When the chips are down, it’s better to have security than none. Better still if your security package is backed by the full force of law, and better again if it has political commitment behind that law — policymakers going out of their way to tell you that nobody is going to mess with your security.
So covered bond investors ought to feel good about the European Bank Resolution and Recovery Directive, a package of rules designed to keep taxpayers from paying for failing banks, and to figure out a way of getting creditors to recapitalise failing banks without actually winding up the bank.
Investors in bank capital and senior unsecured debt have spent a large part of the last four years watching regulators reform the capital structure of banks. Some capital instruments now arguably rank below common equity, while depositor preference has got more and more explicit — subordinating “senior” further and further.
Covered bond investors have been one of the winners from this. Rather than being bailed-in — forcibly written-down to recapitalise failing institutions — covered bonds will be protected, along with employee salaries, fiduciary liabilities, and retail deposits.
However, the wording of the directive still leaves room for covered bond investors to worry. Authorities can bail in liabilities where “collateral has been pledged that exceeds the value of the assets, pledge, lien or collateral against which it is secured”.
This could mean covered bonds losing their over-collateralisation at bank resolution. So instead of being left with collateral to cover, say, 130% of covered bonds, a resolution authority could seize the 30%, leaving bondholders with only coverage for 100% of liabilities. And in a jurisdiction where a big bank is failing, the value of the loans remaining is likely to dwindle, assuming they were even marked correctly in the first place.
Member states are allowed to create a carve-out for covered bonds, which would free resolution authorities to go after other secured creditors, such as repo collateral, while leaving covered bonds untouched.
In the latest, unpublished, version of the rules, member states will be required to create this carve-out, a move that is probably essential for the harmonisation of European rules. Since European authorities are planning to agree on a Single Resolution Mechanism by the end of April, which spreads the costs and risks of bank resolution across Europe, member states will be looking for assurances that bank creditors in other European jurisdictions take losses on the same terms as their own bank creditors.
“It’s definitely a safe haven instrument in a resolution — we never really had doubts that this would eventually be confirmed by the resolution text,” says Ralf Grossman, head of covered bond origination at Société Générale.
Into the details
Although this confirms that the authorities will support the market, there is also the difficult question of which over-collateralisation. Covered bonds have voluntary OC, occasionally contractual OC, and legislative OC. In some jurisdictions, such as Spain, effectively the whole mortgage book of an issuing bank is available to pay covered bondholders, so one interpretation of the cover pool in Spain could be all of a bank’s mortgage assets.
Details on what might be termed reverse bail-in are also sketchy. While unlikely, covered bond investors could end up short of asset cover in a resolution, especially if cover pools featured highly volatile assets such as commercial property lending.
Grossman asks: “What happens if the cover pool is insufficient? It is a very remote scenario, but it’s an issue where investors would appreciate clarification. Would the resolution authority need to replenish?”
The covered bond market also needs to think about the effects of current regulation. If regulators cannot go after covered bond OC, then this could make hard limits on asset encumbrance more likely, potentially restricting covered bond supply.
Arguably, the BRRD already has a provision on encumbrance, in the shape of a requirement to issue a proportion of bail-in-able liabilities.
“We don’t expect limits on asset encumbrance, but the bail-in buffer achieves a similar effect — banks need to have a certain proportion of liabilities that can bear losses, so that restricts the proportion of liabilities that can be secured,” says Klaus Zacchi Rindholt, head of cover pool management at Danske Bank.
He adds: “It seems counter-productive to restrict asset encumbrance, since in a crisis situation, you don’t want a bank to only access the central bank — you want them to be able to encumber their assets to raise secured funding in the market.”
Some covered bond bankers think this debate is irrelevant. One covered bond origination specialist argues that the only rational action for resolution authorities is to buy covered bondholders out at par for cash and set the cover pool adrift from the bank.
But Grossman disagrees: “Buying out the cover pool could be an option, but investors expect to be paid back, with interest, at the expected maturity — neither early nor late. It certainly is not the idea of the BRRD to encourage authorities to buy out cover pools, and it doesn’t change the discussion.”
Other commentators, including the Bank of England, say resolutions are unpredictable and highly political. Depositor preference, or other forms of preference for retail clients at banks, could be suddenly added to resolution packages under political pressure.
So whatever the rules say now, this can only be a rough guide to what happens under resolution. Covered bondholders need to expect the unexpected.
Liquidity tangle
Figuring out whether covered bonds are liquid is just as difficult as figuring out what happens to them when a bank fails. If covered bond investors are definitely off the hook for bank failure, they might see a natural safe-haven bid — so they would remain liquid in times of crisis.
This matters because if covered bonds count as regulatory liquidity, then banks have an extra reason to buy them. And if they count as the top class of regulatory liquidity, this reason is very strong.
Regulatory liquidity here means assets that count towards the liquidity coverage ratio. This tells banks that they need to figure out what kind of drain on funds they would see over 30 days of stressed market conditions, and hold assets to cover this outflow.
Enter the debate about liquidity. Since the scenario planning is for a big bank under stressed conditions, it is untestable, so the EBA and others try to extrapolate from a series of measures — prices, bid-offers, daily volumes, price volatility which assets banks should hold to cover crisis events.
Covered bonds in the original draft rules were Level 2 assets, so they could only make up 40% of regulatory liquidity, and their value took a 15% haircut when counted for liquidity purposes.
But some countries, such as Denmark, which have tiny government bond markets but enormous covered bond markets, complained; their banks would struggle to meet European liquidity requirements just from govvies, and they wanted to count covered bonds as Level 1.
The EBA judged covered bonds to be among the most liquid assets when it published its technical work on them in December, which has prompted further howls from the market.
The Danish banks and their regulator asked the EBA why, if its own study considered them most liquid, did it continue to put covered bonds in Level 2 of regulatory liquidity? One theory is that since the Basel rules define covered bonds as Level 2, the EBA is under international pressure not to give way to special treatment for its supervised banks (Europe’s covered bond market is by far the world’s largest).
“My feeling is that in the end covered bonds will get into Level 1 of the LCR. The push from the Ecofin and the Danes is very strong, and although the EBA is on the other side, their own study shows covered bonds are as liquid as govvies,” says Grossman.
Danske’s Rindholt says: “We fully support the EBA’s own technical study on liquidity, showing covered bonds are as liquid as government bonds, as well as supporting the efforts of the government and the central bank to make sure Danish banks are not disadvantaged.”
Market participants also point out that liquidity in the future (the EBA’s study was backward-looking) would be defined by the regulatory treatment, not the other way around. If banks had to hold large volumes of covered bonds in portfolios unaffected by haircuts that they were supposed to regularly churn, this would make covered bonds de facto liquid.
If covered bonds are explicitly exempted from bail-in, this would also undercut the wrong-way risk that seems built into the product — since the liquidity scenario is about a big bank going through a stressed period, bank obligations of any sort might be expected to be an offer-only market at the same time.
The trouble with cheap money
While a possible exemption from bail-in (and a deadline for bail-in that keeps shifting) the basis between covered bonds and senior should be widening, as the credit quality of senior unsecured declines relative to secured.
But instead, senior has never traded tighter to covered. Technicals, in the form of cheap money across all the central banks, have overwhelmed fundamentals.
Covered bonds have also become caught up in the peripheral collapse and recovery trade. They are a way to express a view on Spain generically. There is tiering between better and worse banks, but national champions tend to trade flat to each other.
Correlation, on the way down and the way up, has joined cheap money in rolling over on credit fundamentals.
Analysts, such Fritz Engelhard’s team at Barclays, see a buying opportunity, pitching relative value plays between senior and covered deals. “The tightening of the swap spread differential between senior and covered bonds provides an opportunity to protect portfolios against adverse scenarios, in which we would expect covered bonds to outperform senior bonds,” they wrote last month (see table).
But even if covered bonds get a firm regulatory boost, such as pan-European commitment to leave them out of a bail-in forever and to add them to the top category of liquidity, this cannot counterbalance the flood of cheap money pushing senior unsecured tighter faster.
Until that tide goes out, covered bonds, like the rest of credit, will trade on that, not on regulation.