ABN Amro, BNP Paribas, Crédit Agricole and Crédit Mutuel CIC have removed swaps from their programmes, thereby eliminating hedging arrangements, that not so long ago were universally considered beneficial for covered bonds and their credit quality. But times have changed.
Swaps are used in covered bonds principally to hedge differences between floating rate mortgages, the assets of the cover pool, and fixed rate covered bonds, the pool liabilities. Swaps are also used to hedge against adverse currency movements, containing, for example, the currency exposure for a pool of sterling-denominated mortgages backing a euro-denominated covered bond.
The catalyst that has caused these banks, all based in the eurozone, to remove swaps has been the Liquidity Coverage Ratio (LCR).
As most banks aspire to have their covered bonds eligible for the LCR under the best possible conditions, the rules say they must plan for a three notch rating downgrade of the parent banks. For many single A-rated banks this would take them close to the investment grade threshold. This, in turn, would obligate them to add considerably more collateral to their cover pools, and potentially substitute internally arranged swaps with expensively procured external swaps provided by higher rated banks.
In practice this would oblige issuers to post at least 10% more collateral into their programmes. For a substantial €20bn programme, that would mean €2bn of extra collateral to make sure the programme meets the LCR rules, cutting the efficiency of covered bond funding.
If it came to that, finding an alternative external swap provider to step in for a bank on the brink of junk could prove near impossible, or at least very expensive. However, by removing swaps, issuers don’t need to prepare for such an eventuality. They only need to hold sufficient collateral to meet rating agency requirements, which are invariably easier to fulfill than the challenging LCR test.
But the motivation to remove swaps is not just about issuers wanting to improve their funding efficiency.
Removing swaps is also good for investors because they become less exposed to swap counterparty risk. With an internal swap, which are the most commonly used in covered bonds, there is a direct link back to the originator, also the first recourse for the credit risk of the bond. In a highly stressed market environment, originators may not be able to fulfill their swap obligations and investors would then face additional risks that had been associated with the swap.
But removing swaps can really only be done by certain banks. Issuers of euro covered bonds outside the eurozone cannot remove their cross-currency swaps. Even for eurozone banks, it is easier to strip out swaps which are internal, as these can be cancelled without incurring a termination cost.
The final consideration is duration. Once swaps are removed banks have every incentive to issue fixed rate bonds with a maturity that closely matches the average duration of cover assets, because this gives them a natural hedge. And with rates being at an all-time low, mortgage borrowers are increasingly fixing the cost of their loans for as long as possible. That means banks, such as ABN Amro and Crédit Agricole, have every incentive to fund at the long end of the curve.
As long duration fixed rate mortgage production become more prevalent across Europe, eurozone issuers’ cover pools will also increase in duration. So issuers that are readily able to access long end funding may be most likely to ditch the swap.
Once they’re done, such bonds are not only more transparent, but by virtue of their ultra-long maturities, they also give real money buyers the higher yield they are looking for. For the right banks, removing swaps is a winner for all parties.