The UK has joined the club of European nations with a legal framework for its covered bonds. But the new regime is unlikely any time soon to dent the dominance of its German equivalent, the Pfandbrief, which has had over 200 years of history to build up its reputation and investor base.
The UK regime should eventually give a boost to its covered bond market both in issuance and investor demand. But it has had the misfortune to launch in particularly inauspicious times for financial markets, so short term UK covered bonds are unlikely to make much of an impact.
Covered bonds are investment grade instruments issued by banks and other credit institutions that are backed by a ring-fenced pool of assets. Should the issuer become insolvent, covered bond investors have a prior claim on these assets. The assets backing them are mortgages or public sector loans.
Principled approach
Covered bonds had existed in the UK previously under contractual arrangements but the new rules give those instruments that meet the specified criteria a considerable advantage. The UK regulator has taken a principles-based approach, which specifies the minimum quality of assets that can go into the asset pool backing the bond, how the issuer must keep the asset pool topped up to maintain quality, and what would happen in the case of the issuer’s insolvency. And the regulator, the Financial Services Authority, has oversight over the bonds. Banks issuing regulated bonds benefit from lower capital requirements to back them, compared with unregulated bonds.
Having the legislation to back the instruments also bestows advantages on them under the Ucits eligible assets rules. Whereas Ucits funds are limited to 5 per cent from one issuer of non-regulated covered bonds, this rises to 25 per cent from one issuer for regulated bonds, and up to 80 per cent of a fund may be invested in regulated covered bonds.
Prospective investors in UK covered bonds should in future see these instruments in a different light. “Apart from having high quality assets in the scheme, there is a whole set of arrangements for oversight of it,” says Jane Lowe, director of markets at the Investment Management Association. “That would give anybody considerable comfort.”
Impressive set-up
The particular way the regime has been set up gets the thumbs up from industry insiders. “Some jurisdictions allow much more flexibility in the types of assets going in, and the UK set quite a narrow definition of what you are allowed to do, which is great for the existing programmes," says Richard Kemmish, head of covered bond origination at Credit Suisse.
Heiko Langer, an analyst at BNP Paribas also welcomed the way the new rules have been drafted: “The legal framework had to be put in place with an existing market. The main aim was to set up a framework that would embrace most of the existing structure. I think that has been achieved very well.”
In the long term UK banks and credit institutions should find covered bonds useful for raising cash.
“Once this liquidity crisis is solved, I think covered bonds are likely to re-emerge from it showing that in some instances it can give you access to cheap funding when other funding sources are disappearing,” says Mr Langer. “We haven’t seen any UK issuance for a while right now. The market seems to be not very open for it.”
They are a cost effective financing tool, compared with senior unsecured debt, and in some cases as a replacement for securitisation, says Mr Kemmish.
“A year ago the difference between the average UK bond and the average German covered bond was around 3 to 5 basis points,” he notes. “Given that both have rock solid credit you could speculate that the 3 to 5 basis points was purely because of the lack of regulation in the UK. With the new regulation there is no reason why theoretically they shouldn’t trade at the same level. Obviously we are a long way from that, but when the market returns to normal it should help spreads a bit.”
Banks enjoy favourable risk weightings for their investments in regulated covered bonds: “Under Basel II or the European capital requirement directive, there is a specific exemption for covered bonds - you can have a lower risk weighting for them if they fulfil the criteria of Ucits 22(4),” says Ralf Grossmann, head of covered bond origination at Société Générale Corporate and Investment Banking. “That is now the case for UK covered bonds as well.”
But for the moment the market is likely to tread water until some stability returns. Bernd Volk, covered bond analyst for Deutsche Bank, says investors at the moment are preoccupied by credit risk:
“It’s important for the UK covered bonds to attract investor interest for this product. The typical rates investors who prefer liquidity products would care more about credit risk at the moment. It’s important to make clear there is limited credit risk so that fixed income investors can buy this as an agency or government surrogate. The ultimate goal is that covered bonds are compared more with agency bonds than with senior bank bonds.”
In a time when the reputation of asset backed securities has taken a knock, investors are more likely to see these bonds in a favourable light. Covered bonds are not about transferring risk to bondholders. Securitisations on the other hand have different tranches with varying levels of risk from AAA to risk on a par with equities.
One key difference is that the pool of assets underlying covered bonds is dynamic, continually managed to keep up its quality.
“In covered bonds you have a dynamic portfolio of cover assets; in almost all securitisations you have a static portfolio,” says Mr Grossmann. “Which means, in securitisations, you segregate a dedicated pool of assets and then if this asset pool deteriorates, that is a problem for the bondholders. In covered bonds you have a dynamic pool so the bank is also backing it with its equity so you have a double recourse, which applies to the UK covered framework. This means you always have a senior unsecured claim against the issuing bank and on top of that you have recourse to this cover pool.”
Jumbo covered market
According to Deutsche Bank, last year was the most challenging for the jumbo covered bond market (issuance of more than €1bn or larger), due to increase in risk premiums, concerns about the health of financial institutions and declines in global real estate markets. According to its February report, Global Markets Research Fixed Income, until last summer pricing among the increasing number of issuers from different countries had remained similar, but then spreads began to diverge reflecting the different risk profiles of issuers and different structures. In the jumbo market Germany remains the dominant market for bonds outstanding with 36.4 per cent of the market last year. But its position is increasingly challenged by Spain’s cedulas hipotecarias whose share reached 29.7 per cent last year. This is significant, considering that Germany had an 87 per cent share at the beginning of 2002.
But the German Pfandbrief regime is undergoing a structural change. Under its rules for public Pfandbriefe, permitted assets backing the bonds included Landesbank and savings bank loans which were guaranteed by government. New issues by Landesbanks and savings banks have now been outlawed under EU law.
“Around 40 per cent of the average cover pool of public Pfandbriefe still consists of loans to Landesbanks and savings banks, but state guarantees have been abolished by the EU so all these loans and bonds will mature in the coming years to 2015 and cannot be substituted,” says Mr Volk. “So the outstanding volume of public Pfandbriefe will continue to shrink . You will see a bigger relative importance of mortgage Pfandbriefe in the German market.”
HIGH QUALITY LOANS NO PROTECTION FOR FANNIE MAE AND FREDDIE MAC
Fannie Mae and Freddie Mac have not been immune to the fallout from the subprime crisis in the US, in spite of the fact that their involvement in US mortgages is limited to high quality loans. In fact the two government sponsored enterprises (GSEs) have found themselves battered by the crisis, resulting in plummeting share prices.
The recent relaxation of rules on capital reserves has been widely welcomed as a way of getting the US housing market moving again, by injecting up to $200bn of liquidity. The Office of Federal Housing Enterprise Oversight announced in March that it would allow a significant portion of the GSEs’ 30 per cent OFHEO-directed capital surplus to be invested in mortgages and mortgage-backed securities. OFHEO director James Lockhart insisted that both companies had “prudent cushions above OFHEO-directed capital requirements”.
“Furthermore we recognise the need to ensure that their capital levels are strong, protecting them from unforeseen risks as the market recovers,” he says.
Fannie Mae and Freddie Mac have been tainted by the contagion of subprime troubles which has spread over into the US higher quality mortgage market.
 | “From 2005 onward lending standards kept weakening,” says Ajay Rajadhyaksha, a director and head of US fixed income strategy at Barclays Capital. “There was no market discipline, when lending standards weakened they weakened not only in subprime but also on the higher part of the mortgage credit spectrum, those parts of the spectrum that Fannie Mae and Freddie Mac do guarantee.” |
The two organisations’ vulnerability to the crisis is a function of their leveraged status. With only around $35bn each in capital reserves, they jointly guarantee mortgages worth about $4000bn and they buy mortgages worth around $1500bn. Normally the market would penalise that degree of leverage by pushing up the cost of debt, but the two GSEs are privileged by their implicit government guarantees, so normal market mechanisms do not apply.
“Virtually no one disputes the GSEs are textbook definitions of ‘too big to fail’,” says Mr Rajadhyaksha. “I very much believe the implicit guarantee can become explicit.”
The US mortgage market is worth $10,500bn, of which 70 per cent are agency mortgages. In the last two or three months agency mortgages have seen spreads widen significantly. That could be seen as a cause for concern, but for the agencies' privileged government backed position.
“Typically the GSEs would come in and buy mortgages, it would make economic sense,” says Mr Rajadhyaksha. “In the near term the relaxation of capital reserve rules is positive: it prevents the agency mortgage market from going into a tailspin which it was going into. What worries me is it pushes the problem further down the line. There is a chance that it is concentrated in these two entities rather than being spread out in other entities in smaller proportions.”
