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The case for structured covered bonds can only get louder

Banks are considering new financing tools that respond to the changing regulatory and supervisory environment. Structured covered bonds backed by assets that are not eligible for traditional covered bonds could be the answer. Unlike senior unsecured bonds, they would be ring-fenced from bank resolution regimes. Bill Thornhill reports.

  • 23 Nov 2011
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When a putative deal can precisely respond to the differing needs of both buyers and sellers, the chances of its success are good. A few German banks, which have been unable to access competitive sources of funding in the senior unsecured market, are now looking at alternative ways of financing assets that are ineligible for inclusion in covered bonds. And investors, who are concerned about the risks of senior unsecured bail-ins, are increasingly looking at secure instruments that protect them from bank resolutions. Though covered bonds and securitisations provide this protection, the former is expensive and low yielding while the latter continues to suffer from a lack of trust.

Put these two sides together and the case for a dual recourse structure backed by assets that may more commonly have been used in the securitisation market could make sense.

"There could be a move towards more secured funding as issuers search for alternatives to the senior unsecured market, which could be subject to ‘bail-in regulation’ in the near future," said Marc Stacey, portfolio manager at Bluebay Asset Management.

Other investment managers agree and are already detecting alterations in their client mandates.

"Mandates from pension funds and other clients are evolving," says Colin Fleury, a portfolio manager at Henderson Global Investors. "Those that have historically been more broadly index-based, may include clients that are becoming increasingly focused on the amount of unsecured financial institutional risk in portfolios. This could mean that in a year’s time we may be inclined to look at a broader range of secured issuance structures for certain client portfolios."

A dual recourse instrument, which has the structural features of a covered bond, but is backed by assets not legally enshrined, could be just the answer. The idea was first touted in Germany, though, given the common cross-border themes that need to be addressed, it may not necessarily be the first jurisdiction to issue such a deal.

From an issuer’s perspective, if it is not looking to achieve risk transfer and rather it is more focused on funding, an instrument that can use those assets on its balance sheet that are lying idle — such as ineligible Pfandbrief assets — deserves to be looked at.

A hybrid dual recourse structure like this could appeal to several pockets of demand. "Senior unsecured and ABS investors may be inclined to look — the former because of bail-in fears, the latter because they want to get exposure to the underlying assets," says Boudewijn Dierick, a structurer at BNP Paribas.

Aside from the problems posed by the senior unsecured market, the CLO market is also practically closed, "so there are not many alternatives to fund bank SME loan portfolios," says Dierick. "It’s therefore logical issuers would look at new alternative funding structures."

Added to the prospective disenchanted senior investors and ABS investors there are likely to be a few of the more sophisticated covered bond investors who may also be tempted to take a look. These potential buyers are familiar with the dual recourse structure of covered bonds but more importantly they are likely to have the resources to undertake the due diligence that would be required to undertake such as novel investment. Moreover, they could be lured by the additional yield pick-up versus traditional deals.

But, as Bernd Volk, Deutsche Bank covered bond research analyst points out, typical Pfandbrief investors are likely to remain cautious in the beginning and may require a big premium.

What is beyond doubt is that the dividing lines between these various groups of buyers are becoming blurred. This wasn’t the case even a year ago, but the changing regulatory and resolution environment has catalysed investors and issuers to start thinking very differently.

Consumer loans and high LTV mortgage loans have both been touted as possible assets to back such deals, but structuring professionals believe SME loans are likely to prove among the most saleable of all assets.

"SME loans are plentiful and are politically advantageous in the sense they channel money into the real economy, so compared to high LTV commercial real estate or mortgage loans these assets could be an easier win," explains one structured finance specialist at a UK bank.

Whatever the asset that’s eventually decided on, Bluebay’s Stacey says investors will need to get comfortable with the liquidity available in the product, as well as the recovery of the secured assets in a stressed environment before they are willing to value and invest in the structure.

Duration appeal

One factor likely to make SME loans more appealing from a risk and recovery perspective is their shorter duration. Because of this the refinancing risk inherent in the structure is going to be lower than a traditional covered bond backed by residential mortgage loans. This is because short dated assets can more easily match the liability profile of debt issued in covered bonds.

By contrast, the assets of a transaction backed purely by mortgages are typically 20 or 30 years while the liabilities are invariably much shorter. This mismatch is the source of much rating agency consternation and is therefore one of the main drivers of covered bond rating downgrades. Issuers usually mitigate this risk by increasing the level of over-collateralisation.

In the case of Eurohypo’s mortgage backed Pfandbriefe the over-collateralisation now stands at around 24%, while for Deutsche Pfandbriefbank and HypoRe the ratios are even higher.

But, if the duration of assets and liabilities can be matched, then the amount of over-collateralisation required to offset refinancing risk would be much lower.

"The amortisation profile is key," in determining the new structure’s economic viability, says Stefan Krauss, a partner at law firm Hengler Mueller in Frankfurt. "If we can match the assets with the liabilities then refinancing risk is reduced, allowing the covered bond rating to be more de-linked from the issuer’s rating."

On the other hand, the underlying default risk of SME loans is far greater than that of a vast pool of first ranking mortgage loans secured on residential properties that have a low loan to value — not that that should present an insurmountable problem.

Rating agencies and banks have reams of data going back through several economic cycles enabling them to accurately describe the loss-given default and probability of default in SME portfolios.

That means they should be able accurately to size the over-collateralisation needed to achieve a triple-A rating with some certainty.

Though many typical SME loans that could be used as collateral do not have a public rating, banks and ratings agencies are able to calculate the so called ‘shadow’ or internal rating. German SME loans, for example, are typically rated in the low double-B area while SME loans elsewhere in Western Europe are usually rated in the high single-B area.

For granular pools backed by thousands of loans, credit enhancement in a securitisation, which is the same term as over-collateralisation in a covered bond, would need to be about 35% to achieve a triple-A rating. However, since the loans would remain on the balance sheet of the issuer, which the investor has recourse to as well, it’s possible this level would be less.

Not that that the level of over-collateralisation is likely to present a problem. Banks have plenty of collateral, it’s the funding that’s the problem. "The level of prospective over-collateralisation needed to reach triple-A may be less important than the additional funding that banks can raise," says BNP Paribas’ Dierick.

From a structuring perspective, the main challenge would be to get a sufficiently granular pool of loans to ensure that concentration risks, by region and industry, are mitigated.

One of the big problems that German mezzanine SME CLO securitisation structures have is that they were not granular enough and because of that, the securitisation’s ratings were unreliable.

By contrast, the ratings in UK and counter-intuitively Spanish SME CLOs held up remarkably well. This was mainly because the pool of obligors in both jurisdictions ran to 1,000s, rather than the hundreds or less in many German SME CLO deals.

A question of spread

Since it is likely that a hybrid structure could work for a targeted mix of investors the next question and the one that is likely to present a big challenge will be determining the spread. "Issuers will be hoping to get covered bond funding but investors will want senior returns," as one banker neatly puts it.

There is a wide span between these two extremes, especially in Germany. Five year covered bonds can typically price in the region of 10bp-50bp over mid-swaps depending on the name, but their senior unsecured CDS debt trades at plus 220bp and 250bp respectively for Deutsche Bank and Commerzbank.

Apart from senior unsecured, the other comparable is with existing securitisations backed by SME loans. "Issuers would be looking to price with a margin above Pfandbriefe, as opposed to the wider securitisation price levels," says Gareth Davies, head of European ABS and covered bond research at JP Morgan.

"Assuming SME assets yield an average of 300bp, it’s not clear whether this would be enough to fund the liabilities at today’s elevated levels," says Davies, with reference to current secondary trading levels of securitisations.

Aside from pricing, the universe of European investors in the ABS market is not what it used to be and to that extent "seems to be a deterrent for most originators", says Hengler Mueller’s Krauss.

Krauss made a presentation proposing a structured covered bond in early September at a German bank conference in Frankfurt.

According to the documents, the assets would be sold to a special purpose vehicle and subject to eligibility requirements, asset quality tests and monitoring by a statutory cover pool monitor (verwalter) and supervised by BaFin.

An important factor that the documentation highlights relates to the effectiveness of segregation.

Landesbank Berlin set the precedent for German structured covered bonds, but the means by which it achieved a segregation was ineffective. This was because the structure did not use the refinanzierungsregister (refinancing register).

Under the German Banking Act this register allows for the effective segregation of assets held on a bank’s balance sheet via a special purpose vehicle. Because the Landesbank Berlin structured covered bond did not use the register, investors only had a claim on the proceeds of the assets — and crucially not the assets themselves.

But, according to Krauss, the proposed new structure will use the refinancing register. that allows for the constitution of the cover pool by registering the cover assets.

In other words a true segregation effectively ring-fences the assets from claims other than those of the bondholders.

In the event of the issuer’s insolvency a statutory administrator (sachwalter) would be appointed via the insolvency court. It would be responsible for the management, collection and disposition of cover assets. The administrator’s rights would be no different to those of a Pfandbrief administrator.

  • 23 Nov 2011

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Nov 2014
1 JPMorgan 298,805.91 1181 8.14%
2 Barclays 268,207.66 919 7.30%
3 Citi 262,519.94 1020 7.15%
4 Deutsche Bank 259,366.94 1042 7.06%
5 Bank of America Merrill Lynch 253,285.00 906 6.90%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Nov 2014
1 Deutsche Bank 50,391.33 134 7.40%
2 BNP Paribas 47,024.00 196 6.90%
3 Citi 37,662.62 104 5.53%
4 HSBC 32,812.42 174 4.82%
5 Credit Agricole CIB 32,328.17 135 4.75%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Nov 2014
1 JPMorgan 24,215.02 117 9.07%
2 Goldman Sachs 23,224.16 78 8.70%
3 Deutsche Bank 20,943.82 79 7.85%
4 UBS 20,462.41 83 7.67%
5 Bank of America Merrill Lynch 19,151.02 70 7.17%