” she says.
Eric Reither, partner at Norton Rose, expressed concern that
an issuer’s inability to increase overcollateralisation to maintain
the ratings on its bonds could negatively impact investor confi -
dence in the product.
“Remember that the current overcollateralisation limits in
Canadian programmes are contractual and intended to protect
the issuing institution and its depositors, but can be waived by
the institution,” says Reither, “so that if one of the Canadian
banks hits the contractual 10% limit, all that means is no-one
can require the bank to put up any more assets even if that
means a ratings downgrade for the bonds, but the bank can put
up more assets if it wants to.”
However, Heberlein notes that putting an OC limit into law
does remove some uncertainty.
“A legally prescribed upper limit on over collateralisation
(OC) protects depositors and senior unsecured debtholders
against excessive subordination and removes uncertainty of
senior unsecured claims against OC, which will not be needed
for the covered bonds repayment,” she says.
And Bernd Volk, head of covered bond research at Deutsche
Bank, commended the Canadian consultation document on pro-
tecting the rights of depositors and senior unsecured debtholders.
“What I like about the Canadians,” he said, “is that they are
tackling the issue of implicitly guaranteeing covered bonds by
simply adjusting OC levels.
“I think the OC ceiling is a tough pill to swallow for the Ca-
nadian covered bond market as it reduces the fl exibility of is-
suers. While it should be dropped, I have great respect for the
regulator making the point.”
Demanding demand loansAmong other issues being debated is the operation of demand
loans, which are a feature of Canadian covered bond pro-
grammes. Th e Department of Finance acknowledges the ad-
vantage of these for issuers.
“As a matter of practice, Canadian issuers transfer more as-
sets to the SPV than is required to satisfy the ACT,” it said. “Th e
transfer of these excess assets allows the issuer to easily replace
non-performing assets backing a particular covered bonds is-
suance with assets that have already been reviewed by credit
ratings agencies. Issuers are also able to go to market with new
covered bond issuances more quickly because they have a stock
of assets already in the SPV.”
However, the Department of Finance said that while they
may lower costs for issuers, demand loans can increase the risk
to depositors or other creditors of the issuer.
“To protect depositors and other creditors, current Cana-
dian practice is to allow the issuer to demand repayment of
the excess assets at any time, called a demand loan,” it said,
“although the time period allowed for repayment continues to
present some risk to depositors and creditors of the issuer.
In the consultation paper the Department of Finance pro-
poses regulating the use of a demand loan, for example legislat-
ing the timing of repayment to, for example, 60 days.
Fitch expressed concerns about the potential for the pro-
posed workings of the demand loan reducing the amount of
liquidity available.
“Th e reimbursement of the demand loan post issuer insol-
vency could draw on market liquidity that would then be avail-
able to absorb subsequent asset sales to meet covered bond
Cathy Cranston: “The legislation is being perceived positively by investors”
July 2011 The Covered Bond Report 41
CANADA: RULES
principal redemptions,” says Vanessa Purwin, a director in
Fitch’s US RMBS group responsible for North American cov-
ered bond ratings. “Repayment of the demand loan in kind via
the delivery of mortgage loans rather than cash to the insolvent
issuer would neutralise this risk.”
Fleming at Norton Rose also questions how demand loans
are being dealt with in the consultation.
“Our concern is that the legislation would regulate the use of
a demand loan and valuations used in this connection,” he says.
“Th is is more on the prudential side or regulation.
“To the extent it should be dealt with at all, it should be dealt
with by policy of the prudential regulator.”
Th e federal prudential regulator, the Offi ce of the Superintend-
ent of Financial Institutions (OSFI), was the fi rst Canadian author-
ity to lay down any rules for covered bonds, setting a 4% limit on
issuance as a proportion of total assets. DBRS has asked if this 4%
limit on federally regulated fi nancial institutions will be changed.
“We think it’s something that the legislation needs to clarify,”
says Marriott at DBRS, “but it’s really under the superintendent of
the Offi ce of the Superintendent of Financial Institutions, who are
a separate entity but certainly confer with the fi nance department.”
Norton Rose’s Reither said clarifi cation is also needed on
who the registrar would be under the proposed framework.
“One of the questions from the consultation paper is who
the covered bond registrar should be,” he says. “Our view is that
it should be a regulator who is interested in the welfare of cov-
ered bondholders and independent, in terms of representing
the prudential concerns of creditors of the issuers.”
FRFIs only need apply?Marc MacMullin, partner at McCarthy Tetrault, says his con-
cern — beyond those already mentioned — is for legislation to
be as supportive as possible of outstanding covered bonds.
“At this stage, it remains unclear how certain features of the
statutory framework in its legislative form will apply to Cana-
dian fi nancial institutions’ covered bond programmes,” he says.
Moody’s noted that the legislation would only apply to fed-
erally regulated fi nancial institutions (FRFIs) and not, for ex-
ample, to Caisse Centrale Desjardins. Quebec’s Autorité des
marchés fi nanciers has issued guidance for the issuance of
covered bonds by credit unions it oversees, including Caisse
Centrale Desjardins, but this is not equivalent to the proposed
federal legislative framework.
For its part, DBRS is, however, confi dent that the legislation
would be applicable to any fi nancial institution that wanted to
tap into it.
“Th ey — provincial regulated fi nancial institutions and
credit unions — wouldn’t want to be left out of the framework,”
says Marriott at DBRS. “What the government is likely to do is
to say if you want to go through this legislative framework then
whatever fi nancial regulation governs the issuing institution
you have to operate within this legislation.”
Market participants were unclear about when the next step
towards implementation will take place.
“Our expectation is this will move ahead, but it would be less
than a qualifi ed guess to suggest a timeframe,” says Marriott.
Although most market participants believe any impact upon
the Canadian covered bond market will be slight — given its
prior strengths and trading levels — spreads in the US dollar
market were seen to tighten a few basis points aft er the consul-
tation paper was released.
“Th e legislation is being perceived positively by investors,”
says Cranston at BMO, “but I don’t think you’re going to see any
real material spread tightening.
“Th e most important piece is that it will bring more inves-
tors into the product because they will be able to tick that box,
which may ultimately lead to some spread tightening.”
Outstanding and % of Assets (Jan 31, 2011)
Source: CIBC
-
1
2
3
4
5
6
7
8
9
10
BMO BNS CIBC NBC RBC TD CCDQ
C$(bn)
0%
1%
2%
3%
4%% of Assets
Eric Reither: OC ceiling could negatively impact investor confi dence
July 2011 The Covered Bond Report 43
ANALYSE THIS: SOLVENCY IIANALYSE THIS: SOLVENCY II
“It’s the end of the world as
they know it.”
Th is slightly adjusted
REM song title is the per-
fect characterisation of
what will happen for insurance companies
from 2013 onwards. (Solvency II does not
cover pension funds, by the way.)
In the past, insurance companies had
to hold one lump sum of capital that had
to cover all of the diff erent risks they ran.
Th ere was no diff erentiation between the
individual risk factors. In a somewhat
similar manner to the introduction of
Basel II for banks, Solvency II will force
insurance companies to hold capital
based on the individual risks they hold
in their balance sheets going forward
from underwriting risk to investment
risk. Th is will have signifi cant implica-
tions for their investments, which will
not all be treated equally in this regard.
Capital charges will diff er by asset class,
maturity and rating.
Under Solvency II, the capital require-
ments will be determined by a number
of risk modules (see Chart 1). One of
the modules is the market risk module,
which in turn is split into a number of
components that cover risk factors from
interest rate risk to currency, equity, and
real estate market risk.
Th e situation for covered bonds in a
nutshell: they are treated favourably ver-
sus senior unsecured bonds and ABS, but
are at a huge disadvantage to sovereign
bonds.
Covered bonds receive special treat-
ment in two risk components: in the con-
centration risk component they benefi t
from a higher concentration limit; and
in the spread risk component they enjoy
lower capital charges compared with sen-
ior unsecured exposure or securitisation.
One of the main determinants of the
ultimate capital charges of bond invest-
ments is the spread risk component.
While sovereign bonds do not have to be
allocated any capital at all in this respect
as long as they are rated at least double-A,
triple-A rated covered bonds will bear a
capital charge of 0.6% per year of duration
(see Chart 2). Th e way it looks at the mo-
ment, special treatment is, however, only
valid as long as the rating is at triple-A.
Strangely, double-A rated covered bonds
are treated like senior unsecured bonds
and have a 1.1% capital charge per year of
duration, even though both logic as well
as statistics strongly suggest better treat-
ment compared with senior unsecured
bonds at the double-A rating level, too. A
single-A rated senior bond’s capital charge
comes in at 1.4% per year of duration.
The relationship between the du-
It’s the end of the world as they know it
Solvency II is yet to be fi nalised, but the new capital framework for insur-ance companies will have far reaching consequences for their investment strategies. How covered bonds come out of this could have a major impact on issuers’ funding strategies and business models. Florian Eichert, Crédit
Agricole CIB’s senior covered bond analyst, assesses the likely consequences.
Source: CEIOPS, Crédit Agricole CIB
Spread risk
Concen-tration
risk
Interest rate risk
Currency risk
Property risk
Equity risk
Illiquidity risk
CB directly affected
CB directly affected
CB indirectly affected
CB potentially indirectly affected
CB unaffected
CB unaffected
CB unaffected
Chart 1: Market risk modules in Solvency II and their relevance for covered bonds
44 The Covered Bond Report July 2011
ANALYSE THIS: SOLVENCY IIANALYSE THIS: SOLVENCY II
ration of a bond and its capital charge
is a linear one. If we look at a triple-A
rated covered bond with a duration of
10 years the initial capital charge in the
first year is therefore 6%, for a double-A
rated covered bond 9%, and for a single-
A rated senior bond 14%. This number
does not stay static over time, though.
These very same positions are one year
closer to maturity one year later, which
means that the capital charge also goes
down, to that of a nine year duration
bond.
We would therefore assume that a buy-
and-hold investor will also focus on an av-
erage capital charge over the lifetime of a
bond and not only on the fi rst year fi gure.
For the triple-A rated covered bond this
average capital charge over the lifetime
of the bond comes in at around 3.3%, for
the double-A rated covered bond 6.1%,
and for the single-A rated senior 7.7%. If
the plan is to dispose of the position in,
say, four years’ time, the average capital
charge is calculated taking into account
only those fi rst four years, which will of
course mean a higher charge compared
with holding it to maturity (see Chart 3).
Irrespective of the investment
horizon, the need to hold higher
levels of capital for one investment over
another will prompt insurance compa-
nies to require compensation for the
cost of holding that additional capital.
Since the capital charge is higher the
longer the bond, the required spread
premium will have to go up as well and
spread curves steepen at the long end.
To come up with figures for these re-
quired spread premiums, it is important
to make clear that several factors are
driving this calculation:
tion, the higher the capital charge, and
the higher the required spread.
the higher the capital charge, and
as a result the higher the required
spread will be.
longer the position is held, the lower
the average capital charge, the lower
the additional spread requirement.
ance company: the higher this is,
the more pick-up is needed from the
investment to cover the capital cost
of the investment.
It is very important to stress that there
will be no uniform answer applicable to
all insurance companies. Th e results can
and probably will diff er from company
to company as the input factors into the
calculation are company-specifi c.
Below, we have plotted the spread pre-
miums necessary to make up for the dif-
16141210
86420
10 9 8 7 6 5 4 3 2 1
AAA covered bondAverage AAA CB
AA covered bondAverage AA CB
A seniorAverage A sen.
Source: CEIOPS, Crédit Agricole CIB
Chart 3: Capital charges over time based on remaining duration of the bond as well as average capital charge for 10Y duration bonds which are held to maturity
“Insurance companies are not the driving force behind spreads at the short to mid part
of the curve”
CHART 2: Spread risk factors by bond type and rating per 1Y duration
Type of bond Rating Spread risk factor
Corporate bonds, sub + hybrid debt, ABS, CDO AAA 0.90%
AA 1.10%
A 1.40%
BBB 2.50%
BB 4.50%
B or lower 7.50%
Unrated 3.00%
Covered Bonds AAA 0.60%
Governments, central banks, multilateral development banks, international organisations AAA 0%
AA 0%
A 1.10%
BBB 1.40%
BB 2.50%
B or lower 4.50%
Unrated 3.00%
Source: CEIOPS, Crédit Agricole CIB
July 2011 The Covered Bond Report 45
ANALYSE THIS: SOLVENCY II
ferent capital charges for bonds with dif-
ferent durations. To show how diff erent
the numbers can be from one insurance
company to another, we have calculated
the required premiums for diff erent cost
of capital levels. We have assumed a buy-
and-hold attitude to make things simpler.
For this exercise, we compare triple-A
rated covered bonds with double-A rat-
ed covered bonds, triple-A rated sover-
eign bonds, and single-A rated senior
unsecured bonds (see Chart 4).
When running this scenario analysis,
the required spread pick-up for an insur-
ance company with an internal cost of
capital of 15% is as follows:
triple-A rated covered bond: 11bp for
two years, 23bp for fi ve year, 41bp for
10 years, and 60bp for 15 years
triple-A rated sovereign: 14bp for two
years, 27bp for fi ve years, 50bp for 10
years, and 72bp for 15 years
A rated covered bond: 18bp for two
years, 36bp for fi ve years, 66bp for 10
years, and 96bp for 15 years
One thing to keep in mind at this
point is the following: insurance com-
panies are not the driving force behind
spreads at the short to mid part of the
curve. Insurance companies have only
bought around 3% of this year’s fi ve year
issuance, for example. Th is compares
with insurance sector participation of
almost one-third in deals that came to
the market with a maturity beyond 10
years. Th e shorter deals are mostly infl u-
Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs AA covered
Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs AA soverign
Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs A senior
2 5 10 15 2 5 10 15 2 5 10 15
908070605040302010
0
120
100
80
60
40
20
0
140
120
100
80
60
40
20
0
5% 10% 15% 20% 5% 10% 15% 20%5% 10% 15% 20% 5% 10% 15% 20%
Source: CEIOPS, Crédit Agricole CIB Source: CEIOPS, Crédit Agricole CIBSource: CEIOPS, Crédit Agricole CIB
Chart 4
Florian Eichert: “Covered bonds receive special treatment
ANALYSE THIS: SOLVENCY II
46 The Covered Bond Report July 2011
ANALYSE THIS: SOLVENCY II
enced by banks and asset managers (with
banks having bought around 40% of this
year’s fi ve year deals and asset managers
around 35%).
Basel III, especially the liquidity cov-
erage ratio, is pushing banks to shift
their investments increasingly from sen-
ior unsecured bonds — which are not
considered eligible investments under
the LCR — to covered bonds — which
can form up to 40% of liquidity portfo-
lios. Th erefore, as a rule of thumb, in the
seven year segment increased demand
from banks should outweigh the insur-
ance sector’s new approach (see Chart 5).
What of registered covered bonds/Schuldscheine?
One of the main challenges of Solvency
II will be a strict mark to market require-
ment on both the asset and the liabil-
ity side of insurance companies’ balance
sheets. Th is will apply irrespective of the
accounting treatment. Focusing on the
asset side, it will mean that there will be
no diff erentiation between registered and
bearer bonds anymore. Th at insurance
companies did not have to worry about
mark-to-market losses on registered
bonds in the past certainly made it eas-
ier for them to buy long dated exposure
away from national champions. For the
purposes of Solvency and the capital as-
pect, this benefi t will cease to exist.
One thing to keep in mind at this
point, however, is that accounting ben-
efits of registered bonds under IFRS,
which are usually classified as held to
maturity assets, are not affected by Sol-
vency II. Since insurance companies
will therefore be faced with conflicting
standards, the big question going for-
ward is: which standard will they use to
steer their operations? (see Chart 6)Should all insurance companies steer
their operations based on Solvency II
— marking to market every single posi-
tion irrespective of its accounting treat-
ment — the eff ects on the registered cov-
ered bond market would be devastating.
Worse, though, would be the repercus-
sions for the senior unsecured Schuld-
schein market. Above all, many smaller
issuers would fi nd it very hard to access
long dated senior funding above every-
thing else. Th e eff ects will be much more
muted on the other hand, if insurance
companies continue to steer their opera-
tions based on IFRS or national GAAP.
Early indications from the insurance
sector seem to suggest that there will be
a mix of the two. Some companies will
be steering based on Solvency II, while
others will primarily focus on IFRS when
making strategic decisions, provided
they also have suffi cient capital to fulfi l
the solvency requirements at the same
time. Solvency II will therefore not be
the end of these sectors, but it will cer-
tainly dampen demand and reduce previ-
ously existing spread diff erences between
bearer and registered bonds.
Chart 6: Effect on covered bond issuers depends on which standards insurance companies use
Standard used to steer operationsDifferentiation between registered and bearer bonds
Effect
Effect on covered bond issuers
IFRS Solvency II
Yes
Still incentive to buy registered
Neutral
No incentive to favour registered over bearer
Negative
No
Source: Crédit Agricole CIB
“It will reduce previously existing spread differences between bearer and
registered bonds”
“The treatment of mortgages in the current form would be the mother
of all competition distortions”
100%90%80%70%60%50%40%30%20%10%
0%
3Y segment 5Y segment 7Y segment 10Y segment 10Y+ segment
<3Y <3Y<3Y<3Y 5Y5Y5Y5Y 7Y7Y7Y7Y 10Y10Y10Y10Y 10+Y10+Y10+Y10+Y2008 2009 2010 2011 2008 2009 2010 20112008 2009 2010 20112008 2009 2010 2011
Banks Asset Manager Central Banks Insurance Companies Others
Source: Crédit Agricole CIB
2008 2009 2010 2011
Chart 5: Investor distribution new benchmark covered bond deals by maturity bracket and investor type in %
July 2011 The Covered Bond Report 47
ANALYSE THIS: SOLVENCY II
Competition distortion anyone?Comparing covered bonds with, for ex-
ample, sovereign bonds, one can get the
feeling that covered bonds are treated
unfairly. However, if one compares the
treatment of covered bonds with the
way direct mortgages were treated un-
der QIS5, this disadvantage seems rather
negligible. Indeed one could be forgiven
for thinking that bank and insurance reg-
ulators have not had the slightest clue of
each other’s existence in recent years be-
cause they surely have not discussed this
one; the way banks and insurance com-
panies have to treat mortgages are light
years apart, creating massive arbitrage
opportunities between the two camps.
only 15% capital against the unse-
cured part of a mortgage
to direct real estate risk is applied, i.e. a
25% assumed value decline covers all
of the risk involved irrespective of the
location or use of the property
Eff ectively, this means that for any mort-
gage with an LTV below 75%, insurance
companies do not have to hold any capi-
tal. Th erefore, if Solvency II is imple-
mented unchanged, the following would
be the case:
versifi ed and actively managed cover
pool made up of purely German resi-
dential mortgages with an average
LTV of, say, 45%, additional over-col-
lateralisation of 15%, and which off ers
an additional claim on the issuer will
have a higher capital charge than one
individual commercial mortgage loan
We understand that Solvency II is not
yet fully fi nalised in several areas and the
treatment of mortgages is among these.
Both the European Insurance & Occupa-
tional Pensions Authority (EIOPA) and
the European Commission seem to have
realised the gravity of this divergence and
want to harmonise the regulatory land-
scape for insurance companies and banks
in the best possible way. Th e treatment of
mortgages in the current form, however,
would be the mother of all competition
distortions and it remains to be seen
what is still possible this late in the Sol-
vency II process, or what will have to be
delayed until the next Solvency update.
If approved in its current form, it
would cause serious problems above all
for specialised commercial real estate
lenders. At least until rectifi ed in a later
Solvency edition, insurance companies
would be far more competitive in this
fi eld and in many cases in a position to
price these banks out of the market. Since
there is no diff erentiation for capital
purposes, we do not think that the resi-
dential mortgage market with its much
smaller individual loan volumes and
lower margins will be a major target for
the insurance sector.
So how will insurers reposition themselves?
Th e overall eff ect of Solvency II is still
“The value of a triple-A rating will
become fairly large for insurance companies”
“And I feel fi ne”
48 The Covered Bond Report July 2011
ANALYSE THIS: SOLVENCY II
hard to gauge and it will always vary
from insurance company to insurance
company. There are, however, a few
general statements that can be made in
our view:
-
quirements for all assets and liabilities
under Solvency II, the differentiation
between registered and bearer bonds
will shrink going forward, as Solvency
II does not foresee any differences in
treatment. Issuers will not get as much
out of this sector of the covered bond
market as previously.
to focus on long assets to match their
long liabilities. They could, however,
aim to achieve this by using long dat-
ed capital efficient products — such as
government bonds — and concentrate
capital intensive products towards the
short to medium part of the curve.
Senior unsecured exposure (which
includes non-triple-A rated covered
bonds!) could be shifted to the very
short end, while triple-A rated cov-
ered bonds could still be an invest-
ment of choice out to, say, the 10-12
year part of the curve.
-
come fairly large for insurance com-
panies. In the example above, the
spread difference for double-A and
triple-A covered bonds with a dura-
tion of 10 years is around 40bp if the
insurance investor has to generate a
RoE of 15% and holds the bonds to
maturity. In addition to spread levels,
ultimate demand from the insurance
sector will also be far lower for cov-
ered bonds rated below triple-A at the
mid to longer end.
-
er dated capital intensive products,
they are likely to pass on the higher
capital charges from the spread risk
component to the issuers. As a result,
spread curves will have to steepen at
the long end.
-
surance companies will have an in-
creased incentive to become active in
buying them directly, as opposed to
buying mortgage exposure indirectly
through covered bonds. This could
damage new business prospects for
commercial real estate lenders, as they
are priced out of the market. There
might be some changes to this in the
months to come.
Overall impact on issuers and Basel III interplay
Solvency II will not only change the way
covered bond spreads behave and how
insurance companies will operate in the
market; it will also have material conse-
quences for the overall funding structure
of covered bond issuers. This becomes
particularly apparent when looking
at the combined effects of Solvency II
and Basel III.
The Basel III rules are aimed at term-
ing out the funding of banks, encourag-
ing them to issue longer dated debt. At
the same time, however, Solvency II
will reduce demand or at least increase
spreads for the very same longer dated
issuance, above all for senior unsecured
funding but also for covered bonds.
Looking beyond the public benchmark
market, private placements of both cov-
ered bonds as well as senior unsecured
were always prominent with insurance
companies and provided very long dated
funding for banks. Looking into the fu-
ture, though, Solvency II will make it
harder for issuers to issue long dated reg-
istered covered bonds or Schuldscheine
as they are treated the same way as bearer
bonds from a capital charge perspective.
In particular, German Pfandbrief issu-
ers who have relied on Schuldscheine to
fund their overcollateralisation will have
to pay up significantly or try to find new
funding sources.
As a result, the combination of the
two reforms clearly favours one bank
business model over the other: big uni-
versal banks with solid deposit bases
are the least affected institutions, while
wholesale funded specialised banks are
put at a huge disadvantage.
Changes should still be considered for final rules
As mentioned previously, there are no fi-
nal rules of Solvency II yet. Since Solvency
II will come into force in 2013 and there
have already been five quantitative impact
studies, a major overhaul of the system
at this stage seems out of the question.
Smaller changes for the better, on the oth-
er hand, cannot be ruled out in our view.
One area in which some alterations
would definitely make sense compared
with QIS5 is the spread risk component.
Its current set-up encourages insurance
companies to focus their long dated in-
vestment exposure towards sovereign
bonds and reduce the average duration
of their capital intensive products. In
this respect, there are a few points that
we would consider very sensible and use-
ful changes or adjustments to the current
set-up of Solvency II:
-
one involved to strengthen the long
term investment character of insurance
companies. Capital charges should re-
flect this and not grow in a linear rela-
tionship with an investment’s duration.
If the additional capital charge for later
years gets smaller, this could encour-
age insurance companies to remain ac-
tive in longer dated bonds.
beneficial treatment of covered bonds
to only triple-A rated bonds. Recov-
ery assumptions for covered bonds
are typically far higher than equally
rated senior unsecured bonds, irre-
spective of their absolute rating level.
In addition to that, the actual spread
volatility of double-A rated covered
bonds during the crisis has been well
below that of double-A corporate
bonds. Therefore, special treatment
for double-A covered bonds relative
to double-A senior unsecured bonds
seems justified as well.
These two changes alone would in our
view reduce the overall negative impact
of Solvency II on non-sovereign bond
markets and help stabilise both banks
and insurance companies.
“The combination of the two reforms
clearly favours one bank business model
over the other”
July 2011 The Covered Bond Report 49
FULL DISCLOSURE
New arrivals and visitors to London were introduced to local pastimes after Nomura’s syndicate drinks on 15 June.
Photos from the 9th annual Trophée de Golf Crédit Foncier, which was held at Golf du Lys Chantilly on 7 July.
From fairway to oche
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In Germany and abroad, investors appreciate its first-class quality and the yield pick-up.
Attributes it owes to the stringent German Pfandbrief Act and a strong interest group that
ensures the Pfandbrief stays the benchmark on the Covered Bond market.
For more information, go to: www.pfandbrief.org
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