GlobalCapital: How do you model recovery?
Boehm, Pimco: In periods of market stress, everybody wants to sell which makes it difficult to get a fair price for such a portfolio, but I can explain what we do. As a proxy, we use the prepayment and default rates provided by the RMBS market for the specific country in question. If you have that data then you can take a look into the covered pool make some assumptions. If the cover pool has non-mortgage backed assets in the pool, then we need to make assumptions reflecting the risk characteristics of those assets.
Say, for example, that 50% of the pool is exposed to Italy. Then you can ask, how much of that would you expect to default and how much should prepay based on Italian RMBS data. Then you can offset those receivables against the coupon requirement of the covered bond. Based on this information it is possible to calculate how long your cashflow will be sufficient to fulfil the coupon requirement.
It is actually possible in many cases to do some very effective modelling. For example, you could accurately model whether a five or six year bond would be able to pay the coupon over the next three years. You can do this analysis for a range of covered bonds and then you can invest on the basis of which gives you the most coverage for the coupon payment.
This is one additional layer of analysis used at Pimco to help get an idea how long with certainty the cashflow from cover assets is sufficient to pay coupons. Even if the issuer defaults, it doesn’t necessarily mean that the covered bond itself defaults. As long as asset coverage is adequate and mortgages continue to repay, there is a low probability of default. In this scenario, the covered bond is similar to an RMBS security hence the appropriateness of using these securities in modelling recovery rates post issuer default. The probability of covered bond default rises when homeowners cannot pay their mortgages and the issuer is no longer a going concern to be the backstop for coupon payments or redemptions.