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Emerging Markets

An asset class for all seasons

Regulatory incentives and structural security have drawn investors and issuers alike into the covered bond world. Steven Gilmore looks at how the product acquired its privileged position in the capital structure of Europe’s banks, its treatment under incoming regulation, and whether concern around asset encumbrance is warranted.

  • 28 Sep 2011
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Japanese bankers are trying to convince politicians to write a covered bond law. In South Korea, the Financial Supervisory Service (FSS) and Financial Services Commission (FSC) published guidelines in June to provide a framework for covered bond issuance. Moody’s recently said that a proposal from the Brazilian Association of Real Estate Loans and Savings Companies to create domestic covered bonds would be credit positive for the nation’s banks. And there is hope that legislation in Mexico will be passed before the end of the year. The role envisaged for covered bonds in these disparate jurisdictions, however, is far from uniform.

In Brazil the mortgage industry hopes that a new source of funding will ameliorate a housing deficit of 8m units. Before the crisis Mexico relied on RMBS for mortgage funding but during the turmoil of the last four years many transactions were downgraded.

"The local RMBS market shut down," says Cristina Costa, senior analyst, covered bond markets, at Natixis. "Because of this the government decided to look towards covered bonds as a safer product."

In Japan an ageing population and a high savings rate limit mortgage lending. Japanese covered bonds would instead be backed largely by loans to local authorities. Domestic lobbyists hope that the product’s secure structure will create an alternative to government bonds.

It is what the FSS/FCC in South Korea hope will allow banks to diversify their funding instruments and encourage them to offer more long term and fixed rate mortgage loans instead of short term and floating rate ones.

In Europe, the Americas and Asia, the security covered bonds offer to investors, and the confidence this engenders, have played a key role in their adoption.



Right place, right time

Their rise to prominence began with the crisis, and a decision by the European Central Bank that covered bonds were a solution to the problem of how to stabilise capital markets.

"There were decisions that fostered the importance of covered bonds, namely the €60bn purchase programme," says Florian Hillenbrand, covered bond analyst at UniCredit. "It became a self-fulfilling prophecy, in that if regulatory authorities say something will become more important going forward and act accordingly then it becomes more important."

The ECB’s decision was not arbitrary. Covered bonds proved inherently suitable for a time when stability and security became sought after above all else.

"The crisis was a catalyst for the broadening of the covered bond market, particularly in Europe," says Hillenbrand. "In tough times the promise of a bank to pay might not be enough, so there was pressure to place something on top of this and it was certainly brought along by the crisis."

Though even before 2007 jurisdictions outside Europe were considering the product, without the financial turmoil the pivotal importance of covered bonds was by no means inevitable. Although as Hans Lentz, head of fixed income syndicate at Lloyds Banking Group, points out, one reason why the market may have grown without the crisis is that it was built on the German Pfandbrief market. "One point for covered over securitisation was market commitment from traders to quote prices, and so perceived liquidity increased their appeal," he says.

Apart from this it’s doubtful that the covered bond market would have grown more than any other. The first Jumbo Pfandbrief was issued in 1994, and for the next 10 years there were between three and 10 inaugural benchmark issuers each year. In 2007 there were 12. Between 2008 and 2010 there were 60.

The qualities that made covered bonds the tool of choice have been well documented, though the suggestion that since their birth in 1769 there has never been a payment problem, let alone a default, is disingenuous. Nonetheless, the covered bond has provided a secure, liquid and largely triple-A product with which to fund mortgages. Their volatility-adjusted spreads have historically outperformed other asset classes, and they have proved more robust against downgrades. Credit enhancement reduces the risk that an issuer will be forced to sell the bond because it has fallen below a certain rating.

"Though that has finally happened to many covered bonds it has taken four years of crisis," says Hillenbrand.



The only game in town

However, covered bonds have become more than a funding tool for some issuers; they have become a lifeline to the capital markets. Banks no longer have the same incentives to hold the senior unsecured debt of their peers, and the threat of bail-ins has drained the traditional buyer base. At the same time the financial health of many banks has made the spread at which such debt would be offered publicly prohibitively expensive.

"Covered bonds have become a necessary funding tool," says Jennifer Levy, covered bond analyst at Natixis. "Some issuers in jurisdictions like Spain have had real difficulties in the senior market and can only rely on covered bonds."

In Spain, benchmark covered bonds as a proportion of senior and covered bond issuance have risen from 55% in 2007 to 66% in 2011, according to HSBC data.

At the same time a new demographic of covered bond investor has formed. Generalised credit buyers are moving allocation away from senior and securitisation and into covered bonds.

"Some existing and former securitisation investors, in particular from jurisdictions like the US, are beginning to buy covered bonds," says Robert Plehn, head of structured securitisation at Lloyds Banking Group. "These investors are comfortable buying mortgage risk and while they look at the different liability structures from a relative value perspective, if they are bank or insurance company investors, they are also clearly influenced by the favourable regulatory treatment of covered bonds."

While Spanish borrowers have enjoyed support from generalised credit buyers, the insurance companies and bank treasuries have headed north. In core Europe and the Nordic region issuers are not hamstrung by dependence on one asset class. Instead they have responded to an increase in demand due to the favourable treatment of covered bonds in almost all regulatory initiatives.

"The drivers of demand have increased the specialist pool of investors, meaning specific portfolios or allocations which are going exclusively to covered bonds," says Andrew Porter, global head of covered bonds at HSBC.

Under the proposed regulatory framework of Solvency II, for instance, covered bonds provide a favourable return on capital usage, and as a result insurance companies with little or no involvement in the asset class have become active in the euro, dollar and sterling markets.

"The UK is a good illustration of this," says Porter. "Insurance companies with no covered bond investments whatsoever have started up portfolios, and you’ve seen similar movements in Switzerland and Italy."

Similarly, under CRD IV proposals covered bonds are included in a range of liquid assets, which has resulted in bank treasuries setting up covered bond portfolios for the first time.

"Banks in the UK, continental Europe and the Nordic region have started to include covered bonds from €500m to a few billion and this will continue to provide an important part of new issue order books," says Porter.

Regulated financial institution securitisation investors that used to be big buyers of RMBS have replaced RMBS purchases with covered bonds. This, says Plehn, is primarily because of the favourable treatment covered bonds receive under the Basel III liquidity rules.



A matter of life and death

The growing importance of covered bonds has raised concern about asset encumbrance — the subordination of senior unsecured investors and in some cases retail depositors. A variety of solutions to the problem have been sought.

In certain jurisdictions limits on issuance as a proportion of total assets, as a proportion of tier one capital, and a cap on over-collateralisation are in place. Given the existence of these mitigants and the volumes concerned, many market participants remain untroubled by the issue.

"Fitch released a study in March reporting that on average covered bonds represent less than 10% of bank’s liabilities plus equities," says Levy. "So it’s not that important right now, covered bonds are a valuable source of funding."

Cedric Perrier, covered bond and FIG syndicate at Natixis, says that many new covered issuers are smaller entities, and have less assets and smaller funding requirements. "They are not necessarily benchmark issuers so encumbrance is less of a problem," he adds.

The real problem, says Hillenbrand, is not the existence of a covered bond product but rather the over-collateralisation. "A covered programme lowers your funding costs, broadens the investor base and allows a bank to access ECB funding with its own bonds," he says. "Senior unsecured investors might suffer an increase in loss-given default, but the overall probability of default drops dramatically."

The problem is that when over-collateralisation is taken into consideration asset encumbrance can increase sharply.

"OC requirements increased massively during the crisis, and when OC is taken into account you really start to take assets away from unsecured debtors for covered bond investors," says Hillenbrand. "This is where the loss-given default impact becomes a lot stronger, and it’s easy to imagine a scenario where the senior unsecured investor is in a worse position."

Canada, where legislation may be in place by the end of the year, has recognised this threat. "The proposal in Canadian law is to cap over-collateralisation at a maximum of 10%," says Hillenbrand. "This is both a blessing and a curse."

In light of stringent rating agency requirements, and the growing importance of retaining a triple-A rating, some market participants believe this measure could be detrimental to issuers.

"The Canadian cap on over-collateralisation is the only measure that I’m not comfortable with," says Costa. "Rating agencies are focusing more on ALM and liquidity and so forcing issuers to hold more OC to maintain a triple-A rating."

The danger is that a bank reliant upon its covered bonds in a difficult market will be unable to raise its OC in order to retain market access with a triple-A product.

In the US, the Federal Deposit Insurance Committee proposed a structure where, as the post-insolvency manager of the cover pool, it would have the option to continue payments to investors or sell the covered bond structure, and still have access to over-collateralisation.

This discussion is particularly pertinent to Europe, where insolvency law has not yet been reconciled with the uncertainties of administering a cover pool post-insolvency.

"EU insolvency law requires administrators to make up a list of all liabilities and assets in the insolvency estate," says Hillenbrand. "But they are unable to do this as they cannot be aware of all possible contingent claims from covered bond investors nor the contingent assets in the cover poll."

Technically, says Hillenbrand, an administrator could not pay out a single euro to unsecured debtors as the administrator does not know what the total claims from covered bond investors will be, and whether the pool is of sufficient value to meet these claims.

Whatever the solution a balance needs to be struck between the advantages of a covered bond programme, and the problems it creates concerning insolvency and senior unsecured debt.

"You have to concede that there is a trade-off between the viability of the model and what happens in the event of insolvency," says Julia Hoggett, head of financial institutions group covered bond and flow financing business, EMEA at Bank of America Merrill Lynch in London. "You decide that the benefit this provides during the life of the bank is worth the cost incurred in death."

The benefits are a liquid mortgage market for retail and a flight to quality funding vehicle. Unfortunately it makes senior unsecured issuance more expensive for banks because it subordinates unsecured creditors in a default event.

"Basel III assumes that having a functioning mortgage market, and a mechanism which banks can use to access competitive financing in a broad range of market environments, is of strategic and structural importance," she says. "They are regulating in such a way as to maintain it." This, she adds, is why covered bonds as a bank product are being singled out by regulators.



Regulatory wrangling

Yet despite being singled out by regulators for special treatment, the same initiatives that have brought bank treasuries and insurance companies into the covered bond world provide issuers with cause for complaint.

The Net Stable Funding Ratio proposed within Basel III, for instance, does not include covered bonds with maturities of less than one year as stable funding.

"You destabilise the situation where you push liabilities to one year longer than your assets," says Hillenbrand. "You’re always long duration, which is an open interest rate risk position, and you risk being short of collateral."

Under the Liquidity Coverage Ratio covered bonds are classed as Category 2 assets, and thus restricted to 40% of the entire pool of liquid assets, and subjected to a haircut of 15%. Greek sovereign bonds, like all sovereign debt, can be held without restrictions.

"In the case of the LCR there is a strong impression that it is not about the fundamental reality but political decision making," says Hillenbrand.

Solvency II subjects triple-A rated covered bonds to a 0.6% capital charge for each year of duration. Double-A rated covered bonds are treated like corporate bonds, and are subject to a 1.1% capital charge for each year of duration. Crédit Agricole analyst Florian Eichert says that logic and statistics suggest better treatment, and as the spread risk factor almost doubles from 0.6 to 1.1 should a bond be downgraded from AAA to AA+, Solvency II introduces a "very dangerous rating cliff".

In the UK, the Independent Commission on Banking has recommended ringfencing the retail banking activities of UK financial institutions to protect depositors and taxpayers. This has implications for covered bond issuance. Universal banks would continue to provide retail banking services within separate capitalised subsidiaries. However, Deutsche Bank analysts say that there are not enough UK retail deposits to cover UK retail loans. Should covered bonds form part of the retail entity they would make up a large proportion of the balance sheet, and potentially lower depositor protection.

The proposed bail-in of senior unsecured debt may also affect covered bonds.

"One constraint that needs to be thought through, though it will take time for a definitive answer, are guidelines from the FSB on the European bail-in framework," says Porter.

At some point there will be clear delineation between the proportion or amount of a bank’s liabilities that can be bailed-in during a resolution. If covered bonds and retail deposits make up a large proportion of liabilities, says Porter, this will have implications for how much the rest of the balance sheet must bear. "This would constrain covered bond issuance and would require a clear increase in subordinated debt as well," he adds.

These are points of real importance, and though the privileged position of covered bonds in the capital structure is firmly enshrined, blanket regulation across different jurisdictions is proving challenging. The reality, says Hoggett, is that different markets operate in different ways, with different opinions on how things should work.

Another problem is that when regulation is applied it often has unexpected consequences. Market participants are concerned that covered bonds are being promoted to the detriment of senior unsecured debt. Encumbering more assets for covered bonds then makes senior even less attractive and even harder to issue. The ascendance of covered bonds, suggest some, may preclude the full recovery of other markets.

"There have been discussions in the UK and Europe about how to accelerate and promote the recovery of the securitisation market," says Plehn. "Regulators are incentivising bank and insurance company investors to buy covered bonds as compared to RMBS and ABS, and if they want to promote the recovery of the securitisation market they will need to put the product on a more level playing field with covered bonds."
  • 28 Sep 2011

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 20 Oct 2014
1 HSBC 45,452.86 307 0.00%
2 Citi 43,253.65 214 0.00%
3 JPMorgan 37,633.32 164 0.00%
4 Deutsche Bank 31,769.17 161 0.00%
5 Bank of America Merrill Lynch 24,070.56 131 0.00%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 21 Oct 2014
1 Citi 11,936.75 53 10.74%
2 HSBC 11,252.06 44 10.12%
3 JPMorgan 11,171.33 36 10.05%
4 Bank of America Merrill Lynch 11,029.46 41 9.92%
5 Deutsche Bank 9,109.83 32 8.20%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 21 Oct 2014
1 Citi 14,311.28 56 0.00%
2 JPMorgan 12,715.85 38 0.00%
3 HSBC 9,229.41 40 0.00%
4 Deutsche Bank 8,882.51 37 0.00%
5 Barclays 8,593.93 26 0.00%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 20 Oct 2014
1 Goldman Sachs 337.31 112 7.73%
2 JPMorgan 312.96 103 7.17%
3 Bank of America Merrill Lynch 265.63 81 6.08%
4 Lazard 257.50 126 5.90%
5 Deutsche Bank 254.78 94 5.84%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 21 Oct 2014
1 ING 1,794.39 18 7.86%
2 SG Corporate & Investment Banking 1,756.32 12 7.69%
3 UniCredit 1,732.50 13 7.59%
4 RBS 1,692.14 6 7.41%
5 Citi 1,529.52 13 6.70%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 22 Oct 2014
1 Standard Chartered Bank 3,393.34 33 5.02%
2 AXIS Bank 2,887.35 77 4.27%
3 HSBC 2,429.75 26 3.60%
4 Deutsche Bank 2,311.91 33 3.42%
5 ICICI Bank 2,046.44 54 3.03%