Covered bond harmonisation won’t prevent fragmentation

This is because harmonisation cannot separate the credit performance of either the cover pool assets or the issuer from that of the country of origin. However, the concept of an optional 29^th covered bond framework may be helpful for a limited number of debut issuers.

Last Wednesday, the European Commission (EC) issued a consultation paper outlining plans to harmonise more than 20 national covered bond frameworks in the European Union (EU). The proposals will raise standards in most jurisdictions as they would oblige lawmakers to adopt a number of features that, according to Moody’s, are credit-positive.

Most of the changes were outlined by the European Banking Authority last year. While some progress has been made by a few countries since then, a little help from the Commission could spur the process on. Should the EBA’s guidelines should get better traction with the Commission’s help, covered bonds should become easier to understand and invest in.

But it would be wrong to believe that adoption of the EBA’s best-in-class measures would prevent market fragmentation from reoccurring.

Covered bond spreads will always be affected by national macroeconomic fundamentals, no matter how good the legal framework is, or for that matter, how delinked the structure is from the credit of the issuer.

In a public-sector backed programme the underlying loans are as closely correlated to the sovereign risk as they can be.

As a consequence, during the sovereign crisis, these bonds, which had previously been considered of a higher credit quality than mortgage-backed deals, were demoted to a lower standing.

Mortgage-backed deals should also be affected by the weaker economic growth that is associated with sovereign stress because it usually leads to higher unemployment. With homeowners less able to afford mortgage repayments, delinquency and default rates would be expected to rise.

The performance of commercial mortgage loans that are also eligible for these deals, would also suffer as the ability of companies to earn income and repay the loans would be correlated to the strength of the national economy.

Finally, the credit quality of the issuer itself would be expected to suffer as higher non-performing loans, lower profits and falling capitalisation ratios impinge on the issuing institution’s credit quality, hitting spreads and borrowing costs.

Harmonisation cannot therefore hope to prevent fragmentation from reoccurring, but it should at least make the asset class easier for investors to understand which is useful, especially in times of stress.

The EC has also proposed setting up another regime that issuers could voluntarily use.

Given existing borrowers from well-established markets already have a loyal investor base who understand their product, it is difficult to imagine why they would be tempted to take advantage of such a law.

However, new borrowers from less well established countries, such as those in parts of Central and Eastern Europe, could be interested assuming their national laws are deficient or non-existent.

But, a 29^th regime would presumably need to be policed, by the European Central Bank within the remit of the Single Supervisory Mechanism, as opposed to the national regulator.

From that perspective a 29^th regime may only be useful to a limited proportion of financial institutions in Europe.