Covered bonds have had a good crisis. Banks with no programmes have established them; jurisdictions with no law have passed them. For the tottering banks on the European periphery, covered bonds are the only route to market access. For the rest of the banks, they will be the only funding tool where banks get regulatory benefit from cross-holding each others debt, as they will count in the Basel III liquidity coverage ratio.
Where there is a threat to senior unsecured bank debt from resolution regimes and bail-ins, covered bonds shine through as the only long term funding tool that definitely will not be made to bear losses. Nervous credit investors are already buying covered bonds in large numbers, and as other jurisdictions pass resolution regimes, this trend will accelerate.
But in a world where covered bonds reign supreme, senior unsecured debt holders, equity investors and other bank creditors will be looking nervously over their shoulder for signs of asset encumbrance. As banks rotate good assets into cover pools and bad assets out, senior ratings can come under pressure — a theme that regulators so far have given little attention to. But as depositors are the biggest senior unsecured creditors of the universal banks, regulators will be sitting up and taking notice.
Senior to senior?
Resolution regimes are in place in Germany, Denmark and the UK, giving regulators the power to enforce burden-sharing for senior unsecured debt holders (and keep taxpayers and depositors off the hook). The European Commission in January made it clear that it wanted a resolution regime that could "write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses".
Covered bond investors’ first claim is on the cover pool assets but if that proves insufficient, then they also have a claim on the estate of the insolvent bank that ranks pari passu with senior unsecured creditors. This means the concept of bail-in will never apply to covered bondholders.
If the cover pool defaults (leaving covered bond investors with a senior claim on the issuing bank), that means the issuer must already be in insolvency, as it has defaulted on its on-balance sheet obligation to maintain the cover pool at a sufficient level of collateralisation.
As one covered bond market participant put it: "One might ask what the economic value of the dual claim of covered bonds is... but that’s a different story."
"Bail-in proposals will never affect covered bonds," says Christoph Anhamm, head of covered bonds at Royal Bank of Scotland. "The very nature of a covered bond means that it is outside of this discussion. To include covered bonds in a bail-in proposal would mean taking away say, 20% or 30% of the cover pool. That would be against Ucits, against any covered bond law, against principles of contract law, and — in some circumstances — against political will."
Anhamm adds that these discussions are essentially academic.
"The market assumes the insolvency would work in a certain way, but we haven’t seen the mechanics in action."
Christopher Walsh, capital markets partner at Clifford Chance, says that regulations for dealing with banks in crisis is now in place, but that this should still be viewed as more of a guide as to what could happen in a crisis situation than a definitive legal framework.
"We saw in the last crisis that regulators are willing to do whatever it takes to keep banks afloat. Governments can always pass new legislation giving themselves new powers in a crisis. That said, they have shown pretty clearly that they are unwilling to do anything that could fundamentally damage the infrastructure of the capital markets, and covered bonds remain one of the most secure instruments around."
Even if a crisis throws up unexpected effects, and knowing that covered bond insolvency has yet to be properly tested, investors need to consider whether regulators would risk cutting off the safest and most long term funding tools banks possess for the sake of making covered bond investors share the pain. The harder regulators come down on senior unsecured creditors, the better the demand for bail-in-proof debt — meaning covered bonds will benefit.
Basel in brief
While resolution regimes push credit investors out of senior unsecured and into covered bonds, the Basel III framework looks set to unite regulators around covered bonds as a liquid instrument, which can account for up to 40% of a bank’s liquid asset portfolios. Banks will have to hold more liquid assets, and liquid assets will be more strictly defined than ever before under Basel III.
Covered bonds are the only bank funding tool included in the eligible Liquidity Coverage Ratio assets, joining highly rated corporate debt in the Level 2 category. Banks can hold up to 40% of their liquidity portfolio in these forms, with a haircut of up to 15%.
Bank liquidity needs mean more demand for covered bonds — though how much is not clear.
RBS’s Anhamm says: "The liquidity element is also hard to quantify. The best guess is that there could be somewhere between Eu20bn and Eu50bn of new annual demand for liquid covered bonds, but that’s a wide range that equates to 10%-20% of annual benchmark supply."
However, doubt remains about the scope of this guideline. Basel III is supposed to be a global agreement between regulators, but several jurisdictions do not even allow their institutions to issue covered bonds. Basel III specifies that only covered bonds "subject by law to special public supervision designed to protect bond holders" will be included in the buffer. The US and Australia are the most notable jurisdictions without covered bond laws. Foreign issuers have issued regulated covered bonds in dollars and Australian dollars, but it is still unclear whether these instruments would be considered liquid assets.
Apra, the Australian regulator, ruled out covered bonds for liquidity purposes in February. However, the US appears to be on the brink of passing a covered bond law.
A covered bond market participant says: "The crucial driver will be to what extent the liquidity coverage ratio becomes a global issue. The US doesn’t even have a covered bond law, but Basel III is supposed to apply everywhere. If the US banks start to hold them for liquidity purposes, the impact would be enormous. We can stop worrying about the future, and just issue covered bonds day and night."
There are also questions over the Basel timeline, with the Liquidity Coverage Ratio set to come in from 2015. However, stronger global banks are already starting to publicise their Basel readiness, and the market may encourage earlier action.
"In general, covered bonds are better yielding than the alternatives in the liquid asset portfolios," says Ralf Burmeister, a covered bond analyst at LBBW. "However, the switch, if it happens, will be a long term process. Banks won’t be dropping senior bank debt, but they won’t be reinvesting in it either. They’ll let it mature, and gradually increase their covered bond holdings."
Burmeister also highlights threats to this picture. He points out that counting covered bonds as liquid assets didn’t do anything to decrease the interconnectedness of the financial system, which regulators originally appeared to want.
He also flagged up the European Union’s changes to the Markets in Financial Instruments Directives (Mifid) as an area with potential to hurt covered bonds — particularly in their role as liquid instruments. The Mifid initiative could see trade transparency overhauled.
Burmeister explains. "Mifid could be a big change — it comes from retail involvement in equities, and tries to ensure that retail investors get the best possible price at any time," he says. "If the implementation goes wrong, that means less liquidity in covered bonds. Traders will be less willing to do market making, because it won’t pay off to carry inventory if everyone knows you have it."
Over-indulgence and hangover While covered bonds look set to benefit from liquidity rules and senior bail-ins, the exceptional volumes so far in 2011 have encouraged regulators to look further at the risks of asset encumbrance — if a bank issues too many covered bonds, that can mean it has tied up its best assets in segregated cover pools, which is dangerous for depositors, senior unsecured bondholders, and shareholders.
Sally Onions, covered bond partner at Allen & Overy, says regulators are starting to pay much more attention to asset encumbrance.
"It’s definitely on the radar, but they’re looking at things in a holistic way — not just the absolute level of covered bond usage, but other funding tools that tie up assets. Regulators will be interested in encumbrance levels, even where domestic legislation does not have a hard level on the volume of assets that can be placed within a cover pool."
RBS’s Anhamm agrees that a single level makes little sense.
"There is no ‘one size fits all’ answer," he says. "Every country has its own covered bond model, and every bank has a different business model, a different funding and capital strategy, and a different mix of assets and liabilities on the balance sheet. As such, it really takes an individual analysis to ‘right size’ a covered bond programme for an issuer."
LBBW’s Burmeister also points to distortion in the mortgage market if covered bonds become the bank funding tool of choice, encouraging banks to originate accordingly.
"If covered bonds do become the main bank funding tool, this creates its own problems," he says. "Covered bonds need over-collateralisation, and by definition that cannot be financed by covered bonds. If every bank goes out and issues loads of covered bonds, this will squeeze margins across the industry."
He points to the LTV requirements of covered bonds, ranging from 60% to 80% depending on jurisdiction, as risking distortion.
"Business above that level, or with different collateral, cannot be financed by covered bonds, and so a preponderance of covered bonds could create market distortion on that side."
Future funding?
While Burmeister’s point stands for existing covered bond laws, several market participants see the potential for the instrument to be useful in other areas.
Clifford Chance’s Walsh says: "Covered bonds are still really only utilising residential mortgages as an asset base, except in the German Pfandbriefe market, and are purely a bank financing tool right now. But covered bonds can certainly do more than that. Both within regulated covered bonds and outside the regulatory framework, you can use a much wider variety of assets as collateral for covered bonds."
Paul-Michael Rebus, structured finance partner at Eversheds agrees, saying that the market could evolve to permit a broader issuance and asset base.
"As covered bond legislation stands now, it’s very much a credit institution product, but that doesn’t mean the product doesn’t have the potential to evolve beyond that. The finance industry is full of innovative people always seeing new structures to satisfy investor demand."
If regulators encourage covered bonds with one hand — regulatory capital, liquidity and resolution regimes — they could see covered bonds slip away from the other, as issuers choose to move outside specific covered bond laws to innovate in the field. Then we could see the re-emergence of the structured covered bond market, and a much greater challenge for covered bond regulation.