The Covered Bond Report Issue 3

www.coveredbondreport.com July 2011

Fall of the sovereign

Will covered bonds rise amid the ruin?

CRD IVEverything to play for

CanadaRules and legislates

ICMAAnti-whispering campaign

The CoveredBond Report

Covered bonds?

Highly rated covered bonds backed by mortgages

Average LTV of 60.5%

Match-funded structure

Core capital ratio of 18.6%

Largest mortgage bond issuer in Europe

nykredit.com/ir

Figures as of 17 March 2011

July 2011 The Covered Bond Report 1

CONTENTS

FROM THE EDITOR

3 It’s all in the timing

MONITOR

5 Legislation & regulation

11 Ratings

15 Market

20 People

22

5

15

Cover StorySOVEREIGNS VERSUS COVERED

22 Fall of the sovereign

Sue Rust reports.


2 The Covered Bond Report July 2011


30

CRD IV: GAME ON

30 Everything to play for

Neil Day

CANADIAN MOMENTUM

36 Canada rules and legislates

Maiya Keidan

ANALYSE THIS: SOLVENCY II

42 It’s the end of the world as they know it

FULL DISCLOSURE

49 From fairway to oche

36

42

CONTENTS

FROM THE EDITOR


Would the European Commission’s

CRD IV proposals have been more

definite in a less uncertain world?

Merely publishing a timely

and relevant magazine is fraught

enough without the fate of the

euro-zone changing on a daily basis. Producing an inter-

national framework that will see the financial system safely

through its ups and Lehmans is asking for trouble at any

time — even more so when a euro-zone sovereign is on the

verge of defaulting.

Small wonder that the EC passed on most of the big

decisions, leaving the European Banking Authority to

carry the can. Would Commissioner Barnier really have

stood up and declared sovereign debt to be the nec plus ultra of liquid assets a day before haircuts for Greek

bondholders were revealed?

That said, leaked drafts of the EC proposals seen by

The Covered Bond Report suggest that the decision to

leave open a final definition of liquid assets was not taken

at the last minute. However, this should only give en-

couragement to covered bond supporters, some of whom

have already taken heart from being offered a second op-

portunity to lobby for better treatment.

What the Commission did lay down, though, was a

tough wish-list for the EBA to use when examining which

asset classes are fit for liquidity buffers. To name but three: a

proven record of price stability; maximum bid/ask spreads;

and transparent pricing and post-trade information.

While the list of criteria is welcome in that it gives

everyone a clearer idea of what needs to be done to win

over the EBA, satisfying them will be no easy task. Is the

covered bond industry up to the challenge?

Four years have now passed since the onset of the

crisis and in many of these areas little progress has been

made. Less time remains until implementation in 2015,

let alone until the EBA reports back to the Commission.

The clock is ticking.

It’s all in the timing

The CoveredBond Reportwww.coveredbondreport.com

EditorialManaging Editor Neil Day

+44 20 7415 [email protected]

Deputy Editor Sue [email protected]

Reporter Maiya [email protected]

Design & ProductionCreative Director: Garrett FallonSenior Designer: Sheldon Pink

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The Covered Bond Report is a Newtype Media publication

25, Finsbury Business Centre40 Bowling Green Lane

London EC1R 0NE+44 20 7415 7185

www.coveredbondreport.com July 2011

Fall of the sovereign

Will covered bonds rise amid the ruin?

CRD IVEverything to play for

CanadaRules and legislates

ICMAAnti-whispering campaign



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.


MONITOR: LEGISLATION & REGULATION

Stark and potentially unbridgeable di-

visions between the FDIC and covered

bond proponents led by Republican Con-

gressman Scott Garrett were laid bare as

the House Financial Services Committee

passed the United States Covered Bonds

Act of 2011 on 22 June.

Garrett complained of a breakdown in

communications with the regulator while

former HFSC chairman Democrat Bar-

ney Frank tried to introduce two amend-

ments at the behest of the FDIC that the

Republican said would render the bill

ineff ective.

And although FDIC chairman Sheila

Bair’s term of offi ce ended in July, cov-

ered bond supporters already fear that

her expected successor, Martin Gruen-

berg, will adopt a similar stance and

place obstacles in the way of the develop-

ment of a US market.

Garrett’s bill — co-sponsored by

Democrat Carolyn Maloney — was ulti-

mately passed by a comfortable 44 votes

to seven, but the potential pitfalls facing

the proposed legislation on its way to

being signed into law were laid bare by

votes on Frank’s amendments. Although

Garrett warned that “you would no long-

er have a covered bond marketplace” if

the amendments were passed, they were

only narrowly defeated, each by 28 ayes

to 26 nays.

Frank’s amendments would have giv-

en the FDIC more far-reaching powers

than those envisaged in Garrett’s legisla-

tion. Frank said that his fi rst amendment

had been draft ed in close co-operation

with the FDIC, which he said was con-

cerned not with the concept of covered

bonds, but the extent to which it and the

Deposit Insurance Fund are protected.

The amendments would have al-

lowed the FDIC to repudiate covered

bonds following a bank default and

would have capped maximum overcol-

lateralisation levels and after the hearing

Moody’s backed up Garrett by saying

that “both would have hurt the develop-

ment of the market”.

“Th e repudiation power in the re-

jected amendment was better for inves-

tors than the FDIC’s current repudiation

power because the amendment required

the FDIC to pay off investors in full rather

than up to the market value of the cover

pool,” said the rating agency. “However,

the amendment would have exposed in-

vestors to an early pay-off , which existing

covered bond investors do not want.

“Furthermore, a cap on the amount

of overcollateralisation would reduce the

resiliency of covered bonds, preventing

issuers from adding collateral to main-

tain the credit strength of the covered

bonds if the issuer deteriorates.”

Concerns addressed ‘time and time again’

Garrett pointed out that an earlier ver-

sion of the bill that had contained less

protection for the FDIC had been passed

by the committee last year under the

chairmanship of Barney Frank with bi-

partisan support, including that of Frank.

Garrett went on to say that he noted

that Frank had enjoyed “a positive work-

ing relationship and dialogue with the

FDIC”, before saying:

“Would that it be the case that we had

continued to have that relationship with

the FDIC as well. I thought we had it for a

long period of time and members on the

other side of the aisle, their staff knows

that we engaged in numerous hours of

staff to staff discussions on various por-

tions of the bill, but I will point out that

that for some reason or another, despite

those ongoing discussions that we were

able to continue to have on a member to

member and staff to staff member level

here in the House, the FDIC, for what-

ever reason, decided to stop responding

to our staff ’s e-mails.

“So as of last week those aspects of

discussions that we would want to have

with the FDIC came to an abrupt halt.

We were sending over e-mails as to what

UNITED STATES

FDIC fi ght ahead after bill passes

Will Martin Gruenberg take over Sheila Bair’s position?

“The FDIC decided to stop responding to our staff’s e-mails”

Legislation & Regulation



we thought we could do to improve the

bill to make changes to address their

concerns, and those ended at that point

in time.”

Garrett went on to say that while he

was pleased that member to member dis-

cussions could continue, he could not sup-

port Frank’s amendment because of what

he said it would lead to: “Th ere would not

be any investors interested in the market-

place were this amendment to pass.”

He said that Frank’s amendments

would introduce too much uncertainty

into the instruments, such that investors

would either not be interested in them or

only at a price that would not make them

viable. He went on to point out several

ways in which the diff erent versions of

bills he has introduced had progressively

included more and more concessions

to the FDIC over more than two years,

“time and time again”.

HFSC chairman, Republican Spen-

cer Bachus, also said that the com-

mittee had “tried very hard to accom-

modate the FDIC”, which had, he said,

only the day before indicated that it

had three problems with the bill that

were being addressed.

Reconciliation impossible?Frank responded by acknowledging that

there was a clear diff erence of opinion

between the FDIC and those pushing for

covered bonds. He said that those sup-

porting the bill had “overestimated” the

extent to which agreement with the FDIC

had been reached.

Two amendments that offered con-

cessions to the FDIC were nevertheless

approved.

One, from Democrat Carolyn

Maloney, co-sponsor of the bill, extends

from 180 days to one year the period the

FDIC has to fi nd an institution to take

over a covered bond programme in the

event it is appointed conservator or re-

ceiver of a failed issuer.

Maloney said that the FDIC support-

ed the amendment, which she said was

designed to give the regulator as much

fl exibility as possible and to protect the

Deposit Insurance Fund. Th e FDIC had

argued that it is more diffi cult to sell off

a covered bond programme than other

banks’ assets and products, particularly if

a number of institutions are failing.

An amendment allowing a covered

bond issuer’s regulator to place a cap on

covered bond issuance relative to total

assets was approved. Th is was introduced

by Republican John Campbell, who had

expressed disapproval of the bill in a sub-

committee markup in May but ultimately

voted in favour of the bill. He said that

the possibility of including a number had

been discussed, but that this would be left

to regulators rather than legislated for.

Th e FDIC has previously set a 4% limit.

The end of Bair’s term as chairman

had held out the prospect of a change in

the FDIC’s position, but there have al-

ready been signs that acting chairman

Martin Gruenberg will adopt a similar

position to his predecessor. DBRS, for

example, suggested this might be the

case in mid-July when discussing lob-

bying of the FDIC to relinquish its first

right to cover pool assets in the event of

an issuer default.

“Vice chairman of the FDIC Martin

Gruenberg, who some believe will be

President Obama’s choice to succeed

Chairman Bair, recently reiterated a

variation of this position stating that in

the event of a bank failure, the FDIC,

and not investors, should have first

rights to any excess collateral included

in a covered-bond offering,” said the

rating agency.

Th ere are also fears that time could be

running out for legislation to be passed

in this Congress. While the HFSC vote

and Republican control should smooth

the bill’s passage through the House of

Representatives, observers are less cer-

tain about the Senate.

“Th e length of the remaining legisla-

tive calendar has become a serious con-

sideration, particularly for Senate ac-

tion,” said Jerry Marlatt, senior of counsel

at Morrison Foerster. “Th e Senate has not

previously considered a covered bond

bill and, accordingly, there is much to be

done for the Senate staff to be prepared

to take informed positions on a bill. Per-

haps the most important factor in mov-

ing a bill quickly through the Senate will

be who sponsors the bill.

“As previously reported, Senator

Charles Schumer (D-NY), who is a key

senator on the Senate Banking Com-

mittee, has said that he would consider

introducing a covered bond statute.

Sponsorship by Senator Schumer would

greatly enhance the prospects for the bill

moving quickly.”

“The legislative calendar has

become a serious consideration”

Barney Frank: supporters of bill overestimated any agreement with FDIC


AUSTRIA

Forum discusses steps to uniform lawMoves towards harmonising Austria’s covered bonds under a single law were discussed at the first conference of the Österreichisches Pfandbrief und Cov-ered Bond Forum at the end of May.

According to DZ Bank covered bond analyst Michael Spies, representatives of the Austrian central bank (Oesterrei-chische Nationalbank) and the finance ministry said that the harmonisation of laws governing Austrian covered bonds would be on their agenda.

Martin Schweitzer, speaking on be-half of the Österreichisches Pfandbrief und Covered Bond Forum, told The Covered Bond Report that a single cov-ered bond law was not imminent but

would be the ultimate outcome of work to improve the Austrian framework.

“We are heading towards one law,” he said. “But before that there will definitely be intermediary steps to further harmo-nise the existing ‘two-plus’ frameworks.

“There will be harmonisation in terms of transparency, in terms of fur-ther quality improvements.”

Austrian covered bonds are either Pfandbriefe issued under the Mortgage Banking Act, which in 2005 brought together the old Mortgage Banking Act and the Pfandbrief Law, or Fundi-erte Bankschuldverschreibungen. Er-ste Group Bank and UniCredit Bank Austria, for example, issue under the

Mortgage Banking Act, while Kommu-nalkredit Austria and Bawag PSK issue Fundierte Bankschuldverschreibungen.

The Österreichisches Pfandbrief und Covered Bond Forum was launched in January by Austria’s leading covered bond issuers, representing Bawag PSK, Erste Group, Kommunalkredit Austria, Österreichische Volksbanken, Raiffeisen Bankengruppe, UniCredit Bank Austria, and Hypoverband.

Schweitzer said that the forum would not only be working on legisla-tive changes.

“It’s about transparency in the market, speaking with one voice, and being vis-ible on the European stage,” he said.


The prospect of standalone covered bond

issuance from South Korean banks has

increased following the release of covered

bond guidelines by the country’s regula-

tors in late June.

The Financial Services Commission

(FSC) and Financial Supervisory Service

(FSS) described the guidelines as part of

measures to implement “Comprehensive

Measures on Household Debt”.

“The guidelines are intended to pro-

vide a framework for covered bond issu-

ances, diversifying banks’ financing in-

struments and encouraging banks to offer

more long term and fixed rate mortgage

loans instead of short term and floating

rate ones,” said the FSC and the FSS.

The “best practice guidelines” run to a

mere two pages, but contain rules on key

features of issuance — see box.

Issuers permitted under the guidelines

include banks, agricultural and fishery

co-operatives, the Korean Development

Bank, Export-Import Bank of Korea, In-

dustrial Bank of Korea, and securitisation

vehicles under the Act on Asset-Backed

Securitization.

The cover pool may comprise: first

priority mortgage loans with maximum

secured amounts of 120% or more of the

actual loan amount, a 70% loan-to-value

cap, and no delinquencies in excess of 60

days; cash; ABS backed by such mortgage

loans or cash; mortgage backed bonds is-

sued by Korea Housing Finance Corpora-

tion (KHFC); and mortgage backed secu-

rities issued by KHFC.

“After monitoring the issuances of cov-

ered bonds in the future, we will have fur-

ther discussions on whether to come up

with legally binding regulations on cov-

ered bond issuances,” said the regulators.

Jerome Cheng, vice president, senior

credit officer at Moody’s, told The Covered

Bond Report that the establishment of a

covered bond framework has been under

discussion for quite some time.

“Market participants have been lobby-

ing government to enact a law or publish

guidelines,” he said. “From market par-

ticipants’ perspective, having guidelines

will allow originators to structure covered

bonds with a higher degree of certainty.

“The guidelines, which we have not yet

assessed, should give additional comfort

to investors.”

Previously only one Korean bank has

issued a covered bond on a standalone

basis — Kookmin Bank, with a $1bn is-

sue in 2009. State-run KHFC sold a sec-

ond international covered bond issue — a

$500m five year — on 18 July, but its issu-

ance is under an act governing the insti-

tution and the bond is backed by pooled

collateral from its member banks.

SOUTH KOREA

Korean rules raise solo supply hopesKey features of Korea’s guidelines:

or greater

of total liabilities

“Covered bonds could be observed trading through government bonds” page 24



ECBC DATA

Issuance rises, ECB share fallsThe volume of covered bonds outstand-ing rose to Eu2.5tr in 2010, according to data published by the European Cov-ered Bond Council, as their funding role gained in prominence.

In 2009 outstanding covered bond volumes were Eu2.4tr. Last year Eu606.7bn of new covered bonds were issued, versus Eu529.8bn in 2009.

Denmark had the highest total issu-ance last year, at Eu148.6bn, followed by Germany (Eu87bn) and Sweden (Eu80bn).

Mortgage backed covered bonds’ share of the total increased, with public sector covered bonds standing at only 24% of issuance in 2010, down from 29% in 2009 and 58% back in 2003.

The ratio of mortgage backed covered bonds outstanding relative to outstanding mortgage loans increased in all countries aside from the UK and Germany, where the ratio remained the same — although in Germany, and some other countries, mortgage backed covered bond volumes

do not accurately reflect the amounts backed by residential mortgages.

Landesbank Baden-Württemberg analysts compared mortgage backed covered bond volumes with mortgage lending volumes and ABS issuance. They found that even in countries where se-curitisation has been increasingly used, such as Italy and Portugal, covered bond funding has increased its share of hous-ing finance. In the UK the share of RMBS has fallen over the last two years, while covered bonds have held steady.

They also looked at volumes in the two asset classes relative to their use as European Central Bank collateral and found that fewer than 18% of eligible covered bonds are being used for refi-nancing via the Eurosystem — less than in 2009 and compared with 38% of available ABS.

“In other words, considerably more covered bonds were placed in the mar-ket or not acquired with the immediate intention of using them as collateral,” they said.

The Association of Swedish Covered Bond

Issuers (ASCB) and the Pfandbrief & Cov-

ered Bond Forum Austria have welcomed

an ICMA Covered Bond Investor Council

transparency initiative in responses to a

consultation on the proposed standards,

but several national groupings have said

they need more time to consider them.

Responses to the consultation were due

by 30 June and a spokesperson for the CBIC

said that the consultation had in general

been received quite positively. The Euro-

pean Covered Bond Council — also speak-

ing for some national associations — and

European Central Bank are understood to

be among those parties that contributed to

the consultation by the deadline.

However, the Austrian association

(Österreichisches Pfandbrief und Cov-

ered Bond Forum), which got back to the

CBIC, said that it would need a couple

more weeks to agree a common Austrian

position, and other national associations

were not in a position to respond by the

deadline. The Italian Banking Associa-

tion (ABI) was due to meet to prepare a

response as The Covered Bond Report

was going to press, said an official at the

association. The Covered Bond Report

understands that the Association of Ger-

man Pfandbrief Banks (vdp) had not yet

formally submitted a response.

Sweden’s ASCB said in a submission

dated 27 June that it welcomed the CBIC

initiative and would recommend its mem-

bers have common cover pool information

set up “largely in line with your proposal”.

The association disagreed on several

points it said were of a more “technical na-

ture”. For example, the ASCB took issue with

a suggestion that issuers should have to pro-

duce margin calculations, saying that these

were not always available or appropriate. It

also said that it did not see why breaking out

covered bond funding into bearer and regis-

tered formats was necessary.

The Swedes noted that some data fields

suggested by the CBIC were not relevant

in their case as most Swedish issuers are

specialised mortgage entities that do not

conduct other business.

TRANSPARENCY

First CBIC responses favourable

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2004 2005 2006 2007 2008 2009 20100.0%

4.0%

8.0%

12.0%

16.0%

20.0%

24.0%

28.0%

32.0%

total eliible collateral (€bn) eligible covered bonds (€bn)covered bonds used as a % of eligible cb (rhs)

Volume of assets considered eligible and the share of deposited covered bonds in the total eligible volume of covered bonds (rhs)

Sources: ECB, LBBW Credit Research


MONITOR: LEGISLATION UK

The Investment Management Asso-

ciation believes UK Regulated Covered

Bonds lack “the very high degree of

certainty” that should be expected of a

regulated product, and that the frame-

work needs more significant changes

than those being proposed in a review.

In its response to a consultation on

proposals announced in April by HM

Treasury and the Financial Services Au-

thority, which ended on 1 July, the IMA

said that it was unfortunate that, as be-

fore the UK framework’s introduction

in 2008, it was not pre-consulted on re-

form proposals.

“Th is is unfortunate since it would ap-

pear that an assumption has been made

that the regime needs little change, where-

as we would argue that it might benefi t

from more signifi cant change,” said Jane

Lowe, the IMA’s director of markets.

The association outlined several con-

cerns relating to the transparency and

structure of UK RCBs, and urged HM

Treasury to tackle these, even if such re-

form was not envisaged in the timetable

for the review of the framework.

“For investors, the RCB regime is

lacking the very high degree of certainty

that should be expected of a regulated

product,” said the IMA. “For issuers, the

regime runs the risk that over time it

will fail to attract long term stable inves-

tors into the product.

“If the impact of bank resolution and

bail-in extends also to the RCB regime,

this is likely to lead to a gradual with-

drawal of long term investors from bank

funding, leaving banks with a different

and probably less stable investor base.”

Some market participants had sug-

gested that such bail-in questions might

have been sufficiently addressed when

the review was announced. However,

the IMA said that the introduction of

bail-ins of senior debt might affect the

RCB regime and that to maintain inves-

tor confidence the RCB should be clear-

ly carved out of bail-in requirements.

“This is particularly important as

in contrast to many EU RCB regimes,

a UK RCB is a senior unsecured bond

and only becomes ‘secured’ by way of a

guarantee on ‘default’,” said the associa-

tion. “In a special resolution situation,

this means that the guarantee may not

be triggered under the relevant contract

because the issuer is not deemed to be

in default.”

Investor data demands confl ictThe IMA said that covered bonds have

been increasingly taken up by its mem-

bers in the past year but that they have

not found the documentation “user-

friendly”.

“Key information is frequently bur-

ied deep within detailed prospectuses

(400+ pages is not unusual),” said the

IMA. “Whilst they are able to manage

this, we question why it should be nec-

essary for a regulated product.”

The association argues in favour of

disclosure of loan level data in line with

Bank of England requirements.

“This is a much needed measure to

improve investor confidence and trans-

parency for Regulated Covered Bonds,”

it said.

However, the Covered Bond Investor

Council said in a response to the con-

sultation that loan-by-loan disclosure

of cover pool assets, as required by the

Bank of England, “would contaminate

the reputation of high quality the cov-

ered bonds product has in the market”.

Asset backed securitisation (ABS)

products and covered bonds need to

be distinguished, it said, in particular

with respect to the level of information

required.

“Covered bond pools need to be

monitored by investors but maybe not

nearly as frequently as ABS pools as

long as the pool is fairly elitist from

its creation onwards and substitution

mechanisms are in place,” said the coun-

cil, which has called for aggregated data

it believes would be more useful. The

dynamic nature of cover pools makes

regular loan-level disclosure superflu-

ous, it added.

Th e level of transparency that inves-

tors should be provided with was the

only point of contention raised in the

CBIC’s submission, with the council say-

ing that it is “generally positive” toward

the changes proposed by the review.

RCB REVIEW

IMA cites weaknesses in UK consultationJane Lowe: “It might benefi t

from more signifi cant change.”

“Key information is frequently buried”

“Sovereign investors are more vulnerable to potential haircuts” page 25



Recent amendments to Spain’s legal

framework for mortgage loans weaken

creditors’ recourse to low income borrow-

ers, but preserves full recourse mecha-

nisms in the Spanish market, according to

Fitch and Moody’s.

Spain’s parliament passed a resolu-

tion, Royal Decree 8/2011, on 30 June

that, among other changes, increases the

threshold of defaulted borrower income

that is ring-fenced from a claiming credi-

tor. The new law became effective on 7

July, and was put forward by the ruling So-

cialist party, the main opposition People’s

Party and Catalan group Convergencia i

Union, demonstrating widespread sup-

port for the move.

Alvaro Gil, director, covered bonds at

Fitch, said that a motivation behind ini-

tiatives to end or modify full recourse was

the large number of legal cases for repos-

sessions since 2008. There have also been

recent protests in support of borrowers

facing repossession.

According to statistics from the Span-

ish judicial system cited by Moody’s, the

number of foreclosures reached 93,000 in

2010, up 260% from 2007 levels. Fitch said

that legal cases for repossessions since

2008 totalled 240,000.

Under Spanish law mortgage borrow-

ers remain personally liable for their debt

after foreclosure, instead of being able, as

is the case in some countries, to discharge

that debt in bankruptcy.

“Full recourse to current and future as-

sets and income of the obligor is system-

atically used by banks to ensure full re-

covery on defaulted mortgages when the

foreclosed property value at auction does

not cover the outstanding debt,” said Car-

los Masip, director, RMBS at Fitch.

The rating agency said that although

newly approved changes to Spain’s mort-

gage loan framework may reduce the

strength of full recourse from a cashflow

perspective, in particular for low income

borrowers in negative equity situations,

it continues to consider the Spanish debt

market as one featuring full recourse.

“Fitch recognises that there are many

disincentives that a sensible borrower will

consider before defaulting on its mortgage

loan to take advantage of the newly-ap-

proved measures,” it said.

Such disincentives include the alterna-

tive costs of occupancy such as property

rental or the potential loss of fiscal ben-

efits, according to Fitch.

“The full recourse mechanism over

borrower’s existing and future assets per-

sists by law, and would disqualify default-

ed borrowers from owning other assets or

from generating additional income in the

future,” it said.

In Fitch’s view the new law could trig-

ger a tightening effect on mortgage under-

writing policies, in particular with regards

to loan-to-value ratios for low income

borrowers.

Moody’s said that the revised frame-

work introduces three main changes. A

first involves raising the threshold that full

recourse to a defaulted borrower’s exist-

ing and future income is applicable to, a

change that Moody’s described as “cur-

tailing the rights of creditors to attach the

wages of borrowers who default on their

mortgage loans”.

But it said that this measure will have

a negligible impact on the Spanish RMBS

market because most of a mortgage loan’s

recovery stems from the effective sale of

a property, and not from the personal li-

ability remaining against a mortgage bor-

rower if the foreclosure process ends with

any debt outstanding.

The new framework also raises the

minimum percentage of the property

value – from 50% to 60% – at which a

bank can repossess a mortgaged property

if the foreclosure process ends with no

offers. Carlos Terre, director, structured

credit at Fitch, said this will shift poten-

tial losses from the obligors’ side to the

banks’ side, but that the rating agency

considers the effect on recovery assump-

tions to be neutral.

Moody’s highlighted a third amend-

ment, which reduces the amount that a

party has to deposit upfront to participate

at a property auction.

“Lowering the liquidity require-

ment may attract more bidders; the third

amendment may thus be considered cred-

it-positive, so long as it forms an incentive

for third parties to bid at mortgage auc-

tions,” said Moody’s.

SPAIN

Full recourse withstands populist move

Source: Plataforma Afectados por la Hipoteca

“Incentives to repay are still in force”


SOLVENCY II

Covered to keep shine despite low returns

MONITOR: RATINGS

Bayerische Landesbank put on hold a

new covered bond issue on 6 July in re-

sponse to Moody’s that morning plac-

ing its Pfandbrief ratings on review for

downgrade alongside those of three oth-

er public sector banks.

“Since announcing a 10 year Jumbo

Öff entliche Pfandbriefe transaction yes-

terday, BayernLB has achieved a strong

momentum in the shadow order book

process,” the issuer said in a statement.

“However, the issuer has decided to delay

marketing the transaction following the

Moody’s announcement this morning.

“BayernLB would like to express their

thanks to those investors who have al-

ready shown their support. Th e decision

was taken in the interest of protecting

BayernLB’s investor base.”

Crédit Agricole, Credit Suisse, Deut-

sche Bank and Royal Bank of Scotland

had the mandate for the transaction and

a syndicate offi cial at one of the leads said

that preparations for the transaction had

gone very well, and that the decision to not

proceed was taken solely on the basis of

Moody’s action, which he described as “ab-

solutely unprecedented” and “ridiculous”.

“We had a good IoI book and were

ready to go,” he said.

BayernLB’s mortgage and public sec-

tor covered bonds are rated triple-A by

Moody’s, but the ratings were placed on

review for possible downgrade alongside

those of Pfandbriefe issued by HSH Nor-

dbank, WestLB, and Deutsche Kredit-

bank, aft er Moody’s placed the respective

issuer ratings on review for downgrade

the previous week.

A covered bond analyst described

Moody’s action with respect to BayernLB’s

public sector Pfandbriefe as a sign of the

rating agency’s willingness “to go the edge”

given that the rating of the public sector

covered bonds could sustain a three notch

issuer downgrade before being cut, accord-

ing to the rating agency’s methodology.

MOODY’S

‘Unprecedented’ move blocks BayernLB deal

BayernLB: “Had a good IoI book and was ready to go.”

Full implementation in 2013 of Sol-

vency II rules in their latest iteration

could lower the appeal of covered bonds

on the basis of their capital-adjusted

returns and thereby render them more

expensive to issue, according to Fitch.

However, the rating agency said in a

June report that the security the asset

class off ers means they will remain at-

tractive to insurers.

Th is dynamic would be one among

many — such as a shift from long term

to shorter term debt, and an increase in

the attractiveness of higher rated corpo-

rate debt and government bonds — that

would occur as a result of insurers, the

largest investor group in Europe, mak-

ing signifi cant changes to their asset

portfolios to optimise their capital posi-

tions, according to Fitch.

In a summary introducing the re-

port, the rating agency said that an in-

crease in the attractiveness of covered

bonds would be one of the main eff ects

of insurers adjusting their asset portfo-

lios to optimise capital positions.

However, in a section dedicated to

covered bonds the rating agency said

that although triple-A rated covered

bonds have a lower capital charge than

other corporates, “the charge is rela-

tively punitive compared with the risk

and returns currently available, making

them less attractive than other bonds on

a pure return-on-capital basis under the

(credit) spread module” (see chart).

With banks under pressure to in-

crease funding, a reduction in demand

could increase covered bond pricing,

the report added.

However, Fitch ended its assessment

of the impact on covered bonds on a

positive note, saying that the asset class

is likely to remain attractive to insurers

because of their “very safe nature”.

Comparison of Bond Returns under Solvency II (Taking into account cost of capital)

Issuer (Dated) Duration Rating Category Standalone capital charge* –standard formula (%)

Spread overswap (bps)

Return onequity (%)

Tesco (2014) 2.5 ‘A’ 3.5% (2* , 1.4%) 50 14.0

BAA (2041) 14 ‘A’ 19.6% (14*, 1.4%) 200 10.2

Deutsche Bank covered bond (2018) 6 ‘AAA’ 3.6% (6*, 0.6%) 10 7.8

* assuming duration matching using swaps. Source: Bloomberg, Fitch

Ratings


MONITOR: RATINGS

A revised approach to Danish covered

bonds from Moody’s resulting in nega-

tive rating actions has raised tensions

with Danish issuers, leading to Realkredit

Danmark terminating its collaboration

with the rating agency and others seeking

ways to escape the rating pressure.

Moody’s on 10 June increased the refi -

nancing margins and lowered the Timely

Payment Indicator (TPI) from “very

high” to “high” for the covered bonds

of fi ve Danish issuers, citing increased

refi nancing risk due to a material rise in

adjustable-rate mortgage (ARM) loans,

and reduced systemic support and cred-

itworthiness.

Among measures taken by Danish

mortgage banks in response to Moody’s

move was Realkredit Danmark’s decision

to drop the rating agency.

“Realkredit Danmark has discussed

the fundamentals of the matter with

Moody’s in order to understand the ra-

tionale behind its rating model, but has

concluded that the parties disagree about

the fundamentals,” it said on 23 June.

Moody’s went on to cut three Danish

mortgage credit institutions’ issuer rat-

ings on 1 July and lowered covered bonds

issued out of BRFkredit Capital Centre E

from Aa1 to Aa2.

However, with the Danish commu-

nity increasingly vocal in its criticism

of the rating agency, Moody’s put out a

special comment on the Danish covered

bond system in which its strengths were

highlighted.

“Despite weakening issuer credit

strength and our assessment of increased

refi nancing risk, the position of Den-

mark as having one of the strongest cov-

ered bond frameworks in Europe has not

changed,” said Moody’s, adding that the

new refi nancing margins are the lowest

in Europe and that the TPIs are among

the highest in Europe.

Moody’s methodological revisions

coincide with increased scrutiny of

Denmark’s mortgage financing system

by the country’s central bank, which has

highlighted a reduction in refinancing

risk linked to ARM loans and a reduc-

tion in risks surrounding continuous

loan-to-value requirements as ways in

which financial stability needs to be

strengthened.

Th ese recommendations and Moody’s

changes were among “future business

conditions” cited by Nykredit Realkredit

in an announcement from 21 June setting

out a fi ve point operational plan. Th is in-

cludes funding ARM loans with bonds is-

sued out of a special capital centre so that

these “may be given an independent, and

possibly lower, rating leading to lower

overcollateralisation requirements as a

result of Moody’s announcement”.

Surprised and confusedRealkredit Danmark will also establish a

new capital centre for the fi nancing of its

ARM loans, but in contrast to Nykredit

decided not to continue its collaboration

with Moody’s.

“Th e decision was taken because

Moody’s, as a result of its model calcula-

tions, demanded that Realkredit Danmark

provide an additional excess cover of

Dkr32.5bn (Eu4.36bn) if it wanted to keep

its current AAA rating,” said the issuer.

Realkredit Danmark said that it is in the

position to provide excess cover through

the issuance of junior covered bonds or

through a loan from its parent, Danske

Bank, but Moody’s on 14 July placed on re-

view for downgrade covered bonds issued

out of the issuer’s Capital Centre S because

the collateral had not yet been added.

Other rating agencies could gain from

the fall-out, with Realkredit Danmark

potentially turning from Moody’s to

Fitch — Standard & Poor’s already rates

its covered bonds AAA.

BRFkredit is in talks with S&P about

rating its capital centres aft er saying that

it was “surprised and unable to under-

stand” Moody’s actions. Th e move was

announced on 6 July as one of a pack-

age of measures from BRFkredit, which

Moody’s cut to Baa3 on 1 July.

Th e bank said that it will keep Moody’s

as a “co-operation partner” and establish

a new capital centre (H) that will prima-

rily refi nance ARM loans, in line with

Nykredit Realkredit’s and Realkredit

Danmark’s plans.

Th e issuer had made a commitment

in the documentation of covered bonds

issued out of capital centre E to maintain

a Aa1 rating by injecting capital if nec-

essary, but BRFkredit said that Moody’s

methodology made achieving such a rat-

ing impossible.

DENMARK

Danes up in arms amid Moody’s fall-out

Moody’s offi ces in New York

“The parties disagree about the

fundamentals”


MONITOR: RATINGS

COUNTERPARTY CRITERIA

S&P hears warnings about proposals’ effectStandard & Poor’s proposals for assess-ing counterparty risk in covered bonds would have a disproportionate effect on ratings compared with asset-liability mismatch (ALMM) risk, issuers and in-vestors have told the rating agency.

They consider counterparty risk to be mainly an issuer risk, with investors pleased at the prospect of increased trans-parency about derivative counterparty risks in programmes, said S&P in an interim re-port published on 7 June.

However, the rating agency said that the majority of investors and issuers ap-peared to view counterparty risk as sec-ondary to an issuer’s ability to pay its covered bond obligations.

“Most investors and issuers consid-ered that counterparty risk, if assessed using the 2011 request for comment as

currently proposed, would have a dis-proportionate effect on covered bond ratings compared with asset-liability mismatch risk, as assessed using the ‘2009 ALMM criteria’,” said S&P.

DZ Bank analyst Jörg Homey drew at-tention to S&P disclosing that many issuers would consider the move to cap covered bond ratings by reference to the rating agency’s new counterparty criteria as — in Homey’s words — an “over-reaction”.

S&P said it will respond to feedback “by changing the criteria if we deem it necessary, by explaining the original pro-posals more clearly to remove ambiguity, or by leaving the proposals unchanged”.

Homey said that programmes where the issuer acts as a counterparty will be hit particularly hard.

“The decisive question in this case

is probably going to be whether S&P is satisfi ed by the precautions taken to replace the bank as counterparty for its own cover assets in the event of a downgrade,” he said.

Increased issuance of covered bonds and

renewed repo activity raise asset encum-

brance issues, according to Fitch, but the

rating agency sees the trend easing, even

if bank funding costs remain elevated.

Regulatory reforms, increased risk aver-

sion and other measures pushing the asset

class to the fore have led to greater use of

covered bonds, said the rating agency in a

report in June, adding that the increased

take-up of the asset class will hit a peak.

“Fitch believes that the limited supply

of high quality cover pool assets and na-

tional regulatory limits, if properly mon-

itored and enforced, serve as checks to

the use of covered bonds, allaying some

investor concerns over high issuance vol-

umes in recent months,” it said.

Th e rating agency said that a high de-

pendence on secured funding could con-

strain ratings and that an over-reliance

on this type of fi nancing could encumber

most assets on the company’s balance

sheet, reducing overall fi nancial fl exibility.

“In addition, a high concentration of

secured fi nancing increases the risk that

unsecured creditors could be adversely af-

fected as secured creditors may have prior-

ity claims to higher-quality assets,” it said.

“If the industry shift s to a signifi cantly

higher level of secured funding versus his-

torical levels, Issuer Default Ratings (IDRs)

could come under pressure and unsecured

debt ratings could fall below the IDR due to

lower recovery expectations.”

Fitch nevertheless noted the benefi ts

covered bonds can carry for issuers from

a ratings perspective.

“Most global trading banks did not

have a covered bond programme prior

to the crisis, but many have established

such programmes in the past two years,”

it said. “As such, the use of covered bonds

by these banks remains limited, but rep-

resents a funding source off ering poten-

tial diversifi cation and maturity exten-

sion benefi ts. Th is potential has yet to be

fully tapped by these banks.”

FITCH

Encumbrance a concern, but checks exist

Jörg Homey: Rating cap seen as “over-reaction”

New Issuance in Debt Markets (Euro Zone) Excludes issues <USD50mCovered bonds (not retained) Covered bonds (retained) Senior unsecured debt(USDbn)

700600500400300200100

0

Source: Dealogic, Fitch

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

“You look at the debt-to-GDP ratio in Canada, it’s very impressive indeed” page 39


MONITOR: RATINGS

Moody’s made good on a commitment

to deliver more timely covered bond

data by skipping Q4 2010 and moving

straight from Q3 2010 to Q1 2011 with

its latest quarterly monitoring report,

released on 11 July.

The rating agency said that it has been

focusing on producing more up to date

information since its last overview, which

was released in April.

“The delay between the publication

date of this report and the date the in-

formation relates to [up to 31 March] has

halved since the last monitoring report

was published,” said Moody’s. “Going

forward, Moody’s aims to produce this

report within three months of the date

the information relates to.

“The production of timely data has

also extended to the production of

the performance overviews, which are

published for every covered bond pro-

gramme included in this report. Moody’s

aims to publish all performance over-

views within six weeks from the date the

required information is received from

the covered bond issuer.”

Since the end of the last quarter

Moody’s has revised its assumptions

with regard to Danish covered bonds

and taken action in relation to several

programmes from the country. Data on

Danish covered bond programmes in the

overview was therefore incomplete, with

the rating agency referring to recent re-

leases. (See separate article for coverage

of Moody’s Danish actions.)

Among the largest changes in aggre-

gate country data given by Moody’s were

figures relating to Portuguese covered

bond programmes, even though the data

relates to a period before the rating agen-

cy cut Portugal to junk on 5 July.

The biggest fall in average surplus

overcollateralisation for a country was

in Portugal, where the figure fell from

18% to 5%. All Portuguese covered bond

programmes were cut by two or three

notches in between the ends of Q3 2010

and Q1 2011.

Three tiers for investorsThe rating agency also launched a re-

search service in June packaging its

covered bond research with analyses of

sponsor banks and related sovereigns.

“We’ve tried to complement the cov-

ered bond research by adding in sovereign

research as well as the issuing banks’ re-

search,” said Arlene Kearns, senior product

strategies in Moody’s structured finance

group. “The feedback that we’ve gotten

from the marketplace is that they look at

the sovereign first, the issuer next, and the

programme third — not necessarily in that

prescriptive order, but those are the three

tiers that they look to do analysis on, and

their focus depends on the situation.

“For example, if an investor has ex-

posure to a covered bond programme in

Canada, the focus of their credit monitor-

ing right now may just be on the issuing

bank, versus Spain where their current

focus may be on the sovereign, the bank,

and the cover pool detail.”

Kearns said that the launch of the serv-

ice also reflects developments in the cov-

ered bond market and its investor base.

“There’s an overwhelming sense that

US investors are interested in the space,

but they represent credit investors much

more than rates investors, like the tradi-

tional buyer-base,” she said. “This is all

the way from your typical high grade

credit investor to your hedge funds that

are looking at more high risk exposure.

“Their expectations are definitely differ-

ent from the traditional rates investor. They

are looking for cover pool information and

detail and looking to do that deep dive.”

MOODY’S

Timelier quarterly report presages latest trendsAverage cover pool losses by country: mortgage backed covered bonds

Average cover pool losses by country: public sector backed covered bonds

3% 4%7%

5%11%

3% 4% 5%

16%

5% 5% 4%

11% 9%12%

16%

29%

15%

9%

27%

21%

10%

15%

8%

0%5%

10%15%20%25%30%35%

Collateral risk Market risk

3% 3% 3%

7%

3%

7%

19%

11% 9%

24%

7%

18%

0%

5%

10%

15%

20%

25%

30%

Austria France Ireland Italy Germany Spain

Collateral risk Market risk

Finlan

d

Fran

ce

Germ

any

Italy

Irelan

d

Nether

lands

Norway

Portu

gal

Spain

Swed

en

United

King

dom

United

King

dom

(non-

bulle

t)

Source: Moody’s

“They represent credit investors

much more than rates investors”


MONITOR: MARKET

Syndicate bankers are awaiting the details

of prospective ICMA best practice guide-

lines to see if primary market practices

will have to change in ways that could in-

crease execution risk for covered bonds,

resulting in issuers having to pay higher

new issue premiums.

Th e International Capital Market Asso-

ciation (ICMA) is working toward a set of

best practice guidelines aimed at increas-

ing transparency in new issues, through

changes to the way in which information

is communicated at various stages of the

new issue process. Any such guidelines

could aff ect the practice of price whisper-

ing, with the release of updates on order

book sizes also under scrutiny.

Banks’ eff orts to get in line with the

impending guidelines have already had an

impact on the primary market.

When Landesbank Baden-Württem-

berg sold a debut benchmark mortgage

Pfandbrief on 4 July, a Eu500m six year

deal, leads Natixis, LBBW, Royal Bank

of Scotland and UniCredit launched the

deal without having gone out with a price

whisper, despite market conditions being

fragile, if stable.

Jörg Huber, head of funding and investor

relations, treasury at LBBW, said that initial

feedback was positive, but non-committal in

the absence of a pricing indication.

“Unfortunately there was recently an

ICMA announcement recommending not

to use price whispers,” he told Th e Cov-

ered Bond Report, “which makes it quite

diffi cult to fi nd the right clearing level.

“Th is meant that we couldn’t inform

the sales teams what our initial pricing

ideas were to get relevant feedback, so

it took a bit longer to establish what the

right level was.”

Th is was deemed to be represented

by the 18bp-19bp over mid-swaps range,

with the leads taking indications of inter-

est at that level and order books growing

quickly once they were offi cially opened,

according to Huber. Th e deal was ulti-

mately priced at 18bp over on the back of

a Eu750m order book.

“We hit it spot-on, but the proce-

dure could have been smoother,” he said.

“Th ese kinds of guidelines are harming

the proper evaluation process, but we had

to deal with that.”

Go the extra mileRuari Ewing, director, primary markets,

market practice and regulatory policy at

the International Capital Market Associa-

tion (ICMA), told Th e Covered Bond Re-

port that the association had in October

2010 added an explanatory memorandum

on pre-sounding, bookbuilding and allo-

cations to its handbook, and that several

roundtables with investors had been con-

ducted over the past couple of years, most

recently in May.

“Banks are now continuing their dis-

cussions internally, with some already

starting to draw conclusions and move

ahead with new practices,” he said.

One practice being scrutinised is that

of price whispers, which Ewing character-

ised as an interim step aft er pre-sounding

but before bookbuilding has begun on the

basis of offi cial guidance. He said that the

practice of price whispers had emerged in

response to the fi nancial and sovereign

debt crises.

“In an easy market you can go straight

to guidance, but in volatile markets you’re

dealing with a completely diff erent kettle

of fi sh,” he said.

Although price whispers can be shared

with many market participants, some are

arguing that the information needs to be

communicated to a larger audience, ac-

cording to Ewing.

“Th e aim is to go out much wider with

a whisper than before,” he said. “With in-

creasing volatility there is a feeling that it is

important to go the extra mile. Under the

old system you could always miss a hand-

ful of accounts, and this new approach is

trying to wrap up that residual end.”

In practice this means that banks are

looking at ways to modify their commu-

nication to better reach transactions’ tar-

get audiences, said Ewing, which could

involve sending information as they have

been doing but also potentially dissemi-

nating it by way of news-feeds, among

other options.

Th e Covered Bond Report under-

stands that ICMA has been seeking to

release a formal publication that would

most likely be in the form of an addition

to the association’s primary market hand-

book. However, it is not clear how detailed

or prescriptive this might be.

Broadbrush adoptionAlthough fi nal guidelines have not been

drawn up, syndicate offi cials said that

market participants have already been im-

plementing what one banker described as

“broadbrush” changes to new issue prac-

ICMA

Anti-whispering campaign ‘counterproductive’

Jörg Huber: “These kinds of guidelines are harming the proper

evaluation process.”

Market


MONITOR: MARKET

tices in line with where discussions have

been heading.

Syndicate bankers described ICMA’s

position as aiming to ensure that everyone

who could be involved in a transaction has

access to public information, with inves-

tors pushing to do away with whispers and

other practices that could involve them

being made privy to inside information

and/or wall-crossed. ICMA explains wall-

crossing as being sounded for a potential

transaction on the basis of information

that may amount to inside information

and that could make investors subject to

legal restrictions, such as restrictions on

trading in related securities.

A syndicate offi cial said that one out-

come of discussions taking place could be

that the term “whisper” is no longer used,

partly on account of its connotations of

secrecy.

Terminology is not likely to be the

only feature of primary market activity

set to change, however, with a syndicate

banker saying that the ideas under dis-

cussion will also change the dynamics of

pre-sounding.

“Pre-sounding will be on a more public

basis,” he said. “Th e process will be slightly

diff erent, designed to make it more trans-

parent.”

Another syndicate offi cial said that IC-

MA’s guidelines had left him unimpressed

because of the increased execution risk

they would involve for borrowers. Inves-

tors, on the other hand, deemed infor-

mation such as price whispers and order

book updates to be relevant.

Th e guidelines were “slightly confusing

and counterproductive”, said the syndicate

offi cial.

Th e debate in part echoes that that took

place in the covered bond market last year

when the Covered Bond Investor Council

(CBIC) in January 2010 called for an end

to the practice of building shadow order

books based on price whispers.

A leading covered bond investor told

Th e Covered Bond Report that his posi-

tion remained unchanged today and that

he is still dissatisfi ed with what he called

pre-sounding. It was unfair for only a

handful of investors to be given prelimi-

nary pricing thoughts, while others only

belatedly received this information and

had little time to place orders given short

bookbuilding periods, he said.

While issuers are eager to avoid execu-

tion risk, the portfolio manager said that

he did not consider there to be any stigma

attached to not completing a deal or hav-

ing to widen pricing, and that this could in

any case also happen if a new issue project

had been pre-sounded.

He urged a return to traditional deal

execution methods, citing high issuance

volumes this year and the lack of failed

transactions

“Th e crisis mode for covered bonds

doesn’t make sense,” he said.

Less fear of failure?Making it more diffi cult to arrive at the ap-

propriate initial guidance for a transaction

by prohibiting discreet discussions with a

small number of key investors would in-

crease execution risk or the risk of an issu-

er fi nding itself in a position where it has

to pull a deal. Th is could result in issuers

having to pay higher new issue premiums

to reduce such risks.

But some bankers questioned whether,

or the degree to which, any new measures

would aff ect new issues, saying that price

whispers already spread quickly and wide-

ly, perhaps reaching more market partici-

pants and journalists than was intended.

“To all intents and purposes, how

many deals have been out where you

haven’t heard a price whisper?” asked one

syndicate offi cial. “A cynic would argue

that if it is not in writing then it is easier to

more elegantly step back or adjust levels,

but I’m not 100% convinced by that.

“When it’s announced, it’s announced.”

Others said that those pulling deals

could in future be less stigmatised for

doing so. One syndicate banker said that

market participants’ judgements of pulled

deals had already eased over the past three

years, and that such occurrences were less

conversational.

He identifi ed the return of retention

deals as a possible outcome of any new

guidelines on the communication of up-

dates on order book sizes — something

that bankers said is also being debated. Th e

Covered Bond Report understands that

lead manager and trading orders being in-

cluded in order books that may otherwise

not be fully covered is a focus of scrutiny.

Th e syndicate offi cial said that a po-

tential clampdown on including lead

manager orders in order book sizes and/

or potentially requiring such orders to be

identifi ed separately could lead to the re-

turn of retention deals because such rules

would make it more diffi cult for banks to

give the impressions that deals are being

successfully handled in pot format.

“The crisis mode for covered bonds

doesn’t make sense.”

Ruari Ewing: “The aim is to go out much wider with a whisper.”


MONITOR: MARKET

Moving into the second half of the year

after an increasingly fraught first six

months, covered bond analysts were con-

sidering the prospect that covered bond

issuance might not meet the projections

they made at the turn of the year.

“Everything is stuck on the topic of

the euro-zone,” says Bernd Volk, head of

covered bond research at Deutsche Bank.

“The covered bond market will continue

on a slower pace even though a resolu-

tion is found for Greece, also due to pre-

funding and the declining funding needs

of numerous issuers.”

Deutsche Bank had estimated

Eu250bn in euro benchmark issuance for

the year, a number Volk now considers

impossible.

“Due to all this rating action and

market concern I think the market will

be happy if we do another Eu60bn and

hit Eu200bn, but I think everyone will

probably struggle with market issuance,”

he says.

“France will be crucial in reaching

Eu200bn,” he adds, “which is the best we

can hope for. If they issue a lot, we’ll have

a lot more volume.”

French issuers sold some Eu37bn of

benchmarks, including taps, in the first

half of the year.

Danske Bank had forecast Eu226bn

in gross supply for 2011, and some 62%

of that volume was issued in the first

six months of 2011. By comparison,

Eu185bn hit the market in 2010, accord-

ing to the Danish bank.

“There’s still a lot of uncertainty be-

cause market access is very much linked

to the sovereign debt crisis,” says Chris-

tian Riemann-Andersen, senior analyst

at Danske. “If they don’t come up with

a sustainable solution for Greece, who

knows what will happen?

“But if they do, we might even see

more issuance than we have forecast,

driven by the peripheral countries.”

Covered bond analysts say that sup-

ply in different currencies could affect

what should be expected from each ju-

risdiction.

“The UK is a little bit behind what we

had expected,” says Riemann-Andersen,

“but we stick to the forecast as most UK

banks have large refinancing needs.

“The joker that could take euro sup-

ply lower than projected is of course di-

versification into US dollars or British

pounds.”

UK banks issued some Eu10bn in

the first of the year in euros, according

to Danske, when the bank had forecast

Eu22bn for the year.

Florian Hillenbrand, senior credit

analyst at UniCredit, attributed the UK

shortfall to a greater trend towards US

dollars.

“There is one respect that weighs

heavy on euro issuance,” he says. “That’s

the US. What we see right now is in

countries where they have to swap their

issuance back into their home currency

(the UK, Norway, and Denmark), we

have seen active US dollar issuance.

“This is something that will poten-

tially drag euro issuers toward the dollar

market.”

New Zealand and Australia are con-

sidered minor players, with market par-

ticipants undecided as to whether Aus-

tralian issuers will even come to market

this year.

“For Australia, we have a cautious

estimate of Eu2bn, but there also might

be nothing if the upcoming law gets de-

layed” says Danske’s Riemann-Andersen.

Other jurisdictions have meanwhile

surprised to the upside.

“Italy has done pretty well as they

benefitted from the relief in the sovereign

market earlier this year,” adds Riemann-

Andersen.

Italian banks sold some Eu14bn of

benchmark euro covered bonds, com-

pared with Eu20bn forecast by Danske.

UniCredit’s Hillenbrand foresees

heavy issuance in September.

“Last year we had Eu27bn in in Sep-

tember,” he says. “I would be quite sur-

prised to see anything less than this

number after we saw record issuance in

September through March.”

SUPPLY

Wildcards undermine H2 forecasts

0

10

20

30

40

50

60

German

y

Franc

e

Irelan

d

Luxe

mbour

g

Spain

UK

Austr

ia

Finlan

d Ita

ly

The N

etherl

ands

US

Swed

en

Portu

gal

Canad

a

Norway

Denmar

k

Greece

Switz

erlan

d

New Z

ealan

d

2010 2011 ytd 2011e

UniCredit H2 supply forecasts

Source: UniCredit Research

Diversification into dollars or pounds

“the joker”

“The legislation is being perceived positively by investors” page 40


MONITOR: MARKET

Westpac NZ fi nally came to the market

with its fi rst covered bond in early June

aft er postponing its plans in February,

but hopes of further supply from New

Zealand were dashed when ANZ Nation-

al postponed a debut, euro denominated

deal on 22 June.

In February Westpac NZ had cited

poor market conditions and an earth-

quake in New Zealand when delaying its

inaugural covered bond. But at its second

attempt, Westpac NZ’s leads — Barclays

Capital, BNP Paribas and UBS — built a

book of Eu1.3bn for the Eu1bn fi ve year

issue and priced it at 75bp over mid-

swaps on 9 June.

A Bank of New Zealand seven year

was the only other New Zealand covered

bond outstanding in euros and a syndi-

cate offi cial at one of Westpac NZ’s leads

said that this was trading in the low 70s

mid over swaps. BNZ issued its Eu1bn

seven year at 62bp over mid-swaps last

November.

A syndicate offi cial away from the

leads suggested pricing was more real-

istic than when Westpac NZ had previ-

ously approached the market.

“Th at was aft er the Christchurch

earthquake, but I don’t think they really

had a trade then,” he says.

Bankers said that they were somewhat

surprised at the level Westpac NZ needed

to pay given its qualities, and struggled to

explain why the New Zealand banks did

not trade tighter.

“Th e bank is relatively small,” suggest-

ed one, “even if it’s part of a bigger group,

and the fact that it is non-ECB collateral

doesn’t help.”

Th e New Zealand sector faced further

challenges in June when ANZ National

postponed a new issue project until aft er

the summer in light of rapidly deteriorat-

ing market conditions aft er having gone

on a roadshow for a debut covered bond.

A syndicate banker familiar with the

New Zealand bank’s plans said that feed-

back from the roadshow had been “quite

strong” but that as a well funded issuer

ANZ felt it did not need to rush to launch

a deal in such uncertain markets.

Aussie cheer for BNZ, DnB NorBNZ found conditions closer to home

more conducive, selling a debut, A$700m

(Eu512m) fi ve year covered bond at 88bp

over swaps on 7 June via HSBC, RBC and

RBS. Th is was larger than the A$500m

originally targeted, with oversubscrip-

tion also allowing pricing at the tight end

of the guidance of 88bp-90bp.

Comparing this with Westpac NZ’s

euro benchmark launched two days later,

a banker away from the two deals said

that BNZ’s level translated to around

30bp over Euribor, meaning that it had

saved about 45bp versus where Westpac

NZ had funded in euros.

DnB Nor Boligkreditt also found suc-

cess in Aussie dollars, becoming the fi rst

European issuer to sell a covered bond

in the currency since the onset of the fi -

nancial crisis when it sold a A$600m fi ve

year at 85bp over mid-swaps on 8 June

via ANZ, Deutsche Bank and HSBC.

“Th e target was to print a deal like

this, with a A$500m minimum size,”

Th or Tellefsen, senior vice president and

head of long term funding at DnB Nor,

told Th e Covered Bond Report. “For us

it’s all about investor diversifi cation.”

He said that the pricing was more or

less in line with what DnB Nor could

achieve in the US dollar covered bond

market or in euros. Th e proceeds of the

Australian dollar issue were swapped to

dollar Libor at 61bp — DnB Nor issued

a fi ve year dollar benchmark at the end

of March at 66bp over that was trading in

the high 50s.

AUSTRALIA/NEW ZEALAND

Westpac NZ on, but ANZ off, as Kiwis travel

Westpac NZ rescue helicopter

DnB Nor, Oslo


MONITOR: MARKET

Issuers found the euro primary market in-

creasingly challenging through June and

the fi rst half of July, as investors retreated

fi rst to only names from core jurisdictions

and then onto the sidelines completely.

Greece proved to be a major wrecking

ball as the market awaited Greek prime

minister George Papandreou’s attempt to

withstand a vote of confi dence on 19 June

by reshuffl ing his cabinet and then pushing

through a new austerity package on 29 June.

A relief rally on the back of the success-

ful initiatives allowed Eu1bn plus of cov-

ered bond funding to be raised by Caisse

de Refi nancement de l’Habitat and BNP

Paribas Home Loans SFH, but the diffi -

culty of tapping into even such issuance

windows was demonstrated when Fin-

land’s OP Mortgage Bank struggled to get

a Eu1bn seven year away at the same time.

But worse was to come as fears of con-

tagion spread. Aft er Landesbank Baden-

Württemberg and CM-CIC Home Loan

SFH sold benchmarks in the fi rst full

week of July, benchmark euro issuance

came to a standstill.

“It’s a very quiet, very political mar-

ket,” said Christoph Alenfeld, syndicate

offi cial at DZ Bank. “It’s really turned

sour lately, and given the political situa-

tion, no one is really surprised by this.”

June had started well for Italian banks,

with UniCredit and Credito Emiliano

selling benchmarks — the latter its debut

covered bond. But the country took a hit

on 24 June when Moody’s placed covered

bond programmes of fi ve Italian fi nan-

cial institutions on review for possible

downgrade — the republic’s Aa2 rating

had been put on review a week earlier —

dashing the hopes of compatriots queu-

ing to issue.

However, Italy’s travails in the covered

bond market were minor in comparison

with Spain’s. Only one Spanish issuer ap-

proached the market and it found the

environment unwelcoming: a Eu1bn fi ve

year issue for Santander backed by public

sector collateral was widely criticised as

poorly timed and aggressively priced.

“Just because one day the indices are

trading better, it doesn’t mean that inves-

tors are going to wake up and decide that,

just having sold Spain, they are going to

start buying again,” said a syndicate offi -

cial away from the leads. “I wouldn’t have

recommended going ahead unless I want-

ed to be left with Eu100m on my book.”

However, some market participants

said that the overall performance of the

asset class in the face of tough economic

conditions had shown it in a positive light.

“Th e covered bond market has shown

a great amount of resilience to the situ-

ation in southern Europe,” said Per Høg

Jensen, vice president, DCM origination

at Danske Bank. “It’s a good testimony

to the market that deals still are getting

done in the covered space.”

He cited as an example a Eu500m fi ve

year mortgage Pfandbrief from newcom-

er ING-DiBa, which had been warmly re-

ceived on 22 June, with the order books

more than twice subscribed in spite of

what some market participants consid-

ered tight pricing.

EUROS

Issuers steer clear of Greek wrecking ball

Prime minister George Papandreou: survived two tests

0

100

200

300

400

500

600

700

800

900

11-rpA11-naJ01-tcO01-luJ

bp

iBoxx € France Covered Structured iBoxx € Netherlands Covered iBoxx € Portugal CoverediBoxx € Spain Covered iBoxx € UK Covered iBoxx € France Covered LegaliBoxx € Hypothekenpfandbriefe iBoxx € Ireland Covered iBoxx € Norway CoverediBoxx € Oeffentliche Pfandbriefe iBoxx € Sweden Covered iBoxx € Italy Covered

Spread performance by sector

Source: UniCredit Research

“OC ceiling could negatively impact investor confi dence” page 41


MONITOR: PEOPLE & INSTITUTIONS

LBBW

Rath heads for Commerz

Former UBS credit trader Michael Rudd

has joined RBC Capital Markets as a

director of its fi xed income platform in

New York.

Rudd will work closely with Catherine

Chere, a credit trader in London. RBC

said this will better enable it to provide

clients with the ability to trade covered

bonds and Yankee banks.

In January RBC hired Ben Colice as

head of covered bonds origination from

Barclays Capital.

“Currently, we have the right number

of people in place given the size of the

market,” Mike Meyer, head of US credit,

RBC Capital Markets, told Th e Covered

Bond Report, “and we’ll be in a good

place to add more people if needed. We’re

positioned well to grow the business.

“We think the market is going to

continue to grow in Canada and Europe

and though there are still some ques-

tions around US and Australian markets,

we are optimistic about growth there as

well.”

Th ere has been ample US dollar cov-

ered bond issuance out of Canada, added

Meyer.

“If US legislation passes, we would be

in a very good place,” he said.

RBC

Rudd hired on US hopes

Michael Rudd: latest RBC hire

Denis Rath: from covered to senior

People & Institutions

“If US legislation passes, we would be in a very good place”

Denis Rath is leaving Landesbank Baden-Württemberg to join Commerz-bank’s DCM syndicate team as a vice president in London.

Rath is on gardening leave and will be joining Commerzbank by the beginning of 2012. He had been working at LBBW for fi ve years, most recently as debt capital markets syn-dicate manager sharing responsibility

for covered bonds.Earlier this year Martin Rohland

joined Barclays Capital’s syndicate af-ter having left LBBW, while a year ago head of syndicate Vincent Hoarau went to Crédit Agricole.

At Commerzbank, Rath will be fo-cused on senior unsecured bonds. He will report to Hugh Carter in London and Joachim Heppe in Frankfurt.

Don’t forget to visit our website at:

www.coveredbondreport.com


MONITOR: PEOPLE & INSTITUTIONS

Landesbank Baden-Württemberg has

appointed long-serving analyst Alexan-

dra Hauser to its covered bond team to

replace Jan King, who is due to leave the

bank this autumn, while Ralf Burmeister

is also departing.

Burmeister, who was head of covered

bonds and fi nancials research at LBBW,

is understood to have lined up a posi-

tion at German asset manager DWS In-

vestments. Currently on paternity leave,

joined LBBW in 2000 and became head

of the covered bond and fi nancials re-

search team in November 2007.

King is set to join Royal Bank of

Scotland in London, with one of the UK

bank’s previous covered bond analysts,

Sophia Kwon, having moved internally to

work in debt capital markets. King joined

LBBW in 2006.

LBBW’s Hauser began working as a

senior credit analyst on covered bonds at

the beginning of this July, and will share

responsibility for the bank’s covered

bond research with Christian Enger, also

senior credit analyst at the bank.

Before moving to her new role Hauser

worked for 12 years as an equities analyst,

most recently as manager of LBBW’s engi-

neering and industrial equities team. She

joined LBBW in 1994, and aft er completing

a training programme worked in the bank’s

controlling department for four years.

Her focus was on strategic bank man-

agement, dealing with issues concerning

asset and liability management in the

context of refi nancing requirements, in-

cluding in relation to specifi c products

such as Pfandbriefe, Hauser told Th e

Covered Bond Report.

ANALYSTS

LBBW brings in Hauser

Alexandra Hauser: credit switch

NBIM

New role for NielsenClaus Tofte Nielsen, chairman of the Covered Bond Investor Council, has taken on the role of head of position management, allocation strategies, at Norges Bank Investment Man-agement.

Nielsen was until recently senior portfolio manager at NBIM, which manages Norway’s oil fund, the Gov-ernment Pension Fund Global, but is now heading the allocation strategies department.

The department is responsible for the overall risk positioning of the fund, overlay positions establish-ing total fund exposures, as well as management of dedicated portfolios in chosen market segments. Nielsen’s appointment comes after a series of top level organisational changes, in March and April.

TRADING

Poli leaves BAMLNicolas Poli has left Bank of America

Merrill Lynch, where he was a director

and worked on the sovereign, supra-

national and agency and covered bond

trading desk.

He joined Merrill Lynch in mid-2008

from Calyon. Th e Covered Bond Report

understands that Poli will be re-emerg-

ing in a similar role at a leading covered

bond house aft er his departure in June.

Meanwhile, Crédit Agricole has hired

Matej Chytil from National Bank of Slo-

vakia to work as a covered bond trader.

BARCLAYS

Harju joins from S&PJussi Harju joined Barclays Capital in May

from Standard & Poor’s, where he was re-

sponsible for rating UK, Scandinavian and

Dutch covered bond programmes.

As European Strategy analyst, he and

Fritz Engelhard, German head of strategy,

are primarily responsible for Barclays’ cov-

ered bond research, while Michaela Seimen

works on SSA and covered bond research.

Harju’s hire follows the departure of

Leef Dierks, who left Barclays’ research

team last year to join Morgan Stanley as

head of covered bond and SSA strategy.

STRUCTURING

Credit Suisse hires BNP Paribas’ Peacocke Hamish Peakcocke is understood to be joining Credit Suisse from BNP Paribas.

Peacocke worked in covered bond structuring at BNP Paribas and is expected

to fi ll a similar role when he joins Credit Suisse.

Arjan Verbeek heads flow ABS and covered bond structuring at BNP Paribas.

The French bank ranks top of the covered bond league table for benchmark cov-

ered bonds in all currencies.


COVER STORY: SOVEREIGNS VERSUS COVERED



I f secondary market trends are anything to go by, cov-

ered bonds issued out of countries such as Ireland,

Greece and Portugal have been deemed less risky than

their respective sovereign debt as they have become

engulfed by the euro-zone crisis.

“Covered bonds trading in line or inside respective sover-

eign levels can be considered a feature of the so-called ‘periph-

eral economies’ and as a crisis signal,” says Leef Dierks, head

of covered bond and SSA strategy at Morgan Stanley. “It shows

that covered bonds are viewed as equal to or better than sover-

eign debt in risk terms.”

Dierks noted back in April that in all European economies

that experienced funding difficulties and/or were subject to

support measures from the European Union and International

Monetary Fund — Ireland and Greece, at the time — covered

bonds could be observed trading through government bonds.

This was before Portugal also received a Eu78bn bailout package

from the EU and the IMF agreed at the beginning of May, but

Dierks observed that already the average correlation between

swap spread movements of Portuguese government bonds and

those of the country’s mortgage covered bonds (obrigações

hipotecarias) had also started to decline.

The development of such a relationship can make sense,

say investors.

Roger Doig, senior credit analyst at Schroders, points to the

example of McDonald’s at one point in 2010 trading tighter

than the US sovereign, and says that covered bonds could also

be candidates for such behaviour.

“You would need a cover pool with extremely strong operat-

ing rules, where government bonds cannot serve as alternative

collateral and where there are very strict limits on factors such

as loan-to-value ratios,” he says. “Ultimately a triple-A rating

stems not from recourse to the sponsor bank but from confi-

dence in the management of the cover pool and low to no cor-

relation between the collateral and the sovereign situation.”

The importance of good quality, non-public sector assets as

collateral was also highlighted by a large covered bond investor.

“Take the Greek situation, where it now seems that there

will be some type of voluntary rollover,” he says. “The prob-

lems there have not been caused by the mortgage market but

by an inefficient public sector and uncompetitive economy, so

you could argue that this is a case where covered bonds should

come out better than government debt.”

Although such an argument would be more difficult to make

with respect to Ireland, he adds, given that many of the coun-

try’s problems are linked to the housing market.

Vincent Cooper, financials analyst at hedge fund BlueMoun-

tain Capital Management, says that in a distressed sovereign

scenario covered bonds issued out of a country can justifiably

trade through the sovereign, the key reason being covered

bondholders’ recourse to a pool of collateral.

“To the extent that you are comfortable with the underpinning

legal framework, the recourse does provide significant enhance-

ment to the security of your investment,” he says. “We are seeing

examples of that in the sovereign space where sovereign investors

are more vulnerable to potential haircuts without any real claim to

assets and also face the likelihood that there will be a number of

preferred creditors ranking ahead of them, such as the IMF.”

BlueMountain, for one, has taken a more active interest in

covered bonds partly on account of recent price movements in

the market resulting from sovereign developments in the pe-

riphery, according to Cooper.

“With the weakness in peripheral Europe we have seen some

pretty distressed prices in parts of the covered bond market,

Fall of the sovereignThe theory is simple: sovereign debt is the risk free asset class; covered

bonds appeal to those looking for safety but extra yield. But today investors are faced with the possibility of an EU state defaulting. Which asset class

will prove to have been the least risky should doomsday arrive?Sue Rust reports.



which have provided good opportunities for us,” he says. “Cov-

ered bonds in places like Ireland, Portugal and Spain are trading

at yields that are similarly interesting to those on subordinated

bank debt.”

Technical and fundamental doubtsHowever, although Greek, Irish, and Portuguese covered bonds

have been trading inside levels on their sovereign’s debt, this

relationship has yet to manifest itself in the primary market and

the large investor says that this renders it less meaningful.

“People say it does not matter as long you don’t have a pri-

mary issue price tighter than the sovereign,” he says, “but we

will not see this because it would kill a bank from Ireland or

Portugal to issue at this kind of levels.”

And Heiko Langer, senior covered bond analyst at BNP Pari-

bas, says there are limits on the extent to which covered bond

spreads can decouple from sovereign spreads.

“There are some investors out there who value the fact

that they have tangible collateral as opposed to just a promise

from a sovereign to pay back their debt based on tax income,”

he says. “But if you are realistic, most institutional investors

need a country allowance to also hold covered bonds from

that country.

“So if they are not allowed to pick up Irish exposure they will

not be allowed to buy more Irish covered bonds, and people

may also oft en sell government bonds before covered bonds or

what is more easy to sell, especially in distressed times.”

Greater liquidity in the government bond market than in the

covered bond market can also help explain why some covered

bonds have been trading tighter than their sovereigns, he adds,

with covered bond spreads reacting more sluggishly than those

for government bonds.

“I am aware of some Portuguese covered bonds continuously

trading through their sovereign,” he says, “but not necessarily

because there are so many people out there taking a view that

they are better off holding covered bonds from Portugal than

the sovereign debt.

“Th ere are a lot of technical reasons that can lead to that type

of behaviour.”

And Schroders’ Doig argues that despite it being possible

that covered bonds will trade through sovereigns — because of

the lack of correlation between a mortgage pool and the “idi-

osyncratic” problems facing the sovereign — there are factors

working against this.

“Banks are typically large holders of government bonds, and

to the extent that cover pool assets are correlated to a bank’s un-

secured rating you will get a feed-through: worsening sovereign

Leef Dierks: “Covered bonds could be observedtrading through government bonds”

Ass

et s

wap

spr

ead

(bp)

-400

-300

-200

-100

0

100

200

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11

Italy Spain Portugal Ireland

Spread between sovereigns and covered bonds (iBoxx aggregates)

Source: Markit, Morgan Stanley



spreads can drive out senior unsecured spread, which can take

secured spreads wider,” he says.

An investor would also need to believe that the country’s

mortgage market could prosper when the sovereign is in trou-

ble or defaults, adds Doig.

“Th e weakness in the country’s economy probably mitigates

against a housing market doing well because of the intercon-

nectedness of it all,” he says.

Can bail-ins be escaped?As European policymakers strive to avert a Greek default that

could trigger a Lehman Brothers-style meltdown and to con-

tain a wider sovereign debt crisis, their eff orts have focussed on

involving the private sector in a restructuring of the country’s

maturing debt. One high profi le proposal was that originated

by the French banking federation, which foresaw the country’s

banks voluntarily rolling over a portion of maturing Greek

bonds into new government bonds, the idea being that other

fi nancial institutions would also take part.

However, contrary to the initiative’s aims, Fitch and Stand-

ard & Poor’s reacted to the rollover plan by announcing that

they would consider such an initiative to constitute a default,

and at the time Th e Covered Bond Report went to press Eu-

ropean leaders were searching for a new strategy as part of a

second bailout plan for Greece.

Tim Skeet, managing director, fi nancial institutions group at

Royal Bank of Scotland, says that the impact on covered bonds

of a restructuring or default is hard to gauge, with challenges on

multiple levels. Investors’ decisions should therefore be taken

on the basis of a “big picture” view.

“On paper, if there is a restructuring of sovereign debt the

status of covered bonds should not be directly impacted,” he

says, “but from a credit perspective they are bound to get hit.

“You will want to buy or hold such covered bonds on credit

fundamentals because you will be exposed to credit events and

rating risk. Th eoretically the credit of covered bonds should

hold up, but in practice that is very unclear.”

Covered bonds’ exemption from bail-in discussions surround-

ing sovereign and senior unsecured debt is also pertinent to the

assessment of sovereign and covered bond risk, according to Skeet.

“If covered bonds are not bail-inable then you should be able

to get your money back when it is due regardless of what is hap-

pening to the sponsor bank or the sovereign,” he says. “By defi -

nition you are talking about covered bonds being the most sen-

ior of all debt categories in a country, but they are not risk-free.

“If there is a super meltdown bringing down the banks and

the economy, including the payment systems, mortgage bor-

rowers will not have the means of servicing their debt so over-

collateralisation levels will be insuffi cient and possibly irrele-

vant — where are you going to get your money from?” he adds.

Fitch sets out roadmapMuch depends on the nature of any further deterioration of

Greece’s debt problems and how this is managed, say market

participants.

-700

-600

-500

-400

-300

-200

-100

0

100

200

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11

Ass

et s

wap

spr

ead

(bp)

3.375% BES Feb 2015 - 4.200% PGB Oct 2016 3.875% CGD Dec 2016 - 4.200% PGB Oct 2016 3.375% BCP Oct 2016 - 4.200% PGB Oct 2016 3.250% BPI Jan 2016 - 4.200% PGB Oct 2016

Spread between Portugal and Portuguese covered bonds

Source: Morgan Stanley

Vincent Cooper: “Sovereign investors are more vulnerable to potential haircuts”



In a statement setting out the rating implications for struc-

tured fi nance securities and covered bonds of a restructuring or

rollover of Greek debt, Fitch said that for a covered bond rating

to exceed the issuer default rating of the relevant euro-zone sov-

ereign the rating agency must expect that the country’s fi nancial

payment system will continue to operate, without interruption,

at all times throughout the lives of the transactions and their

underlying pools of assets.

“It is possible that a country’s payment system will continue

to operate throughout a period in which the debt obligations

of the sovereign and even individual fi nancial institutions un-

dergo some form of restructuring, particularly if such events

are anticipated and overseen in an orderly manner by external

parties such as the International Monetary Fund,” it added.

Cashflows in securitisations could therefore be maintained

and payments made as required despite the potential techni-

cal insolvency and liquidity problems that could be created

for banks as a result of some form of restructuring or default,

it believes.

Skeet says that references to problems such as the uninter-

rupted operation of a fi nancial payment system illustrate that

for technical reasons the “super-seniority” of covered bond-

holders may not matter.

In contrast to securitisations, said Fitch, covered bond rat-

ings would continue to be tied to the ratings of their issuers,

which the agency would be likely to cut in the event of a further

downgrade of the Greek sovereign.

Th e impact on the issuer ratings would take into account

whether the restructuring or rollover event “is accompanied by

fi rm commitments from the European authorities for general

bank re-capitalisation and re-fi nancing, as well as its anticipat-

ed eff ects on the individual banks,” said Fitch.

And while market participants emphasise the value of cov-

ered bondholders’ claims on collateral, the performance of

those assets is anything but certain in the context of a sovereign

under stress, as Fitch highlights in the case of Greece.

“Th e implementation of more severe austerity measures, de-

clining economic output and ongoing political tension all have

the potential to reduce the ability and/or willingness of bor-

rowers to make payments on their loans and have a detrimental

eff ect on asset prices,” it said.

Negative feedback loopsWhether or not it will all boil down to the assets in cover pools

depends on the extent to which issuing fi nancial institutions,

domestic and international, can survive a sovereign debt crisis,

a debt restructuring, or, ultimately, a default.

In a research note exploring ways to bring Greece back to

solvency Barclays Capital economists described the impact sov-

ereign fears have had on domestic fi nancial institutions, espe-

cially their funding costs.

“Profi tability is a key concern, as margins are further

squeezed,” they said. “Deposit wars are still ongoing in Spain

and are becoming a threat in Italy as well. More generally, el-

evated sovereign spreads add pressure on fi nancial and nonfi -

nancial corporates, putting downward pressure on credit supply

and investment decisions, thereby creating a negative feedback

loop into the economy.”

A report published by the Bank for International Settle-

ment’s Committee on the Global Financial System (CGFS) in

July described the causality between sovereign risk and the cost

and composition of bank funding.

“Higher sovereign risk since late 2009 has pushed up the cost

and adversely aff ected the composition of some euro area banks’

funding, with the extent of the impact broadly in line with the

deterioration in the creditworthiness of the home sovereign,”

it said. “Banks in Greece, Ireland and Portugal have found it

diffi cult to raise wholesale debt and deposits, and have become

reliant on central bank liquidity.

“Th e increase in the cost of wholesale funding has spilled

over to banks located in other European countries, although to

a much lesser extent.”

As Th e Covered Bond Report was going to press the euro-

zone crisis had reached Italy’s doorstep. Analysts at Landesbank

Baden-Württemberg noted that a key cause for concern was

how intertwined are the sovereign and its banks, also citing the

CGFS report.

“The Bank for International Settlements offered some

ideas as to why rising credit risks at state level also impact

negatively on the funding situation of the banks in question,”

they said. “The BIS makes out in particular four transmission

channels, above all impending writedowns on banks’ sover-

eign debt portfolios.

Roger Doig: “Weakness in a country’s economy probably mitigates against the housing market doing well”



“Especially in developed countries, banks typically have

high exposures to their home state according to the BIS. For

example, the exposure of Italian banks to the Italian state repre-

sents nearly 70% of the banks’ capital.”

Standard & Poor’s has said that the magnitude of the im-

pact on Greek banks of any restructuring of the sovereign’s debt

would largely depend on the amount of debt aff ected and the

terms and conditions of a restructuring.

Greek banks’ capital bases could be affected by any such

restructuring, it said, adding that the effect would vary ac-

cording to whether the potential restructuring involves:

principal haircuts; a lengthening of debt maturities by ex-

tending the maturities of existing debt or by exchanging ex-

isting bonds for longer term new debt; or altering the level

of the coupon on any new bonds offered in exchange relative

to the original debt. The impact would also depend on any

forbearance in its recognition.

“As a result, scenarios for Greek banks in the event of a po-

tential Greek government debt restructuring range from being

able to operate with capital levels above minimum regulatory

limits, for example, if the government debt restructuring af-

fects only part of the government debt, to potentially facing

insolvency in the more negative scenarios affecting the whole

of rated banks’ large portfolios of Greek government debt,”

said S&P.

Euro exit caveatSchroders’ Doig says that with regard to Greece the intercon-

nectedness of its debt burden, and the state of its economy

and its banks means that trade ideas promoting Greek covered

bonds are not appealing.

“A few people on the sell-side have pushed Greek covered

bonds on the basis that the country’s housing market is not

what has caused the problems,” he says, “but Greece has gone

far enough that that is no longer compelling.

“Th ere is material enough a risk there — if the country

leaves the euro you lose value on the cover pool assets and

clearly there are also many problems with the sponsor banks

given that they hold a lot of Greek debt and are losing deposi-

tors due to sovereign worries.”

And while similar arguments made about Portuguese cov-

ered bonds are worth listening to, adds Doig, there is a risk

that the Portuguese sovereign will go in a similar direction

as Greece.

“We see the logic of that argument, but whether it is a risk

worth taking I am not sure,” he says. “If you felt that a sovereign

was going to be in trouble that would raise signifi cant uncer-

tainty about the value of your collateral.”

Other investors and analysts contrast a well-managed restruc-

turing or selective default with the altogether more worrying out-

come of Greece or another country leaving the euro-zone.

Such a move has been contemplated in some commentaries

on the sovereign debt crisis, but is deemed unlikely and a fate

that European policymakers are desperate to avoid. Nonethe-

less, market participants brought up the hypothetical case for

discussion, pointing to the uncertainty this would create, not

least because the underlying mortgages would be repaid in a

new, local currency while the covered bonds remained denomi-

nated in euros.

ECB collateral or junk?Short of the doomsday scenario of default, market participants

have been analysing the likelihood of covered bonds following

sovereigns over another threshold: that from investment grade

to junk. Covered bonds must have at least one investment grade

rating to retain eligibility for ECB repo operations — although

there is speculation that the ECB could waive the requirement

were this to happen.

As sovereigns have been stripped of their investment grade

ratings, the way in which rating agencies view the transmission

of sovereign risk to banks and, in turn, from issuers to covered

bonds has been key in this regard.

Greek covered bond programmes, for example, were down-

graded to junk by Moody’s in June, with their eligibility for repo

with the European Central Bank hinging on Fitch continuing to

rate them investment grade. It looked set to do so, with Fitch on

15 July cutting programmes of four Greek banks to BBB- and

indicating that restructurings of covered bonds embarked upon

by the issuers would stave off a cut to junk.

A four notch cut of Portugal to junk status by Moody’s at the

beginning of July, meanwhile, was considered likely to lead to

downgrades of Portuguese covered bonds because of the link-

age under Moody’s methodology between a sovereign’s ratings

Jane Soldera: “As the sovereign’s creditworthiness weakens so does that of the banking system”



and that of its banks, and the relationship between banks’ rat-

ings and those of their covered bonds, said analysts.

“Even taking into account Portugal currently having only

a negative outlook compared to the review for downgrade of

Greece in June 2010, the new Portuguese sovereign rating of

Ba2 (compared to Ba1 of Greece in June 2010) is a tough new

reference for covered bonds,” said Bernd Volk, head of covered

bond research at Deutsche Bank.

Morgan Stanley’s Dierks highlighted the possibility of junk

status for Portuguese covered bonds.

“In light of the ongoing rating migration, we caution that

it will only be a matter of time before further downgrades, in

some cases potentially to the sub-investment grade, might oc-

cur,” he said.

Jane Soldera, senior credit officer at Moody’s, says that

if banks are being downgraded in lockstep with cuts of the

sovereign rating, covered bonds would be affected under the

rating agency’s expected loss modelling. This determines ex-

pected loss as a function of an issuer’s probability of default

and the stressed losses on cover pool assets following an is-

suer default.

“We might also lower the Timely Payment Indicator (TPI)

to refl ect our view of a lower likelihood of timely payments fol-

lowing an issuer default,” she says. “Th is would cap the covered

bond rating relative to the bank rating.”

Th e most important factor infl uencing the TPIs would be

Moody’s view on refi nancing risk in the environment where the

sovereign credit is weak.

“Our concern would be that as the sovereign’s creditwor-

thiness weakens so does that of the banking system, with the

sovereign being less able to provide support (directly or in-

directly) for covered bonds where the issuing bank has got

into trouble,” says Soldera. “Mitigants of refinancing risk such

as government intervention would be seen as increasingly

threatened as the sovereign becomes weaker.”

The continued importance of ratings for investors not-

withstanding, many market participants have bemoaned

what they see as overly mechanical rating actions. RBS’s

Skeet says that investors need to look through the technical-

ity of rating decisions.

“Many rating triggers are somewhat artifi cial,” he says.

“Downgrades happen but does it really mean bonds are less

likely to perform?

“Th e expansion of the investor base, as credit and ABS buy-

ers have become involved, means that covered bonds are being

looked at on fundamental grounds,” he adds. “To not do so is

the day before yesterday’s strategy.”

Germany prepares to take the strain as the sovereign debt crisis reaches Italy — as interpreted by German cartoonist Horsch, fi rst published in LBBW’s Covered Bonds Weekly

Tim Skeet: “Downgrades happen but does it really mean bonds are less likely to perform?”

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


CRD IV: GAME ON


CRD IV: GAME ON

“Anyone who was hoping that the European

Commission’s new draft would provide

a clear definition of the status of covered

bonds in the calculation of banks’ liquidity

cover ratios must now be disappointed. The

debate will now be carried forward to the next round.”

Indeed.

Heading into the summer recess, Brussels-watchers, lobby-

ists, and basically anyone with an interest in the covered bond

market had been awaiting the European Commission’s propos-

als for the fourth iteration of the Capital Requirements Direc-

tive to see if and how it might deviate from the Basel III frame-

work set out by the Basel Committee for Banking Supervision.

Not only had observers been trying to second guess how the

Bank for International Settlement body’s plan would be trans-

posed into the European Union, but even the date of the EC’s

announcement was the subject of speculation.

But when, on 20 July, Commissioner Michel Barnier finally

delivered the CRD IV proposal, it did little to bring the frenzy

of speculation to an end. DZ Bank analysts’ reaction to the pro-

posals, quoted above, summed up how the draft failed to offer

any conclusion to the debate.

The disappointment was all the stronger given how impor-

tant CRD IV is to the fate of covered bonds.

A key objective for covered bond market supporters — and

others who believe they should have a greater role in financial

stability — has been for the asset class to be granted better treat-

ment in Liquidity Coverage Ratios than that envisaged by the

Basel Committee.

Under the Basel III framework it proposed in December, cov-

ered bonds are considered Level II assets in LCRs. This means

that, alongside high quality non-financial corporate bonds, they

can comprise up to 40% of liquidity buffers that banks will have

to hold, and will be subject to haircuts of at least 15%.

While this should prove supportive of covered bonds, some of

those lobbying for better treatment would like to see them eligi-

ble as Level I assets, which include principally government bonds

free from such limits or haircuts. A group of countries, led by

Denmark and Germany but including several other jurisdictions,

last year put forward a proposal whereby covered bonds meeting

certain strict criteria would be granted Level I status.

EBA terms of referenceRather than deliver a verdict on what assets should qualify for

Level I or Level II status, the EC’s CRD IV proposal pushed

back any such decision, instead leaving the responsibility to the

European Banking Authority. The regulator is due to report its

findings after an analysis of potentially eligible assets by the end

of 2013, in time for implementation in 2015.

Cognisant of the focus on covered bonds’ role in liquidity buff-

ers, the EC specifically addressed the fate of the asset class in a set of

Frequently Asked Questions released alongside the CRD IV draft.

“For the LCR, a particular focus of the observation period

will be set on the definition of liquid assets,” said the Commis-

sion. “EBA will test different criteria for measuring how liquid

securities are under stressed market conditions.

“This will prepare the ground for a decision before 2015 that

will ultimately determine the eligibility criteria for the two tiers

of the liquidity buffer.”

Although the EBA is left to report thus, the criteria it must

use when deciding how liquid securities are were specified by

the Commission — see table on Article 481.

The Basel Committee’s Level I and II assets are meanwhile

transposed into transferable assets of “high” or “extremely high”

Everything to play forThe European Commission’s CRD IV draft has left open as many questions

as it answered. A deferral of the definition of assets eligible for liquidity buffers means that lobbying is set to continue. But should covered bond supporters really be encouraged by the lack of news? Neil Day reports.

The criteria upon which the EBA is to base its decision, listed in Article 481, are:

of Annex VI


CRD IV: GAME ON

liquidity and credit quality, as per the Commission’s list of as-

sets that will comprise liquidity buff ers (in Article 404):

these deposits can be withdrawn in times of stress;

credit quality;

the central government of a Member State or a third country

if the institution incurs a liquidity risk in that Member State

or third country that it covers by holding those liquid assets;

Until the EBA gives its verdict on which assets can be clas-

sifi ed as being of high or extremely high liquidity and credit

quality, “competent authorities” are to provide guidance based

on these criteria to fi nancial institutions, which will decide

themselves what qualifi es.

While the EC draft off ered no more clarity as to whether or not

covered bonds might win better treatment than that proposed

by the Basel Committee, those that had been most vigorously

lobbying for changes have taken heart from the proposals.

Th e Association of Danish Mortgage Banks (Realkreditrå-

det) welcomed the Commission’s paper, saying that it holds out

the possibility of their covered bonds being treated on a par

with their government bonds.

“Th e European Commission has taken heed of one of the

crucial Danish arguments in favour of the Danish mortgage

system,” said Jan Knøsgaard, deputy director general of the as-

sociation. “Th e Commission recognises the fact that diff erences

exist between the covered bonds of diff erent countries.

“It is very encouraging that the coming liquidity rules will be

expanded with a set of quality criteria.”

Commissioner Barnier had stressed in his announcement of

the proposals that while it was important for the EC to respect

the Basel Committee’s framework, it should take into account

European “specifi cities”. Th e Commission also stressed that the

observation period should be used to the fullest possible extent.

Moody’s — with whom the Danish mortgage industry has re-

cently been arguing — echoed the Danes’ positive spin on the draft .

“Th e proposal is credit positive for Danish fi nancial insti-

tutions, which hold large portfolios of covered bonds because

it eases the fulfi llment of liquidity requirements in a country

where other top-tier assets such as sovereign bonds are not

plentiful,” said Moody’s vice president and senior credit offi cer

Oscar Heemskerk in a report. “At the same time, covered bonds

ensure that liquidity buff ers consist of high quality assets.”

Th e Association of German Pfandbrief Banks (vdp) also

found succour in the proposals.

“Th e vdp believes that progress has also been made in terms

of recognizing Pfandbriefe as highly liquid investment instru-

ments for the liquidity buff er, which all banks will in future be

required to maintain,” it said. “Th us, in the Association’s opin-

ion, it can no longer be ruled out that, according to the crite-

ria still to be developed by the European Banking Authority,

Pfandbriefe may also be included in the highest possible cat-

egory for securities.”

However, other market participants believe that there is lit-

tle chance of any meaningful change from Basel III. Florian

Hillenbrand, senior credit analyst at UniCredit, says that while

there are diff erences of opinion as to whether or not covered

bonds might yet gain better treatment, he does not see that hap-

Michel Barnier: “We take into account the specifi cities of the European banking sector”

EBA offi ce: “Fate of covered bonds in European Banking Authority’s hands”


CRD IV: GAME ON

pening — even if he does not believe this is justifi ed.

“From my perspective, I rather see covered bonds being put

at a signifi cant disadvantage compared with what we had be-

fore,” he says, “because they get worse treatment in compari-

son to assets that are defi nitely more risky, less liquid and more

volatile.

“Most covered bonds have been more liquid and more stable

than Greek or Portuguese government debt, but they are put in

a worse position — in particular with regards to the Liquidity

Cover Ratio.”

Just as covered bond supporters have been aspiring to equal

status with government bonds, proponents of securitisation

have been hoping that certain asset backed securities — notably

high quality residential mortgage backed securities — might be

deemed fi t for liquidity buff ers. A key argument in favour of

this has been that their credit quality — unlike that of covered

bonds — is not linked to issuers, i.e. banks — with all other

fi nancial institutions debt excluded from LCRs.

Th e lack of fi nality in the EC’s draft was also considered pos-

itive by those advocating this position.

“Th e observation and parallel running periods must be fully

utilised before long lasting and wide reaching operational issues

are settled,” said the British Bankers’ Association. “We support

the Commission’s decision to introduce the liquidity coverage

ratio as a reporting standard to allow the industry time to work

with the Basel Committee and to identify which assets should

qualify for the buff er where, in particular, we believe good qual-

ity retail mortgage backed securities should stand alongside

covered bonds.”

Outgoing Basel Committee chairman and Dutch central

bank governor Nout Wellink had, in April, raised the prospect

of MBS being included in the LCR.

“As you probably know, MBS securities are not recognised

in the LCR buff er,” said Wellink. “Increased transparency and

market liquidity, for instance through market quotation, would

increase the likelihood that MBS securities would be recog-

nised as liquid assets.”

While the securitisation market has an initiative dubbed

Prime Collateral Securities aimed at enhancing the sector in a

way that would gain it better regulatory treatment, the covered

bond industry has been engaged in a “labelling” initiative, led

by the European Covered Bond Council and supported by the

European Central Bank. Market participants say that any “la-

bel” that results from this could become a term of reference for

the European Banking Authority when it delivers its response

to the Commission at the end of 2013.

Whatever the precise state of play with regard to liquidity buff -

ers, the vdp could claim a late goal in one of the few areas where

a defi nitive answer to the future of covered bonds was given by

the EC draft . Th e German association welcomed a move to as-

sign for the fi rst time covered bond risk weightings on the basis

of their ratings.

Under Basel II, covered bonds’ risk weightings were as-

signed based on the creditworthiness of issuers (under Option

2) or their sovereign (Option 1). Under Basel III’s standardised

(rather than internal ratings based or IRB) approach, if the CRD

IV draft remains unchanged, covered bond ratings will deter-

mine the risk weighting — although they will still be one step

removed, with the credit quality step referred to in the draft .

Covered bonds with credit quality step 1 will have a 10% risk

weighting, step 2 and 3 20%, step 4 and 5 50%, and step 6 100%.

According to DZ’s analysts, there is no universally accepted

defi nition as to how ratings of Fitch, Moody’s and Standard &

Poor’s map onto the diff erent credit quality steps, and the EBA is

charged with coming up with an assignment structure. But were

the EBA to rule in line with Germany’s BaFin, for example, the

mapping would be as per the accompanying table (see next page). Th e change will halve the amount of capital that fi nancial in-

stitutions using the standardised approach will have to hold for

many covered bonds. DZ analysts use mortgage covered bonds

ratings from Fitch and Moody’s (at the time of writing) mean

that the covered bonds would be 10% risk weighted under Basel

III, whereas if the risk weighting were based on the rating of

the bank’s senior unsecured bonds or Portugal’s triple-B ratings

from Fitch and S&P (with the second best rating decisive), they

would be 20% risk weighted — or 50% were it to be based on

Moody’s Ba2 rating of Portugal.

Some observers have played down the importance of the

change in risk weighting, given that bigger players will be using

the IRB approach, but DZ’s analysts said that the move is still

relevant.

“Even if the new standard approach rules will not aff ect

many large and mid-size banks that apply the advanced ap-

proach,” they said, “we believe that the new regulations could

tend to lighten the capital requirements of many smaller banks

that follow the standard approach on effi ciency grounds.”

Jan Bettink: leverage ratio “would be bad news for the public sector”


CRD IV: GAME ON

And even those that played down the impact of the change

have been encouraged by it.

“In our view, while covered bonds are not a delinked prod-

uct, the new risk weighting rules confi rm that the EU remains

supportive for covered bonds,” says Bernd Volk, head of cov-

ered bond research at Deutsche Bank.

We can’t wait!According to the vdp, the change to how covered bond weight-

ings are calculated was made late in the draft ing process and

followed an intervention by the German delegation. Bettink

said that the move was “an important sign of the institutional

support in Europe for the Pfandbrief ”.

Th e association said that in principle it welcomed the draft

directive.

“Th e passages of the Brussels draft directive that are relevant

to the Pfandbrief largely take the special safety of Pfandbriefe

and other covered bonds into consideration,” said Jan Bettink,

president of the vdp.

But the vdp called for continued lobbying from German

representatives in Brussels, in particular on the proposed in-

troduction of a leverage ratio from 2018. It said that if this is

introduced as a mandatory supervisory ratio, Pfandbrief banks’

“traditionally conservative cover loan business”, particularly

low margin public sector lending, would be jeopardised.

“At the same time, this would be bad news for the public sec-

tor, because German Pfandbrief banks play a major role in the

fi nancing, above all, of German local authorities,” said Bettink.

Th e vdp has called for the leverage ratio to be introduced

purely as an observation metric and some analysts have sup-

ported it in this regard.

“Th e — in our view completely inconsistent — leverage ratio

will be subject to an ‘extensive monitoring procedure’ before

decisions on the implementation are made,” says UniCredit’s

Hillenbrand. “We regard this as rather positive since we believe

that the non risk adjusted nature of the leverage ratio stands in

stark contrast to everything that has been tried or achieved in

order to stabilize banks in the past.

“In fact, the leverage ratio would represent a de-stabilising

factor. Hence, the ‘extensive monitoring procedure’ leaves at

least a slight chance that the leverage ratio will not come into

force.”

Hillenbrand also highlights how implementation of the Net

Stable Funding Ratio is up in the air.

“For the NSFR, the Commission will analyse how such a

structural requirement plays out across the EU banking sector,

notably as regards its ability to provide long term funding to

support the real economy,” he says.

Th e news that implementation will not take place until 2018

at the earliest was welcomed by the Danes.

“Th e future of adjustable rate mortgage loans is still uncer-

tain,” said Realkreditrådet’s Knøsgaard. “Th e uncertainty has

already depressed the sentiment among homeowners and in-

vestors, which is not good at all.

“On the bright side, however, we are pleased to note that no

devastating rule will be introduced right away. It is crucial that

the current proposal is changed.”

With such rhetoric echoing the language used ahead of the

release of the CRD IV draft , market participants can surely look

forward to at least another couple of years of lobbying. Indeed

the release of CRD IV has left open at least as many questions as

it answered — and some debates have hardly even been touched

upon yet.

“Will there be a distinction between jumbo covered bonds and

other covered bonds?” asked DZ’s analysts. “We can’t wait!”

MAPPING OF RATING GRADES TO REGULATORY CREDIT QUALITY STEPS

1 Aaa to Aa3 10%

2 A1 to A3 20%

3 Baa1 to Baa3 20%

4 Ba1 to Ba3 50%

5 B1 to B3 50%

6 Caa1 and below CCC+ and below 100%

Bernd Volk: “The EU remains supportive for covered bonds”


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.

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


CANADA: RULES


CANADA: RULES

While Canadian issuers have not accessed

the euro market since September 2008,

they have found the US dollar market

highly receptive to their trades in the

past 18 months. In 2010 they raised some

$14bn in the 144A market after Canadian Imperial Bank of Com-

merce reopened the US market to covered bonds that January,

and four issuers have collectively raised $5.5bn this year.

In the first month of the year Canada’s big five banks were

joined in the covered bond market by National Bank of Can-

ada. It inaugurated a $5bn programme with a $1bn three year

benchmark through Barclays Capital, Citi, Morgan Stanley and

National Bank Financial.

Quebec’s Caisse Centrale Desjardins launched its first cov-

ered bond in March, a $1bn five year via Barclays Capital,

HSBC, Morgan Stanley and RBS. The issue was the first from

Canada’s credit union sector and other such institutions are ex-

ploring the possibility of establishing programmes.

Some 64% of Canadian covered bonds outstanding are now

denominated in US dollars.

“American investors are generally much more comfortable

with Canada than pick-a-name-out-of-Europe,” says Wojtek Nie-

brzydowski, vice president, treasury at CIBC. “That’s partially

a function of geographic proximity combined with economic

proximity (the North American Free Trade Agreement, for ex-

ample), and a continuous lack of bad news out of the jurisdiction.

“If you are in the US, chances are you’d be much more exposed

to the news from Canada than the news from Belgium, right?”

Canada is, for all intents and purposes, “golden” right now,

says Niebrzydowski.

“In relative terms as compared to other jurisdictions, all

Canadian banks came effectively unscathed through the near

end of the world,” he said. “If people were to have concerns

about the fiscal viability of the Canadian federal government

we would be facing much bigger problems globally.

“So, now you have a combination of a strong sovereign with

a reasonably strong banking system.”

Canada’s banking system has been ranked the world’s sound-

est by the World Economic Forum in its last three annual sur-

veys. And covered bond market participants hold the country’s

covered bonds in similarly high regard.

“You look at the debt-to-GDP ratio in Canada,” says Derry

Hubbard, head of FIG syndicate at BNP Paribas, “it’s very im-

pressive indeed.

“The other major component of that in terms of the recent cri-

sis is that there was no failure in the banking sector, so you genu-

inely had a picture of very strong balance sheets from very well run

banks — banks that went into the crisis with very high ratings and

also came out of the crisis and still have very strong ratings.”

Hubbard says that Canada is one of those key jurisdictions

to be involved in.

“It’s just a very positive cocktail of factors where you have, in

the face of a worsening general backdrop in terms of the general

picture,” he says, “a very clear diamond on the horizon.

“If you look at where spreads were across the board, but in

particular with a view to Canada, anyone who participated in

these deals, going back a couple years, did very well. Spreads

have been very stable and performed well.”

CMHC ensures US welcomeA DCM banker says a lot of US banks are involved in Canadian

covered bond deals with the CMHC guarantee.

“It’s also been a great way to start the US market,” she says.

“Investors, especially in the US, really value the CMHC backed

mortgages in these cover pools.

“US investors really give the Canadians credit for this fact.”

Canadian cover pools — with the exception of Royal Bank of

Canada’s — consist entirely of Canadian residential mortgages

that are insured by Canada Mortgage & Housing Corporation

(CMHC). Under the Bank Act, banks have to have insurance on

mortgages that have a loan-to-value ratio (LTV) over a certain

level, which the customer pays for. In addition, issuers can pur-

chase bulk insurance.

“What this means in essence is that the cover pool has the

The US has become a second home for Canada’s banks as, buoyed by CMHC-insured collateral, they have crossed the border to sell increasing volumes of covered bonds. Planned legislation could help their cause in Europe — although there are concerns that it could prove too inflexible.

Maiya Keidan reports.

Canada rules and legislates


CANADA: RULES

full backing of the Canadian government,” says Cathy Cran-

ston, senior vice president, financial strategy at BMO, an is-

suer whose programme is backed solely by mortgages insured

by CMHC.

Jerry Marriott, managing director, Canadian structured

fi nance at DBRS commends the Canadian covered bond pro-

grammes for utilising the insured residential mortgages in their

cover pools — while acknowledging that RBC faces no disad-

vantages in its use of uninsured mortgages given the quality of

the mortgages in that bank’s portfolio.

“Th e other Canadian banks had decided to use CMHC in-

sured mortgages in their cover pools fi rstly, because they have

a lot of insured mortgages in their portfolios, and secondly, be-

cause it removed any uncertainty regarding credit quality for

investors due to the Canadian government guarantee of CMHC

insurance,” says Marriott. “We certainly don’t see that there’s

any disadvantage in terms of RBC having non-insured mort-

gages which are conventional mortgages that generally have

extremely high quality.”

As well as in US dollars, Canadian issuers have blazed a trail

in other currencies, notably the Australian dollar. CIBC reo-

pened the Australian dollar market for covered bonds in Oc-

tober 2010, with a A$750m three year and has since returned

alongside Bank of Nova Scotia this year as Australian banks are

preparing to issue covered bonds for the fi rst time under an

upcoming legislative framework.

Euro drought to end?Th ough Canadian euro issuance came to a halt in September

2008 due to an unattractive cross currency basis, a near fl at basis

swap from euros into dollars recently is said by bankers to have

increased the likelihood of a Canadian issuer accessing the euro

market for the fi rst time since the collapse of Lehman Brothers.

“Th e basis swap is in their favour right now,” said a covered

bond banker in early July, “so yes, I think they’re watching the

market. I think if we see a drop of 4bp-5bp more in their favour,

then they will look at accessing the market.

“Th e question is whether this would be the best time for

them to issue given that they haven’t been in the market for

some time.”

Hubbard at BNP Paribas says the basis swap had been very

discouraging.

“I think that it has kept a lot of these issuers away,” he says,

“much to the disappointment of European investors.

“One thing you need to realise is that when euro based issu-

ers have been issuing in US dollars and bringing those dollars

back into euros they have picked up a very signifi cant spread in

the cross-currency basis, and this factor has kept a lot of issuers

that have natural dollar needs in the dollar market and away

from the euro.”

Euro denominated issues amount to 18% (Eu9.8bn) of total

outstanding Canadian covered bonds. Th ere are three Cana-

dian euro denominated covered bonds outstanding.

Canadian covered bonds have been priced tighter than those

from other, European jurisdictions in US dollars, but this is the

reverse of the situation that has prevailed when Canadians have

issued in euros, where Canada’s banks have always had to pay

a premium over core European covered bonds in the primary

market. Th is, alongside the unfavourable basis swap, has been

cited as a factor for the lack of euro issuance from Canadians.

Market participants say that they could not be sure of what

impact pending Canadian covered bond legislation could have

on Canadian ventures into the euro market.

“It’s diffi cult to say whether the proposed legislation has any

eff ect on the European markets,” says Niebrzydowski at CIBC.

Issuance by year

-

2

4

6

8

10

12

14

16

18

20

2007 2008 2009 2010 2011

C$(bn)

BMO BMO BMO

BNS

BNSNBC

RBCRBC

RBC

RBC

TD

CIBC

CIBC

CIBC

CIBC

RBC

CCDQ

Source: CIBC

Wojtek Niebrzydowski: “All Canadian banks came effectively unscathed through the near end of the world”


CANADA: RULES

“I think we probably won’t know until there is actually a Cana-

dian issue in euros.”

Covered win in re-electionTh e Canadian Department of Finance released a consultation

paper on plans to introduce a legislative covered bond frame-

work on 11 May. Th is followed the 2 May re-election of Con-

servative prime minister Stephen Harper, who was voted in

with a majority, as opposed to his previous minority, which had

fi rst announced plans to work towards Canadian covered bond

legislation back in March 2010.

Th ough some market participants have questioned whether

legislation is even necessary for a jurisdiction with the strengths

of Canada, the paper was mainly greeted with enthusiasm.

“We’re very supportive of the legislation,” says Cranston at

BMO. “We’ve been working as an industry to get that moving

for a while, and we think it will provide greater clarity and cer-

tainty for investors.

“Th e issue is not that we felt it was necessary — as we have a

structural and legal system in Canada that we felt didn’t require

legislation — but there are a lot of investors that are precluded

from investing in covered bonds that aren’t underneath a legis-

lative framework.”

Andrew Fleming, senior partner at Norton Rose, welcomes

the step.

“I would say we are very encouraged by the tone of the con-

sultation paper and by the fact we have a majority government

in Canada, so that makes it even more achievable in terms of

getting legislation in the near term,” he says.

Aaron Palmer, a partner at Blake, Cassels & Graydon, was

also encouraged by the government’s move.

“Canada’s adoption of a legislative framework for covered

bonds will be a welcome development for issuers and investors

alike,” he said. “Strengthening and clarifying investor rights in

covered assets upon an issuer’s insolvency should bring Cana-

da’s position into line with other countries that have adopted

legislative frameworks.”

Palmer said he found interesting the proposed scope of eligi-

bility criteria for covered assets and issuers.

“Cover pools for legislative covered bonds would be lim-

ited to residential mortgages, unlike the recent US proposal

that would open up the US covered bond market to other as-

set classes, like autos, credit cards, and student loans,” he said.

“[Th e Department of] Finance suggests that the more modest

the scope of permitted assets will simplify the process and per-

mit a more rapid implementation of a legislative regime.”

OC medicine hard to swallowAlthough market participants were keen on the launch of the

consultation paper, elements of the document were greeted

with some concern.

One potentially worrying proposal is a maximum overcol-

lateralisation level called for by the paper. Th e prevailing Ca-

nadian practice is for issuers to set a maximum overcollater-

alisation of 11%, although this is described in documentation

not in terms of overcollateralisation, but as a contractual mini-

mum asset percentage of 90%. Th is is contractual and can be

amended by the issuer, but the consultation document proposes

codifying it at 10%. Th e Department of Finance proposed that

this maximum be included in the legislation because it believes

the rights of covered bond holders must be balanced with those

of other creditors and depositors.

S&P OVERVIEW OF PROPOSALS UNDER THE CONSULTATION PAPERAsset segregation Legal sale to a special purpose entity (SPE)

Eligible assets Residential mortgage loans for properties located in Canada

Asset valuation The introduction of a standardised approach to value the assets in the cover pool, and standard-ised testing

Eligible issuers Federally regulated fi nancial institutions (FRFIs) — although non-FRFIs would be permitted to sell assets to FRFIs in order to benefi t from the framework

Overcollateralisation A standardised maximum level of overcollater-alisation

Demand loan Defi ned as the excess overcollateralisation above the required overcollateralisation to pass the asset coverage test. The issuer may call the de-mand loan at any time, and the loan may have to be called based on certain triggers

Disclosure Minimum disclosure standards to be defi ned

Role of covered bond registrar

To be defi ned

Source: Standard & Poor’s

Derry Hubbard: “You look at the debt-to-GDP ratio in Canada, it’s very impressive indeed”


CANADA: RULES

Despite most Canadian programmes having overcollater-

alisation levels nowhere near the proposed 10% ceiling — with

most programmes sitting at around 5%, according to BMO’s

Cranston — market participants from banks, rating agencies

and law fi rms see negative consequences of the limit.

“It’s not ideal to have a limit on the overcollateralisation —

not that you want to get near or above 10%,” she says. “Th e issue

is that the OC limit is unique to Canada, so that’s never good.”

Rating agencies S&P, Fitch and DBRS have all raised con-

cerns about this limit preventing issuers from mitigating against

potential risks in their covered bonds in the future.

S&P says a key feature of a covered bond is a dynamic cover

pool and that a static overcollateralisation level may not be suf-

fi cient to protect against future risks.

“Th e consultation paper proposes codifying a maximum

level of overcollateralisation,” said the rating agency in research

on the Canadian consultation paper. “Th is would in our view

enshrine in law the current status quo, would remove an ele-

ment of fl exibility, and could constrain issuers from managing

their covered bond programmes.”

Hélène Heberlein, managing director and head of Fitch’s

covered bonds group, says that this could constrain the ratings

that Canadian programmes can achieve.

“It may preclude high ratings on some covered bonds if the

OC supporting a given rate exceeds 10%,” she says.

Eric Reither, partner at Norton Rose, expressed concern that

an issuer’s inability to increase overcollateralisation to maintain

the ratings on its bonds could negatively impact investor confi -

dence in the product.

“Remember that the current overcollateralisation limits in

Canadian programmes are contractual and intended to protect

the issuing institution and its depositors, but can be waived by

the institution,” says Reither, “so that if one of the Canadian

banks hits the contractual 10% limit, all that means is no-one

can require the bank to put up any more assets even if that

means a ratings downgrade for the bonds, but the bank can put

up more assets if it wants to.”

However, Heberlein notes that putting an OC limit into law

does remove some uncertainty.

“A legally prescribed upper limit on over collateralisation

(OC) protects depositors and senior unsecured debtholders

against excessive subordination and removes uncertainty of

senior unsecured claims against OC, which will not be needed

for the covered bonds repayment,” she says.

And Bernd Volk, head of covered bond research at Deutsche

Bank, commended the Canadian consultation document on pro-

tecting the rights of depositors and senior unsecured debtholders.

“What I like about the Canadians,” he said, “is that they are

tackling the issue of implicitly guaranteeing covered bonds by

simply adjusting OC levels.

“I think the OC ceiling is a tough pill to swallow for the Ca-

nadian covered bond market as it reduces the fl exibility of is-

suers. While it should be dropped, I have great respect for the

regulator making the point.”

Demanding demand loansAmong other issues being debated is the operation of demand

loans, which are a feature of Canadian covered bond pro-

grammes. Th e Department of Finance acknowledges the ad-

vantage of these for issuers.

“As a matter of practice, Canadian issuers transfer more as-

sets to the SPV than is required to satisfy the ACT,” it said. “Th e

transfer of these excess assets allows the issuer to easily replace

non-performing assets backing a particular covered bonds is-

suance with assets that have already been reviewed by credit

ratings agencies. Issuers are also able to go to market with new

covered bond issuances more quickly because they have a stock

of assets already in the SPV.”

However, the Department of Finance said that while they

may lower costs for issuers, demand loans can increase the risk

to depositors or other creditors of the issuer.

“To protect depositors and other creditors, current Cana-

dian practice is to allow the issuer to demand repayment of

the excess assets at any time, called a demand loan,” it said,

“although the time period allowed for repayment continues to

present some risk to depositors and creditors of the issuer.

In the consultation paper the Department of Finance pro-

poses regulating the use of a demand loan, for example legislat-

ing the timing of repayment to, for example, 60 days.

Fitch expressed concerns about the potential for the pro-

posed workings of the demand loan reducing the amount of

liquidity available.

“Th e reimbursement of the demand loan post issuer insol-

vency could draw on market liquidity that would then be avail-

able to absorb subsequent asset sales to meet covered bond

Cathy Cranston: “The legislation is being perceived positively by investors”


CANADA: RULES

principal redemptions,” says Vanessa Purwin, a director in

Fitch’s US RMBS group responsible for North American cov-

ered bond ratings. “Repayment of the demand loan in kind via

the delivery of mortgage loans rather than cash to the insolvent

issuer would neutralise this risk.”

Fleming at Norton Rose also questions how demand loans

are being dealt with in the consultation.

“Our concern is that the legislation would regulate the use of

a demand loan and valuations used in this connection,” he says.

“Th is is more on the prudential side or regulation.

“To the extent it should be dealt with at all, it should be dealt

with by policy of the prudential regulator.”

Th e federal prudential regulator, the Offi ce of the Superintend-

ent of Financial Institutions (OSFI), was the fi rst Canadian author-

ity to lay down any rules for covered bonds, setting a 4% limit on

issuance as a proportion of total assets. DBRS has asked if this 4%

limit on federally regulated fi nancial institutions will be changed.

“We think it’s something that the legislation needs to clarify,”

says Marriott at DBRS, “but it’s really under the superintendent of

the Offi ce of the Superintendent of Financial Institutions, who are

a separate entity but certainly confer with the fi nance department.”

Norton Rose’s Reither said clarifi cation is also needed on

who the registrar would be under the proposed framework.

“One of the questions from the consultation paper is who

the covered bond registrar should be,” he says. “Our view is that

it should be a regulator who is interested in the welfare of cov-

ered bondholders and independent, in terms of representing

the prudential concerns of creditors of the issuers.”

FRFIs only need apply?Marc MacMullin, partner at McCarthy Tetrault, says his con-

cern — beyond those already mentioned — is for legislation to

be as supportive as possible of outstanding covered bonds.

“At this stage, it remains unclear how certain features of the

statutory framework in its legislative form will apply to Cana-

dian fi nancial institutions’ covered bond programmes,” he says.

Moody’s noted that the legislation would only apply to fed-

erally regulated fi nancial institutions (FRFIs) and not, for ex-

ample, to Caisse Centrale Desjardins. Quebec’s Autorité des

marchés fi nanciers has issued guidance for the issuance of

covered bonds by credit unions it oversees, including Caisse

Centrale Desjardins, but this is not equivalent to the proposed

federal legislative framework.

For its part, DBRS is, however, confi dent that the legislation

would be applicable to any fi nancial institution that wanted to

tap into it.

“Th ey — provincial regulated fi nancial institutions and

credit unions — wouldn’t want to be left out of the framework,”

says Marriott at DBRS. “What the government is likely to do is

to say if you want to go through this legislative framework then

whatever fi nancial regulation governs the issuing institution

you have to operate within this legislation.”

Market participants were unclear about when the next step

towards implementation will take place.

“Our expectation is this will move ahead, but it would be less

than a qualifi ed guess to suggest a timeframe,” says Marriott.

Although most market participants believe any impact upon

the Canadian covered bond market will be slight — given its

prior strengths and trading levels — spreads in the US dollar

market were seen to tighten a few basis points aft er the consul-

tation paper was released.

“Th e legislation is being perceived positively by investors,”

says Cranston at BMO, “but I don’t think you’re going to see any

real material spread tightening.

“Th e most important piece is that it will bring more inves-

tors into the product because they will be able to tick that box,

which may ultimately lead to some spread tightening.”

Outstanding and % of Assets (Jan 31, 2011)

Source: CIBC

-

1

2

3

4

5

6

7

8

9

10

BMO BNS CIBC NBC RBC TD CCDQ

C$(bn)

0%

1%

2%

3%

4%% of Assets

Eric Reither: OC ceiling could negatively impact investor confi dence




ANALYSE THIS: SOLVENCY IIANALYSE THIS: SOLVENCY II

“It’s the end of the world as

they know it.”

Th is slightly adjusted

REM song title is the per-

fect characterisation of

what will happen for insurance companies

from 2013 onwards. (Solvency II does not

cover pension funds, by the way.)

In the past, insurance companies had

to hold one lump sum of capital that had

to cover all of the diff erent risks they ran.

Th ere was no diff erentiation between the

individual risk factors. In a somewhat

similar manner to the introduction of

Basel II for banks, Solvency II will force

insurance companies to hold capital

based on the individual risks they hold

in their balance sheets going forward

from underwriting risk to investment

risk. Th is will have signifi cant implica-

tions for their investments, which will

not all be treated equally in this regard.

Capital charges will diff er by asset class,

maturity and rating.

Under Solvency II, the capital require-

ments will be determined by a number

of risk modules (see Chart 1). One of

the modules is the market risk module,

which in turn is split into a number of

components that cover risk factors from

interest rate risk to currency, equity, and

real estate market risk.

Th e situation for covered bonds in a

nutshell: they are treated favourably ver-

sus senior unsecured bonds and ABS, but

are at a huge disadvantage to sovereign

bonds.

Covered bonds receive special treat-

ment in two risk components: in the con-

centration risk component they benefi t

from a higher concentration limit; and

in the spread risk component they enjoy

lower capital charges compared with sen-

ior unsecured exposure or securitisation.

One of the main determinants of the

ultimate capital charges of bond invest-

ments is the spread risk component.

While sovereign bonds do not have to be

allocated any capital at all in this respect

as long as they are rated at least double-A,

triple-A rated covered bonds will bear a

capital charge of 0.6% per year of duration

(see Chart 2). Th e way it looks at the mo-

ment, special treatment is, however, only

valid as long as the rating is at triple-A.

Strangely, double-A rated covered bonds

are treated like senior unsecured bonds

and have a 1.1% capital charge per year of

duration, even though both logic as well

as statistics strongly suggest better treat-

ment compared with senior unsecured

bonds at the double-A rating level, too. A

single-A rated senior bond’s capital charge

comes in at 1.4% per year of duration.

The relationship between the du-

It’s the end of the world as they know it

Solvency II is yet to be fi nalised, but the new capital framework for insur-ance companies will have far reaching consequences for their investment strategies. How covered bonds come out of this could have a major impact on issuers’ funding strategies and business models. Florian Eichert, Crédit

Agricole CIB’s senior covered bond analyst, assesses the likely consequences.

Source: CEIOPS, Crédit Agricole CIB

Spread risk

Concen-tration

risk

Interest rate risk

Currency risk

Property risk

Equity risk

Illiquidity risk

CB directly affected

CB directly affected

CB indirectly affected

CB potentially indirectly affected

CB unaffected

CB unaffected

CB unaffected

Chart 1: Market risk modules in Solvency II and their relevance for covered bonds


ANALYSE THIS: SOLVENCY IIANALYSE THIS: SOLVENCY II

ration of a bond and its capital charge

is a linear one. If we look at a triple-A

rated covered bond with a duration of

10 years the initial capital charge in the

first year is therefore 6%, for a double-A

rated covered bond 9%, and for a single-

A rated senior bond 14%. This number

does not stay static over time, though.

These very same positions are one year

closer to maturity one year later, which

means that the capital charge also goes

down, to that of a nine year duration

bond.

We would therefore assume that a buy-

and-hold investor will also focus on an av-

erage capital charge over the lifetime of a

bond and not only on the fi rst year fi gure.

For the triple-A rated covered bond this

average capital charge over the lifetime

of the bond comes in at around 3.3%, for

the double-A rated covered bond 6.1%,

and for the single-A rated senior 7.7%. If

the plan is to dispose of the position in,

say, four years’ time, the average capital

charge is calculated taking into account

only those fi rst four years, which will of

course mean a higher charge compared

with holding it to maturity (see Chart 3).

Irrespective of the investment

horizon, the need to hold higher

levels of capital for one investment over

another will prompt insurance compa-

nies to require compensation for the

cost of holding that additional capital.

Since the capital charge is higher the

longer the bond, the required spread

premium will have to go up as well and

spread curves steepen at the long end.

To come up with figures for these re-

quired spread premiums, it is important

to make clear that several factors are

driving this calculation:

tion, the higher the capital charge, and

the higher the required spread.

the higher the capital charge, and

as a result the higher the required

spread will be.

longer the position is held, the lower

the average capital charge, the lower

the additional spread requirement.

ance company: the higher this is,

the more pick-up is needed from the

investment to cover the capital cost

of the investment.

It is very important to stress that there

will be no uniform answer applicable to

all insurance companies. Th e results can

and probably will diff er from company

to company as the input factors into the

calculation are company-specifi c.

Below, we have plotted the spread pre-

miums necessary to make up for the dif-

16141210

86420

10 9 8 7 6 5 4 3 2 1

AAA covered bondAverage AAA CB

AA covered bondAverage AA CB

A seniorAverage A sen.


Chart 3: Capital charges over time based on remaining duration of the bond as well as average capital charge for 10Y duration bonds which are held to maturity

“Insurance companies are not the driving force behind spreads at the short to mid part

of the curve”

CHART 2: Spread risk factors by bond type and rating per 1Y duration

Type of bond Rating Spread risk factor

Corporate bonds, sub + hybrid debt, ABS, CDO AAA 0.90%

AA 1.10%

A 1.40%

BBB 2.50%

BB 4.50%

B or lower 7.50%

Unrated 3.00%

Covered Bonds AAA 0.60%

Governments, central banks, multilateral development banks, international organisations AAA 0%

AA 0%

A 1.10%

BBB 1.40%

BB 2.50%

B or lower 4.50%

Unrated 3.00%




ferent capital charges for bonds with dif-

ferent durations. To show how diff erent

the numbers can be from one insurance

company to another, we have calculated

the required premiums for diff erent cost

of capital levels. We have assumed a buy-

and-hold attitude to make things simpler.

For this exercise, we compare triple-A

rated covered bonds with double-A rat-

ed covered bonds, triple-A rated sover-

eign bonds, and single-A rated senior

unsecured bonds (see Chart 4).

When running this scenario analysis,

the required spread pick-up for an insur-

ance company with an internal cost of

capital of 15% is as follows:

triple-A rated covered bond: 11bp for

two years, 23bp for fi ve year, 41bp for

10 years, and 60bp for 15 years

triple-A rated sovereign: 14bp for two

years, 27bp for fi ve years, 50bp for 10

years, and 72bp for 15 years

A rated covered bond: 18bp for two

years, 36bp for fi ve years, 66bp for 10

years, and 96bp for 15 years

One thing to keep in mind at this

point is the following: insurance com-

panies are not the driving force behind

spreads at the short to mid part of the

curve. Insurance companies have only

bought around 3% of this year’s fi ve year

issuance, for example. Th is compares

with insurance sector participation of

almost one-third in deals that came to

the market with a maturity beyond 10

years. Th e shorter deals are mostly infl u-

Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs AA covered

Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs AA soverign

Required spread pick-up based on bond’s duration and insurance companies’ internal cost of capital:AAA covered vs A senior

2 5 10 15 2 5 10 15 2 5 10 15

908070605040302010

0

120

100

80

60

40

20

0

140

120

100

80

60

40

20

0

5% 10% 15% 20% 5% 10% 15% 20%5% 10% 15% 20% 5% 10% 15% 20%

Source: CEIOPS, Crédit Agricole CIB Source: CEIOPS, Crédit Agricole CIBSource: CEIOPS, Crédit Agricole CIB

Chart 4

Florian Eichert: “Covered bonds receive special treatment




enced by banks and asset managers (with

banks having bought around 40% of this

year’s fi ve year deals and asset managers

around 35%).

Basel III, especially the liquidity cov-

erage ratio, is pushing banks to shift

their investments increasingly from sen-

ior unsecured bonds — which are not

considered eligible investments under

the LCR — to covered bonds — which

can form up to 40% of liquidity portfo-

lios. Th erefore, as a rule of thumb, in the

seven year segment increased demand

from banks should outweigh the insur-

ance sector’s new approach (see Chart 5).

What of registered covered bonds/Schuldscheine?

One of the main challenges of Solvency

II will be a strict mark to market require-

ment on both the asset and the liabil-

ity side of insurance companies’ balance

sheets. Th is will apply irrespective of the

accounting treatment. Focusing on the

asset side, it will mean that there will be

no diff erentiation between registered and

bearer bonds anymore. Th at insurance

companies did not have to worry about

mark-to-market losses on registered

bonds in the past certainly made it eas-

ier for them to buy long dated exposure

away from national champions. For the

purposes of Solvency and the capital as-

pect, this benefi t will cease to exist.

One thing to keep in mind at this

point, however, is that accounting ben-

efits of registered bonds under IFRS,

which are usually classified as held to

maturity assets, are not affected by Sol-

vency II. Since insurance companies

will therefore be faced with conflicting

standards, the big question going for-

ward is: which standard will they use to

steer their operations? (see Chart 6)Should all insurance companies steer

their operations based on Solvency II

— marking to market every single posi-

tion irrespective of its accounting treat-

ment — the eff ects on the registered cov-

ered bond market would be devastating.

Worse, though, would be the repercus-

sions for the senior unsecured Schuld-

schein market. Above all, many smaller

issuers would fi nd it very hard to access

long dated senior funding above every-

thing else. Th e eff ects will be much more

muted on the other hand, if insurance

companies continue to steer their opera-

tions based on IFRS or national GAAP.

Early indications from the insurance

sector seem to suggest that there will be

a mix of the two. Some companies will

be steering based on Solvency II, while

others will primarily focus on IFRS when

making strategic decisions, provided

they also have suffi cient capital to fulfi l

the solvency requirements at the same

time. Solvency II will therefore not be

the end of these sectors, but it will cer-

tainly dampen demand and reduce previ-

ously existing spread diff erences between

bearer and registered bonds.

Chart 6: Effect on covered bond issuers depends on which standards insurance companies use

Standard used to steer operationsDifferentiation between registered and bearer bonds

Effect

Effect on covered bond issuers

IFRS Solvency II

Yes

Still incentive to buy registered

Neutral

No incentive to favour registered over bearer

Negative

No

Source: Crédit Agricole CIB

“It will reduce previously existing spread differences between bearer and

registered bonds”

“The treatment of mortgages in the current form would be the mother

of all competition distortions”

100%90%80%70%60%50%40%30%20%10%

0%

3Y segment 5Y segment 7Y segment 10Y segment 10Y+ segment

<3Y <3Y<3Y<3Y 5Y5Y5Y5Y 7Y7Y7Y7Y 10Y10Y10Y10Y 10+Y10+Y10+Y10+Y2008 2009 2010 2011 2008 2009 2010 20112008 2009 2010 20112008 2009 2010 2011

Banks Asset Manager Central Banks Insurance Companies Others

Source: Crédit Agricole CIB

2008 2009 2010 2011

Chart 5: Investor distribution new benchmark covered bond deals by maturity bracket and investor type in %



Competition distortion anyone?Comparing covered bonds with, for ex-

ample, sovereign bonds, one can get the

feeling that covered bonds are treated

unfairly. However, if one compares the

treatment of covered bonds with the

way direct mortgages were treated un-

der QIS5, this disadvantage seems rather

negligible. Indeed one could be forgiven

for thinking that bank and insurance reg-

ulators have not had the slightest clue of

each other’s existence in recent years be-

cause they surely have not discussed this

one; the way banks and insurance com-

panies have to treat mortgages are light

years apart, creating massive arbitrage

opportunities between the two camps.

only 15% capital against the unse-

cured part of a mortgage

to direct real estate risk is applied, i.e. a

25% assumed value decline covers all

of the risk involved irrespective of the

location or use of the property

Eff ectively, this means that for any mort-

gage with an LTV below 75%, insurance

companies do not have to hold any capi-

tal. Th erefore, if Solvency II is imple-

mented unchanged, the following would

be the case:

versifi ed and actively managed cover

pool made up of purely German resi-

dential mortgages with an average

LTV of, say, 45%, additional over-col-

lateralisation of 15%, and which off ers

an additional claim on the issuer will

have a higher capital charge than one

individual commercial mortgage loan

We understand that Solvency II is not

yet fully fi nalised in several areas and the

treatment of mortgages is among these.

Both the European Insurance & Occupa-

tional Pensions Authority (EIOPA) and

the European Commission seem to have

realised the gravity of this divergence and

want to harmonise the regulatory land-

scape for insurance companies and banks

in the best possible way. Th e treatment of

mortgages in the current form, however,

would be the mother of all competition

distortions and it remains to be seen

what is still possible this late in the Sol-

vency II process, or what will have to be

delayed until the next Solvency update.

If approved in its current form, it

would cause serious problems above all

for specialised commercial real estate

lenders. At least until rectifi ed in a later

Solvency edition, insurance companies

would be far more competitive in this

fi eld and in many cases in a position to

price these banks out of the market. Since

there is no diff erentiation for capital

purposes, we do not think that the resi-

dential mortgage market with its much

smaller individual loan volumes and

lower margins will be a major target for

the insurance sector.

So how will insurers reposition themselves?

Th e overall eff ect of Solvency II is still

“The value of a triple-A rating will

become fairly large for insurance companies”

“And I feel fi ne”



hard to gauge and it will always vary

from insurance company to insurance

company. There are, however, a few

general statements that can be made in

our view:

-

quirements for all assets and liabilities

under Solvency II, the differentiation

between registered and bearer bonds

will shrink going forward, as Solvency

II does not foresee any differences in

treatment. Issuers will not get as much

out of this sector of the covered bond

market as previously.

to focus on long assets to match their

long liabilities. They could, however,

aim to achieve this by using long dat-

ed capital efficient products — such as

government bonds — and concentrate

capital intensive products towards the

short to medium part of the curve.

Senior unsecured exposure (which

includes non-triple-A rated covered

bonds!) could be shifted to the very

short end, while triple-A rated cov-

ered bonds could still be an invest-

ment of choice out to, say, the 10-12

year part of the curve.

-

come fairly large for insurance com-

panies. In the example above, the

spread difference for double-A and

triple-A covered bonds with a dura-

tion of 10 years is around 40bp if the

insurance investor has to generate a

RoE of 15% and holds the bonds to

maturity. In addition to spread levels,

ultimate demand from the insurance

sector will also be far lower for cov-

ered bonds rated below triple-A at the

mid to longer end.

-

er dated capital intensive products,

they are likely to pass on the higher

capital charges from the spread risk

component to the issuers. As a result,

spread curves will have to steepen at

the long end.

-

surance companies will have an in-

creased incentive to become active in

buying them directly, as opposed to

buying mortgage exposure indirectly

through covered bonds. This could

damage new business prospects for

commercial real estate lenders, as they

are priced out of the market. There

might be some changes to this in the

months to come.

Overall impact on issuers and Basel III interplay

Solvency II will not only change the way

covered bond spreads behave and how

insurance companies will operate in the

market; it will also have material conse-

quences for the overall funding structure

of covered bond issuers. This becomes

particularly apparent when looking

at the combined effects of Solvency II

and Basel III.

The Basel III rules are aimed at term-

ing out the funding of banks, encourag-

ing them to issue longer dated debt. At

the same time, however, Solvency II

will reduce demand or at least increase

spreads for the very same longer dated

issuance, above all for senior unsecured

funding but also for covered bonds.

Looking beyond the public benchmark

market, private placements of both cov-

ered bonds as well as senior unsecured

were always prominent with insurance

companies and provided very long dated

funding for banks. Looking into the fu-

ture, though, Solvency II will make it

harder for issuers to issue long dated reg-

istered covered bonds or Schuldscheine

as they are treated the same way as bearer

bonds from a capital charge perspective.

In particular, German Pfandbrief issu-

ers who have relied on Schuldscheine to

fund their overcollateralisation will have

to pay up significantly or try to find new

funding sources.

As a result, the combination of the

two reforms clearly favours one bank

business model over the other: big uni-

versal banks with solid deposit bases

are the least affected institutions, while

wholesale funded specialised banks are

put at a huge disadvantage.

Changes should still be considered for final rules

As mentioned previously, there are no fi-

nal rules of Solvency II yet. Since Solvency

II will come into force in 2013 and there

have already been five quantitative impact

studies, a major overhaul of the system

at this stage seems out of the question.

Smaller changes for the better, on the oth-

er hand, cannot be ruled out in our view.

One area in which some alterations

would definitely make sense compared

with QIS5 is the spread risk component.

Its current set-up encourages insurance

companies to focus their long dated in-

vestment exposure towards sovereign

bonds and reduce the average duration

of their capital intensive products. In

this respect, there are a few points that

we would consider very sensible and use-

ful changes or adjustments to the current

set-up of Solvency II:

-

one involved to strengthen the long

term investment character of insurance

companies. Capital charges should re-

flect this and not grow in a linear rela-

tionship with an investment’s duration.

If the additional capital charge for later

years gets smaller, this could encour-

age insurance companies to remain ac-

tive in longer dated bonds.

beneficial treatment of covered bonds

to only triple-A rated bonds. Recov-

ery assumptions for covered bonds

are typically far higher than equally

rated senior unsecured bonds, irre-

spective of their absolute rating level.

In addition to that, the actual spread

volatility of double-A rated covered

bonds during the crisis has been well

below that of double-A corporate

bonds. Therefore, special treatment

for double-A covered bonds relative

to double-A senior unsecured bonds

seems justified as well.

These two changes alone would in our

view reduce the overall negative impact

of Solvency II on non-sovereign bond

markets and help stabilise both banks

and insurance companies.

“The combination of the two reforms

clearly favours one bank business model

over the other”


FULL DISCLOSURE

New arrivals and visitors to London were introduced to local pastimes after Nomura’s syndicate drinks on 15 June.

Photos from the 9th annual Trophée de Golf Crédit Foncier, which was held at Golf du Lys Chantilly on 7 July.

From fairway to oche

An equation that always works. Even in troubled times, the

Pfandbrief is an especially sound investment with a tried and tested market infrastructure.

In Germany and abroad, investors appreciate its first-class quality and the yield pick-up.

Attributes it owes to the stringent German Pfandbrief Act and a strong interest group that

ensures the Pfandbrief stays the benchmark on the Covered Bond market.

For more information, go to: www.pfandbrief.org

simply pfandbriefsimply good

Aareal Bank + BayernLB + Berlin Hyp + Bremer Landesbank + Commerzbank + COREALCREDIT BANK + DekaBank + Deutsche Apotheker- und Ärztebank +

Deutsche Hypo + Deutsche Pfandbriefbank + Deutsche Schif fsbank + Dexia Kommunalbank + DG HYP + DKB + Düsseldorfer Hypothekenbank + DVB Bank +

Eurohypo + Hamburger Sparkasse + Helaba Landesbank Hessen-Thüringen + HSH Nordbank + IKB Deutsche Industriebank + ING-DiBa + Kreissparkasse Köln +

LBB Landesbank Berlin + LBBW + Münchener Hyp + NORD/LB + Postbank + SaarLB + Santander Consumer Bank + SEB + Sparkasse KölnBonn + UniCredit Bank +

VALOVIS BANK + WarburgHyp + Westdeutsche ImmobilienBank + WestLB + WL BANK + Wüstenrot Bank = ASSOCIATION OF GERMAN PFANDBRIEF BANKS

The Covered Bond Report Issue 3

Documents