GlobalCapital: How quickly can OC evaporate in a stressed market?
Burmeister, DeAWM: In theory OC can disappear overnight. An issuer could take out all the excess OC for use in other parts of the bank which could potentially leave the programme with the legally required minimum.
Falling house prices can quickly lead to an erosion of OC, but in this case the loss is likely to have been anticipated. Take, for example, the Irish or the Spanish story, in those cases you wouldn’t have been surprised to see a drop in OC.
But this is not something that should cause too much concern because all things being equal a lower evaluation will mean issuance goes down. Obviously it is a different story if the re-evaluation mortgage collateral drives your OC level below the regulatory requirements.
Gotrane, Caffil: The legal framework is an important consideration. In France, for example, the SCF is a separate legal entity and assets are generally transferred via true sale. Under such a model, it may be more complicated for an issuer to reduce the OC compared to a structure where the cover pool is on the same balance sheet, or where the cover assets are only transferred post default of the sponsor bank.
Secondly, and this seems more important to me, the incentives of the issuer are central. If you are specialised lender and you rely to a large extent on covered bond funding, then you have a strong interest to maintain the OC even in difficult periods to protect your access to the market. On the other hand, if you are a diversified commercial bank, the covered bond programme will just be one of many funding tools. It is much easier in that case to abandon the voluntary OC.
Another question is whether regulators will get more involved in this matter. Recent amendments in Germany, where the regulator may now set minimum OC levels on a bank-by-bank basis, and in France where the minimum OC was increased to 5%, may be first steps in that direction.
Costa CGD: Even high levels of OC may not be enough to ensure full repayment of all bonds issued after a fire-sale of the collateral, especially in the cases where the whole financial system is in severe stress, and not just the bank itself. The use of soft bullet structures grants issuers more time to raise liquidity, without entering in default, and before starting to liquidate cover assets. The adoption of structural features designed to avoid fire-sales such as pass-through covered bonds can mitigate this effect even further and consequently the need for higher levels of OC.
Boehm, Pimco: OC that exceeds the amount required by law can theoretically vanish quickly in a stress scenario. So one should evaluate a covered bond under the assumption that it meets only its legal minimum OC as there are no guarantees to anything that exceeds that.
There are even some examples where issuers have scaled back the amount of OC to the legal minimum because they are less concerned about maintaining the covered bond current ratings and more focused on optimising balance sheet. Or in some instances it is not important to maintain the rating as the covered bond programme is in wind-down mode.