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Comment

Conditional pass throughs should be unconditionally welcomed

The conditional pass through structure for covered bonds being marketed by NIBC is far from the sort of sweeping revolutionary change that some are suggesting. Rather it would resolve a number of problems that exist in the present covered bond structure and there is proof that other techniques that have similar effects have been easily digested by bondholders before.

NIBC is promoting the idea of a conditional pass through structure for covered bonds. While some fear that would mark a sweeping change without precedent, there is plenty of evidence to suggest similar ideas have worked before and that they can go a long way to sorting out current glitches in the covered bond structure.

The conditional pass through changes what happens in the event of a default. If the issuer goes bankrupt, liquidity in the cover pool is insufficient to pay out, the pool fails an amortisation test — which assesses what the pool would recover in the event of a fire sale — and a creditor’s meeting does not come down in favour of immediate repayment including partial losses, then cash flows from the pool pass straight to bondholders, and the period over which they do can be extended beyond the maturity of the original bond.

Most importantly, it deals with the main pitfall of the current covered bond structure by specifying what happens when an issuer defaults.

Following an issuer and covered bond default, when a redemption payment is due the trustee of a hard bullet bond may be obliged to sell pool assets to meet it. But forced sellers never attract the best bid, especially in distressed markets.

As more redemptions fall due, the continued forced sale of assets could deplete the pool to such an extent that it becomes exhausted before the final liability is due. In other words, the longer maturing debt holders rank junior to the shorter maturing debt holders.

Trustees are legally obliged to represent the interests of all investors alike and may decide that the prudent approach is not to force a sale into a depressed market, but allow the loans to amortise over time. But as it is at the trustee’s discretion and since no issuer or covered bond default has ever been called, there is no precedent to go by. By laying out what would happen in the event of default, the uncertainty is removed.

The conditional pass through still gives investors full recourse to the issuer as well as the collateral. It has an asset coverage test and all those things that are designed to protect investors that securitisations never had.

It also ticks all the regulatory boxes. It would have a preferential risk-weighting, which due to the increased likelihood of a high credit rating, will be more favourable than a bullet maturing covered bond from the same issuer. And it complies with both the Capital Requirements Directive as well as the Undertakings for Collective Investments in Transferable Securities Directive.

It should also attract a lower repo haircut from the European Central Bank than a hard bullet bond from the same issuer thanks to the higher credit rating.

Finally, it would make a bond eligible for inclusion in all the covered bond indices, which means some investors will be obliged to buy it.

Soft bullet maturities already document what happens in the event of default and the market has dealt with these comfortably. Northern Rock did it almost a decade ago and people learned to live with it. By the time — years later — that Barclays came to switch its hard bullet programme to a one year extendible soft bullet investors hardly noticed.

Other issuers have followed suit since then, setting something of a precedent for NIBC’s conditional pass through. There is no reasons why NIBC’s idea should not be adopted wholesale.

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