The recently published Covered Bond Directive is widely considered positive for the overall product, with Moody’s recently saying it would maintain and enhance the credit strength of European covered bonds.
The Directive sets a minimum level of overcolateralisation, defines the sorts of assets that can secure a deal, and calls for a cash buffer with enough liquidity to cover the next 180 days of payments.
There’s a lot else in there besides to boost overall transparency, and give investors a basic level of certainty about what a covered bond really is, and what can be taken for granted, as well as providing a strong guidepost for the CEE countries developing new covered bond laws.
However, the real work has yet to be done. It’s now up to the respective national supervisors to take up the baton and make improvements to existing covered bond legislation.
Since the Directive gives national supervisors discretion on many topics, there's room for interpretation as it moves to national law — and there will still be variation between national regimes.
Most regimes already comply with the broad principles of the directive — save for Spain where there is scope for greater change. Even there, though, it's not clear the overall credit quality of the product will be improved. Under today's regime, Cédulas investors have a claim on the whole mortgage portfolio of the issuing bank, rather than a smaller segregated portion as specified by the Directive. In other words, the total level of collateral protection will fall.
Moody’s reckons that some features of the Directive could even be credit negative, depending on their implementation. For example, the Directive requires member states to restrict triggers that could lead to maturity extensions on covered bonds, creating a number of uncertainties.
The directive also allows for some 'double-counting' between general bank liquidity reserves and covered bond liquidity reserves, meaning covered bond investors may partially lose access to liquidity if the issuer ceases to make payments on the covered bonds.
But BRRD, by contrast, offers more definite protection for investors. It categorically states that covered bonds, and the swaps that guarantee payments, are excluded from a bank’s resolution. In France, for example, the resolution authority of a bank is mandated to ensure the continuity of payments to covered bond holders at all times.
Because of the protection provided by BRRD to the product, various rating agencies have applied rating upgrades. Fitch applies a two notch rating cushion relative to an issuer’s rating, while Moody’s applies an upgrade of one to two notches.
So, despite some concerns around the regulatory conflict of interest between protecting the interests of covered bond holders and the bank’s resolution of the bank, investors can lean on the BRRD, which does more than the Covered Bond Directive to boost the product.