When RMBS are safer than covered bonds
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When RMBS are safer than covered bonds

Covered bonds and RMBS share important similarities which both the European Central Bank and Bank of England acknowledged last year in a discussion paper. As the two asset classes evolve, their vastly different regulatory treatment should become more difficult to justify.

A comparison of Rabobank’s Storm 2015-1 RMBS, originated by its Obvion subsidiary, to a forthcoming conditional pass through covered bond to be issued by Van Lanschot Bankiers shows that regulation remains a more important determinant of price than fundamental credit risk.

Van Lanschot (BBB+/A-) is a smaller, weaker institution than Rabobank (Aa2/A+/AA-/AA(hi)). Van Lanschot’s forthcoming covered bond will be backed by a cover pool which has a higher credit risk than any other Dutch mortgage covered bond programme, according to Fitch. 

About 70% of the mortgages are interest-only, which the agency says have higher risk of default, while Fitch has not even been sent any income details for the borrowers.

In the event of the issuer’s default and a failed amortisation test, the conditional pass through pay down may not be vastly different from Storm 2015-1. The mortgages have an average life of 18.8 years, and interest-only borrowers are typically in no hurry to pay principal.

Given the strategic importance of the Storm programme as Rabobank’s main mortgage funding tool, Rabobank and Obvion’s interests are fully aligned with investors’. This suggests that although the programme is technically non-recourse, the risk of maturity extension is limited and the risk is not so different from Van Lanschot’s covered bond.

Storm is backed by a cover pool that meets the highest transparency standards set by the Prime Collateralised Securities initiative. And though Van Lanschot’s covered bond is likely to comply with the European Covered Bond Council’s label initiative, Fitch didn’t receive any income information on the borrowers behind the loans so it had to assume a conservative debt-to-income-ratio of 35% for all of them.

Despite the better collateral, stronger issuer, similar paydown and high level of transparency, the capital charge for holding a triple A rated piece of Storm for a bank investor under the standardised approach is 1.6%, or double the amount investors must hold for the covered bond to be issued by Van Lanschot.

And because Storm doesn’t get into the top 1B level in the Liquidity Coverage Ratio, bank investors can buy no more deals like it up to no more than 15% of their liquidity portfolios, and must apply a 25% valuation haircut. In contrast, they can buy up to 70% of their portfolio with a 7% haircut for deals like Van Lanschot’s covered bond.

For these reasons — that are driven more by regulation than a credit assessment — the RMBS appeals to smaller universe of buyers which translates to a relatively higher cost of funding. Storm priced last week at 26bp over three month Euribor.

In contrast Van Lanschot’s forthcoming covered bond should price through mid-swaps. The closest comparable, NIBC’s 1.25% April 2019 was recently indicated at 8bp through mid-swaps, which suggests fair value for the new deal of around 5bp to 6bp through.

Given the much tighter spread for these bonds covered bond investors who are not constrained by bank or insurance regulation should consider buying prime Dutch RMBS. More importantly, the two deals illustrate how misconceived and ill-judged regulations drive a wedge between economic reality and price.     

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