The Covered Bond Report Issue 1

www.coveredbondreport.com March 2011

To the lifeboats!

Can covered bonds offer safetyafter bail-in panic?

AustraliaA whole new ball game

SterlingUK gains home advantage

US legislationThe FDIC rears its head

The CoveredBond Report

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EUR 1,000,000,000 EUR 1,250,000,000

EUR 1,250,000,000 EUR 1,250,000,000 EUR 1,500,000,000 EUR 1,000,000,000

Joint Bookrunner Joint Bookrunner

Joint Bookrunner Joint Bookrunner Joint Bookrunner Joint Bookrunner

4.25% French Obligations Foncières

Due 2021

3.5% Dutch Legal Covered Bond

Due 2018

3.9% French Covered Bond

Due 2021


Due 2015

4.125% Cédulas Hipotecarias Due 2014

4% Hypotheken PfandbriefDue 2021

DEXIA MUNICIPAL AGENCY ABN AMRO

CAISSE DE REFINANCEMENT DE L’HABITAT

GCEBANCO BILBAO VIZCAYA

ARGENTARIAERSTE GROUP BANK AG

EUR 1,000,000,000

Joint Bookrunner

2.75% Öffentlicher PfandbriefDue 2016

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Joint Bookrunner Joint Bookrunner Joint Bookrunner

5.250% Covered Bond (Italian OBG)Due 2023


Due 2023


Due 2016

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ary

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UNICREDIT SpA SOCIETE GENERALE SCF CIF EUROMORTGAGE

EUR 2,000,000,000

Joint Bookrunner

3.250% Dutch Covered Bond

Due 2016

ING BANK N.V.Febr

uary

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1

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Joint Bookrunner


Due 2014

CREDIT AGRICOLE COVERED BONDS

Janu

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March 2011 The Covered Bond Report 1

CONTENTS

FROM THE EDITOR

3 Aim high

MONITOR

4 Legislation & regulation8 Market11 People & institutions14 Ratings

BUY-SIDE: ICMA’S CBIC

16 The voice for investors

ANALYSE THIS: COVER POOL DISCLOSURE

19 Living with the data deficitsIs legal or voluntary disclosure yielding the most useful information? Florian Hillenbrand, senior covered bond analyst at UniCredit, weighs the results and recommends how investors cope with a lack of transparency.

36

16

19

Cover StoryBAIL-INS

36 Room for everyone?European Commission bail-in proposals have prompted senior unsecured investors to seek the security of covered bonds, raising fears of an over-reliance on the asset class among the buy and supply sides. But proponents warn that investors have nothing to fear but fear itself. By Neil Day and Maiya Keidan


2 The Covered Bond Report March 2011


22

STERLING MARKET

22 UK gains home advantageLast November the first sizeable sterling UK covered bond in four years kicked off what market participants hope could become a stable source of funding. Can UK financial institutions get better results at home? By Hardeep Dhillon

COUNTRY PROFILE

28 Australia winds up for deliveryAfter years of watching from the stands, Australia’s banks are taking a run up for issuance as early as the third quarter. The banking industry is therefore hard at work ensuring the right balance is struck between issuer and investor needs in impending legislation. But could RMBS and smaller banks be dismissed cheaply? By Neil Day

OBLIGATIONS A L’HABITAT

42 France’s new modelThe latest fashion in Paris this spring is the obligation à l’habitat. Created by bringing France’s common law covered bonds under a legislative framework, the new instrument offers a new take on an old favourite. As such, can it command couture prices? By Neil Day

LEGAL BRIEF

46 US: Today’s reality & tomorrow’s potentialThe US Covered Bond Act of 2011 has reignited the debate over whether legislation is necessary to seed issuance and, if so, how it should relate to the Federal Deposit Insurance Corporation. Lawton Camp and John Hwang of Allen & Overy in New York examine the proposed bill and the arguments being made against it.

FULL DISCLOSURE

52 Postcards from Mainz and Washington

28

42

CONTENTS


FROM THE EDITOR

Welcome to the launch edition of The Covered Bond Report, the first maga-

zine dedicated to the asset class.

We launch at a critical moment in

its history.

After years of skirting the issue, the biggest market of

them all, the US, is poised to make a decision on whether

or not to put in place the foundations necessary for cov-

ered bonds to thrive.

This has thrown the spotlight on some of the funda-

mental arguments surrounding the asset class, and never

before have so many governments, regulators and inves-

tors scrutinised the pros and cons of covered bonds in

such depth.

In Australia, interested parties are seeking to strike

the right balance between issuers’ and investors’ needs

after finally winning around public opinion. In the UK

and elsewhere, investors new to the product are asking

tough questions of issuers. And at a European level, the

industry faces a battle to achieve what it considers cov-

ered bonds’ rightful position to be under Basel III.

An immediate focus of attention is transparency, a

theme that runs through many of the articles in this issue.

Among these is a column from the International Capital

Market Association’s Covered Bond Investor Council, in

which the buy-side’s agenda is laid out.

If proponents of covered bonds are to win over scep-

tics and doubters, to win over investors and regulatory

authorities, they must engage them. Their opponents

surely will.

Few asset classes have come out of the financial crisis

in such good shape as covered bonds, but being the least

worst option is not enough.

Neil Day, Managing Editor

Aim high

The CoveredBond Reportwww.coveredbondreport.com

EditorialManaging Editor Neil Day

+44 20 7263 [email protected]

Reporter Maiya [email protected]

ContributorHardeep Dhillon

Design & ProductionCreative Director: Garrett FallonSenior Designer: Sheldon Pink

PrintingWyndeham Grange Ltd

Advertising [email protected]

Subscriber [email protected]

[email protected]

The Covered Bond Report is a Newtype Media publication

38a Bramshill GardensLondon, UKNW5 1JH

+44 20 7263 2732


To the lifeboats!







MONITOR: LEGISLATION & REGULATION

The introduction into the House of Rep-

resentatives of a new bill on 8 March put

covered bonds firmly on the agenda in

the US, as supporters and critics posi-

tioned themselves for what looks set to

be a tough fight to get legislation final-

ised this year.

Republican Congressman Scott Garrett,

who has led the US covered bond push,

made the opening gambit, introducing the

latest iteration of proposed legislation to the

House Financial Services Subcommittee on

capital markets, insurance and Government

Sponsored Enterprises. The bill is co-spon-

sored by Democrat Carolyn Maloney.

Supporters of legislation have hoped

that the passage of the Dodd-Frank Act

last summer would help clear the way for

due consideration to be given to a covered

bond bill, with Washington’s focus on GSE

reform helping put it on the agenda.

However, at a hearing on 11 March of

the subcommittee, which Garrett chairs,

it quickly became clear that the United

States Covered Bond Act of 2011 (HR

940) could become bogged down in the

objections of the Federal Deposit Insur-

ance Corporation, which have stifled

previous efforts to stimulate a US market.

“We support the covered bond mar-

ket,” FDIC chairman Sheila Bair had

said only a week earlier, before adding

a caveat that was expanded upon in the

regulator’s submission to the subcom-

mittee hearing: “I think it is important to

get it right and we don’t want the FDIC

as the implied government guarantor of

covered bonds.”

In its subsequent submission, the FDIC

said that any legislation “must preserve the

flexibility that current law provides to the

FDIC in resolving failed banks” and that

“any legislation that fails to preserve these

important receivership authorities would

make the FDIC the de facto guarantor of

covered bonds and the de facto insurer of

covered bonds investors”.

Witnesses testifying at the hearing,

aware that the issue of whether tax-

payer support would be necessary for a

market to develop, were quick to rebut

such claims.

“HR940 does not provide an explicit

federal guarantee of covered bonds is-

sued under the provisions of this bill,”

said Bert Ely, a financial institutions

and monetary policy consultant. “Fur-

ther, no provision in HR 940 even sug-

gests an implicit federal guarantee of

covered bonds.”

And Tim Skeet, board member of the

International Capital Market Association,

said that – contrary to claims made by fel-

low witness Stephen Andrews, president

and CEO of the Bank of Alameda, a com-

munity bank European covered bonds did

WASHINGTON

FDIC unmoved by new US covered bond push

“We don’t want the FDIC as the implied government guarantor”

US Bank Covered Bond Capacity

3Q10 2009 2008 2007 2006 2005

Aggregate FDIC Insured Depository Institution Liabilities 11,859 11,642 12,550 11,687 10,614 9,761

Capactiy for Covered Bonds Outstanding (4% of Total Liabilities) 474 466 502 467 425 390

Fannie Mae and Freddie Mac MBS Outstanding 4,390 4,761 4,411 4,119 3,454 3,169

Covered Bond Capacity % GSE MBS Outstanding (%) 11 10 11 11 12 12

Fannie Mae and Freddie Mac Mortgage Purchases 643 1,159 915 1,110 867 906

Source: FDIC, Fannie Mae and Freddie Mac public filings, Fitch Ratings.

Legislation & Regulation

Covered bonds?

Aaa/AAA covered bonds backed by mortgages

Average LTV of 60.5%

Match-funded structure

Core capital ratio of 18.5%

Largest mortgage bond issuer in Europe

nykredit.com/ir

Figures as of 17 March 2011


not require government support.

“There are no implicit guarantees,”

he said. “What there is – and we mustn’t

confuse the two things – there’s explicit

legislation, and there is good supervision

provided by arms of the state. But that is

not the same as any form of guarantees –

nor do the investors factor that in.”

The FDIC also claimed that legislation

is unnecessary to stimulate a market, say-

ing that the Best Practices and a Policy

Statement on covered bonds it released

in 2008 were sufficient, and pointing to

issuance before this from Washington

Mutual and Bank of America.

But Ralph Daloisio, chair of the

American Securitization Forum board of

directors, contradicted this.

“Without the right kind of legislation,

there will be no US covered bond mar-

ket,” he said. “It should be clear by now

that a US covered bond market can only

be seeded by a specific enabling act of

legislation, which has, at its cornerstone,

a dedicated legal framework for the treat-

ment of covered bonds in the event the

issuer becomes insolvent.”

FHLBanks enter the debateDemocrat Senator Charles Schumer gave

the covered bond cause a fillip days later,

when he said on 15 March during a Sen-

ate Banking Committee hearing on hous-

ing finance that he is considering intro-

ducing a covered bond bill in the Senate.

Schumer, who co-sponsored with Re-

publican Senator Bob Corker covered

bond legislation introduced into the Sen-

ate in May 2010 – raised the prospect of

introducing legislation when questioning

Geithner – and Shaun Donovan, secre-

tary of the US Department of Housing &

Urban Development – in a hearing fol-

lowing up on the Obama administration’s

“Reforming America’s Housing Market”

report to Congress.

“Covered bonds work in Europe,

haven’t caught on in the US because we

don’t have a statutory framework that

provides certainty regarding their treat-

ment in the event of insolvency,” said

Schumer. “There has been a bill intro-

duced just recently in the House that I’m

considering introducing in the Senate, by

Representatives Garrett and Maloney on

covered bonds.”

The senator noted that Geithner had

indicated a willingness to work with

Congress on exploring a legislative

framework for covered bonds, and asked

him what he thought of the proposed bill

and the FDIC’s concerns.

“Yes, we would support a legislation

that would help create better conditions

for a covered bond market,” said the Treas-

ury Secretary. “It’s important to recognise

that we do have a covered bond market in

the US today in the form of the Federal

Home Loan Banks financing structure. It’s

essentially the functional equivalent.

“The questions you raise about the

FDIC are very legitimate concerns – we

have to work through those. Again, for

this to work, you’d be putting the taxpay-

er in some sense behind private inves-

tors and that has its own consequences.

But that’s something that we can work

through and I think it can play a better

role, a greater role in our system.”

Geithner’s reference to the Federal

Home Loan Banks system recognised

criticisms made by Bank of Alameda’s

Andrews and the FDIC in their com-

ments to the House subcommittee hear-

ing, with the FHLBanks said to be siding

with the regulator and community banks

to fight the introduction of legislation.

Moody’s said in a report that the avail-

ability of covered bonds as an alternate

funding tool could reduce “the overall

footprint and profitability” of FHLBanks.

In a report quoted by Representative

Maloney in the hearing, Fitch noted that

a 4% limit on covered bond issuance rel-

ative to total assets could limit issuance

volumes.

See Legal Brief on pages 46-51 for an explo-ration of the proposed bill and its criticisms.

“We don’t have a statutory framework

that provides certainty”

PROGRESS?

2008: Rocket scientist Neel Kashkari (left), formerly of spacecraft manufac-turer TRW, leads covered bond push.(His time at TRW took in work on the successor to the Hubble Space Telescope.)

2011: Senator Chuck Schumer (right): “That’s why I want to get involved: it’s not rocket science. I can probably deal with it…” (Although he is campaigning for a retired shuttle to go to the Intrepid Museum in New York.)



The Reserve Bank of New Zealand has set

a limit on the amount of assets allowed

to be encumbered by covered bond issu-

ance at 10%, with a review of the limit to

be held within two years.

The New Zealand central bank con-

firmed its position in March, when com-

menting on feedback to a consultation it

had launched in January, where the plan

for such a cap had been set out.

“An initial limit of 10% will allow

banks to develop covered bond pro-

grammes, whilst providing a conserva-

tive ceiling on issuance in the short

term,” said RBNZ deputy governor Grant

Spencer.

Unlike limits set by several other reg-

ulators, which base their limit on issu-

ance relative to total assets or liabilities,

New Zealand references the amount of

assets encumbered for the benefit of cov-

ered bondholders.

Regulators have typically set limits on

covered bond issuance because it subor-

dinates the claims on a bank’s assets of

senior unsecured bondholders and, most

importantly, depositors. However, as

overcollateralisation levels change over

time, the amount of assets encumbered

in favour of covered bondholders will

change even if the amount of issuance

remains consistent.

The RBNZ said in March that there

was broad agreement among respond-

ents to its approach, at least for the short

term, and rebuffed alternatives.

“The Reserve Bank does not consider

that a limit based on the face value of

the bond would be appropriate as it does

not address the primary prudential con-

cern arising from the issuance of covered

bonds, namely the encumbrance of as-

sets,” it said. “The Reserve Bank recog-

nises that this approach places the onus

on institutions to set issuance levels that

include sufficient headroom to reflect the

level of risk of downgrade that is inherent

in their operations.

“As a result, stronger institutions may

feel more comfortable issuing a higher

volume of covered bonds. The Reserve

Bank considers that this outcome is more

appropriate than weaker institutions en-

cumbering a higher proportion of assets

to support the same level of issuance as

more robust entities.”

The central bank said that the review

would consider the level of the constraint

as well as “the merits of adopting a more

case-by case, or sliding scale, approach to

reflect the specific characteristics of the

institution”.

Issuance on holdBank of New Zealand opened the New

Zealand covered bond market in June

2010, shortly after the Reserve Bank had

released its first guidance to recognise

covered bonds. BNZ sold a a NZ$425m

two tranche domestic issue, and followed

this up with a Eu1bn seven year deal in

November.

“This inaugural euro covered bond is-

sue is a very cost effective form of term

funding for BNZ,” said Tim Main, BNZ

treasurer. “It also increases the bank’s ac-

cess to a significantly broader range of

global investors.”

Westpac NZ had hoped to issue its

first covered bond in euros in February,

a five year deal, but put plans on hold

after the Christchurch earthquake and

amid deteriorating market conditions.

Barclays Capital, BNP Paribas, UBS and

Westpac had the mandate for the subsidi-

ary of Australia’s Westpac.

In December a new company, ANZNB

Covered Bond Trust Ltd, was established,

suggesting that ANZ National Bank will

be entering the market, while ASB Bank,

a subsidiary of Commonwealth Bank of

Australia, has indicated an interest in is-

suing covered bonds.


NEW ZEALAND

RBNZ targets encumbrance

STOP PRESS

UK budget promises pro-investor covered bond reviewThe UK government announced plans for a review of the UK covered bond regime as part of its budget on 23 March.

“The Government and the Financial Services Authority (FSA) will shortly publish a review of the UK’s regulatory framework for covered bonds,” said HM Treasury. “The review will consult on measures to enhance the attractiveness of UK covered bonds to investors, making it easier for banks and building societies to raise fund-ing in order to lend to households and businesses.”

See news.coveredbondreport.com for updates.

“It is important to get standardisation of reporting formats” page 24


Market

MONITOR: MARKET

Geopolitical events totally unexpected at

the turn of the year became the key driv-

ers of market sentiment as the first quar-

ter of 2011 drew to a close.

When Fitch surveyed investors in

December about the biggest challenges

ahead for the covered bond market, rev-

olutions in the Middle East and natural

disasters in Japan were so impossible to

forecast that such events barely regis-

tered on investors’ radars, save possibly

as part of a 4% “other” vote.

Another potential challenge not cap-

tured by Fitch’s detailed answers was sup-

ply, as one head of covered bond origina-

tion commented on The Covered Bond

Report’s website. But in the first week of

the year alone issuers piled into the mar-

ket with 15 new benchmarks (of Eu500m

or more), taking the week’s issuance to a

record of more than Eu18bn.

This resulted in a rather predictable

turn of events, as Commerzbank analysts

noted after the record week.

“The market soon began showing

some first signs of fatigue,” they said.

“The spread targets became increasingly

defensive, most new papers are now trad-

ing above their issuance levels, the books

have recently tended to fill up at a more

sluggish pace, and the first postpone-

ments of projects have taken place.

“In view of these contradictory sig-

nals, it is not easy to assess the funda-

mental strength of the market.”

It proved more resilient than could

have been expected, with more than

Eu43bn of benchmarks being priced by

the end of January and over Eu24bn in

February. Around Eu13bn during a slow-

er first half of March took issuance from

1 January to 18 March above Eu80bn.

Regulatory developments helped

maintain the market’s momentum. While

the inclusion of covered bonds in liquid-

ity buffers envisaged under Basel III were

a theme going into the year, a European

Commission paper proposing that senior

unsecured creditors be “bailed-in” when

banks are bailed out catalysed fears of

this outcome, leading to a flight of some

issuers and investors into the secured as-

set class.

In the second week of March only one

new benchmark was launched, a Eu1bn

three and a half year Pfandbrief for

Berlin-Hannoversche Hypothekenbank,

with markets volatile in the wake of the

earthquake, tsunami and nuclear fears

in Japan and awaiting impending United

Nations-sanctioned action against the

Gaddafi regime in Libya.

This overshadowed improved senti-

ment towards southern European debt in

the government markets that might oth-

erwise have opened the door to further

supply from the region. Spanish covered

bonds had rallied since mid-January

and, alongside Italian covered bonds, de-

linked themselves from Portugal.

An EU summit beginning the day of

the Japanese natural disasters had even

raised hopes that the euro-zone’s leaders

might finally be ready to take decisive ac-

tion to stem the region’s debt crisis. As The

Covered Bond Report was being printed,

the outcome of a follow-up meeting on

24-25 March was being awaited.

EUROS

A first quarter of shock and awe

0

50

100

150

200

250

300

350

04/0

1/20

10

18/0

1/20

10

01/0

2/20

10

15/0

2/20

10

01/0

3/20

10

15/0

3/20

10

29/0

3/20

10

12/0

4/20

10

26/0

4/20

10

10/0

5/20

10

24/0

5/20

10

07/0

6/20

10

21/0

6/20

10

05/0

7/20

10

19/0

7/20

10

02/0

8/20

10

16/0

8/20

10

30/0

8/20

10

13/0

9/20

10

27/0

9/20

10

11/1

0/20

10

25/1

0/20

10

08/1

1/20

10

22/1

1/20

10

06/1

2/20

10

20/1

2/20

10

03/0

1/20

11

17/0

1/20

11

31/0

1/20

11

14/0

2/20

11

28/0

2/20

11

14/0

3/20

11

Basi

s po

ints

Date

iBoxx spreads against asset swaps

Canada France Germany Other Spain UK


MONITOR: MARKET

FRANCE

CFF fl ies European fl agCompagnie de Financement Foncier launched the only dollar benchmark for a European issuer in the year to mid-March, with a $1.5bn three year deal that took its dollar benchmark issuance to $6.3bn (Eu4.56bn) since the beginning of 2010.

“Last year we issued $4.8bn in dollar benchmarks and with this transaction we now represent 20% of the existing covered bonds outstanding in the US, so we are defi nitely one of the key players on this market,” said Paul Dudouit, head of medium and long term funding at CFF. “We are now marketing to tier two accounts and we see more and more interest from these, which is very important in terms of diversifi cation, not hav-ing only the big players in-volved.”

However, as The Cov-ered Bond Report was go-ing to press, several issuers, mainly Nordic, were said to be preparing to access the US investor base.

DOLLARS

US goes loonie for Canadians

Marfi n Popular Bank is preparing to launch a debut covered

bond off a Eu2bn programme, which would be the fi rst public

issue from Cyprus aft er the country’s framework was fi nalised

in December.

Th e Marfi n group has previously issued Greek law covered

bonds backed by residential mortgages through Greek subsidi-

ary, Marfi n Egnatia Bank.

“We have experience utilising the Greek assets using the

Greek law and it’s a very good opportunity for us now to use the

Cypriot law,” Dimitrios Spathakis, Marfi n Egnatia bank deputy

head of wholesale funding, told Th e Covered Bond Report.

“Our view is that the law is very strong and it will facilitate

us in going to the market”, he added. “Th ere is a more positive

outlook towards Cypriot as compared with Greek banks.”

Th e bank plans to have two separate programmes, one com-

prising Cypriot assets and the other mainly Greek assets. It

plans to enter the market with residential mortgages and grad-

ually move to commercial assets and eventually to a shipping

portfolio, which Spathakis acknowledges is “the most challeng-

ing one of all”.

Th e Central Bank of Cyprus, the Ministry of Finance and

the Association for Cyprus Banks and all its members worked

together on the project.

“Now the legal and regulatory framework is in place, it is

up to each individual bank to go ahead with its issuing,” said

Christina Antoniou Pierides, senior offi cer at the Association

of Cyprus Banks.

Moody’s has estimated the potential of the Cypriot covered

bond market as Eu4bn.

Marfi n Popular was downgraded from Baa2 to Baa3, on negative

outlook, by the rating agency at the beginning of March. Its Greek

covered bond programme is rated A3, on review for downgrade.

National Bank of Canada sold its fi rst

covered bond in January and Caisse Cen-

trale Desjardins was roadshowing a new

programme for US investors in March,

as Canadian banks picked up where they

left the US dollar market last year.

Dollar issuance, at just four bench-

marks totalling $6bn to mid-March,

was subdued compared with last year’s

surge, especially when compared with

the record volumes witnessed in the euro

market, but Canadian issuers sold three-

quarters of the new dollar supply.

National Bank of Canada’s $1bn three

year 144A issue was sold in late January

aft er Bank of Montreal had returned for

$1.5bn and Canadian Imperial Bank of

Commerce had returned for $2bn.

“People just love Canadian risk,” said a

banker on Bank of Montreal’s deal, “and all

the US investors are happy to add more.”

NBC’s US$5bn (Eu3.75bn/C$4.94bn)

global covered bond programme are

backed by a Canada Mortgage & Hous-

ing Corp (CMHC) insured pool of resi-

dential mortgages, like all of its peers’ bar

Royal Bank of Canada.

Caisse Centrale Desjardins, part of

Quebec’s Desjardins Group of credit

unions, was marketing its new pro-

gramme, also backed by a CMHC pool,

in March with Royal Bank of Scotland.

The Desjardins Group forms Canada’s

largest credit union and would be the

first such institution to enter the cov-

ered bond mark from Canada.

Paul Dudouit, CFF

National Bank of Canada

CYPRUS

Marfi n carries Cypriot hopes

“No evidence to suggest that a legally stipulated publication obligation necessarily leads to a better result” page 19


MONITOR: MARKET

Denmark’s mortgage banks achieved bet-

ter than expected yields in auctions in the

first two weeks of March, despite com-

ments from European Central Bank presi-

dent Jean-Claude Trichet having initially

threatened to push rates higher.

The auctions faced high volatility be-

cause of comments from Trichet suggest-

ing a possible move to tighter monetary

policy at the start of the month and the

Japanese natural disasters.

“The outright yield level increased just

at the start of the auction and then we have

seen this risk aversion scenario after the

events of Japan,” said an analyst at Danske

Bank. “It pushed down the outright yield

levels at the end of the auctions.”

Nykredit Realkredit was the most ac-

tive, selling Dkr80bn in local currency and

Eu1.6bn in euros over an 11 day period.

“The positive thing was that over the

11 days of the auction the average yield

tightened 10bp to swap and that’s defi-

nitely more than usual,” said Nykredit

first vice president Lars Mossing Madsen.

“Another thing of interest was that we saw

the bid-to-cover being much higher than

normal during the auction.”

The average bid-to-cover was 4 times,

compared with 2.6 in December and 3.4

in October.

Realkredit Danmark, a subsidiary

of Danske Bank, had planned to issue

Dkr26.6bn and Eu408m; it came close

to those targets with Dkr26.4bn and

Eu410m. The bank edged up to a bid-to-

cover of 3.2 this month, compared with a

rate of 2 in December.

The Danske analyst said spreads gener-

ally tightened at the auction, in euros and

Danish kroner.

“At the beginning of the auction they

were priced around 40bp-45bp to Eonia,

the one years, and they ended up being

priced around 37bp,” he said.

Nordea Kredit had anticipated a spread

of 57bp over Eonia, according to Jacob

Skinhøj, chief analyst at Nordea Kredit,

but was “very happy” with spread tighten-

ing during the auctions.

The bank issued Eu115m and

Dkr8.205bn over two days, with an aver-

age bid-to-cover of 3 or 4, roughly on par

with previous auctions.

“I think in a world such as that we have

today, with the uncertainty about Japan,

investors go for safe havens and these cov-

ered bonds are a safe haven and will re-

main a safe haven in a situation like this,”

said Skinhøj.

INDEX

CSI: EuropeA new Covered Bond Market Sentiment index (CSI) unveiled by Crédit Agricole in February aims to provide market participants with a quantitative tool to measure confidence across the asset class.

It measures investor and issuer confidence in funding conditions and investment conditions, respectively, resulting in a score on a scale from 0 to 10, with 0 being the worst and 10 the best. Like Germany’s established Ifo Business Climate Index, the CSI includes current situation and expectation components.

“The ultimate goal is to get this established among issuers and investors and get as much feedback so I can actually break it down country by county,” says Crédit Agricole senior covered bond analyst Florian Eichert. “Then the main use would be for the issuer community, for example, to say: ‘OK, it doesn’t make a lot of sense to go marketing in this region.’”

More than 106 investors and 19 issuers from a variety of countries participated in the January survey, released in February, which arrived at an opening level of 5.2. The latest month’s scored edged up to 5.5, but had fewer respondents, with 86 investors and 28 issuers.

Investors and issuers received CSI surveys in the last week of each month and results were produced at the beginning of the following month. Eichert expects the av-erage number of participants to stabilise within the next couple months and attributes the drop in responses to European holidays in some countries when it was conducted.

“I’m surely hoping to get that number up,” he says. “One hundred and six was quite nice, but I’d certainly like to get that number even higher.

Eichert said his survey was greeted with an enthusiastic response, with many investors and issuers showing interest.

“This is kind of what I’ve been doing all along – just trying to talk to issuers and in-vestors and trying to relay the information back and forth,” said Eichert. “I’ve just never done it in as systematic a way as the index before.”

AUCTIONS

Crises lower Danish yields

F1 SDO DKK

3/3 4/3 7/3 8/3 9/3 11/3 14/3 15/3 16/3 17/3

2,30

2,20

2,10

2,00

1,90

1,80

DAILY YIELD (GREY) AND CUMULATIVE AVERAGE YIELD (BLUE) OVER NYKREDIT AUCTIONS


GERMANY

New analyst pairing for DZDZ Bank is hiring Joerg Homey from Moody’s as part of a new pairing for its covered bond research, after Sebastian Sachs left the bank to head up research at Berenberg Bank.

Homey was a vice president and senior analyst at Moody’s. He is set to join DZ in April to work alongside Michael Spies, who joined DZ in November and has been working as a covered bond analyst since January.

Sachs, who worked at DZ from Feb-ruary 2006, left for Berenberg Bank in early March, where he will be establish-ing credit and rates research. Berenberg Bank, which claims to be Germany’s oldest private bank, is headquartered in Hamburg, but Sachs will be based in the bank’s Düsseldorf offi ce when he joins in April.

André Hovora, who previously worked alongside Sachs as a covered bond analyst, recently moved to work in the bank’s credit department.

MONITOR: PEOPLE & INSTITUTIONS

Scott Stengel has joined King & Spald-

ing as a partner from Orrick, Herrington

& Sutcliff e, while a former colleague,

Howard Goldwasser, also recently moved

to a new fi rm.

Stengel is a member of the steer-

ing committee of the US Covered Bond

Council, which operates under the aus-

pices of the Securities Industry & Fi-

nancial Markets Association (Sifma). He

testifi ed in the House Financial Services

Subcommittee hearing on the US Cov-

ered Bond Act of 2011 on 11 March.

“Th is was a compelling opportunity

to join a fi rst class global law fi rm, where

I can draw on an extraordinarily deep

bench of capital markets and regulatory

lawyers to grow the covered bond and the

general banking practices,” Stengel told

Th e Covered Bond Report.

“King & Spalding is widely recog-

nized as a global leader in both finance

and real estate, and our expertise there

will be critical to clients as we move for-

ward on covered bonds as well as GSE

reform in the US.”

Stengel worked at Orrick from 1997

until February.

Goldwasser, who worked with Sten-

gel for many years at Orrick before join-

ing Allen & Overy in 2006, joined K&L

Gates last month. He arrived at K&L

Gates from Curtis, Mallet-Prevost, Colt

& Mosle, which he had joined after leav-

ing A&O in September 2009.

“To me, one of the big draws at K&L

Gates is that the firm has one of the mar-

ket-leading housing finance practices in

the US and can offer a level of expertise

in that space that will position us well

when the covered bond market starts up

in the US,” said Goldwasser. “And it also

has a very international footprint.”

Goldwasser has been a member of

the US Covered Bond Council and

the American Securitization Forum’s

covered bond sub-forum. At A&O, he

worked on the first US covered bond

programmes and some of the early Ca-

nadian programmes.

HIRES

Syndicate movesLorenz Altenburg returned to covered

bond syndicate in late February, joining

Nomura from Crédit Agricole.

Altenburg worked in covered bond

syndication for Société Générale in Paris

until late 2009, before moving to sover-

eign, supranational and agency trading.

He left SG to join Crédit Agricole in Lon-

don in a similar role in December.

Meanwhile, Martin Rohland will

be joining Barclays Capital’s syndi-

cate desk in April. He will be joining

from Landesbank Baden-Württemberg,

where he was a director on the bank’s

fixed income syndicate.

LEGAL

Orrick alumni on the move

Scott Stengel: Capitol witness

Sebastian Sachs: head for Berenberg

“This was a compelling opportunity

to join a fi rst class global law fi rm”

People & Institutions


MONITOR: PEOPLE & INSTITUTIONS/RATINGS

SPAIN

Multi-cédulas withstand cutFitch cut 51 classes of multi-cédulas issues on 10 March, driven by collateralisa-tion rates, but the impact of the news on the asset class was muted, even along-side a downgrade of the Kingdom of Spain from Aa1 to Aa2 on the same day by Moody’s.

“As far as I can see, things are holding up in the secondary market and they haven’t really been hit too hard,” said one syndicate offi cial. “A couple of basis points widening here and there, but nothing tragic.”

An analyst added: “Spreads will be more driven by headlines on savings banks and details of mergers and not by ratings – at least not as long as they are in double-A territory.”

Fitch cut 50 classes from AAAsf to AAsf and one from AAAsf to AA+sf, with the downgrades relating to 46 transactions. The actions concluded a review of the sector by Fitch.

“CR (collateralisation rate) is the major driver of the downgrades,” said the rat-ing agency. “The agency’s MICH (multi-issuer cédulas hipotecarias) rating meth-odology is based on the ‘fi rst dollar loss principle’ implying that if the weakest link in the CDO failed in a particular stress scenario, regardless of its participation in the overall transaction it would imply a default of the transaction as a whole under such rating stress. MICH transactions have traditionally comprised CH issued by multiple Spanish fi nancial entities.

“Fitch’s CR analysis includes updated cover pool market value risk assump-tions. Market value risk stems from the assumption that in the event of a CH default, the insolvency administrator may be forced to sell cover pool assets at a distressed price in order to meet payments on CHs. This is addressed by applying a refi nancing spread that accounts for the cost of funding of a potential buyer plus a profi t margin. Fitch has updated the components of the liquidity risk market value discount considering current market conditions and future expectations.”

Tim Skeet is understood to be joining

Royal Bank of Scotland, where he will

work in debt capital markets.

Skeet left Bank of America Merrill

Lynch, where he was head of covered bond

origination, in October aft er four years at

the US bank. He has recently been work-

ing as a consultant for Amias Berman.

Skeet is a board member of the Inter-

national Capital Market Association. He

testifi ed on behalf of the association at a

House Financial Services Subcommittee

hearing into US covered bond legislation

in March.

Prior to joining BAML he worked at

ABN Amro before its European invest-

ment banking operations were acquired

by RBS.

NETHERLANDS

ABN builds with HesselsABN Amro has hired Joop Hessels from

ING as it builds out in debt capital markets.

Hessels joined as a director in ABN

Amro’s FIG origination team in March.

Previously he worked at ING as a vice

president in DCM origination, where he

was responsible for coverage of Dutch

and Nordic fi nancial institutions.

At ABN Amro, Hessels reports to

Maurizio Atzori, head of debt capital

markets origination.

ANALYST

Credit Suisse gets WinklerCredit Suisse is understood to have

hired Sabine Winkler as a covered bond

analyst. Winkler resigned from Bank of

America Merrill Lynch in March.

She joined Merrill Lynch in March

2007. Beforehand she worked as a cov-

ered bond analyst at ABN Amro.

Bank of America Merrill Lynch is un-

derstood to be seeking a replacement for

Winkler.

UK

Skeet on way to RBS

Don’t forget to visit our website at www.coveredbondreport.com

Tim Skeet


Did you know that The Covered Bond Report has its own database of benchmarks?

Did you know that we link directly from bond data to relevant coverage?

Did you know that we include price guidance, book sizes and distribution statistics?

Did you know that you can run league tables by country and currency?

To register for trial access to The Covered Bond Report, visit news.coveredbondreport.com or contact Neil Day, Managing Editor, at [email protected]. And don’t forget: if you are an investor in covered bonds you can qualify for free access to the website.

The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.


A request for comment from Standard

& Poor’s is being awaited aft er the rat-

ing agency in January made a last minute

decision in the face of criticism to delay

the application of new counterparty risk

criteria to covered bonds.

Until then the proposed changes had,

not for the first time in S&P’s experi-

ence, cast a shadow over the rating out-

look for the asset class, with those fall-

ing foul of the new criteria due to have

been placed on CreditWatch negative

the following week.

“Had the initial criteria been applied

to the covered bond market,” says an

analyst, “we could have seen a sizeable

chunk of the market being downgraded.

Even covered bonds by well rated issuers

would not have escaped unscathed.”

Market participants had been critical

of the application of the criteria to cov-

ered bonds alongside structured fi nance

transactions, but were not wholly unsym-

pathetic to S&P’s covered bond team.

“It seems S&P has a lot of discussions

internally,” said one analyst, “covered

bonds versus structured fi nance.”

When Fitch released new covered bond

counterparty criteria in mid-March mar-

ket participants contrasted the actions of

the two rating agencies. Th e introduction

of Fitch’s criteria followed an exposure

draft released in October 2010 and a cov-

ered bond banker who had met with Fitch

ahead of its fi nal criteria, and also with S&P

regarding their counterparty criteria, said

that he felt Fitch had handled the changes

to their criteria more carefully.

“Fitch said that there would be some

changes given the feedback that had been

made,” he said. “Th ey were more taking

on board the feedback in terms of what

we wanted to change, making some im-

provements, and they seemed quite open

to the ideas we presented to them.

“We also got the feeling that the whole

approach was more thought-through and

convincing than S&P, where the changes

seem to have been driven by people not

close to covered bonds.”

Fitch described in its release changes

it had made to its proposals in light of in-

dustry feedback.

“Market participants generally ex-

pressed their support for a separate cov-

ered bond-specifi c counterparty criteria

report that takes into account the dual-

recourse and dynamic nature of covered

bond programmes,” it said. “Having

reviewed the feedback, the agency has

made various changes and clarifi cations

to the fi nal counterparty criteria com-

pared to the exposure draft .”

When S&P in January announced

that it was delaying its implementation

to covered bonds of counterparty criteria

for structured fi nance transactions, and

would be reviewing the relevant criteria,

it said that the new review would take

into account “the dual recourse nature of

covered bonds” as well as “the multiple

number of counterparties that may pro-

vide support to the covered bonds”.

A market participant said that he ex-

pected revised proposals from S&P to

emerge by next month.

Th e impact of Fitch’s counterparty

criteria changes is also expected to be

smaller than was feared from S&P’s.

“Th e agency expects that application

of the criteria to existing rated covered

bond programmes will have an immedi-

ate eff ect on a limited number of covered

bond ratings,” it said. “Most programmes,

particularly those with internal counter-

parties, will only be aff ected if the issuer’s

rating deteriorates by several notches.

Th is is based on the expectation that is-

suers, notably of programmes with ex-

tended maturity for principal payments,

will be able and willing to improve the

liquidity protection against potential

missed interest payments shortly aft er an

issuer or account bank default.”

Th e rating agency said that a potential

mitigant issuers may choose to increase

is overcollateralisation.

“If this risk remained insuffi ciently

mitigated, according to the new criteria,

the aff ected programmes’ ratings would

be tied more closely to the applicable Is-

suer Default Rating (IDR) through a

largely increased Discontinuity Factor

(D-Factor),” added Fitch. “Th is may auto-

matically result in downgrading covered

bonds’ ratings from their current level.”

MONITOR: RATINGS

CRITERIA

Fitch counterparties on after S&P delay

“The whole approach was more thought-through and convincing”

Ratings

S&P loomed large


DOWNGRADE

Portuguese on watch

MONITOR: RATINGS

Investors are more willing than previously

to consider buying non-triple-A covered

bonds, according to a survey released by

Fitch last month, which also highlighted

a surprising flexibility among the buy-side

towards innovative structures.

Some 88% of investors surveyed by

the rating agency in December said that

they were prepared to examine non-tri-

ple-A covered bonds, with 14.6% view-

ing a triple-A rating as irrelevant, while

73.2% found it important but were open

to non-triple-A issues.

Hélène Heberlein, managing director,

covered bonds, at Fitch told The Covered

Bond Report she was surprised to find

that “some investors are disregarding the

covered bond rating and looking at the

bank rating first”.

However, a triple-A rating was still

viewed as “very important” by 84.2% of

respondents.

The idea of pass-through covered

bonds was also gaining acceptance, the

survey found. The majority of respond-

ents (52.5%) said they would consider

purchasing either partial or full pass-

through covered bonds. Only 38.8% re-

fused to even consider non-bullet pay-

back structures.

Head of covered bond strategy at Deut-

sche Bank, Bernd Volk, was surprised by

the willingness of investors to accept pass-

through covered bonds when “all existing

pass-through covered bonds are on balance

sheets of central banks for repo reasons”.

“A pass-through structure would re-

duce overcollateralisation requirements,”

he said, “and hence allow higher covered

bond issuance, i.e. the need for expensive

unsecured funding would be reduced.”

Heberlein cautioned that the diversity

of investors polled must be taken into

consideration when noting this result.

“If you had conducted this survey

primarily among insurance companies

and pension funds, they would probably

have said they only want hard bullets,”

she said.

The survey found that 43% of inves-

tors were uncomfortable with the inclu-

sion of residential mortgage backed as-

sets in cover pools, while the remainder

either viewed it as acceptable (19%), rea-

sonable as long as they were compensat-

ed with higher spreads (20%), or stated

no opinion (18%).

Eighty-two investors, all but one based

in Europe, participated in Fitch’s survey.

The majority of respondents, 58%, had

less than Eu5bn of covered bonds under

management, while 34% had between

Eu5bn and Eu50bn, and the remaining

8% upwards of Eu50bn.

FITCH

No triple-A? No problem

“A pass-through structure would reduce overcollateralisation requirements”

The fate of Portuguese covered bonds has been under scrutiny after Moody’s on 15 March cut the sovereign from A1 to A3, putting ratings pressure on the country’s banks.

Moody’s warned in December that if the senior unsecured long term ratings of Caixa Geral de Depósitos or Banco Espiríto Santo were downgraded by more than one notch then the mortgage covered bonds of each bank would be downgraded by one notch.

However, the knock-on effects of the sovereign action on covered bond rat-ings could be limited, suggests Frank Will, head of covered bond and fre-quent borrower strategy at RBS.

“We expect that the Aa2 covered bond rating of BES will be confirmed as we expect only a one notch issuer downgrade (unless the standalone rat-ing of BES is downgraded as well).

“With regard to mortgage cov-ered bonds issued by Caixa Geral de Depósitos,” he added, “we expect a one notch downgrade of the Aa1 cov-

ered bond rating as we view a two notch issuer downgrade as likely (unless the standalone rating of CGD is downgrad-ed by a few notches as well).”

Fitch had the previous week affirmed the triple-A rating of Caixa Geral de Depósitos’ mortgage covered bonds (obrigacoes hipotecarias) and removed them from Rating Watch negative.



TransparencyInvestors have been asked many times by

issuers, in different contexts, what their

information needs are. So far there has

been no unified answer to this question,

but following the growth of the covered

bond market there has been an increased

fragmentation in the type of information

provided by issuers.

The CBIC has set up a transparency

working group that has tried to indentify

the key information that investors in cov-

ered bonds need in order to make a fully

informed investment decision as to covered

bond issues, including their respective cov-

er pools and the issuer itself. It is expected

that the information required would be

available on a regular basis (for example, a

half yearly update) to meet investors’ trans-

parency and information needs.

The CBIC believes it is of vital impor-

tance to improve transparency in order

to increase the investor base. The objec-

tive is to make it possible for investors

and analysts to compare and form an

independent qualified assessment of all

covered bond programmes.

The internationalisation of formerly

domestic covered bond markets began 10

years ago and many European countries

introduced new covered bond legislation

or updated existing rules to be a part of

this development, and to also respond

to the considerable growth of mortgage

lending activities in the European Union.

Each different country’s covered bond

laws regulate what assets are eligible to

back covered bonds, minimum quality

requirements for assets, and how inves-

tors will be protected if the issuing bank

The International Capital Mar-ket Association is one of the few trade associations with a European focus having both buy-side and sell-side representation. One of the Association’s industry groupings, created nearly two years ago — the Covered Bond Investor Council (CBIC) — serves to consider issues related to the evolution of the prod-uct in Europe and the type of infor-mation available to investors.

The Council is an investor driv-en organisation, independent of issuers and the sell-side. It aims to promote the quality of the cov-ered bond product and represent the interests of European covered bond investors. The CBIC promotes greater harmonisation in the mar-ket, the transparency and simplicity of the product, and the quality of the underlying assets.

Nathalie Aubry-Stacey, direc-tor of regulatory policy and market practice at ICMA and secretary of the CBIC, sets out the Council’s agenda.

The voicefor investors

“It is of vital importance to improve transparency in order

to increase the investor base”



goes bankrupt. The legislation therefore

stipulates how the collateral framework

must operate.

It is also clear that the quality of the

information available to investors re-

mains uneven. Key information such as

loan to value (LTV) and non-perform-

ing loans (NPLs), for instance, need to

be fully explained when presented to in-

vestors, allowing them to assess how the

calculations are being made.

The CBIC is also addressing the issue

of creating a level-playing field in terms

of access to this information, looking at

a common platform that would provide

information to investors.

Simplicity and qualityFollowing governmental discussions re-

garding the inclusion of loans to small

and medium sized enterprises (SMEs)

in covered bonds’ cover pools, the CBIC

discussed the definition of a covered

bond and what should be included in the

cover pool.

The CBIC promotes the view that cov-

ered bond pools should be “clean” and

should consist only of specific types of

loan. The CBIC believes that SME loans

do not belong in the covered bond cover

pools. High quality cover pools of cov-

ered bonds should only include tangible

assets with a long historical track record

and/or public loans.

This is considered one of the essen-

tial cornerstones for the future develop-

ment of a sound European covered bond

market. Covered bonds are best used for

strong prime mortgages and some pub-

lic loans.

Likewise, it is important for the CBIC

that covered bonds are not confused with

ABS. The two asset classes attract different

types of investors and by lowering the qual-

ity of the cover pool and therefore blurring

the distinction between the two asset class-

es there is a risk that banks’ accessibility to

term funding may be weakened. The CBIC

will be interacting with the relevant policy-

makers on this specific issue.

There is another question raised by

the directive amending capital require-

ments for trading books and for re-secu-

ritisations and the supervisory review of

remuneration policies (CRD III) propos-

al, as to whether ABS should be allowed

in covered bonds’ cover pools at all. The

proposal highlights that the exception

made for the use of intra-group ABS in

the cover pool could end up being per-

manent as from 2013. The CBIC will also

be considering this issue.

The European covered bond market

as a financing tool for mortgages has

survived the crisis without massive pub-

lic intervention and the CBIC believes

that only a continued focus on uphold-

ing quality will safeguard the market

against any future crisis. Any dilution of

the quality of the product or confusion

with other fixed income products should

be avoided.

EngageThe CBIC has been recognised by regula-

tors as the voice for investors.

However, the CBIC would like to take

the Council further in actively engag-

ing investors with an interest in covered

bonds in its work, and be more active in

the regulatory space.

This market will continue to develop

and it is essential that investors, as a

group, participate in discussion on the

future development of this market which

is so essential for mortgage and public fi-

nancing in Europe.

“The CBIC would like to take the Council further in actively

engaging investors”

CBIC chairman Claus Tofte Nielsen (second from left) engages with (left to right) Michel Stubbe, head of monetary operations analysis division at the ECB,

Deutsche Bank head of covered bond strategy Bernd Volk, HSBC global head of covered bonds Andrew Porter, and Santander’s Antonio Torío, European

Covered Bond Council chairman.

The CoveredBond ReportThe Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.

Are you a covered bond investor?Then you could be receiving free daily news bulletins from The Covered Bond Report and access to its coverage of the market as well as its proprietary database of new issues and cover pool data links.

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*Investors directly linked to covered bond issuers may not qualify for this offer.

When Fitch recently pub-

lished its covered bond

investor survey, it was

hardly surprising to

fi nd that “underlying collateral per-

formance” was ranked second among

the key covered bond spread drivers for

2011 – beaten only by “sovereign risk”.

Th e surprising fact was that “indi-

vidual issuer quality” was completely

missing.

However, since mortgage books usu-

ally constitute a considerable share of

the issuers’ balance sheets, it is quite

reasonable to assume a high correlation

between issuer credit quality and cover

pool performance.

Another aspect also weighs heavily

on the importance of “underlying col-

lateral performance”: numerous classi-

cal ABS/MBS investors have in recent

months – albeit involuntarily – shift ed

away from their original investment

home base and explored the covered

bond universe. Traditionally, invest-

ing in ABS/MBS has meant keeping a

close eye on the cashfl ow situation of

the ABS/MBS collateral. Th e outcome of

these cashfl ow models formed the basis

of conclusions on the future valuation of

the various tranches of a specifi c trans-

action.

But cashfl ow reporting for ABS/MBS

is way beyond what is currently deemed

state-of-the-art in cover pool disclosure

practice among covered bond issuers;

and given the rather complex situation

of covered bonds as quasi-master-trust

structures, it is unlikely to become stand-

ard practice on a broad basis anytime

soon.

Here we provide an overview of

what constitutes state-of-the-art in

various countries with regards

to homogeneity and detailed-

ness of reporting. We discuss

the deficits, and provide

an overview of the range

of opportunities given

the lack of loan-by-

loan data, and how

these deficits can

be overcome by

way of secondary

sources.

Pfandbrief fi rstFor quite some time, the only covered

bond law setting explicit standards for

disclosure of cover pool metrics was

the Pfandbrief Act. Th e relatively young

Greek covered bond law, too, regulates

certain disclosure to the investing pub-

lic. Legislation in some other countries,

such as Spain, tackles disclosure in a dif-

ferent context: not vis-à-vis investors but

regulators, a topic that we do not address

in this context. In fact, aft er the introduc-

tion of §28 Pfandbrief Act, the cover pool

disclosure of German issuers was setting

standards.

However, it was, admittedly, in 2005

that the transparency regulations be-

came legally binding in a format com-


Living with the data defi citsIs legal or voluntary disclosure yielding the most useful information? Florian Hillenbrand, senior covered bond analyst at UniCredit, weighs the results and recommends how investors cope with a lack of transparency.




parable to today and at that time other

markets (except for Germany, France and

Spain) were still in a ramp-up phase: the

UK and Ireland were emerging, Austria

and Luxembourg were absolute niche

markets, while Nordic issuers as well as

Portuguese and Italian banks were still a

long way from issuing.

Since the introduction of the disclo-

sure policy for Pfandbrief issuers in 2005,

German practice has barely changed or

improved. In April 2006 the Associa-

tion of German Pfandbrief Banks (vdp)

started an initiative to further develop

practical issues, such as timeliness of

publication, positioning on the issuers’

webpages, and increasing homogeneity

of publication. Nevertheless, improve-

ments in the form and function of the

disclosures did not materialize until

2010. Most issuers currently present their

historical as well as current cover pool

metrics in harmonized Excel and PDF

format. Furthermore, the vdp provided

an internet platform where investors can

easily access cover pool metrics. Strong

pressure from outside the Pfandbrief

market certainly accelerated the process

of improving quality of disclosure.

In the meantime, Pfandbrief disclo-

sure is quite streamlined and the degree

of detail is also quite solid. According

to the Pfandbrief Act, a Pfandbrief bank

shall publish on a quarterly basis the total

volume of mortgage Pfandbriefe, public

Pfandbriefe, ship Pfandbriefe and aircraft

Pfandbriefe outstanding, as well as the

corresponding cover pools in the amount

of the nominal value, the net present

value and the risk-adjusted net present

value. In addition, issuers have to pub-

lish the maturity structure of each type

of Pfandbrief outstanding, as well as the

fi xed interest periods of the correspond-

ing cover pools in pre-specifi ed bands.

Furthermore, information has to be pro-

vided regarding the share of derivatives

in the pool and the amounts held in the

form of further or substitute collateral.

Mortgage Pfandbrief issuers have

to provide the distribution with the

amounts assigned as cover in their nomi-

nal values according to their amount in

specifi ed tranches, as well as according to

the states in which the real estate collat-

eral is located, and according to the pur-

pose of fi nanced properties. In-arrears

fi gures and foreclosures, etc, must also

be supplied. Issuers of public Pfandbriefe

have to provide information regarding

the individual states in which the bor-

rowers and, in the case of a full guaran-

tee, the guaranteeing bodies are based.

UK raises the stakesAlthough the degree of detail is quite

solid – as previously mentioned – there

is still room for improvement. We have

already mentioned the pressure on Ger-

man issuers from abroad. UK covered

bond issuers were the driving force with

regards to cover pool disclosure, fol-

lowed by US, Canadian and French issu-

ers of non-obligations foncières.

Without any legally binding disclosure

obligation, each group of issuers managed

to establish an outstandingly homogene-

ous, highly detailed reporting format.

Next to the conviction that in the long

term openness pays off in terms of inves-

tors’ trust, the high quality of the reporting

was facilitated by two technical factors.

Firstly, the vast majority of issuers in

the aforementioned countries are experi-

enced ABS/MBS issuers and are therefore

usually eager to meet ABS/MBS report-

ing standards. Secondly, all issuers in

the respective countries or markets have

recently set up covered bond IT systems

and are therefore also technically capable

of producing highly sophisticated data.

Not only do we consider original LTV

ratios as an example of sophisticated

data, but also current ones and even in-

dexed current LTV ratios. Also, the depth

of information on the debtor provided by

some issuers, such as debt-to-income ra-

tios or employment status, is something

that far exceeds what can be considered

standard in Germany.

Th e voluntary disclosure formats we

see also show some higher standards with

regards to frequency of publication. While

quarterly publications can certainly a be

deemed suffi cient as long as the time lag is

not too large, the majority of issuers out-

side the German market are able and will-

ing to stick to a monthly schedule.

A wish listOverall, there is absolutely no evidence

to suggest that a legally stipulated pub-

lication obligation necessarily leads to a

better result than a voluntary publica-

tion. Th e question is rather: is there any

more room for improvement and, if so,

what is the direction of improvement?

In order to point out fi elds of im-

provement, one has to recognize the

limitations of current disclosure formats.

We identify two areas that have become

increasingly important in recent years:

the fi rst is the assessment of liquidity is-

sues; the second, the full comprehension

of credit quality.

With regards to liquidity issues, inves-

tors and analysts are mostly dependent

upon what is published by rating agencies,

which is, however, also the result of agen-

cy models rather than fi gures fed into own

analytical models. Th is is one of the fi elds

in which traditional ABS/MBS investors

request more information. What would

be needed in order to assess liquidity risk

would indeed be classical cashfl ow report-

ing – at least providing cash infl ows and

cash outfl ows per period. However, this

is quite demanding with regards to cover

pool IT. And, since in an ABS/MBS con-

text we have already seen reporting like

this, we do not deem cashfl ow reporting

as unrealistic going forward.

“Discussing both fi elds of improvement

has always been wishful thinking”

Florian Hillenbrand

Th e second aspect – comprehension of

cover pool credit quality – is likely to re-

main a “problem” going forward. In order

to assess credit quality, it is necessary to

either obtain detailed loan-by-loan data

(banking confi dentiality might constitute

an obstacle) or in depth information about

cross-eff ects such as covariances of the

distribution of all details provided in the

cover pool reporting – in layman’s terms:

providing information as to how certain

combinations of characteristics material-

ise. Analyses of the cover pools without

the knowledge of covariances is nothing

but rolling dice, i.e. are higher LTV ratios

(bad) associated with higher (bad) or low-

er (good) debt-to-income ratios? Since in-

formation would be needed for each and

every combination of characteristics, the

complexity becomes ridiculous. Hence, in

this context, going forward we will realis-

tically have to rely on secondary sources,

such as Moody’s collateral score.

Coping strategiesDiscussing both fi elds of improvement

has always been wishful thinking. Th e

question is rather: what is the best ap-

proach for assessing cover pool quality

given current limitations?

As previously indicated, we believe

that, given current defi cits, the most

proper way to assess current cover pool

quality is to use secondary sources.

Moody’s collateral score appears to us

to be the most comprehensible fi gure –

however, Fitch and Standard & Poor’s

provide similar information.

But since we are talking about covered

bond investments that are usually longer

dated, quality is multidimensional: it can

vary over time. Hence, cover pool dis-

closure documents have to be checked

in combination with each investor’s in-

dividual view on the future development

of the asset types in the pool. Th is is of

paramount importance since cover pools

usually refl ect the average business the is-

suer is underwriting; a negative view on

a specifi c type of lending in the pool also

has kickbacks to the issuer itself.

Th is brings us to the last point: changes

in the cover pool must always be assessed

versus the overall business strategy. As an

example, investors should be alerted if a

typical owner-occupied residential mort-

gage lender is adding signifi cant amounts

of buy-to-let loans to its cover

pool without any proper

explanation.

In a

nutshell,

we be-

lieve that

the com-

bination of

an external

quality meas-

urement and an

analysis of cover

pools with respect

to both market ex-

pectation and busi-

ness plan-matching

is the optimal strat-

egy given current con-

straints.


“So, tell me about your cover”



STERLING MARKET: HOME ADVANTAGESTERLING MARKET: HOME ADVANTAGE

Last November the fi rst sizeable sterling UK covered bond in four years kicked off what market participants hope could become a stable source of funding. Can UK fi nancial institutions get better results at home? By Hardeep Dhillon

Sterling gives UK home advantage


STERLING MARKET: HOME ADVANTAGE

£3bn of covered bonds have hit the sterling mar-

ket this year in the wake of a £250m issue for

Leeds Building Society in November, the first

sterling covered bond benchmark in four years.

The surge in supply – from Nationwide Building

Society, Lloyds TSB and Abbey National Treasury Services –

was long overdue in the eyes of many observers.

Indeed the development of the sterling market contrasts

with how the asset class has developed elsewhere.

“Other jurisdictions targeted their domestic markets

and then moved out after that,” says Sally Onions, partner

in the covered bond and securitisation group at Allen &

Overy. “It is a reverse situation in the UK, where issuers ac-

cessed the euro market first and are now further accessing

the sterling market.”

Th e fi rst sterling covered bond backed by UK assets was is-

sued in December 2004, a £500m 20 year transaction off a Bank

of Scotland £3bn Social Housing Covered Bond Programme.

Th is was less than 18 months aft er a euro deal off the bank’s

residential mortgage backed programme had opened the UK

market, and was followed by a £500m fi ve year transaction in

February 2005 and a £500m 10 year in November 2006.

However, the asset class failed to gain a strong foothold and

become a liquid product in the UK.

“We were really focussing on the best way to fund the un-

derlying assets and not on development of the UK investor base

for covered bonds per se,” says Robert Plehn, head of structured

securitisation and covered bonds at Lloyds Banking Group.

“Given UK investor familiarity with the underlying social hous-

ing assets and the bank’s desire not to confuse European inves-

tors with multiple covered bond programmes from the same

issuer, it chose to focus on the UK investor base and only issue

in sterling.

“However, this clearly required a fair degree of education on

the nature of the covered bond instrument. We were still at an

early stage in the use of covered bonds by UK issuers and many

still had not come to market with the traditional resi mortgage

covered bond product that was being sold to European inves-

tors. Our hopes of a development of a deeper and more liquid

sterling investor base were, to a certain extent, curtailed by the

credit crunch.”

He cites other factors relating to the lack of the develop-

ment of the UK investor base, including the fact that many

UK investors were relatively full on UK bank risk and were not

capable of providing for risk adjusted investments in terms

of line allocations. In addition, investors were sanguine with

bank risk and preferred to buy higher yielding bank capital

instruments that provided a pick up to the very tightly priced

covered bonds spreads.

“Covered bonds were not a natural part of investors’ portfo-

lios, which usually would have included equities and real estate

in the risk bucket and Gilts and government securities in the

non-risk bucket,” adds Tim Skeet, board member and adviser

to Covered Bond Investor Council (CBIC) at the International

Capital Market Association.



Andrew Fraser, investment director for fixed income at

Standard Life Investments (SLI), says that at the time of the

Bank of Scotland transaction, banks still had access to relatively

cheaper senior unsecured funding and the securitisation mar-

kets seemed to be the banks’ choice of funding vehicle, rather

than covered bonds.

“Also the legislation was common law, not contractual, and

this all meant that the market remained a niche pre-crisis,”

he says.

Only in March 2008 did the UK’s Regulated Covered Bond

regime come into force.

Moving goalpostsThe situation has since changed dramatically and there has

been a shift in the attitude of portfolio managers and issuers

towards covered bonds.

“There is a strong premium under the Basel III guidelines

for banks to get term funding and that has not been so easy

to achieve over the past few years,” says Ted Lord, head of Eu-

ropean covered bonds at Barclays Capital. “Some UK covered

bond issuers are now more willing to pay much more along the

lines of where the market is.”

Cheaper costs relative to alternative funding sources and

the size achievable in the market prompted Leeds Building

Society to favour the sterling covered bond market, says Paul

Riley, the building society’s group treasurer. He acknowledges

that while funding costs have risen, launching a senior unse-

cured transaction would have been uneconomical and at least

100bp wider than the covered bond issued at Gilts plus 175bp.

“We took on that market leader role because it was the right

trade for us,” he says. “Covered bonds have become vital to us

and the backbone of our funding going forward.”

Riley views the new market as being of strategic impor-

tance to the UK mortgage lending sector in its

ability to raise funding for advancing new

mortgages, particularly if slightly tighter

funding spreads are available. In addition,

he believes that if lenders cannot fund at

the right price in the euro market, the

sterling market could offer cheaper

funding, or vice versa.

“Having that access to a number of

markets provides an advantage to an is-

suer and makes it clear to the investor

community that the issuer

has access to more

than one mar-

ket,” says Riley.

This could

provide a

fillip to UK

i ssuers ,

w h o

have arguably not been given full credit for their strengths or the

UK legislative framework by investors in euros.

“UK investors are generally more prepared to give better

credit to domestic issuers than the continental investors, par-

ticularly in longer dated maturities, and that will help the over-

all pricing dynamic for UK issuers,” says Skeet at ICMA.

Regulatory drivers are meanwhile pushing covered bonds to

play a more prominent part in a bank’s funding profile, according

to SLI’s Fraser. The regulatory backdrop, in terms of bail-in and re-

structuring regulations, could impose losses on senior unsecured

creditors, and execution risk for bank unsecured bonds has risen.

“Covered bonds seem to be exempt from any resolution re-

gime so would not absorb losses at that part of the capital struc-

ture,” says Fraser. “The absolute cost of issuing covered bonds

relative to unsecured is obviously much lower as well for UK

banks so it makes sense for them to issue in covered bond for-

mat while that gap still exists.”

With Basel III regulations requiring banks to term out their

funding much more, using covered bonds as a financing vehicle


“It is important to get standardi-sation of reporting formats”

Andrew Fraser, SLI

“Covered bonds could become a cheap and permanent source of

funding in the UK”Lucette Yvernault, Schroders



allows them to more appropriately match their asset pool with

their liabilities.

“The sterling market will help banks maintain access to capital

markets by providing another funding tool at lower cost, which is

good for liquidity and general treasury operations,” adds Fraser.

Mixed resultsGauging pricing references in a nascent market with few com-

parables has been fairly complex.

“To get a rough idea of similar levels, some investors have looked

at triple-A rated RMBS, some at corporate bonds, while others are

attracted to the favourable spread over UK Gilts,” says Lord.

The pricing rationale for Leeds Building Society was to come

inside where its senior unsecured bonds and UK RMBS were

trading, says Riley, but slightly above euro covered bonds to

provide a new market premium.

“The pricing references were well understood and it was

more of a debate on the size of difference between the three

instruments,” he says.

Leeds priced its £250m 10 year deal at mid-swaps plus 175bp

in November. Since then Nationwide Building Society’s £750m

15 year issue came at 150bp over mid-swaps in late January,

Lloyds TSB’s £1.25bn 18 year at 175bp in early February, and

Abbey’s £1bn 15 year at 158bp over in early March.

For those UK issuers that have access to a range of funding

options including securitisation, euros, or the senior unsecured

markets, the sterling covered bond market may not be the most

economical.

“The cost differential for a bank like HSBC to issue an un-

secured or a covered bond is not going to be that great, so they

may prefer not to encumber assets on their balance sheet under

covered bond legislation,” says Fraser.

There is the potential for non-UK issuers, whether from Eu-

rope or elsewhere, to tap the sterling covered bond market and

target a new investor base. However, bankers say that this might

not benefit European issuers that trade tightly in their own ju-

risdictions if UK investors demand a higher premium for them

to access the UK market.

Plehn at Lloyds notes that the cross-currency swap favours

European issuers in the shorter end and could offer them a pick-

up to offset the higher margin potentially being demanded by

UK investors.

“However, demand is lacking at the short end and when you

go out to 10-15 years, that swap benefit disappears,” he says.

“That differential will start to come in, but it has to make sense

for issuers economically.

“It is an interesting diversification for non-UK issuers,” he

adds, “and ultimately we expect that they will access this market.”

Onions at Allen & Overy believes the sterling covered bond

market will develop alongside the UK securitisation markets.

“It does not seem as though one market is replacing another,

as there is still a market for securitisation and it will be down to

particular investor appetite which bonds they prefer,” she says.

“Covered bonds offer recourse back to the issuer, which is dis-

tinct from securitisation.

“Meanwhile, continuing issuance of residential mortgage-

backed securities under Master Trust and standalone programmes

shows there is still strong demand for securitised paper.”

Winning fansInterest in the sterling covered bond market is already appar-

ent, as there is a ready base of investors attracted to highly rated

long dated bonds in the UK.

“Ratings arbitrage still exists for insurance companies and the

issue of how much capital they must put aside when investing in

the bond market,” Lucette Yvernault, fixed income fund manager

at Schroders. “Senior unsecured bonds carry a lot of capital pen-

alties for them, whereas covered bonds do not as much.”

Under Solvency II insurers will have to hold less risk capital

against a triple-A rated covered bond compared with a similarly

or lesser-rated plain vanilla corporate bond or senior unsecured

bond issued by a UK bank.

“Solvency II will be a driver of demand for the UK covered

bonds and the fact that many UK insurers have long term li-

abilities means it makes sense to match them with these long

dated assets,” says Fraser at SLI.

Leeds Building Society’s Riley believes that in addition to

Solvency II, the advent of a bail-in framework, which will not

affect covered bonds, is another prominent factor driving inves-

tor demand.

“Those two factors have been a catalyst for the speed of cur-

rent development in the market,” he says.

“It does not seem as though one market is replacing another”

Sally Onions, Allen & Overy



Investors also point to the added security of the cover pool

as a primary benefit of covered bonds. In the event of a bank

encountering problems or even insolvency, investors have first

claim on asset within the cover pool, in addition to a claim

against the underlying issuing bank if these assets are insuffi-

cient to cover losses.

“The probability of default is probably much the same be-

tween a covered bond and an unsecured investment in a bank,”

says Fraser at LSI. “But your loss given default is going to be sub-

stantially lower in a covered bond than unsecured bonds.”

Investor confidence in government debt has waned, says Lord

at Barclays Capital, and as spreads on covered bonds are now more

attractive, the asset class is seeing greater interest from those seek-

ing to invest in an ultra-safe long-term product.

“Investors are considering it relatively safer to be in a cov-

ered bond, an instrument that has never seen a payment prob-

lem since they were created in 1769, than certain sovereign

debt,” he adds.

The new generation sterling covered bonds have also been

finding favour with non-UK accounts, with 10% of the Leeds

transaction, for example, distributed into Europe, while 20% of

the Lloyds deal was non-UK, 15% going into continental Europe.

Riley notes that more non-UK investors seem less wary of

taking on UK housing exposure, particularly in seasoned cover

pools, as the threat of a housing bubble in the UK has dissipated

over the course of the last 12 months.

“The housing market is subdued, but the UK has not expe-

rienced significant price deterioration like we saw in Ireland,”

he says. “Therefore non-UK investors are becoming more com-

fortable with the cover pools, the product and the strong quality

of the underlying assets.”

Lord says that the share of overseas demand has the poten-

tial to grow.

“There are large non-UK funds with fairly reasonable ster-

ling portfolios that are able to buy covered bonds but not tri-

ple-A rated RMBS, and demand from central banks with large

sterling reserves,” he says.

As good as their last resultThe UK has already been recognised for having strong disclo-

sure and transparency. Fraser at SLI notes that the UK is more

advanced than some European countries in the reporting of

collateral. While issuers report on a monthly or quarterly ba-

sis in the UK, elsewhere can be published as little as on an

annual basis.

“It is important to get standardisation of reporting formats

so that investors can continually monitor the cover pool,” says

Fraser.

Work by the Bank of England to increase the level of trans-

parency and introduce a national template for UK covered

bonds is a major step forward, says Nathalie Aubry-Stacey, di-

rector of regulatory policy and market practice and secretary of

the Covered Bond Investor Council at ICMA.

“The UK is highly transparent and investors have access to

a lot of information and data,” she says. “Having national tem-

plates in all European jurisdictions will allow investors to com-

pare issuance from different countries on a like-for-like basis.”

Maintaining cover pool quality so it does not deteriorate

over time is one major concern for investors. SLI’s Fraser, for

example, stresses that although a cover pool could initially con-

tain good quality residential mortgage assets, banks in the UK

might have the option to replace these with other assets, such as

commercial mortgages.

“In that scenario, we would question the bank’s actions as

the underlying commercial mortgage market has a different

dynamic and the pool quality would decline,” says SLI’s Fraser.

Yvernault at Schroders believes it is imperative to sub-

stitute any non-performing or high loan-to value (LTV)

loan with a more robust one. Substitution is superior to re-

plenishment, as it does not allow the quality of the covered

bond pool to be diluted over time. She adds that tightening

certain regulations would make sterling covered bonds as

competitive as those on the continent and also reassure for-

eign investors when comparing continental products with

the UK market.

“Once the market fully develops, there is no reason why the

sterling market should not trade on a more comparable level

to the continental market,” says Yvernault. “The covered bond

could become a cheap and permanent source of funding in the

UK, as we have seen through the crisis with well-established

covered bond programmes in Europe.”

“Covered bonds have become vital to us”

Paul Riley, Leeds Building Society

www.terrapinn.com/coveredbonds

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COUNTRY PROFILE: AUSTRALIA



The Australian government’s decision in December

to free Australian financial institutions from the

shackles of the Australian Prudential Regulation

Authority’s strict interpretation of section 13A

of the Banking Act 1959 and allow ADIs to issue

covered bonds represented a victory for the Australian banking

industry after years of lobbying. However, its success was born

out of circumstances quite different from those that prevailed

when David Addis, then chair of the Australian Securitisation

Forum’s prudential committee and head of structured product

origination and sales at ANZ, and Brian Salter, then partner at

Clayton Utz, in 2005 received the letter abridged above.

“Securitisation was in its heyday back then, so you were

getting very tight deals done,” says Addis, now managing di-

rector at Cygnus Advisory. “But covered bonds were better in

a number of ways. They tended to be bullet with a revolving

structure, which regular securitisations here were not, and

they also went for much tighter prices, and in much bigger

volumes than the local RMBS deals.

“And when you are talking billions of dollars and a few basis

points, it’s actually worth quite a lot of money to everyone.”

But Addis acknowledges that a new funding avenue was not

essential in the same way that it had become as lobbying for

covered bonds intensified post GFC – Global Financial Crisis,

as it is commonly known in Australia.

“It would have enabled the banks to open up a new fund-

ing stream,” he says, “which would have been helpful, but there

wasn’t a pressing need in the same way that obviously there has

been since the securitisation market became so restricted.”

With Australian mortgage lenders so reliant on the securiti-

sation markets, the effects of the US sub-prime crisis changed

the Australian financial landscape.

“Most of the non-banks really struggled through the finan-

cial crisis,” says Addis, “because a lot of them relied very heavily

on securitisation and when they couldn’t, they just basically got

Australia winds up for delivery

25 January 2005

Dear Messrs Addis and Salter,

Covered bond holders would have first priority over

assets of an ADI (authorised deposit-taking institu-

tion), ahead of the ADI’s depositors. We cannot see

how such arrangements can be consistent with the

principle underpinning Australia’s depositor prefer-

ence regime that depositors have the ability to claim

on the assets of an ADI in Australia in preference to

all other potential creditors…

In summary, APRA believes that the issuance of cov-

ered bonds would not be consistent with Australia’s

depositor preference regime and it is not, as a mat-

ter of principle, prepared to accept issuance of such

bonds (or structures with equivalent effect) by ADIs

in Australia.

Yours sincerely,

John F Laker

12 December 2010To secure the long-term safety and sustainability of

our financial system, we will… allow all banks, credit

unions and building societies to issue covered bonds

to broaden access to cheaper, more stable and longer-

term funding…The Hon Wayne Swan MP, deputy prime minister and

treasurer

After years of watching from the stands, Australia’s banks are taking a run up for issuance as early as the third quarter. The banking industry is therefore

hard at work ensuring the right balance is struck between issuer and investor needs in impending legislation. But could RMBS and smaller banks be

dismissed cheaply? By Neil Day



slammed by their banks or their funders. One of them had a

lot of short term extendible CP paper in the US market and it

couldn’t roll it over.

“Some, like Aussie Home Loans, which was one of the origi-

nal securitisers, were partially bought out and supported by the

banks, but a lot just stopped writing mortgages because they

just couldn’t fund them. During the GFC the banks’ share of

new mortgage origination went to well over 80%, and the 15%-

20% that they were not actually writing directly, they were ef-

fectively funding through those non-bank originators whom

they chose to support.”

However, Australia’s major banks have also come under

pressure. Although they remain highly, Moody’s, for example,

in mid-February put the Aa1 ratings of the country’s big four

– Australia & New Zealand Banking Corporation, Common-

wealth Bank of Australia, National Australia Bank, and Westpac

Banking Corporation – on review for downgrade.

“The review will focus on the Australian banking system’s

structural sensitivity to conditions in the wholesale funding mar-

ket,” says Patrick Winsbury, a senior vice president at Moody’s.

“The global financial crisis has underlined the speed with which

shifts in investor confidence can impact bank funding, warrant-

ing a review of the four major banks, for whom market funds

comprise on average 43% of total liabilities.”

Gail Kelly, Westpac chief executive officer, told a Senate in-

quiry into the government’s banking reform package in January

that covered bonds should help.

“Covered bonds are valuable for us,” she said. “It’s not a pan-

acea for us, but it’s an important next step to allow us to leverage

our mortgages… that’s very helpful.”

Meanwhile, Cameron Clyne, group CEO of National Aus-

tralia Bank has welcomed the government’s move and said that

covered bonds could help lower funding costs for the bank’s

A$28bn of bonds it was expecting to sell this year.

GFC swings the debateSpeaking at a roundtable for the Deloitte Australian Mortgage

Report 2011: Reforming the Agenda, Axel Boye-Moller, head of

mortgages at Westpac, outlined the challenges facing the Aus-

tralian mortgage industry.

“What we have is a structural issue, with a limited depos-

it pool unable to keep pace with growth,” says Boye-Moller.

“There isn’t enough growth in deposits so we are all just fight-

ing over share. Savings are not being channelled into the bank-

ing system hence banks are reliant on wholesale funding, and

offshore wholesale funding in particular.

“Covered bonds could be part of a solution to this struc-

tural issue and we would support that development. But we

need to think more broadly and consider other measures to

facilitate securitisation of mortgages, as well as increasing the

deposit pool.”

Graham Mott, financial services partner at Deloitte, says

that covered bonds are a must in this context.

“Given how significant their funding challenges on an annu-

al basis are, covered bonds are key for our banks locally, partic-

ularly the majors, to allow them to compete and raise funds on

a global scale,” he says. “That’s got to be the underlying driver

here, which is why the government has relented.”

Addis agrees.

“I expect that Treasury has been convinced that, with the

securitisation market and other bond markets really being

quite subdued, the performance of covered bonds was de-

monstrably better than MBS or other funding through the

GFC,” he says.

Westpac highlighted this in its submission to a Senate in-

quiry in December, ahead of the government’s announcement.

“Covered bonds through the GFC provided a stable source

of funding in other countries, retaining their broad investor ac-

ceptance,” it said. “They have stood the test of time including a

“It’s not a panacea for us, but it’s an important next step.”

Gail Kelly



significant number of economic cycles and financial crises, and

as economic and financial infrastructure has evolved.”

Indeed billions in government guaranteed bank issues ben-

efiting from such support begin come up for redemption from

next year and offering ADIs an alternative funding option that

might appeal to a similar investor base has been cited as an-

other reason for the government’s decision.

And as if these factors were not enough, some observers ar-

gue that the launch in June 2010 of the first covered bond in

New Zealand, by National Australia Bank parent Bank of New

Zealand, was the final straw.

“That was a big help,” says one market participant. “It just

made the Australian position even stranger. It wasn’t just Eu-

rope having covered bonds, it wasn’t just the US and elsewhere,

it was now New Zealand.

“The four major banks in New Zealand are subsidiaries of

the four major banks in Australia, so it made a mockery of the

fact that these same groups were doing it in New Zealand and

yet not at home.”

Boundaries expandedWhile a change to the Banking Act will allow ADIs to add cov-

ered bonds to their funding options, the government will not

give Australian banks free rein to issue covered bonds.

“The Treasury will also consult on the appropriate level of

cap to be placed on covered bond issuance for individual insti-

tutions, for example 5% of an issuer’s total Australian assets,”

it said. “This will ensure a substantial buffer of assets to cover

depositor claims, making it extremely unlikely that a levy under

the Financial Claims Scheme would ever be needed.”

As The Covered Bond Report was going to press, a draft law

for Parliament to consider was imminent, but market partici-

pants have expressed confidence that the paper will double the

5% limit to 10% , a level settled on by the Reserve Bank of New

Zealand in March.

“The 5% level was quite swiftly and successfully explained

as totally inadequate,” says one, “and it looks like being 10%.”

According to calculations by Deloitte’s Mott, were banks

across the board to take full advantage of a 10% limit, issuance

could reach around A$180bn, which is more than twice the out-

standing volume of Australian RMBS.

“Certainly that would be the sort of capacity that the balance

sheets would support,” he says.

While the number is impressive, questions remain.

“Initially the government was thinking only a 5% issuance

limit relative to assets, but it seems there is an acknowledgement

that it needs to be higher in order to make individual issuance

the broader market for Australian covered bonds a meaningful

and worthwhile,” says Alex Sell chief operating officer of the

Australian Securitisation Forum. “That should perhaps mean

that the percentage goes higher but with a secondary limit re-

garding liability mix whereby if you’re very highly dependent

on retail deposits you will be able to issue less than if you are

less exposed. We understand that APRA has been calling for

something along those lines, and this resembles the FSA’s ap-

proach in terms of looking at overall asset encumbrance relative

to liability mix.”

Meanwhile, Fergus Blackstock, head of Australian debt capi-

tal markets at UBS, says that the 10% limit takes into considera-

tions the requirements of a variety of players in the market.

“It’s clearly within the comfort limits of the rating agencies

and it would make it efficient for some of the smaller issuers

who have got smaller balance sheets,” he says.

Investors drive law changeThe minimum that the government needs to do to trigger cov-

ered bond issuance is amend the relevant section of the Bank-

ing Act, which reads: “If an ADI becomes unable to meet its

obligations or suspends payment, the assets of the ADI in Aus-

tralia are to be available to meet that ADI’s deposit liabilities in

Australia in priority to all other liabilities of the ADI.”

However, while this de minimus approach might have been

sufficient in 2005, when markets were roaring and UK banks

were prospering from a similar position to price covered bonds

just a few basis points back from products based on prescriptive

laws, such as Pfandbriefe, the banking industry is now expect-

ing something more thorough.

“The government has already committed itself to amending

the Banking Act to permit covered bonds by removing the ab-

solute depositor preference provision that has been there since

1959,” says Sell, “which you might think means that structured

and legislative would then be possible. But the government has

indicated that it doesn’t wish to see structured covered bonds

coming about.”

While this might previously have disappointed some banks,

all are said to be moving towards a position where they con-

sider a more comprehensive framework to carry benefits for the

industry.

“The push locally has been that we need a legislative frame-

work rather simply progressing with a structured solution,” says

Mott at Deloitte. “And mainly that’s to demonstrate to the global

investor community that Australia has the rigour of a legislative

framework to support its covered bonds.

“The people that we are listening to the most, which is the

right answer, is now the investor community in our positioning

of covered bonds.”

Louise McCoach, a partner at Clayton Utz, echoes this.

“The current iteration of the policy certainly takes into account more of the buy-side perspective.” Louise McCoach



“Certainly the first consultative document tabled by Treas-

ury was very much looking at a de minimus regime, which con-

templated some legislation, but not a regulated regime like the

Regulated Covered Bonds in the UK,” she says. “The industry

was very quick to point out that the consultation process prob-

ably needed to listen a bit harder to what investors had to say,

especially offshore investors that are not used to investing in an

unregulated market.

“Some of that feedback has been taken on board by Treasury

and the current iteration of the policy certainly takes into ac-

count more of the buyside perspective, actually factoring in the

possibility of regulated elements, although elements that do not

seem particularly onerous.”

Sell at the ASF says that one thing this means is that legisla-

tion must produce a homogenous product.

“Issuers want to ensure that when an investor in London or

Oslo picks up an Australian covered bond they don’t need to

worry too much about heterogeneity between Aussie deals,” he

says. “We want them to be able to say: ‘Right, I know that if this

is a legislative, regulated Australian covered bond, then it will

contain these features, so I therefore need to just focus on pric-

ing, the detail of the collateral, and the issuer itself. It’s about

trying to make the investors’ job easier to lower any potential

obstacles to investment.’

“And also making the product as similar as possible to what

they are used to as possible, while making sure that the Austral-

ians are best of breed and can take the best bits from the various

products in Europe.”

Keeping APRA in checkHowever, he stresses that the framework must retain flexibility

and McCoach says that such an approach could yield benefits

for issuers and investors.

“We don’t know necessarily how investors are going to react,

so the sort of structure that the industry has been putting for-

ward is a flexible structure where, yes, we pass some legislation

to implement the necessary framework to allow an Australian

covered bond market to develop, and allow for regulations to

be passed in the future to enable issuers to be flexible enough to

meet needs and to tweak their structures depending on investor

feedback,” she says. “So if anything needed to be done to make

the model more regulated, that could be achieved through reg-

ulation that would be subordinate to legislation, and would be

much easier to enact and pass.”

The imminent legislative proposal is expected to set down

various parameters for Australian covered bonds that will reso-

nate to differing degrees with issuers and investors in different

parts of Europe. In structure, they will resemble the model pio-

neered in the UK.

“They’re going down an SPV route for the structure, rather

than an integrated model as a lot of continental European is-

suers have,” says Alex Chernishev, senior associate in Clayton

Utz’s securitisation team. “The SPV route just requires less ma-

jor surgery in terms of our banking legislation.”

After some suggestions that APRA might act as cover pool

monitor, the role is now considered more likely to be taken up

by auditors or trustees, with conflicts of interest potentially

arising were the regulator responsible for depositor protection

to take on the covered bond function.

The Treasury is also understood to be moving towards set-

ting eligibility criteria for covered bonds, which was not in

initial plans, and laying down how banks would be registered

and regulated under the regime, and who by. Alongside APRA

among Australia’s financial authorities is the Australian Securi-

ties & Investments Commission (ASIC).

Sell says that issuers are keen to ensure that as well as limits

on their activities, there are limits on the regulator’s discretion-

ary powers under the legislation.

“Legislation or regulation should deliver as little supervi-

sory discretion as possible. We want certainty with respect to

overcollateralisation, minimum and maximum levels, so that

an investor knows that APRA can only direct a bank to stop

maintaining a particular level of OC at a given level, rather

than APRA having the discretion to say stop whenever it feels

it needs to.

“That’s designed to give investors certainty and predictabil-

ity about where APRA’s rights of intervention start and stop.”

He says that the second reason is for the benefit of not just

issuers, but also investors.

“We want certainty with respect to overcollateralisation,

minimum and maximum levels, so that an investor knows that

“Most of the non-banks really struggled through

the financial crisis.” David Addis



APRA can only direct a bank to stop maintaining a particular

level of OC at a given level, rather than APRA having the dis-

cretion to say stop whenever they like.

“Th at’s designed to give investors certainty and predictabil-

ity about where APRA’s rights of intervention start and stop.”

CIBC calms nervesWhen announcing its plans in December, the Treasury cited

a recent example of successful covered bond issuance in Aus-

tralia – albeit from an overseas issuer. Th e deal in question was

a A$750m three year issue from Canadian Imperial Bank of

Commerce in October, and it was the fi rst covered bond sold

into Australia since before the GFC, when Dexia Municipal

Agency tapped the market in July 2007. And aft er CIBC’s issue,

Bank of Nova Scotia raised A$1bn.

While covered bonds might be in their infancy in Australia,

Wojtek Niebrzydowski, vice president, treasury, at CIBC, notes

that Australia has a mature fi xed income market, with Kanga-

roo issuance last year totalling around A$30bn.

“Ultimately it’s not going to provide the same volumes that

the US can now and that, theoretically, the euro could, but it

has become a very important secondary market for us,” he says.

However, ahead of CIBC’s second issue, fears that de-

mand for covered bonds – from overseas issuers as well as

forthcoming Australian issuance – could be stymied were

raised when APRA disappointed the market once again, by

stating that under its initial implementation of the Basel III

framework no securities would be eligible as liquidity buffer

Level 2 assets – the category the Basel Committee had en-

couragingly placed them in.

The announcement did not come as a complete surprise,

and not only because of APRA’s historical aversion to cov-

ered bonds. Market participants adjudged APRA’s decision

that covered bonds are not yet sufficiently liquid as fair, and

hold out the hope that a review promised by the regulator

will let covered bonds in around the time Basel III is imple-

mented in 2015.

“I would see APRA coming to the party in the future regard-

ing Level 2 assets,” says Deloitte’s Mott, “and that will also support

this as a funding mechanism through the pricing and liquidity

that it delivers. However, the industry needs to prove up the li-

quidity before APRA responds favourably to their position.”

Market participants also point out that covered bonds could

still be used in liquidity buff ers, since they could become eligi-

ble for the Reserve Bank of Australia’s ordinary Open Market

Operations and then its new committed secured liquidity fa-

cility. Th is is a means by which Australian banks can generate

prudential liquidity to meet the LCR ratio, under an option af-

forded certain countries under Basel III where there is a lack of

Level 1 and Level 2 assets.

Th eir worries were nevertheless eased by the success of a

follow-up transaction by CIBC in early March – although not

without some nerves being suff ered along the way, as a Kan-

garoo issue in the sovereign, supranational and agency sector

– also excluded from LCR ratios – was put on hold. CIBC went

ahead with a A$700m deal through leads CBA, CIBC, HSBC

and UBS and some three-quarters of the covered bond was sold

to banks, the majority in Australia. Niebrzydowski says that this

was similar to bank participation in the issuer’s fi rst Aussie dol-

lar covered bond.

“We had hoped that this would be the case, but we weren’t

certain,” he says. “If it had come prior to the APRA announce-

ment, it would have been less challenging, coming aft er our de-

but and one of our Canadian competitors.

“Once the announcement came out, we spent a fair amount

of time going back and forth looking at whether the market

would still be there, and whether we should still go for a fi ve

year or instead a three and a half year that would take it up to

“I would see APRA coming to the party in the future

regarding Level 2 assets.”Graham Mott



before the January 2015 Basel III imple-

mentation. But ultimately we came to the

conclusion that a five should still work

and it did.”

The five year issue was priced at 74bp

over mid-swaps, while its three year de-

but came at 48bp over. The new issue’s

spread was well inside levels at which

banks had been raising senior unsecured

debt in Australian dollars. Barclays Bank

sold a three year in mid-February at 140bp over and Westpac a

four year in early February at 110bp over, for example.

RMBS on the back foot?More pertinent than comparisons with senior unsecured lev-

els, however, could be the relative pricing of covered bonds

versus RMBS. While there is confidence that an Australian

product akin to European covered bonds will find buyers who

value the structure among an established investor base, there

have been some questions as to how much interest the asset

class might garner among Australian investors more used to

securitisation.

“There was a lot of speculation about this, because the inves-

tor base has been more used to RMBS, which is a higher spread

product,” says Blackstock at UBS. “However, our experience

with both CIBC and Bank of Nova Scotia was that there are

plenty of investors who have a strong appetite for the product

and like the liquidity and the bullet nature.

“So there is proven demand for both.”

Justin Mineef, senior vice president, corporate finance secu-

ritisation at CBA, says that he expects the covered bond inves-

tor base in Australia to be comparable to that for RMBS.

“The investors will be those that we would ordinarily see in

an RMBS book,” he says, “and also that would be both real mon-

ey managers as well as financial institutions, which has always

been a blend in RMBS books. It’s another product, so there’ll be

a different price point, but it’ll be going to pretty much the same

investor base that we’ve got.”

Rob Verlander, head of corporate finance securitisation at

CBA, says that key to what kind of spread investors are willing

to accept will be liquidity considerations.

“They’ll look at covered bonds versus RMBS not only

in terms of credit, but in terms of liquidity,” he says, “and

given the sort of environment we’re in, they’re likely to put

more weight on the notion of liquidity than credit. They’re

already working the triple-A credit in RMBS – with the

performance of that product in this marketplace having

been almost perfect – so you are not dealing with any repu-

tation issues in this market. So then it boils down to issues

of liquidity and it’s quite clear that the double-A bank unse-

cured market, for example, is perceived as more liquid than

the triple-A RMBS market.

“Investors may well consider that they will get more liquidity

out of covered bonds than RMBS, more akin to double-A bank

paper, and be willing to pay for that. It then would be an issue of

how much they are going to pay.”

But others remain cautious.

“It’s difficult to say with certainty until

we see the markets side by side, but what

you can say is that in Australia there isn’t

much of a rates investor base,” says one

market participant. “So investors are pri-

marily credit investors, be they senior

unsecured, bank debt, or RMBS credit

investors.

“The major investor pool will be the global rates investor.

Of course, there is the caveat that the distinction between rates

and credit investors has become blurred, more by rates inves-

tors moving towards credit.”

Some bankers point out that cross-currency swaps today

would make Australian dollar issuance more attractive for

the country’s banks were they to issue now, although the

situation could change by the time their programmes are up

and running.

The other side of the coin is what the covered bond alterna-

tive will mean for issuers’ desire to sell RMBS. Although the

major banks have recently returned to RMBS, their enthusiasm

for the market has been dampened as the levels achievable have

been unattractive versus where they can issue senior unsecured

debt against their double-A ratings – with the aforementioned

caveat that they are on review for downgrade.

“RMBS has sort of gone out of fashion for the major banks

– albeit Westpac did do A$1bn the other day – and the rea-

son is primarily because the price doesn’t stack up. If you’ve got

double-A ratings, why would you be issuing RMBS?

“That said,” he adds, “RMBS have come in from about 160bp

to 100bp while senior unsecured have blown out from around

80bp to as wide as 160bp. Also, they may like the funding di-

versification.”

However, APRA’s harsh treatment of RMBS under APS 120,

where market participants say it is hard to convince the regula-

tor that “significant risk transfer” has occurred, is said to be a

further obstacle for securitisation in the competition with cov-

ered bonds.

Mutuals seek redressWhile the major banks are seen as shoe-ins for covered bond

issuance, the case is not considered so clear for smaller ADIs.

Indeed some have raised concerns about the introduction of

covered bonds in Australia.

Abacus, which represents Australian mutuals, said in No-

vember in its submission to the Senate inquiry into competition

within the banking sector that it strongly rejected the notion

that covered bonds are pro-competitive.

“There is little doubt that the major banks will be able to

source additional lower cost funding through covered bonds,

however it is unlikely that many smaller regional banks, credit

unions or building societies would be able to access funding

through such an instrument,” it said. “Furthermore, the promise

that the issue of covered bonds will have flow on effects for other

Issuance could reach around A$180bn, which is more than

twice the outstanding volume of Australian

RMBS.



lenders because of reduced competition

in other funding markets seems to be il-

lusory.

“It seems unlikely to Abacus that a

major bank will let go of one source of

funds simply because it has found another

source of funds. A more likely proposition

is that the additional funds will be used to

strengthen the position of those banks that

issue covered bonds, to the detriment of

other participants in the market.”

Abacus said that if covered bonds are allowed – and it said

that it was not philosophically against them – credit unions and

building societies should receive corresponding support.

Initially, the government planned to outline a pooling or ag-

gregation model or joint issuance, to ensure that smaller issu-

ers could also benefit, but difficulties in achieving a workable

model are understood to have held back this ambition.

“The lobbying has really decoupled the pooled arrangement

from the direct issuance, which has allowed the direct issuance

to continue through the legislative process and hopefully un-

encumbered allow our ADIs to issue direct to the market,” says

one observer. “The reason for decoupling the pooling is because

of the complexity that’s involved, just the general structuring to

make that happen.

“I still see that you probably need some government inter-

vention somewhere to make that a more simple process for eve-

ryone to enjoy the benefits of covered bonds.”

Jennifer Wu, vice president and senior analyst at Moody’s,

says that cultural differences explain some of the difficulties of

creating a workable aggregation model in Australia.

“Unlike some of the European models where the smaller

banks are actually quite open with each other, in Australia the

credit unions, the smaller mutuals, are more conservative and

protective of their own business,” she says. “So finding a struc-

ture whereby the smaller ADIs, mostly in single-A or Baa range,

can actually be competitive with covered bonds by achieving a

triple-A rating would probably require

some governmental supervision.

“The government will therefore have

to consider how much they want to be

involved.”

The government and smaller banks

are therefore focusing on other meas-

ures that could help them, and the

package of measures that covered

bonds were part of in December con-

tained some moves in this regard.

But some bankers suggest that smaller institutions could by-

pass any attempts at aggregation and access the covered bond

directly on a standalone basis. They point to the success of

smaller issuers with non-triple-A rated covered bonds access-

ing the market in Europe.

“There is merit in lower rated institutions considering the

market,” says CBA’s Mineef, “even if they may be constrained

by their rating, by duration and outright volume. If you are a

lower rated institution, there’s probably more merit in that than

possibly the aggregated model, which is interesting but may not

come together in a practical way, at least in the first instance.

“There is clearly a benefit for the majors of going and issuing

triple-A paper in larger volume here or offshore, but the other

guys can pursue a non-triple-A covered bond market with the

investor base locally. If investors understand the financial insti-

tution and may be a current buyer of their RMBS programme,

then they may well look at it in covered bond format.”

And Verlander says that they may be boosted by a lack of

competing supply.

“The Australian market has very little by way of credit

product,” he says. “That’s particularly evident in the corpo-

rate market, but there isn’t a lot of credit product overall.

So to the extent that you can actually do double-A covered

bonds and offer a reasonable spread, you are probably going

to attract a reasonable level of interest, even if they are tight

relative to RMBS.”

5.0%

10.0%

15.0%

Combined capitals

-5.0%

0.0%

Jan-

06

Mar-0

6

May

-06

Jul-0

6

Sep-

06

Nov-0

6

Jan-

07

Mar-0

7

May

-07

Jul-0

7

Sep-

07

Nov-0

7

Jan-

08

Mar-0

8

May

-08

Jul-0

8

Sep-

08

Nov-0

8

Jan-

09

Mar-0

9

May

-09

Jul-0

9

Sep-

09

Nov-0

9

Jan-

10

Mar-1

0

May

-10

Jul-1

0

Sep-

10

Nov-1

0

Jan-

11

Combined ‘Rest of State’

Source: RP Data–Rismark

Rolling annual change in house values, Capitals v Rest of StateRP Data-Rismark Home Value Index, Seasonally-Adjusted Results, Houses

“Plenty of investors have a strong appetite

for the product and like the liquidity and the bullet nature.”

Fergus Blackstock


COVER STORY: BAIL-INS



Happy New Year? Not for the senior unsecured

market. Issuers and investors were barely back

from their seasonal holidays on 6 January

when the European Commission delivered a

nasty shock.

Expanding upon proposals released in October setting out

the Commission’s proposed framework for crisis management

in the financial sector, the EC launched a consultation that put

more flesh on exactly what “fair burden sharing” might mean

for bank creditors.

“The possible options set out in this consultation would con-

stitute a significant step for the EU in delivering the commitment

made at the G20 summit in June 2010, by ensuring that authori-

ties across the EU have the powers and tools to restructure or

resolve (the process to allow for the managed failure of the finan-

cial institution) all types of financial institution in crisis, without

taxpayers ultimately bearing the burden,” said the Commission.

It said that this “might include possible mechanisms to write

down appropriate classes of the debt of a failing bank to ensure

that its creditors bear losses”.

Commenting on the detail of the proposals, Fitch analysts

spelt out very clearly what this will involve.

“Under this framework, ‘bail-in’ debt would be viewed as a

form of hybrid capital and be rated accordingly,” was the rating

agency’s verdict.

Fitch said that the EC had gone a step further in January

than in its October proposal.

“Rather than pursuing the notion that all banks be potentially

subject to a resolution regime, the Commission suggests that

some institutions may be ‘too large, complex or interconnected’

to be put into a resolution regime and may have to be dealt with

on a going concern basis through the deployment of contractual

‘bail-in’ debt,” said the rating agency. “‘Bail-in’ and resolution are,

therefore, in the first instance mutually exclusive alternatives.Room for everyone?European Commission bail-in proposals have prompted senior unsecured investors to seek the security of covered bonds, raising fears of an over-reliance on the asset class among the buy and supply sides. But proponents warn that investors have nothing to fear but fear itself. By Neil Day and Maiya Keidan

“Although the activation of the ‘bail-in’ trigger might be at the

behest of the regulators, this is nevertheless a contractual mecha-

nism for dealing with a failing bank, akin to hybrid capital.”

And not only would senior unsecured debt be subject to

being bailed in; any bail-in would also be subject to the whims

of regulators.

Georg Grodzki, head of credit research at Legal & Gen-

eral Investment Management, summed up investors’ fears at a

Landesbank Baden-Württemberg covered bond conference in

early February. Whilst he stressed that taxpayers’ money should

not bail out failing banks and their debt holders, he was not im-

pressed with the threat posed to senior debt by the wide rang-

ing discretionary power afforded to regulators in the proposed

bail-in legislation.



“We don’t really want to second guess what individual nation-

al regulators may do with that discretionary power”, he said. ”We

are worried that a more aggressive regulator could be tempted

to bail in senior debt because it is more convenient than to put

a bank into administration and let creditors work out a solution

according to their contractual rights and the insolvency laws.

“Senior debtholders would be at risk of losing money be-

cause of regulators moving the goalposts for a bank’s capital

requirements. This additional risk would have to be compen-

sated for through higher credit spreads. The access to wholesale

markets and the funding costs for banks would also become

more volatile.”

Although the proposals envisage the grandfathering of out-

standing senior unsecured paper and implementation is not

expected until at least 2014, the effect on sentiment towards

senior unsecured debt was immediate, with issuance stymied.

Schadenfreude?Covered bonds, meanwhile, were enjoying a record start to the

year, with more than Eu18bn of benchmark euro issuance in

the first week alone. From almost the very first issues of the

year there were fears that, as on many occasions in the past, the

market was heading for a fall, with the asset class set to be its

own worst enemy with oversupply souring market conditions.

Yet the market proved resilient and more than Eu80bn of

euro benchmark issuance had been digested by mid-March, as

demand proved able to match supply, with investors defecting

from the senior unsecured market into covered bonds.

“What I can see at this very moment, already, is that a lot of

guys from the senior side are calling me up, wanting teachings

on covered bonds and are seriously thinking of switching – at

least some of their money – into covered bonds,” said Crédit

Agricole analyst Florian Eichert in early February.

“I don’t know whether those guys have actually started shift-

ing their holdings, but at least they’re asking a whole lot more

questions than they were in the past and they have been active

in primary market deals like a recent UniCredit OBG.”

Royal Bank of Scotland analyst Frank Will said that he, too, had

noticed a significant shift from senior unsecured to covered bonds.

“People are scared on the senior unsecured side” he said.

“People are looking for alternatives now.”

What seems clear now is that the EC’s plan played into long-

er term trends prevalent in the markets.

“What you can see and feel in the market is that the investor

base is growing, that we have had new investors coming into the

market since January,” says Heiko Langer, senior covered bond

analyst at BNP Paribas. “Whether that is mainly due to this spe-

cific EC paper or is a trend that had started already at the end of

last year and is now accelerating, that is difficult to say.

“But clearly the bail-in theme, which was already around

before that paper, has significantly changed the demand side.”

And Langer believes that the shift is far from over.

“There are a good deal of investors out there who are still

in the research phase and looking at the product but haven’t

started buying yet, and others that have been buying covered

bonds for a long time and are considering buying more,” he

says. “They are switching out of senior, or just running off sen-

ior unsecured exposures as they mature and replace the incom-

ing cash with covered bonds.

“They are looking at other secured instruments as well,” he

adds. “We must not forget that covered bonds are not the only

secured instruments out there and there is a chance that the

revival that we have seen so far in securitisation could develop

further because people might have a preference for security and

if the question is bail-in-able senior or securitised, maybe some

people will say, I’ll rather have the securitised debt.”

Richard Kemmish, head of covered bond origination at

Credit Suisse, echoes this.

“All the bail-in proposals are doing is accelerating a trend

that has been happening for a long time,” he says, “and that is

the trend for more people to realise that they really need secu-

rity in some form, whether it be for credit or regulatory reasons.

People were increasingly nervous about bank credit given eve-

rything that has happened, and covered bonds looked increas-

ingly attractive.

“Brussels and to some extent the ECB had exacerbated that

trend by making the incentives to own covered bonds more

significant. Then suddenly they’ve massively accelerated the

trend by formalising the uncertainty about senior unsecured

bonds with the resolution regime proposals. Formalising that

uncertainty means that a huge number of people have looked to

“The line of covered as the new senior is quite a catchy phrase”

Heiko Langer, BNP Paribas



reallocate large chunks of their portfolio from senior unsecured

into covered.”

And observers point out that while securitisation could yet

compete in offering investors security, it does not benefit from

the regulatory support afforded covered bonds under the Basel

III proposals, where the asset class will be eligible for liquidity

buffers, in Europe at least.

Ever vigilantAs has been the financial markets’ wont since market partici-

pants failed to notice the impending crisis before it struck in

2007, attention quickly turned to seeking out the next potential

problem in the market. Not surprisingly, given their dramati-

cally higher profile, covered bonds came into the firing line.

Posting on M&G’s “Bond Vigilantes” blog in the midst of the

record-breaking start to the year, Matthew Russell, a fixed in-

come manager at M&G at the investment firm, was one investor

to warn against the burgeoning asset class, describing “covered

bonds as the only option for bank funding”.

“A preponderance of covered bonds is clearly not good news

for senior debt holders,” he wrote, “because in the event of a

bank liquidation you are further away from the top of the capi-

tal structure and therefore have a claim over fewer assets than

you would have traditionally had. It will be interesting to see

how the covered bond market develops and what happens to

spreads – what will dominate? Demand or supply?

“This Titanic issuance of covered bonds is more than mov-

ing the proverbial deck chairs around to fund the banks. In fact

senior and subordinated bond holders are being rearranged

further from the safety of government and legal lifeboats.”

Russell was not alone in his opinion, as some of his peers

became concerned and the argument was relayed by the Finan-

cial Times and other established financial markets publications

warning of the dangers of banks becoming over-reliant on cov-

ered bonds.

“I think this was overplayed, the fear of people that banks

will shift dramatically towards covered bond issuance and

stop issuing senior,” says BNP Paribas’ Langer. “The line of

covered as the new senior is quite a catchy phrase and lent

itself well to being a headline on all kinds of reports, includ-

ing research reports. While there is some truth in it, one has

to be realistic.

“One has to look at who the issuers are, what their issuing

potential is, and what their balance sheet structure is. A lot of

the new banks that have entered the market in the last three to

four years are quite diversified universal banks that have a lot of

assets on their balance sheets that are not eligible as collateral

for covered bonds.”

Jan King, covered bond analyst at Landesbank Baden-Würt-

temberg, points out that even those issuers for whom covered

bonds constitute a major funding source will have to retain ac-

cess to senior unsecured debt.

“The question is how overcollateralisation will be funded

going forward,” he said, “because senior unsecured is probably

becoming more unattractive for investors or at least it should

become more expensive. There is in the end still some remain-

ing funding that is needed on an unsecured basis and I think

that’s the challenge going forward.”

An uncommon curseIn early March Fitch published an extensive research report ex-

amining what proportion of banks’ funding came from covered

bonds and found that their use was “modest” – even if the rat-

ing agency said that it was not passing judgement on what the

impact of issuance was on senior creditors.

The rating agency said that only in extreme scenarios would

covered bonds become “more of a curse than a choice”.

“There is an argument that a potential spiralling effect exists,

whereby growing covered bond funding could gradually crowd

out appetite for senior unsecured debt,” said Fitch. “Certainly,

increased issuance of secured funding in a troubled bank may

become more a curse than a choice for treasurers seeking inves-

tors for unsecured issues.

“Apart from such extreme cases, the risk of covered bond

funding reaching a level that acts as a deterrent to potential

senior unsecured debt investors is still small for the majority

of issuing banks.”

While acknowledging the structural subordination covered

bonds cause, Fitch highlighted their positives.

“It makes sense that covered bonds are exempted from

bail-ins” Ralf Grossmann, Société Générale



“The increase in covered bonds funding is compounded by

the over-proportional increase in the size of the cover pool assets,

which collateralise the bonds,” said the rating agency. “Issuers

now provide larger overcollateralisation than in the past to pro-

tect investors against credit and market value risks. This reduces

the assets available to enable repayment of unsecured debt and

depositors in the event of an issuer default. Furthermore, covered

bonds are not the only form of secured funding encumbering as-

sets on banks’ balance sheets. There is also an increased use of

collateral for central bank funding and market repo activity.

“However, Fitch notes that access to alternative, low-cost fund-

ing sources and especially long-term ones is beneficial to a bank’s

creditworthiness and, by extension, to its unsecured creditors.”

Credit Suisse’s Kemmish says that it is important that this

side of the argument is heard and that too great a focus on loss

given default and recovery rates is a danger.

“It is an erroneous but common belief that asset encumbrance

becomes a vicious circle,” he says, “the more covered bonds you

issue, the more difficult it is to issue senior unsecured debt. The

reasoning being that is when the bank goes bust you’ve got all

these German investors in front of you in the queue for the assets.

And who’s going to buy what is effectively subordinated debt?

“That is an overstated problem, but it is something that every

single regulator in the Anglo-Saxon world – unlike almost eve-

rybody in continental Europe – is concerned about. And that is

going to send a negative signal about conflicts of interests within

regulators, suggesting that when something goes wrong they may

try to claw back some of the assets for the unsecured creditors.”

Indeed, with the notable hold-out of a few regulators around

the world solely focused on depositor protection (notably the

Federal Deposit Insurance Corporation in the US), the tide

among governments and financial authorities has turned firmly

in favour of covered bonds.

The nuclear optionThe apparently irresistible momentum driving the covered

bond market could, however, rapidly disappear were covered

bonds ever to be subject to bail-ins themselves.

Although Pfandbriefe are explicitly exempted from German

bank restructuring legislation passed last year, covered bonds

are not mentioned in the EC’s proposal. The newly elected Irish

government has already raised the unexpected spectre of bail-

ing in senior unsecured creditors and popular opinion in Ice-

land has swayed its president into taking decisions that appear

to ignore conventional financial wisdom.

However, few market participants are willing to even con-

sider this scenario.

“In the documents we have seen, and the EC one in particular,

it is not written that covered bonds should be bailed in, whereas

it explicitly mentions senior unsecured, or non-secured debt,”

says Ralf Grossmann, head of covered bond origination at Société

Générale. “And it makes sense that covered bonds are exempted

from bail-ins, because why establish a legal framework that gives

them an exemption from general insolvency legislation – which

covered bond laws in France, Germany and Spain, for example, do

– and then basically declare this null and void by bailing them in?

“It really doesn’t make sense.”

However, he suggests that in countries where covered bonds

are not specifically exempted from bankruptcy proceedings, is-

suers and the authorities might want to take the opportunity

afforded by implementation of any new bail-in regime to make

the asset class’s privileged position explicit.

Credit Suisse’s Kemmish says that he is more concerned

about this possibility being feared than such a scenario ever

coming to pass.

“I think it’s very real that people might think that covered

bonds could be bailed in,” he says, “but, no, I don’t think it could

ever happen. Every regulator understands that they are there to

protect covered bond holders, even if they know that the guy

sitting in the office next to them is trying to protect the unse-

cured depositors.

“It would never come to the case where a government would

make a covered bond default by taking assets away from a pool.

That would cause huge systemic damage.”

Grossmann agrees.

“In the Irish case, there could indeed be a solution where

the senior unsecured debt will be bailed in,” he says, “but would

they go so far as to bail in the covered bonds as well?

“Which would mean that they could forget about covered

bonds for the future, right?”

“It is an erroneous but common belief that asset encumbrance

becomes a vicious circle”Richard Kemmish, Credit Suisse


The Covered Bond Report is the first magazine dedicated to the asset class.If you are an investor or issuer with an interest in covered bonds, then your subscription to The Covered Bond Report’s magazine is free.

To ensure that you receive every copy of The Covered Bond Report, please send an e-mail to Neil Day, Managing Editor, at [email protected]. Alternatively you can enter your details while registering for our website at news.coveredbondreport.com – and access to our online offering is completely free to qualifying investors.


To the lifeboats!






The Covered Bond Report is not only a magazine, but also a website providing news, analysis and data on the market.


FRANCE: OBLIGATIONS A L’HABITAT



The publication of a decree in the Journal Offi-

ciel de la République Française on 25 February

marked the end of a legislative process aimed at

transforming French common law or structured

covered bonds into legislative covered bonds,

newly created obligations à l’habitat. In parallel, enhancements

to France’s obligations foncières have been enacted.

The move paved the way for French issuers to apply to the

Autorité de contrôle prudential (ACP) for licences for their is-

suers to become sociétés de financement a l’habitat (SFHs).

As The Covered Bond Report was going to press, the ACP

was due to hold its monthly meeting at the end of March and

was expected to approve existing issuers’ applications.

Initially, the French authorities and market participants had

considered bringing France’s common law covered bonds un-

der a single framework with its existing obligations foncières.

However, the two asset classes will remain distinct, albeit shar-

ing many features, particularly given the updates to the obliga-

tions foncières framework.

“The SFH legal framework is very similar to the current

contractual framework,” says Nadine Fedon, general manager

of Crédit Agricole Covered Bonds and global head of fund-

ing, Crédit Agricole. “It adds real security for bondholders as

most of the provisions defined contractually are now written

in the law.

“With this modification of the legal framework for French

covered bonds, SCF and SFH have both been made more sound

by the law,” she adds. “There is an obligation to adhere to 2%

overcollateralisation and to have enough liquidity at all times

to ensure any payment in the next 180 days. These two require-

ments have been added to the SCF law and will apply to the SFH

framework accordingly.”

An element of the existing obligations foncières framework

that it will now share with obligations a l’habitat is a contrôleur

spécifique, or specific controller. But aside from this, and the

application for a licence, there is little that issuers need to do to

adapt to the new framework, according to Boudewijn Dierick,

flow ABS and covered bonds structuring at BNP Paribas.

“The original aim on the government’s part was to increase

harmonisation in the asset class, so that they could have eve-

rything covered under one law,” he says, “and then also from

the issuers’ point of view to make them Ucits compliant, which

requires a law.

“But on the other hand, the structures worked very well, so

we didn’t want to make major changes to them.”

The project’s aims segued into developments at a European

level. When the European Central Bank announced its Eu60bn

covered bond purchase programme in May 2009 it had to deal

with the question of whether or not non-Ucits compliant cov-

ered bonds – mainly French structured covered bonds – should

be included. Ultimately it allowed the purchase of covered

bonds that were Ucits compliant or were “offering similar safe-

guards”.

The ECB has since banged the drum for greater harmonisa-

tion of European covered bonds, campaigning for a “label” that

could be applied to the asset class to maintain standards and

make life easier for investors.

“As well as the desire for harmonisation from the French

government side, you also had this theme from the central

banks, the ECB,” says one market participant. “Over the past

France’s new modelThe latest fashion in Paris this spring is the obligation à l’habitat. Created by bringing France’s common law covered bonds under a legislative frame-work, the new instrument offers a new take on an old favourite. As such, can

it command couture prices? By Neil Day

“The structures worked very well, so we didn’t want to make major

changes to them”



couple of years at every conference where Michel Stubbe [head

of the market operations analysis division at the ECB] speaks

he says that we need to have a label and we need to have one

definition, so the fact that all the programmes will be covered

by one law, and be Ucits compliant, will certainly be appreciated

by them.

“It certainly helped push people along.”

Because the underlying assets remain dominated by prêts

cautionnés (guaranteed loans) rather than residential mort-

gages, the new obligations à l’habitat will not achieve Capital

Requirements Directive (CRD) compliance.

Not every issuer will be converted directly into an SFH;

Groupe BPCE will cease issuing covered bonds through GCE

Covered Bonds and Banques Populaires Covered Bonds and in-

stead issue through a new SFH, BPCE Home Loans.

Issuers, not structures, keyWhether or not French issuers will be rewarded by investors for

the introduction of the new law is another question. Some mar-

ket participants say that the conversion to obligations à l’habitat

is unlikely to have much of an impact on pricing, because struc-

tured covered bonds had been trading so well.

Stephane Bataille at Landesbank Baden-Württemberg says

that the lack of discrimination that French common law cov-

ered bonds have previously suffered is demonstrated by the nar-

rowness of spreads between covered bonds launched off BNP

Paribas’ Home Loans programme and by its société de crédit

foncier.

“The spread is between 2bp and 4bp,” he says. “So if Crédit

Agricole, for example, were to issue obligations à l’habitat now

then the advantage would be maybe 1bp-2bp.”

He argues that this is because the spreads at which covered

bonds trade are today more related to the credit of the issuer

than the underlying framework.

“It’s more credit related, more related to news-flow,” he says.

“Particularly if you are talking about strong names, you look

more at the issuer.”

He points to the way in which the relative pricing of com-

mon law and legislative covered bonds changed dramatically

between 2007 and 2010 as the financial crisis moved through

its different stages.

“Beforehand, there was a gap of perhaps 2bp between the

legal and structured issues,” he says, “so BNP Paribas and Dexia

Municipal Agency were trading at almost the same levels. Then

at the end of 2007 nobody wanted to buy structured covered

bonds and their spreads widened significantly versus obliga-

tions foncières.

“But at the end of 2008 and in 2009, this was completely re-

versed. Everyone only looked at the strength of the credit be-

cause of what happened to certain issuers. Nowadays the strong

structured covered bonds are trading well inside those of the

obligations foncières.”

Easing supply pressureHeiko Langer, senior covered bond analyst at BNP Paribas, also

cautions against expectations that the new legislation could re-

sult in any sudden spread moves.

“I don’t anticipate prices moving too noticeably,” he says.

“These French covered bonds already trade pretty tight com-

pared with obligations foncières, and spreads are anyway very

much driven on an issuer by issuer basis, not so much structure

by structure.

“But it should make life a bit easier for the French issuers,”

he adds. “It will help the French issuers broaden their investor

-20.0

0.0

20.0

40.0

60.0

80.0

100.0

2006 2007 2008 2009 2010 2011*

French Contractual vs. Legal Jumbo Covered Bonds

French Contractual Covered Bonds French Legal Covered Bonds

Source: LBBW



bases and, to be honest, that will be quite welcome.

“As everybody knows, there has been a lot of supply out of

France and there’s probably more to come.”

French issuers have been by far the most active in 2011,

selling more than Eu20bn of benchmark covered bonds in the

year to mid-March, equivalent to almost a quarter of total euro

benchmark issuance. Around-two thirds of this French issu-

ance has been from those issuers that will now be issuing obli-

gations à l’habitat.

But some market participants are sceptical that there are ar-

eas for France’s newly legislative covered bonds to reach.

“The French have been hoping that they could place more

with certain investors,” says one covered bond banker, “but we

do not expect that to be the case. If you look at who has been

buying these covered bonds in the past, it is the typical covered

bond investor base.

“Their distribution is already very broad and to my knowl-

edge there are not any investors who do not participate.”

Indeed he says that when he looked at distribution figures

for the two types of French covered bonds, he found that big

banks and funds had been buying more structured covered

bonds than legislative covered bonds out of France.

But Langer says that feedback from investors suggests that

the new law will help issuers broaden their investor bases.

“There are still quite a lot of investors out there who

would like to diversify into other covered bonds, including

French covered bonds, but they are uncomfortable with buy-

ing covered bonds where there is no underlying legal frame-

work,” he says. “I would say this is particularly true for non-

European investors.

“But I have had discussions with lots of German investors

who want to diversify away from Pfandbriefe for line reasons,

and some of the smaller ones haven’t yet bought French covered

bonds so far because of the lack of a legal framework. I there-

fore think it will have an impact on the investor base and allow

the French banks to grow more.”

Market participants are also hopeful that the new law will

clarify for investors France’s covered bond market. This also

takes in a third strain, namely the issuance of Caisse de Refi-

nancement de l’Habitat under its own legislation, which raise

some Eu3.7bn in the first three months of the year.

“Until now, it has been difficult for foreign investors to un-

derstand the situation,” says Géraldine Lamarque, head of fund-

ing, financial communication and market at Crédit Immobilier

de France and CIF Euromortgage, “there having been three

kinds of covered bonds with two legal frameworks and a variety

of contractual programmes. Having three true legal bases now

increases the readability of the French covered bond segment at

a pan-European level.

“This is a very positive signal for a community of investors

looking for clarity, transparency and regulation, and will in-

crease the overall investor base for French covered bonds. The

bigger this base is, the better it is for all French players.”

For more on the new instrument, please see a Crédit Agricole roundtable involving key issuers and investors – “The emergence of Obligations à l’Habitat in the evolving French home loan refi-nancing market” – on The Covered Bond Report website.

“Particularly if you are talking about strong names, you look

more at the issuer.”

-20

0

20

40

60

80

100

France Covered Legal France Covered Structured

Source: iBoxx, Crédit Agricole CIB

iBoxx France Covered Legal vs iBoxx France Structured

2011 2012 2014 2015 2016 2017 2018 2019 20202013

Ass

et s

wap

spr

eads


LEGAL BRIEF: THE US DEBATE

1. What is a covered bond?Covered bonds are bonds that are issued by credit institutions

as senior unsecured debt. The bonds are “covered” by a dynamic

pool of ring fenced assets (the cover pool), usually commer-

cial or residential mortgage loans, and/or public sector assets.

Legally and economically, the cover pool is isolated from the

general assets of the credit institution, and upon the insolvency

of the credit institution the covered bondholders have a prefer-

ential claim on the proceeds of the cover pool.

This dual recourse for investors (to both the general assets

of the issuer, and the proceeds of the cover pool upon issuer

insolvency) enables covered bonds to be issued with a higher

rating than the standard senior, unsecured debt of the issuer.

In contrast to a securitisation structure, the cover pool assets

remain on the issuer’s balance sheet, and the sponsoring bank

retains the related credit and prepayment risk. In contrast to se-

cured debt, after the insolvency of the issuer, the covered bond

holders continue to be paid from the proceeds of the cover pool

and the covered bonds remain outstanding until their original

scheduled maturity.

2. The existing US landscapeThe covered bond market is well developed in Europe; however,

the absence of a specific legal framework for covered bonds in

the United States (which gave rise to investor concerns about

the treatment of covered bonds upon the insolvency of the

sponsoring credit institution) has stifled the development of the

product in the US. While the US-issued covered bond market

has stalled, a significant majority of the largest Canadian banks

and financial institutions have established covered bond pro-

grammes. In 2010 and the first quarter of 2011, European and

Canadian banks have issued more than $35bn of covered bonds

into the US through the 144A market, demonstrating a strong

demand for the product among US investors.

For US issurers, investors were concerned about how the

Federal Deposit Insurance Corporation (FDIC) would treat the

covered bonds upon the occurrence of a receivership or conser-

vatorship with respect to the issuing bank. The FDIC has stated,

that if an insured depository institution (IDI) becomes subject

to a FDIC conservatorship or receivership it currently has three

options with respect to the IDI’s covered bonds:

(i) Affirm: The FDIC can cause the IDI to continue to perform

under the original terms of the covered bond programme.

The FDIC may then transfer the covered bond programme

and the cover pool to a new financial institution.

(ii) Repudiate: The covered bonds become immediately due

and payable, and the FDIC determines the fair market

value of the cover pool and pays the covered bond holders

the lesser of (1) the outstanding principal amount of the

bonds plus interest accrued to the date of appointment of

the FDIC and (2) an amount equal to the fair market value

of the cover pool.

(iii) Repudiate: The covered bonds become immediately due

and payable, and the FDIC allows the covered bond hold-

ers to exercise self-help remedies with respect to the cover

pool resulting in the liquidation of the cover pool and

the covered bond holders receiving the amount equal to

the lesser of (1) the outstanding principal amount of the

bonds plus interest accrued to the date of appointment of

the FDIC and (2) the proceeds from the liquidation of the

cover pool.

Any action with respect to the cover pool is subject to an

automatic stay of 45 or 90 days following the appointment of

the FDIC to the conservatorship or receivership, respectively

(the “automatic stay”). The options available to the FDIC as

described above and the automatic stay provide the FDIC

with a significant amount of flexibility when dealing with

the covered bond programmes of insolvent IDIs. This flex-

ibility leads to uncertainty for covered bond holders. Issuers

of covered bonds have been subject to the additional costs of

maintaining the liquidity that would be needed to make pay-

ments on the covered bonds during these periods after the

appointment of the FDIC.

US: Today’s reality & tomorrow’s potentialThe US Covered Bond Act of 2011 has reignited the debate over whether legislation is necessary to seed issuance and, if so, how it should relate to

the Federal Deposit Insurance Corporation. Lawton Camp and John Hwang of Allen & Overy in New York examine the proposed bill and the

arguments being made against it.



As an indication of (at least limited) support for the devel-

opment of a covered bond market in the US, on 15 July 2008,

the FDIC issued its Final Policy Statement, which set out when

the FDIC will grant expedited access to pledged covered bond

collateral (i.e. when the automatic stay will be reduced to 10

days). The right to damages in the case of an insolvency of the

covered bond issuer was limited under the Policy Statement to

the par value of the covered bonds plus interest accrued to the

date the FDIC is appointed conservator or receiver. The Policy

Statement also required the cover pool to be liquidated using

commercially reasonable and expeditious methods taking into

account existing market conditions. Liquidating the cover pool

expeditiously after a major bank failure exposes the covered

bond holders to significant pricing risk with respect to the cov-

er pool. Finally, the FDIC restricted the eligible assets to limited

categories of residential mortgages or AAA rated mortgage-

backed securities.

On 28 July 2008, the US Department of the Treasury published

a document setting out certain Best Practices in respect of US

covered bonds. The Best Practices were intended to complement

the Policy Statement and, like the Policy Statement, were seen

as a signal of approval and support for the development of the

US covered bond market. The Treasury indicated that the Best

Practices were intended to help standardize US covered bonds

and included an express note that the Treasury fully expected the

structures, collateral and other key terms of US covered bonds to

evolve with the growth of the market in the US.

The Best Practices include provisions with respect to cover

pool assets, overcollateralisation, substitution, asset coverage

testing and monitoring and issuance limitations.

To date, only two covered bond programmes have been set

up by US credit institutions: Washington Mutual in 2006, and

Bank of America, NA in 2007. Both of these programmes at-

tempted to use structural solutions to emulate European cov-

ered bond programmes that are, for the most part, issued under

specific statutory regimes. In addition, both programmes were

created prior to the Policy Statement from the FDIC and the

Best Practices guidance from Treasury. Despite initial indica-

tions of interest, other US credit institutions have not followed

in setting up covered bond programmes of their own, due in

large part to the regulatory uncertainties mentioned above, as

well as the recent general economic climate.

3. US covered bond act of 2011On 4 March 2011, US Representatives Scott Garrett (R-NJ) and

Carolyn Maloney (D-NY) reintroduced a proposed federal cov-

ered bond framework into the US House of Representatives by

way of a bill (HR 290) entitled the “United States Covered Bond

Act of 2011”.

3.1 Key Features of the Act(a) A statutory regime for covered bondsThe Act provides for the establishment of covered bond pro-

grammes by eligible issuers secured by a covered pool consist-

ing of a single class of eligible assets or substitute assets. Each

covered bond programme must be approved by the applicable

covered bond regulator. The Treasury Secretary will establish

a covered bond regulatory oversight programme through which

covered bond programmes will be evaluated, including providing

for additional regulation relating to eligible assets and any estate

created consistent with maximising the value of the cover pool.

(b) Covered bond regulatorThe Act defines the covered bond regulator as (i) the Office of

the Comptroller of the Currency (OCC) in the case of a nation-

al bank, a district bank or an insured federal branch of a foreign

bank; (ii) the FDIC in the case of an insured non-member bank,

including an insured state branch of a foreign bank; (iii) the

Board of Governors of the Federal Reserve System in the case

of a state member bank; (iv) the Office of Thrift Supervision

(which in July 2011 will change to either the OCC or the FDIC

as a result of the Dodd-Frank Wall Street Reform & Consumer

Protection Act) in the case of an insured federal or state savings

association; or (v) the Secretary of the Treasury in the case of an

eligible issuer that is not regulated by a federal banking agency.

(c) Eligible issuersThe Act defines an eligible issuer as any insured depository

institution, bank holding company, savings and loan holding

company, non-bank financial company approved as an eligible

issuer by the applicable covered bond regulator, any subsidiary

of any of the foregoing and any issuer sponsored by one or more

eligible issuers for the sole purpose of issuing covered bonds.

The inclusion of a provision that allows “any issuer sponsored

by one or more eligible issuers” to be an eligible issuer effec-

tively enables smaller banks to join together and issue covered

bonds from a single sponsored issuer (similar to the covered

bond programmes of SpareBank 1 Boligkreditt AS in Norway

and Caisse Central DesJardins du Quebec in Canada).

(d) Covered bonds definitionThe Act defines covered bonds as recourse debt obligations of

eligible issuers that:

(i) have a maturity of not less than one year;

(ii) are secured by a perfected security interest in or other lien

on a cover pool that is owned directly or indirectly by the

issuer of the obligation;

(iii) are issued under a covered bond programme that has been

approved by the applicable covered bond regulator;

(iv) are identified in a register of covered bonds that is main-

tained by the Secretary; and

(v) do not constitute deposits (as defined in the Federal De-

posit Insurance Act).

(e) Cover pool assetsEach cover pool must be made up of assets from a single eligible

asset class, which include the following:

(i) certain identified residential mortgages;

(ii) home equity loans;

(iii) commercial mortgages;



(iv) public sector debt issued by a State, municipality or other

governmental authority or guaranteed by the full faith and

credit of the US Government;

(v) auto loans or leases;

(vi) student loans;

(vii) credit or charge card receivables;

(viii) small business loans; and

(ix) other assets classes designated by the Secretary;

Provided that (i) the relevant loan is not delinquent for

more than 60 consecutive days, and (ii) the asset is not subject

to a prior pledge.

The cover pool may also consist of substitute assets

which may include: (i) cash; (ii) direct obligations of the

US government or guaranteed by the full faith and credit of

the US government; (iii) direct obligations of a US govern-

ment corporation or US government sponsored enterprise

(a GSE) of the highest credit quality (not to exceed 20% of

the cover pool); (iv) overnight investment in federal funds;

and (v) other substitute assets designated by the Secretary;

and may contain ancillary assets (such as interest rate or

currency swaps, credit enhancement and other liquidity ar-

rangements).

The list of eligible asset classes in the Act is broader

than the types of assets that are traditionally used to back

covered bonds (usually residential mortgages and certain

public sector assets). It remains to be seen whether there

will be appetite (on behalf of either issuers or investors) for

covered bonds backed by, for example, auto loans, but the

flexibility that allows issuers to have multiple covered bond

programmes each backed by a different eligible asset class

is encouraging for potential future growth of the market.

(f) Minimum overcollateralisation requirementThe Secretary will establish minimum overcollateralisation re-

quirements for each eligible asset class designed to ensure that

sufficient eligible assets are available to pay interest and principal

on the covered bonds when due, based on credit, collection and

interest rate risk. The assets in the cover pool will be required

to meet the minimum overcollateralisation requirements at all

times. Failure to meet the minimum requirements is a default for

purposes of Section 4 (Resolution Upon Default or Insolvency),

paragraph (a) (Uncured Default Defined) of the Act.

That an overcollateralisation level is mandated by the Act

alleviates concerns in existing US structured covered bonds is-

sued by institutions subject to FDIC supervision that, upon the

appointment of the FDIC as conservator or receiver with re-

spect to a covered bond issuer, investors would lose their rights

to any overcollateralisation in the cover pool. However, as dis-

cussed further in Section 4(a) below, concerns have already

been raised as to whether the overcollateralisation provisions

are sufficiently broad to truly protect investors in the case of

issuer insolvency.

(g) Asset coverage testTo ensure that the assets in the cover pool satisfy the minimum

overcollateralisation requirements at all times, the cover pool

will be required to satisfy an asset coverage test. The asset cov-

erage test will be required to be carried out on a monthly basis

by the issuer and the results are required to be disclosed to the

applicable covered bond regulator, the Secretary and the inden-

ture trustee, along with all covered bond holders.

In addition, the issuer will be required to appoint an inde-

pendent third party to act as asset monitor with respect to the

cover pool, with responsibility for verifying on at least an an-

nual basis whether the cover pool satisfies the asset coverage

test. Likewise, the asset monitor’s findings must be disclosed to

the applicable covered bond regulator, the Secretary, the inden-

ture trustee and the covered bond holders.

While a failure to satisfy the asset coverage test does not

prejudice the eligibility of the covered bonds under the Act,

failure to satisfy the asset coverage test after the cure period

specified in the transaction documents will constitute an event

of default with respect to the programme.

(h) Default and InsolvencyPerhaps the most significant provisions of the Act relate to the

protections that are introduced for covered bond holders fol-

lowing an event of default or insolvency event with respect to

the issuer. As noted above, there were regulatory concerns in

existing US covered bond structures surrounding the rights of

covered bond holders to the cover pool following, in particular,

the appointment of the FDIC as receiver or conservator of the

issuer. The Act introduces measures to relieve these concerns in

three main scenarios, set out below.

(i) Upon the occurrence of an event of default with respect to

a covered bond that occurs prior to the issuer entering into

conservatorship, receivership or analogous proceeding, a

separate estate is created by automatic operation of law (the

John Hwang



“separate estate”). The covered bond regulator will act as or

appoint a trustee. The separate estate consists of the cover

pool (including ancillary assets, and the Act-mandated

overcollateralisation), and is created free of any claim of

the issuer or its conservator or receiver. The separate estate

is fully liable for all claims of covered bond holders under

the covered bonds. The covered bond holders retain a claim

against the issuer for any amounts remaining outstanding

on the covered bonds following full distribution of all the

assets of the separate estate. In addition, the issuer (or its re-

ceiver or conservator) has a claim against the separate estate

for any residual amounts remaining following satisfaction

in full of amounts owing to the covered bond holders.

In an attempt to ensure that there are no disruptions to

cashflows on the covered bonds following an issuer default,

the issuer may be required to continue servicing the cover

pool for 120 days after the creation of the separate estate, in

return for a “fair-market-value fee”. The covered bond regu-

lator, as trustee of the separate estate, may then appoint a

servicer or administrator to service and realise on the cover

pool on an ongoing basis, including by way of liquidating

the cover pool assets, in order that the separate estate con-

tinues to make scheduled interest and principal payments

on the covered bonds.

This provision would allow the servicer or administra-

tor to pursue private market alternatives that meet certain

conditions set out in the Act in the event of a lack of li-

quidity caused by a timing mismatch between the assets

and the covered bond liabilities (i.e. in situations where the

amortisation profiles of the cover pool assets and the cov-

ered bonds do not match exactly). This is in contrast to the

inclusion in a prior draft of the Act of a committed govern-

ment liquidity facility that would have given the separate

estate access to a secured financing facility with the Federal

Reserve Bank, allowing it to raise any funds needed to make

payments on the covered bonds without it having to sell as-

sets in the cover pool under potentially unfavorable market

conditions.

(ii) If the FDIC is appointed as conservator or receiver with

respect to the issuer prior to the occurrence of another

event of default on the covered bonds, the Act confers to

the FDIC the right, for a period of 180 days following its

appointment, to transfer the cover pool (and the relevant

covered bonds and other related obligations) to another en-

tity that is an eligible issuer under the Act that meets all of

the conditions and requirements in the related transaction

documents.

Crucially, the Act also provides that during the 180

day period described above, the FDIC will meet all obliga-

tions (monetary and non-monetary) of the issuer under the

covered bonds and the related transaction documents and

shall fully and timely cure all defaults by the issuer until the

transfer of the cover pool to an eligible issuer as described

above, or delivery by the FDIC of written notice of its elec-

tion to cease further performance under the covered bond

programme. This gives covered bond holders much greater

certainty than in the previous position set out in the Policy

Statement by the FDIC, which could potentially lead them

to incur losses on their investments as a result of the FDIC’s

appointment, notwithstanding the existence of the claim

against the cover pool.

(iii) If either (A) a conservator, receiver or analogous entity other

than the FDIC is appointed with respect to the issuer be-

fore the occurrence of an event of default or (B) the FDIC

is appointed as conservator or receiver with respect to the

issuer but no transfer is completed within the 180 day period

described in (ii) above, the FDIC delivers written notice of

its election to cease further performance under the covered

bond programme or fails to fully and timely satisfy the mon-

etary and nonmonetary obligations or timely cure all defaults

of the issuer under the covered bond programme, a separate

estate is again created by automatic operation of law. The

operative provisions with respect to the separate estate are

identical to those described in paragraph (i) above.

(i) Securities law considerationsCovered bonds that are offered and sold to the public by a bank

(or bank subsidiary) are to be exempt from federal securities

laws, but will be subject to any applicable securities regulations

of such issuer’s primary federal regulator as well as antifraud

rules.

No such exemption is created for covered bonds that are of-

fered and sold to the public by any other non-bank issuer that

are not otherwise exempt from federal securities laws.

4. Comment and concerns(a) Criticism of the Act from the FDIC(i) The FDIC wants covered bonds to be treated in the same

way as other secured debt.

Lawton Camp



As described in the section The Existing US Land-

scape, the FDIC currently has the option to determine the

fair market value of the cover pool or liquidate the cover

pool and obtain immediate access to any overcollateralisa-

tion. Under the Act, if the FDIC does not transfer the cov-

ered bonds and related cover pool, the FDIC retains a re-

sidual interest in the separate estate. The residual value of

the cover pool is therefore not “lost for all other creditors

of the failed bank” as suggested by the FDIC, but rather

converted into a residual interest that can be certificated

and sold to third parties. The holder of the residual in-

terest is entitled to the remaining value of the cover pool

after the covered bonds have been paid in full at their ma-

turity. It is inaccurate to suggest that the residual inter-

est would be entirely illiquid. In fact, the pool of investors

who can invest in certificated residual interest certificates

may be greater than the number of investors who can di-

rectly purchase and hold the eligible assets. The FDIC cor-

rectly points out that the Act provide covered bond hold-

ers with greater rights with respect to the cover pool than

they would have if they were simply secured creditors.

The question is whether these additional rights create sig-

nificant additional burdens on the FDIC and the deposit

insurance fund (DIF) and whether those burdens, if any,

are outweighed by the benefits of covered bond financing.

(ii) The FDIC wants control over the liquidation or transfer of

the cover pool.

The FDIC’s desire to be able to use all of its available op-

tions with respect to the transfer or liquidation of the cover

pool is understandable in light of the FDIC’s mandate to use

“least costly” method to resolve any insolvency of an ADI

and to protect the DIF. However, the optionality provided

to the FDIC creates uncertainty for covered bond holders

that increase the costs of issuance. Currently, the FDIC

has up to 90 days to decide what to do with the covered

bond programme and the related cover pool. During this

time, they are not required to make any payments to cov-

ered bond holders, and if the FDIC chooses to liquidate the

pool, interest will not accrue on the covered bonds from the

time the FDIC is appointed. Under the Act, the FDIC can

take up to 180 days to decide whether to transfer or repudi-

ate the cover bond programme, however, during this time,

the FDIC must continue to pay all amounts owed under the

covered bond programme as they become due. The FDIC

argues that any time limit imposed on the FDIC results in

the FDIC being the de facto guarantor of covered bonds.

(iii) The FDIC believes that the Act will primarily benefit the

large financial institutions.

The Act allows smaller banks to join together to create

a single issuer of covered bonds. As previously described,

similar structures currently exist in Canada and Norway as

well as other jurisdictions.

(iv) The FDIC believes that the legislation fails to recognise that

US banks already have access to a covered bond market and

that covered bonds were successfully issued prior to 2008.

What the FDIC does not acknowledge is that no US en-

tities have issued covered bonds since 2007, while Canadian

and European issuers have sold billions of dollars of cov-

ered bonds to US investors. Further, given the uncertainty

relating to the automatic stay and the liquidation of the

cover pool, US covered bond programmes were forced to

include contingent payment swaps and guaranteed invest-

ment contracts that, given the changes in market conditions

and regulation, may be extremely expensive or unavailable

in the future.

(b) Will the Act protect overcollateralisation in excess of the prescribed minimum?While the Act requires that the covered bond regulator must

determine a minimum overcollateralisation level for each as-

set class, there is no express protection given to overcollater-

alisation in excess of that minimum: the asset coverage test

language, for example, requires that the assets in the cover

pool satisfy the minimum overcollateralisation requirements

set by the covered bond regulator. If the issuer commits addi-

tional overcollateralisation to the cover pool as a result of, for

example, investor demand or to meet rating agency criteria, it

is not clear whether such excess overcollateralisation would

form part of the separate estate (or be transferred to another

issuer) upon the insolvency of the issuer. There is no guar-

antee at this stage that the excess could not be clawed back

by the FDIC or other relevant bankruptcy official appointed

with respect to the issuer, and form part of the issuer’s gen-

eral insolvency estate rather than being ring-fenced in favor

of covered bond holders.

Standard & Poor’s (S&P) began a consultation process

that led to the publication on 16 December 2009 of its “Re-

vised Methodology And Assumptions For Assessing Asset-

Liability Mismatch Risk In Covered Bonds”. These set out a

number of aspects of covered bond legislation that S&P con-

siders are particularly relevant in assessing refinancing risk,

including specifically whether there are any limits to over-

collateralisation levels. If there is any question as to whether

excess overcollateralisation above the Act-mandated mini-

mum will be available to covered bond holders on the default

of the issuer, this will negatively affect S&P’s rating analysis

of US covered bonds.

In its comment piece on a prior draft of the Act entitled “US

Covered Bond Overhaul Would Be Credit Positive Overall,”

Moody’s expressed concern that the draft provisions in relation

to calculation of the minimum overcollateralisation level to be

set by the covered bond regulator (which specifically excludes

liquidity risk associated with the relevant asset class) could re-

sult in the overcollateralisation level being set artificially low.

As investors (and presumably although not specifically dis-

cussed by Moody’s the rating agencies) may well require ad-

ditional overcollateralisation in the cover pool to mitigate the

liquidity risk discussed above, particularly as a result of the re-

moval from the Act of the committed liquidity facility provided

by the Federal Reserve Bank that was proposed in a prior draft

of the Act.



(c) Liquidity: (i) How will scheduled bond payments be met after an issuer

default?

As discussed above, a prior draft previously proposed

by Rep Garrett included a committed government lend-

ing facility that would be accessible to any separate es-

tate following an issuer default. This would have allowed

the separate estate to raise financing to make scheduled

covered bond payments without forcing a fire-sale of the

assets at potentially distressed prices or under unfavora-

ble market conditions, which could leave covered bond

holders without full payment on their investments. The

inclusion of such a government lending facility would

have been a significant difference between the Act and

similar covered bond legislation in Europe, but one that

was welcomed at the time that prior draft of the Act

was introduced by both potential investors and the rat-

ing agencies. However, political pressure seems to have

led to the removal of the proposed facility from the Act

to avoid the appearance that the covered bonds had the

benefit of an implicit government guarantee.

The current proposal in the Act requires the servicer or

administrator of the separate estate to “pursue private market

alternatives” in order to raise funds that will enable it to make

scheduled payments on the covered bonds where there is a

mismatch between the timing of receipt of payments on the

assets and due payments on the covered bonds.

This refinancing risk is a feature of covered bond pro-

grammes in almost all jurisdictions, and has, since the start

of the credit crisis, received increased attention from inves-

tors and the rating agencies alike.

(ii) How do the rating agencies approach liquidity risk?

The credit ratings assigned to covered bonds by the ma-

jor rating agencies may be capped if there are asset-liability

mismatches that are not addressed structurally. The rating

agencies generally evaluate the likelihood that the liquid-

ity risks and liquidation risks created by an asset-liability

mismatch will result in an interruption in the payment of

amounts when due on the covered bonds as a result of an is-

suer default. The asset-liability mismatch results in a liquid-

ity risk due to the fact the amount and timing of payments

produced by the cover pool may vary from the amount and

timing of payments due on the covered bonds. A liquidation

risk exists because a portion of the cover pool may need to

be liquidated under stressed conditions to meet the asset-

liability mismatch while still maintaining enough collateral

to service the remaining debt. In evaluating the liquidity

risks and liquidation risks, the rating agencies consider the

jurisdiction of the covered bond issuer (and the applica-

ble legislative framework, if any), the refinancing options

available to the covered bond programme and the timing

and availability of those refinancing options relative to the

liquidity and credit enhancement available in the covered

bond programme.

(iii) What structural solutions are used to mitigate liquidity

risk?

Although refinancing risk has been the subject of in-

creased scrutiny as a result of the recent financial turmoil, it

is not in itself a new concern. Covered bond programmes in

Europe and Canada in particular have used various struc-

tural features in an attempt to mitigate the risk, including

but not limited to those discussed below.

(A) Extendable maturities (so-called “soft bullet” covered bonds): soft bullet covered bonds provide for the

extension of the maturity date of the covered bonds by a

specified period following the default of the issuer. This al-

lows additional time for assets to be sold to finance repay-

ments and so avoids assets being sold at distressed or fire-

sale prices in order to meet repayment obligations that arise

shortly following default.

(B) Pre-maturity tests: a pre-maturity test looks at the

issuer’s rating at a specified date prior to the maturity of any

series of covered bonds (usually six to 12 months). If the

issuer does not meet the specified rating threshold, it will

be required to post cash to the deal or to begin liquidating

assets immediately following the failed pre-maturity test in

order to raise the required redemption funds.

(C) Minimum liquidity requirement: for example, the

German covered bond legislation requires issuers to test

potential liquidity shortfalls on an ongoing basis over the

next 180 days. If there is a projected liquidity shortfall, it is

compensated for by adding additional liquid assets.

5. ConclusionsIn the FDIC’s Statement of the Federal Deposit Insurance Cor-

poration on Legislative Proposals to Create a Covered Bond

Market in the United States, dated 11 March 2011, the FDIC

states that it has “long worked with the financial industry to es-

tablish a sound foundation for a vibrant covered bond market”.

However, no US originated covered bonds have been issued

since 2007 and the FDIC’s Policy Statement did not result in

the establishment of a single new US covered bond programme.

However, since 2007, at least seven Canadian covered bond

programmes have been created. Further, during this time Eu-

ropean and Canadian issuers of have sold billions of dollars of

non-US covered bonds to US investors.

European and Canadian covered bond issuers have proven

that there is robust demand for covered bonds among US inves-

tors. For US covered bonds to be competitive, the legal frame-

work must be more robust and outcomes must be more certain.

The introduction of the Act forms a very positive step for the

potential US covered bond market in that it addresses the insol-

vency and liquidity concerns related to current US covered bond

programmes. The Act has received initial indications of support

from politicians across the political spectrum and from the issuer

and investor communities alike. It is hoped that by this time next

year, articles will be written not about the introduction or possi-

bility of US covered bond legislation, but instead about the rules

to be promulgated under the Act.


FULL DISCLOSURE

Postcards from the LBBW European Covered Bond Forum, Mainz, where the great and the good of the covered bond market gathered in February. At a gala dinner (bottom left), a surprise guest revealed a new bail-out plan: turn twenty euro notes into fifties.

Washington & MainzThe West Wing, starring (L-R): Chris Russell, legislative director, Rep Scott Garrett, ECBC head Luca Bertalot, and Bert Ely, FDIC-watcher.

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European

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Documents

The Covered Bond Report Issue 1