As the biggest buyer of covered bonds, the European Central Bank is sticking its hand up for investors.
On November 3 the central bank published new guidelines related to monetary policy, repo haircuts and other measures. It said that it intends to increase the haircut for covered bonds with extendable maturities such as soft bullets and conditional pass through deals “to take into account of the additional risk”.
This implies the central bank sees a higher risk than these bonds will decline in value. While that might be true, on pure credit quality, the bonds are surely stronger than the hard bullet structures they replace. The extension gives breathing space and flexibility which should lower the likelihood of a missed payment. That’s why rating agencies give these structures some benefit.
Once an issuer has defaulted on a hard bullet deal, the cover pool administrator is presented with a series of choices, none of which are likely to be good for investors. As there is no option to extend, forced asset sales are possible, and if the prevailing loan prices are low the cover pool will be depleted.
Under the Bank Recovery and Resolution Directive, the ability of local regulators to step in and resolve a covered bond issuer while making the covered bond whole could be compromised. In other words, the flexibility that national regulators historically had to ensure covered bonds did not default may no longer exist. Codifying what happens in the event of an issuer’s default, as conditional pass through deals do, may actually increase the likelihood that investors get fully their money back.
In contrast to the ECB, the European Commission has stuck up for extendible structures. Last week it set out new proposals for how covered bonds should be treated in the Net Stable Funding Ratio and the capital charge they will attract.
Initially the rule had a special exclusion for pure pass-through deals such as Danish covered bonds where the assets and liabilities are fully interdependent. But the new proposals soften this language, and the EC now says other forms of extendible maturity, such as soft bullet bonds and conditional pass through deals, might also be treated better bythe NSFR rules.
More specifically the EC says an NSFR exclusion is possible where there exists “non-discretionary extendible maturity triggers on the covered bonds by one year or more years”.
This means that specialist mortgage banks which only issue covered bonds will not need to fund long term mortgages with short dated senior unsecured bonds to comply with the NSFR rules. They can now fund them more stably with long term covered bonds, provided of course these bonds are soft bullets or conditional pass through structures.
The third corner of the European regulatory trinity comes down on the ECB's side. The European Banking Authority proposes tougher treatment for conditional pass through deals. The EBA's covered bond proposals say issuers of such structures should provide loan level data to investors, while issuers of soft and hard bullet bonds avoid the requirement.
But the additional transparency requirement seems a lot like prejudice against the CPT product.
Once an issuer has become insolvent, a covered bond investor in a bond with any maturity structure will want to get a detailed understanding of the collateral. Loan-by-loan data is useful to help map scenarios for the bond paydown, and the need for such data will become more urgent the closer an issuer gets to insolvency, whatever the maturity structure. If anything, hard and soft bullets should offer more detail on the underlying loans — because they offer less detail on how payments flow through to bondholders after an issuer default
When it comes to covered bonds with extendible structures the evidence shows that the EBA, EC and ECB are all working in their own boxes. While European authorities are pushing harmonisation for the covered bond market, perhaps they could try a little harmonisation at home first.