Jumbo liquidity hit by a big freeze | Old product, new law | Investors force the pace
With no fanfare, no speeches, no toasts or celebratory dinners, the European Union has transformed the covered bond world.
On September 28, a plenary vote in the European Parliament led to the adoption of the Capital Requirements Directive (CRD), the EU’s draft legislation that will implement Basle II. At the time of writing, approval by the EcoFin Council of economics and finance ministers was expected imminently.
“This is the first time there’s been a European-wide piece of legislation for covered bonds,” says Paul O’Connor, head of prudential supervision and risk at the Irish Bankers Federation.
You could be forgiven for not having tracked this in detail. The CRD is a meaty directive. By the time of the plenary vote, MEPs had tabled and voted on some 887 amendments to it – a record. But its treatment of covered bonds did prompt a significant debate. “Initially covered bonds was an issue in the wings, but they were the second-to-last issue to be agreed,” says O’Connor.
The CRD defines the eligibility criteria of different securities for preferential risk weighting. “It doesn’t tell you what a covered bond is,” says O’Connor. Nevertheless, in choosing in the CRD to address covered bonds specifically (something that Basle II does not do), the EU has elaborated on the rather vague definition of a covered bond found in its Ucits collective investments legislation.
The question “What is a covered bond?” is one the market has been asking itself since HBOS’s first UK structured deal in 2003. It has failed to come up with a definitive answer. The EU has.
“By the time the CRD is implemented, Europe’s political and bureaucratic machinery will have redefined what a covered bond is,” says Tim Skeet, managing director, financial institutions origination at ABN Amro.
An end to the guillotine approach
It has done this largely by saying what can or can’t go into a cover pool. For covered bonds backed by loans to the public sector, the CRD says that any EU asset can go into a cover pool, and that non-EU assets are also eligible provided that a minimum 80% of them are AAA or AA-rated. The remainder can be single-A.
The CRD also essentially says that all residential mortgage assets can go into a cover pool, subject to a cap that is a specified percentage of the value of the pledged property.
“This is a fundamental change in the way covered bonds in all countries work,” says Patrick Amat, group finance director at Crédit Immobilier de France (CIF), the French lender that specializes exclusively in residential mortgages. “It avoids the guillotine criterion, where if the LTV is below 60% a loan is fully eligible, and if it is over 60% the loan is fully ineligible.”
The other key provision relating to asset eligibility is a proposed 20% limit on the inclusion of securitization assets in a cover pool, although this has been delayed until 2010 and will be reviewed in the meantime.
The CRD sets a 15% limit on the inclusion of substitution assets in the pool and provides more detail on how they should be managed. It also sets the supervisory loss given default (LGD) level for covered bonds at 11.25% for AAA bonds. O’Connor and others are arguing that 6% would be acceptable.
The result of the first pan-European covered bond legislation should be more equal treatment for issuers. “This is a positive step forward for the marketplace,” says O’Connor. “It means there’s a level playing field out there. No one country has an advantage over another.” But the CRD still needs to be fine-tuned.
Derogation, that’s what you need
In particular, German and French mortgage banks issue covered bonds from a different starting point. Each constituency enjoys advantages and disadvantages. A combination of the CRD and rising house prices could make these more pronounced.
Across Europe, many individuals now have to borrow upwards of 90% of the value of their homes in order to buy them. So defining mortgage loan eligibility for cover pools using LTV ratios is less and less sensible.
German lenders can get around this problem. Say a borrower wants to borrow €95,000 to buy a house worth €100,000. Under German law, a mortgage bank can grant two separate loans – a senior €60,000 loan and a subordinated €35,000 loan. The senior loan now has an LTV less than 60% and so can go into a Pfandbrief cover pool, although the subordinated loan cannot. The guarantees are booked and registered as one mortgage, so the lender doesn’t get hit by extra costs. The borrower is happy, the lender is happy, and the Pfandbrief investor gets a bond issued under one of the most durable regimes around, largely because of its strict LTV limit.
In France, individual mortgage loans cannot be split. Two loans need two mortgages, which are expensive to grant. “You have to pay administrative, legal and notarial costs twice,” says Amat. “That makes this system economically non-viable.”
But French banks do have an advantage over their German counterparts, namely France’s amended securitization law. This confirms that security over receivables is automatically transferred into issuing vehicles with the receivables themselves. In short, French mortgage lenders can do the kind of cost-efficient residential mortgage-backed securitization deals that Germans are only now getting to grips with. So they can securitize their loan portfolios through fonds commun de créances (FCCs – the French securitization vehicle) that reflect the make-up of those portfolios. These FCCs issue units ranging from AAA-rated senior units to subordinated units that carry nearly all the risk. Sociétés de crédit foncier (SCFs or mortgage institutions, set up to issue obligations foncières) can then buy the AAA units, refinancing the purchase in the covered bond market.
For a lender like CIF, this is important. Its main refinancing vehicle, CIF Euromortgage, issues between €3 billion and €4 billion of obligations foncières a year. CIF Euromortgage does not hold housing loans directly. Its assets are either FCCs or RMBS originated by other lenders and acquired to make refinancing deals big enough to tap
the covered bond market. At the end of last year, non-French RMBS made up just under 30% of CIF Euromortgage’s total assets. Its inaugural €1 billion issue back in 2001 was two-thirds backed by European RMBS.
The CRD’s 20% limit on RMBS in cover pools threatens to stop this refinancing. Although there is a temporary derogation for AAA-rated RMBS, some issuers are worried. And the new LTV-style criteria apply to the loans that back the RMBS that back the covered bonds. “That is a nonsense,” says Amat.
Purist or pragmatic?
The fact that the 20% limit will be reviewed in 2010 leads market participants to wonder why it was introduced in the first place.
“A covered bond purist could argue that if you allow unlimited inclusion of securitization assets in cover pools, it is possible for issuers to become some kind of structured investment vehicle, creating pools that are entirely composed of securitizations and issuing to do some kind of covered bond/securitization arbitrage,” says Skeet. “That’s pushing the point. We and many others would like to see the 20% limit taken out.”
Amat refers to a lack of mutual understanding between the market and the legislature. But he also says that German mortgage banks had an interest in retaining their century-old system with its low LTV limit because historically they have not been able to provide rating agencies with enough detailed data on the mortgages that go into their cover pools. “They were frightened by beasts like CIF Euromortgage,” Amat says. Those close to the Verband deutscher Pfandbriefbanken (VDP, formerly the association of German mortgage banks or VDH) say that it now takes a more pragmatic view. The VDP in its new form does, after all, represent all Pfandbrief issuers, not just Germany’s mortgage banks.
And while CIF is an established issuer that might lose out, the CRD could also hinder smaller issuers elsewhere in Europe that want to use similar refinancing structures to tap the covered bond markets. “Germany has 600 Spaarkassen, and the Landesbanken want to finance them,” says Amat. “They will have to pool their assets to be able to issue jumbo Pfandbriefe.” Furthermore, in Spain and the UK mortgage lenders fund in both the RMBS and covered bond markets. Backing covered bonds with RMBS could make sense for an HBOS or an AyT.
Anyway, backing covered bonds with RMBS isn’t just an alternative for issuers that can’t mimic the Germans. “Even if we could split our loans, which the French authorities are considering, we would continue to use RMBS,” says Amat. “It’s a good, modern system suited to rating agency supervision and testing. It’s much safer for investors than giving them a description of a pool of mortgages. Our slogan is: ‘AAA in, AAA out.’”
An internal market for mortgages
Most market participants are confident that the CRD will be amended. It needs to be. “We don’t see any reason to limit the inclusion of securitizations,” says O’Connor. “Including securitizations is key to cross-border funding.” And cross-border funding could be the key to delivering another of the European Commission’s aims – a more competitive mortgage market.
In July, the EC published its Green Paper on mortgage credit in the EU. Internal market and services commissioner Charlie McCreevy said at the time: “More cross-border activity and competition in the EU mortgage market could increase choice, reduce costs and leave more money in people’s pockets at the end of the month.” The launch of the Green Paper began a consultation process on whether and how the EC should try to create an internal market in mortgages.
But while the EC has been pondering how to encourage cross-border borrowing by individuals, some mortgage lenders think it should instead promote real cross-border funding by institutions, and that one of the best ways to do this is to introduce a single European covered bond law.
“Someone buying a house in London isn’t going to borrow from a lender in Italy. That’s impracticable,” says Rob Thomas, senior policy adviser, funding, at the Council of Mortgage Lenders, the UK trade association for residential mortgage lenders. “The way to go is to look at funding. The investor base has become global, but lending is stuck in national silos.”
Rather than superseding national covered bond laws, the CML envisages an alternative issuing framework in the form of what is known as a 26 Regime (one that provides a 26th alternative to the 25 individual national regimes). A German lender, for example, could choose to issue under its own national Pfandbrief law or under this new European covered bond law.
There is a 26 Regime in operation already that allows companies to be based and regulated in the EU as a societas europaea rather than under one particular member state’s company law. Allianz became an SE in September, although it was the first European business of any significant size to do so in 30 years.
“Problems with 26 Regimes arise where complex issues make interlinking between national law and pan-European law too difficult,” says Thomas. “That isn’t the case with covered bonds. We certainly believe this is worth exploring to see if it’s achievable.”
What happens if it is achievable? “If people found it a better regime under which to issue covered bonds, it would effectively create a common covered-bond market across Europe,” says Thomas. “Liquidity is pretty critical in keeping borrowing costs down, and this would be a much bigger market than anyone, even Germany, could sustain on their own.”
A single funding market would be a major step forward. “Some people miss this point,” says Thomas. “They think the funding market is already global because the investor base is global.”
The CML has presented its ideas to the EC since the Green Paper was published, and the EC is talking about setting up an ad hoc working group to look at funding issues before it publishes a White Paper, scheduled for autumn 2006.
“This would be one of the easiest wins in integrating European mortgage markets,” says Thomas.
An ambitious vision
Building a single European covered bond market, based on a single covered bond law, could help new issuers from jurisdictions that have been overlooked in the great covered bond bonanza of the past three years. For many investors, these are not worth the extra time and effort spent examining yet another new legal framework when supply will always be limited and diversification buyers will pile into any new names.
“It is true that some investors like having different jurisdictions to choose from, but that only applies to investors who like doing, and can do, their homework on different jurisdictions,” says Thomas. “That’s a systemic inefficiency.” With most new covered bond jurisdictions introducing their own covered bond laws, even potentially sizeable markets such as Poland can struggle to gain investors’ attention. The smaller the market is, the bigger the problem. “There is an inherent disadvantage with this fragmented structure,” says Thomas. “A single law would be a pick-up for borrowers, especially in smaller countries. That should be attractive to the Commission.”
A single European covered bond law was unimaginable for market participants until recently. Thomas’s and the CML’s vision is an ambitious one. “I think it’s optimistic, but if they can pull it off, great,” says one issuer. But the CRD sets an important precedent. And if, as is often predicted, the covered bond market will soon stretch from the Atlantic to the Urals and beyond, decisions taken in Brussels, Strasbourg and Luxembourg will be as important as those made in Frankfurt, Paris, Madrid, and London.
