Aspects of European Union commercial law Laws6905

Legal and market features of covered bonds

Their future in the aftermath of the financial crisis

Ariech Matiok

MIL Sydney UNI

SID: 310295106

Abstract1

In the context of the recent credit crunch, sparked

off by the sub-prime crisis, investors, credit

institutions and governments have raised concern

about securitisation and its typical originate-to-

distribute model. This concern has led lenders in the

mortgage market to search for reliable funding. Many

are pointing to covered bonds as an alternative which

benefits from a well-established market and a

favourable regulatory framework that can contribute

to the financial stability of the markets. Whether

these prospects are realistic is still to be

determined.

This paper attempts to shed some light on the role of

covered bonds as a money market tool through a

preliminary descriptive approach to its concept,

history and main characteristics, with a focus on the

European market and its legal framework. It

subsequently provides a comparative analysis of

legal-based and structured covered bonds, with a

special consideration for the UK and Spanish regimes,1 Appropriate referencing and written style in this paper are, wheneverpossible, in accordance with the Sydney Law Review citation guide.

Ariech MatiokSID:310295106

1

and briefly discusses the differences and

similarities between covered bonds and securitisation

Finally, it examines the impact of the financial

crisis on this debt instrument and outlines the

recent developments in covered bond legislation and

the different measures introduced (or in the process

of being so) by international institutions, such as

the European Central Bank covered bond purchase

programme or the reform of the Basel Accords to the

extent that it affects covered bonds.

Table of contents

I. Introduction.................................................3

II. Historical background of covered bonds............................4

III. Definition and main features of covered bonds......................7

IV. Commercial drivers of covered bonds............................15

V. Types of Covered Bonds.......................................16

Case study: UK and Spanish covered bonds................20

a) UK covered bonds....................................20

b) Spanish covered bonds...............................24

VI. Relationship between covered bonds and securitisation: differences and similarities..................................................28

VII. Operational and legal risks of covered bonds......................33

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VIII. Impact of the credit crunch on covered bonds.....................36

IX. Conclusions: future of covered bonds.............................41

Bibliography and reference materials......................46

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I. Introduction

Covered bonds are long-term debt instruments which are

collateralised by specific assets of the issuer of the bonds

(“cover-pool” assets), to which investors (“bond holders”) have

a preferential claim in the event of default on the issuer, as

well as a claim on the issuer itself (“dual-recourse”

instrument).

The eligibility criteria of the cover-pool assets, as well as

other safety features, are dependant on the particular

jurisdiction of issuance, but they generally include mortgage

loans on both residential and commercial properties and public

sector debt2. As it happens with other types of collateral, the

cover-pool assets are meant to remain under the ownership of the

issuer and, subsequently, on the issuer’s balance sheet for

accounting purposes. The lack of credit risk transfer and the

recourse to the issuer distinguish covered bonds from other

securities such as asset-backed securities, both characteristics

having significant consequences for issuers and investors alike.

Prior to the credit market turmoil, covered bonds were

increasingly used in the European market as they constituted a

2 In some European Union Member States, asset-backed and mortgage-backed securities are eligible for assets-pool within quantitativelimits and subject to conditions related to types, seniority andquality thereof. Likewise, exposures to bank accounts and high-ratedsecurities are allowed in certain jurisdictions as temporarysubstitute assets and subject to certain percentages over the coverpool.

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cost-efficient instrument for credit institutions to meet their

long-term funding needs in addition to other financial tools

such as retail deposits, particularly within the commercial real

estate markets, and offered investors a high-quality product

with also a relatively high return.

Similarly to what has occurred with securitisation, the covered

bonds market has also been affected by the recent credit crunch,

as it is indicated by decreasing issuance volumes during the

last years.

However, some experts and market participants have shared the

view that covered bonds are to be considered the best

alternative to certain highly-leveraged securitisation

instruments which, through financial engineering techniques,

have proven to be of high risk for the purposes of the financial

markets’ stability3. Indeed, according to some experts, the

covered bond market is compelled to play a pivotal role in the

exit strategies from government and central bank support.

A significant example of the high importance of covered bonds

for the financial system stability has been the decision of the

European Central Bank in 2009 to launch a EUR 60 billion covered

3 As per Hyun Song Shin, however, both securitisation and covered bondslead to concentrate the risks in the financial intermediary sectorwith damaging consequences for financial stability. See generally HyunSong Shin, Financial intermediation and the post-crisis financial system (8th BIS AnnualConference, June 2009).

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bond purchase program until the end of June 2010 in order to

boost both primary and secondary covered bond markets4.

II. Historical background of covered bonds

Covered bonds emerged originally in Prussia around the 18th

century as a new mortgage finance mechanism introduced by King

Frederick the Great in the wake of the Seven Years War, in order

to restore liquidity for the nobility, whose lands and financial

position had been battered by the conflict. Through the

establishment of a public law association (“Landschaften”), landed

nobles could access agricultural credit by issuing full recourse

bonds using the nobles’ estates as collateral. Members of the

association could have a right to credit from it, delivered in

the form of a security (the “Pfandbrief”), which a member could

sell to investors to raise cash.

Along the 19th century, a formal legal framework was established

including some of the current features of covered bonds such as

the ring-fencing of cover-pool assets and the investors’

recourse to both the cover-pool assets and the issuer in the

event of default. The Pfandbrief system then proliferated

throughout Europe, becoming a popular method of refinancing

4 See generally European Covered Bond Council, European Covered BondFactbook (5th ed, 2010).

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public sector debt. However, their successful influence

decreased after the mid-twentieth century, being displaced by

retail deposits as a source of mortgage financing.

That situation changed with the internationalisation of formerly

domestic covered bond markets due to introduction of the first

benchmark market for German Pfandbrief (the “Jumbo” market) in

1995, attracting international institutional investors and

providing the necessary market liquidity for public sector

funding.

Subsequently, the introduction of the Euro currency led

investors to intensify their search for liquid products since

they could no longer rely on the different European currencies

as a diversification mechanism. Consequently, many European

countries introduced specific covered bond legislation or

updated existing rules to be a part of this development and to

also respond to the considerable growth of the European mortgage

lending market.

As a result, the covered bond market has developed into the most

important privately issued bond segment in Europe’s capital

markets, with a volume of over €2.4 trillion outstanding covered

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bonds at the end of 20095. Covered bonds issued from Denmark,

Germany, France, Sweden and Spain accounted for the vast

majority of the total issuance in the European capital markets

in 2009, which reveals that this market is relatively

concentrated in a few countries6.

However, recent regulatory developments in about 25 different

European countries reveals a strong expectation that the covered

bond market will continue to growth, particularly in Central and

Eastern European countries as an instrument to raise funds for

their real estate markets, which have sharply increased

recently7.

Furthermore, the covered bonds market is currently extending

further from the traditional European market to areas such as

North America and the Asia-Pacific region. For instance, the

5 European Covered Bond Council, European Covered Bond Factbook (5th ed,2010).6 The “benchmark” covered bonds, that is, Euro-denominated, bulletmaturity, fixed annual coupon bonds with a defined minimum outstandingvolume, are the largest European bond market after government issuedsecurities. The largest issuers of covered bonds in the first quarterof 2010 were, respectively, France, Spain, Germany, Sweden and theUnited Kingdom. See generally European Covered Bond Council, EuropeanCovered Bond Factbook (5th ed, 2010).According to the European Mortgage Federation, Spain, Germany,Austria, UK, Norway and France represented nearly 70% of the issuersin the overall covered bond market at the end of July this year. Seegenerally European Mortgage Federation, Mortgage info (September, 2010).7 For instance, Belgium passed a law in October 2009 that allowscovered bonds to be issued while Cyprus is currently undertaking thedevelopment of covered bond legislation. See generally EuropeanCentral Bank, Financial Integration in Europe (April, 2010).

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first U.S. issuer to enter the covered bond market was

Washington Mutual in September 20068. Subsequently, in May 2009,

Kookmin Bank became the first Asian issuer of covered bonds by

introducing a structure mechanism similar to that used in the

United Kingdom9.

In 2010, Korea Housing Finance Corporation has issued USD 500

million covered bonds to facilitate the supply of housing

finance on a long-term basis, this time such bonds relying upon

a statutory framework, which gives investors a priority claim on

the cover-pool assets. Likewise, New Zealand has recently become

the first Australasian country to enact covered bonds

legislation and its national bank is responsible for the first

issuance of covered bonds in the region.

As a result, although by the end of 2007, still 75% of the total

outstanding amount of covered bonds was denominated in euro10,

the covered bond market is becoming more global, thereby

increasing issuance in other currencies, which ultimately allows

issuers to benefit from foreign exchange developments,

geographical diversification and a wider investors’ base.

8 See, for example, Steven L. Schwarcz, ‘The Conundrum of CoveredBonds’ (September 2010): < http://ssrn.com/abstract=1661018> (20 Sept2010) at 5.9 Id at 6.10 European Central Bank, Covered bonds in the EU financial system (December, 2008).

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Compared with other debt securities, its dual recourse nature

should theoretically make covered bonds resilient to shocks on

either the issuer or the collateral itself. However, as it

happened with the rest of financial securities market, the

recent global financial crisis has also affected this market.

III. Definition and main features of covered bonds

The term “covered bonds” did not exist a decade ago. They were

previously referred to simply as mortgage bonds (if backed by

mortgages) or as the respective national products within the

European market that are today eligible as “covered bonds”. This

was a reflection of the old national scope of the covered bond

markets.

Throughout the upcoming years, “covered bonds” became a sort of

brand name rather than an officially defined financial

instrument. Still today, the existence of many different types

of covered bonds has not helped the arising of a worldwide

accepted definition.

Turning to the European Union regulatory framework, the former

Article 22 (4) of the Directive 85/611/EEC on the coordination of laws,

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regulations and administrative provisions relating to Undertakings for Collective

Investments in Transferable Securities (hereinafter UCITS)11 defined the

minimum features for covered bonds to be eligible for a

privileged treatment within the European financial market

regulation as follows:

“… bonds issued by a credit institution which has its registered office in a

Member State, … subject by law to special public supervision [whose]

sums … shall be invested in accordance with the law in assets which,

during the whole period of validity of the bonds, are capable of covering

claims attaching to the bonds and which, in the event of failure of the

issuer, would be used on a priority basis for the reimbursement of the

principal and payment of the accrued interest”.

In other words, the covered bond issuance, limited to credit

institutions, has to be governed by a special legal framework,

which necessarily involves a special prudential public

supervision. Additionally, the eligibility criteria for cover-

pool assets shall be defined by law and issuers must provide

sufficient collateral throughout the whole term of the covered

bonds to eventually cover bond holders’ priority claims on the

aforementioned pool in case of default on the issuer.

11 Please note that the Directive 2009/65/EC will replace the previousDirective 85/611/EC on 1st July 2011 and Article 22 (4) will berenumbered to Article 52 (4).

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Furthermore, the European Union Capital Requirements Directive 2006/48/EC

(CRD)12, which revises the supervisory regulations governing the

capital adequacy of all credit institutions and investment

services providers within the European Union, incorporated by

reference the aforementioned definition, and set out also the

minimum standards for the collateral to be eligible as cover-

pool assets, thereby allowing privileged credit risk weightings

for covered bonds issued under such legal framework13, as opposed

to Basel II where covered bonds are treated similarly to

unsecured bank bonds in terms of credit risk weighting

calculations.

In this regard, covered bonds have to fulfil the following

requirements:

a) Compliance with the standards of Article 52 (4) UCITS

b) Cover-pool assets must be constituted only of

specifically-defined types of collateral with high credit

quality amongst the following:

12 On 30th June 2010, the European Parliament adopted an amendment tothe CRD concerning the application of a reduced LGD of 11.25% andlimitations for the inclusions of mortgage-backed securities in coverpools (Loss Given Default is a method of calculating the amountof funds that is lost by a bank or other financial institution when aborrower defaults on a loan).13 Mere examples of this more favourable treatment are the specificrules on the calculation of banks’ capital requirements for creditrisk and the increased percentage limit on the concentration ofinvestments in securities when investing in covered bonds (from 5% upto a maximum of 25%).

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i. Exposures to public sector entities

ii. Exposures to institutions

iii. Mortgage loans (both commercial and residential) which

meet certain minimum requirements in terms of mortgage

property valuation and monitoring

iv. Senior mortgage-backed securities issued by

securitisation entities

v. Ship loans14

c) Quantitative restrictions on certain types of cover assets

(i.e. a maximum of 15% exposure to credit institutions)

d) Issuers of covered bonds backed by mortgage loans must

meet certain minimum requirements regarding mortgage

property valuation and monitoring

Notwithstanding the former, it cannot be extracted from the

former European Union (EU) legal framework an exhaustive

statutory definition universally accepted, as it proves the fact

that even EU Member States, other than accepting certain

harmonised features and risk profiles for covered bonds, have

developed their own legislation to regulate the legal

intricacies of their respective national covered bond regimes,

such as the general requirements for issuers, the powers of

14 Please note that the range of eligible cover assets is ultimatelydefined on a national level. Where covered bonds backed by mortgageloans are present in all countries with covered bond systems, coveredbonds supported by public sector loans and ship loans can be found ina limited number of European countries.

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authorities and other entities responsible for supervisory

tasks, investors’ rights in the event of insolvency, and so on15.

Likewise, some experts16 have considered that the literacy of the

Article 22 (4) UCITS does not adequately differentiate covered

bonds from ordinary secured bonds, which are also long-term debt

instruments secured by assets of the issuer with full unsecured

recourse by the bond holders to the issuer in the event of a

collateral deficiency.

The closest to a shared definition, however, can be found in the

so-called “essential features” 17 of covered bonds defined by the

European Covered Bond Council (ECBC), which are common to both

legislative and structured regimes: “ring-fencing” and

overcollateralisation18.

15 The legal framework is generally completed by secondary legislationenacted by governments or supervisory authorities which develops moredetailed aspects such as eligibility requirements, minimumcollateralisation levels, asset-liability management and monitoringprocedures. Finally, aspects which are not covered by laws or otherrulings are self-regulated by virtue of contracts and offeringcirculars (i.e. further protection for investors, disclosurerequirements on issuers and the composition of cover pools, etc).16 See, for example, Steven L. Schwarcz, ‘The Conundrum of CoveredBonds’ (September 2010): < http://ssrn.com/abstract=1661018> (20 Sept2010) at 11.17 European Covered Bond Council, ‘Essential Features of CoveredBonds’: <http://ecbc.hypo.org/Content/Default.asp?PageID=367> (2 Oct2010).18 Please note that the protection provided in covered bonds by therequirements of ring-fencing and overcollateralisation can also beachieved in secured bond transactions by contractual covenants.

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1. The bond is issued by –or bondholders otherwise have full recourse to- a credit

institution which is subject to public supervision and regulation

In the majority of covered bond issuances, the issuer is a

credit institution19, giving investors direct full recourse to

the credit institution insolvency estate. However, some

structures can be created whereby covered bonds are issued by a

special purpose vehicle, which on-lends the proceeds to a credit

institution, then providing indirectly bond holders with full

recourse to the underlying credit institution.

2. Bondholders have a claim against a cover pool of financial assets in priority to the

unsecured creditors of the credit institution

Financial assets likely to constitute cover pools may include

loans, bonds, cash deposits and even derivatives designed to

hedge interest and currency risks between the cover assets and

the issued covered bonds, that is, the claims of the issuer

against its swap counterparty under the swap agreement may be

eligible for inclusion in the asset pool20. In the last decade,19 By credit institutions, it should be generally understood entitieslicensed under the relevant jurisdiction to carry on bankingactivities and subject to public supervision and regulation, whichprescribes standards for the management of credit, liquidity, interestrate and operational risks. 20 JJ de Vries Robbé, Structured Finance: On from the Credit Crunch – The Road toRecovery (2009) at 180-181. An asset swap transaction is an agreementwhereby an investor, holding a fixed rate covered bond wanting toeliminate the fixed interest rate risk, pays the swap dealer the fixedrate coupon while receiving floating rate payments plus or minus a

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mortgage loans have gained importance in the composition of the

cover pool against the share of loans to public sector, which

has significantly diminished.

According to the ECBC, a cover pool is “a clearly identified, ‘ring-fenced’

pool of assets dedicated to secure the covered bonds”. Absent default, the

issuer will normally repay principal and interest on the covered

bonds to bond holders from its cash flow, with the cover-pool

assets remaining as collateral. In the event of the insolvency

of the credit institution, the assets in the cover pool will be

used to repay the covered bond holders before they are made

available for the benefit of the credit institution’s unsecured

creditors. Should such assets happen to be insufficient for full

re-payment; investors will also have an unsecured claim against

the issuer’s full resources.

Some experts have showed concerns about this dual-recourse

nature of covered bonds and their over collateralisation

requirements in terms of good financial policies as they entail

in practice a virtual shift of the whole issuer’s insolvency

risk to unsecured creditors.

spread, which is said to reflect the credit risk of the issuer.

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The mechanism to “ring-fence” the cover pool varies, depending

on the relevant jurisdiction. Generally, the legal basis is

provided either by specific legislation, which excludes by fiat

the cover pool from the insolvency estate of the issuer, -

thereby superseding the general insolvency law-, or by general

insolvency law which provides directly covered bond holders with

a preferred claim within the insolvency estate itself. In some

other jurisdictions, the cover pool is preserved from the

insolvency estate of the issuer by being transferred to a

special purpose vehicle, which guarantees the credit

institution’s obligations under the covered bond.

3. The credit institution has the ongoing obligation to maintain sufficient assets in the

cover pool to satisfy the claims of covered bondholders at all times

In fact, most jurisdictions require a certain level of

overcollateralization, that is, a surplus of collateral value

over indebtedness. In other words, the value of the cover pool

has to exceed the value of the outstanding covered bonds either

by a prescribed amount set out by specific legislation, by

contractual arrangements governing the covered bond issuance or

a combination of both (i.e. further levels of voluntary

overcollateralization).

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The aforementioned feature constitutes an ongoing obligation for

the credit institution to ensure that the aggregate principal

amount of cover-pool assets plus the aggregate interest yield on

the cover pool are at all times equal or higher than the

aggregate value of the outstanding covered bonds issued plus the

interest payable on the latter.

Therefore, it may be necessary for the issuer to add further

assets to the cover pool to compensate for matured or defaulted

assets. In addition, the credit institution may be required to

comply with specific provisions in order to mitigate different

kinds of risks related to the management of cover pool and

covered bonds (mainly, interest rate, currency and maturity

mismatch risks).

4. The obligations of the credit institution in respect of the cover pool are supervised by

public or other independent bodies

By supervision, it should be understood a specific supervision

of the credit institution’s obligations regarding the cover pool

for the benefit of covered bond holders, which is additional to

the global supervision over the whole credit institution in

terms of financial stability of the markets and customer

protection. In accordance with the ECBC, some common features of

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such specific supervision include the appointment of a monitor

subject to regulatory approval, periodic audits of the cover

pool by the monitor, and ongoing management and maintenance of

the cover pool upon the credit institution’s insolvency.

These “essential features” can be achieved either by statutory

provisions in legislative regimes or by contract under

structured regimes, including usually the relevant mandates such

as the nomination of an independent auditor and either the

selling of the cover-pool assets to a wholly-owned special

purpose vehicle for the sole purpose of acquiring the corporate

legal independence from the issuer in terms of bankruptcy-

remoteness, or the sheltering of certain assets from claims by

the issuer’s ordinary creditors.

IV. Commercial drivers of covered bonds

Covered bonds have advantages to all parties involved in their

issuance. From the issuer’s perspective, covered bonds are an

additional funding source, which enables credit institutions to

obtain lower cost of funding, as generally covered bonds achieve

higher credit rating than the issuer’s rating itself, thereby

facilitating the granting of mortgage loans for both residential

and commercial properties, and/or to finance public sector debt.

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For such purpose, issuers normally require a funding instrument

of longer term than retail deposits and other money market

instruments of borrowings, helping to reduce the funding

liquidity risk of a credit institution which operates in the

mortgage lending market, as mortgages loans are long-term credit

instruments.

From the investor’s perspective, covered bonds are normally low-

risk, highly rated bonds, particularly due to their dual-

recourse nature and, in most jurisdictions, a legislative

framework favourable to investors which guarantees the

enforceability of their preferential claims over the cover-pool

assets and the adequacy thereof21, easing this way the assessment

of risks related to compliant covered bonds.

Within the covered bonds market, special consideration needs to

be done to mortgage covered bonds as they provide investors with

a more favourable risk-return profile than high-quality agency

or government bonds, maintaining more or less similar low-risk

levels (at least until the outbreak of the financial crisis).

21 Generally, the claim given to covered bond holders against theissuer’s estate, should the issuer become insolvent, ranks pari passuwith those of other unsecured creditors. However, in the case ofSpanish covered bonds (called “cédulas hipotecarias”), the preferentialclaim given to their holders is on the whole portfolio of mortgagesloans and not just a segregated amount of assets.

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They are also considered a helpful tool for diversifying the

issuer’s funding structure, contributing to diminish the

concentration risk, as residential mortgages give rise to highly

fragmented portfolios, and facilitate their asset-liability

management.22

Indeed, the importance of covered bonds in the European

financial market is underlined by their function as a

refinancing tool of residential property loan for credit

institutions, whose lending portfolio has been mainly

constituted by mortgage loans in the recent years.

Additionally, the creation of jumbo covered bonds markets helped

to enhance secondary market liquidity, thereby broadening the

investor base (i.e. insurance companies, pension funds, mutual

funds, specialised funds, etc.) From a credit-risk perspective,

covered bonds are driven to fill the gap between the government

bond and unsecured corporate debt markets23.

V. Types of Covered Bonds

22 In this context, asset-liability management refers to therequirement that the outstanding covered bonds must be at all timessecured by sufficient assets whose nominal amount and yielding atleast equals the outstanding volume. Some countries have evenintroduced additional net-present value asset/liability matchingrules. 23 European Central Bank, Covered bonds in the EU financial system (December,2008) at 11.

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The majority of countries within the European covered bond

market have promulgated specific covered bond legislation in

order to ensure the enforceability of the cover-pool assets

which secured the covered bonds against other creditors of the

issuer, whereas a few others rely on contractual protections

enforceable under general commercial law. Traditionally

countries such as United Kingdom or The Netherlands had been

structured regimes.

However, the international trend is heading towards legislative

regimes as countries like Canada and Australia are considering

the introduction of covered bond legislation, while in the US

the Congress is currently considering a legislative covered bond

regime to supplement structured covered bond offerings.

In the United Kingdom, as of 2008 covered bonds can be issued

under both legislative and structured regimes, and it is

possible that sometimes both regimes overlap as it occurs with

the so-called “enhanced covered bonds”, which rely on contract

to provide investors with additional protections to the

legislative provisions24.

24 European Covered Bond Council, European Covered Bond Factbook (5th ed, 2010).

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When the covered bond issuance is governed by special laws

and/or by binding regulations of a public supervisory authority,

specifically dedicated to regulate the covered bond market by

stipulating the main characteristics of the covered bonds and

the quality standards of the cover-pool assets, it is said that

there is a special-law based framework, as opposed to structured

regimes, also known as general-law based frameworks, where

covered bonds are issued under general law and whose main

features are set out by means of contractual arrangements.

Generally, covered bonds issued under legislative regimes are

more likely to benefit from preferential risk weightings as they

are required to comply with a statutory framework which provides

investors with a high degree of certainty in relation to their

legal rights and obligations in the event of default on the

issuer. For instance, covered bonds issued in compliance with

the requirements of Article 22 (4) UCITS and paragraphs 68 to

71, Annex VI of the CRD are generally considered as particularly

safe investments, to such an extent that the European Central

Bank has included UCITS compliant covered bonds on the

Eurosystem’s Single List as an eligible type of high-quality

collateral.

Other preferential treatments given to UCITS compliant covered

bonds are, for instance, the easement of prudential investment

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limits25, and the exemption of the “close links” rule with self-

issued bonds in the Euro- system26 which allows issuers to use

their own covered bonds directly as collateral with the European

Central Bank.

In special-law based frameworks, the issuer is normally required

to obtain a license to issue covered bonds, being in certain

jurisdictions required to be either banks or other government-

regulated financial institutions. In terms of special

supervision, this competence is usually assigned to public

authorities such as the banking supervision authority or the

financial market regulator.

Likewise, covered bonds issued under legislative regimes enjoy

lower transaction costs than structured covered bonds as the

latter normally will have to build up a complex contractual

structuring to replicate the essential legal features and

economic effects of covered bonds. On the contrary, the main

disadvantage of legislative regimes is the lack of flexibility

as they often limit the types of collateral that are entitled to

25 Investment funds and insurance companies are allowed to invest up to25% and 40% respectively of their assets in UCITS compliant coveredbonds of a single issuer. 26 According to such rule, a counterparty to the European Central Bankmay not submit an asset-backed security as collateral when it (or anythird party that has close links to it) provides support to thatasset-backed security whether by entering into a currency hedge withthe issuer or guarantor of the asset-backed security or by providingliquidity support of more than 20% of the nominal value of the asset-backed security. European Central Bank, The Implementation on Monetary Policyin the Euro Area, (November, 2008).

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serve as cover-pool assets27, or the level of concentration risk

on a single issuer to a prescribed percentage of the cover-pool.

By contrast, structured regimes are said to encompass less legal

certainty as their enforceability (i.e. the effectiveness of the

ring-fencing, the prescribed amount of overcollateralization,

etc.) will be ultimately reliant on a contract and on the

commercial and insolvency laws of the relevant jurisdiction.

Simultaneously, transaction costs are normally higher since

ring-fencing requires issuers to create complex structures such

as the setting of a special purpose vehicle to purchase the

cover-pool assets for the benefit of the covered bond holders28.

Furthermore, in terms of special supervision, the issuer, at its

own expense, will have to nominate an external auditor to

undertake the audits of the cover pool, and to appoint a bond

trustee to safeguard bond holders’ interests.

However, the main advantage of structured regimes is flexibility

in terms of eligibility of the cover-pool assets29, the ability

27 For instance, in the case of mortgage loans, the criterion accordingto which the value of the properties is determined (prudent marketvalue, mortgage lending value, etc) is crucial. The European Union’sCapital Requirements Directive (CRD) limits residential mortgage loanseligible for collateralisation of covered bonds to those with a loan-to-value (LTV) ratio of 80% or less (that is the ratio between theamount of the credit exposure and the estimated value of the realestate acting as collateral).28 Under certain structures, however, the assets-pool is nottransferred to the special purpose vehicle, remaining on the balancesheet of the originator which, in return, pledges those assets as aguarantee in favour of the investors. 29 For instance, under special-law based frameworks, it is likely tofind rules which prohibit the issuer to mix heterogeneous assetswithin the same cover-pool. However, the homogeneity of cover-poolassets may also result indirectly from the specialisation of the

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to diversify issuers’ cover-pools, their credit quality, the

level of overcollateralization, the nature of the investors and

issuers (i.e. companies different from credit or financial

institutions) and other type of requirements30. Having said that,

it is possible to find issuances of structured covered bonds in

jurisdictions where there is a special-law based framework. The

rationale of this is to enable issuers to tailor the

characteristics of covered bond programmes to suit market

conditions and the preferences of prospective investors without

having to comply with their domestic legislation31.

Case study: UK and Spanish covered bonds

a) UK covered bonds

issuer. 30 Under some legislative regimes, there are geographical restrictionson the location of properties which serve as collateral for bothmortgages and public sector loans (i.e. the European Economic Area,countries members of the Organisation for Economic Co-operation andDevelopment, domestic area only, etc). 31 That is the case of France where the traditional “Obligations Foncières”,strictly regulated by statute, has been to some extent recentlydisplaced by some market participants, longing for bypassing highrestrictions (such as the necessary constitution of a specific creditinstitution –“Société de Crédit Foncier”- to issue the bonds) throughstructured schemes. Moreover, the statutory framework is currentlybeing amended to introduce a new type of covered bond –“Obligations àl’Habitat”- with the purpose of substituting the current structured coveredbonds and providing them with a legal framework. Boudewijn Dierick,‘Covered Bond Legislative Developments in France: introducing the“Obligations à l’Habitat” framwork’ in European Mortgage Federation, Mortgageinfo (September, 2010).

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The UK covered bonds market came into existence relatively

recently32 under a general-law based framework whereby similar

economic and legal effects were achieved through the issuance of

bonds by financial issuers guaranteed by a related entity to

which the issuer sold assets, the proceeds thereof being loaned

to the guarantor to fund the purchase.

Despite the fact that structured covered bonds issued by UK

entities were recognised as secured products, they, however, did

not fulfil all the requirements set out in Article 22 (4) of the

UCITS (mainly, the absence of explicit regulation and

supervision under legal framework).

With the purpose of enabling UK covered bonds to enjoy higher

prudential investment limits and preferential risk weightings, a

statutory mechanism was introduced in 2008 with the enactment of

the Regulated Covered Bond Regulations, thereby making them competitive

with dedicated-law based offerings from other European

jurisdictions. Nowadays, the statutory covered bonds dominate

the UK covered bond market.

Pursuant to such legislation, the Financial Services Authority

(FSA) is the entity in charge of the supervision of the covered

bonds market, which conducts a register of issuers and covered

bonds compliant with the regulations. Issuers are required to be

32 The first issuance is dated 2003 by the HBOS Treasury Services.

27

credit institutions authorised in the UK to carry out regulated

financial activities.

Nevertheless, there are still some elements of the regulated

covered bonds which are governed by contract. One example is the

structure created to achieve the asset segregation from the

insolvency estate of the issuer through a true sale of all

cover-pool assets (including, if any, substitute assets and/or

swap agreements) to a special purpose vehicle -usually under the

legal form of a limited liability partnership-, which guarantees

the issuer’s obligations arising out of the issuance of the

covered bonds and provides security over the cover-pool assets

to a security trustee acting on behalf of the investors.

In the event of a default on the issuer or other trigger events,

the special purpose vehicle becomes obligated to pay the covered

bond holders under the guarantee with the proceeds derived from

the cover-pool assets, in accordance with the original schedule

of payments of interest and principal33. Should these proceeds be

insufficient to fully meet the obligations to covered bond

holders, they will still have a claim against the issuer for the

shortfall on an unsecured basis.

33 Please note that the delivery of a notice to pay by the trustee doesnot accelerate per se payments on the covered bonds by the specialpurpose vehicle. An early redemption of the covered bonds will occurif the special purpose vehicle either fails to make payments on thecovered bonds as they fall due under the guarantee or insolvencyproceedings on the special purpose vehicle itself are commenced.

28

The assignment of the mortgages to the special purpose vehicle

is made by means of an equitable assignment, which entails that

previous notice to mortgagors is not required (otherwise, it

would become an almost impossible task) and, consequently, the

legal title over the assets remains with the issuer, who holds

it on trust for the benefit of the special purpose vehicle as an

equitable assignee. This way there is no direct legal

relationship between the underlying cover-pool assets and the

covered bonds.

However, following the occurrence of an insolvency event or any

other trigger events where agreed, mortgagors must be notified

of the assignment so that the whole legal title is effectively

assigned to the special purpose vehicle, and the latter is then

entitled to sell the cover-pool assets to service the covered

bonds.

In terms of eligibility criteria, the UK legislation follows the

criteria of the EU Capital Requirements Directive, subject to

even more severe restrictions in certain cases, but at the same

time it permits loans to registered social landlords and to

public-private partnerships as eligible assets, which are,

however, excluded from the CRD34. In all cases, the FSA has a

right to reject cover assets that, in spite of meeting the

34 In these cases, it is to be assumed that these covered bonds may notqualify for preferential risk weightings and prudential investmentsratios in other European jurisdictions.

29

statutory requirements, their quality is considered detrimental

to the interests of investors.

A minimum of overcollateralization is not prescribed by law so

it is the responsibility of the FSA to set out such on a case-

by-case basis, looking at the quality of the cover-pool assets,

the existence of risk-mitigation instruments, and asset-

liability mismatches, amongst other aspects.

In spite of the possibility that the sufficiency tests of the

cover-pool collateral are regulated in the covered bond

programme itself, issuers are, however, obliged to undertake a

dynamic asset coverage test on a monthly basis to ensure that a

particular level of overcollateralization is satisfied.

Despite the existence of any substitution assets and any risk-

management tools, following the occurrence of a downgrade of the

issuer below investment grade, the special purpose vehicle is

required to establish and maintain a reserve fund out of the

income received from the cover-pool assets. Such fund is

retained in a guarantee investment certificate (GIC) account. If

an eventual notice of payment is delivered by the trustee, the

special purpose vehicle will use the reserve fund to meet its

obligations under the guarantee.

Unlike, for instance, Spanish covered bonds, cover assets can be

located in the European Economic Area, Switzerland, US, Japan,

Canada, Australia and New Zealand other than in the UK.

30

b) Spanish Covered bonds

In spite of a market perception of increased riskiness

associated with the growing exposures of credit institutions to

an overvalued housing market, Spain is still the second largest

covered bond market after Germany with a total outstanding

volume of €353 billion at the end of 200935. This well-developed

market is dominated by mortgage covered bonds36, and it benefits

from a well-established legal framework determined by the

following legislation:

i. Act 2/1981 on the regulation of the mortgage market

ii. Act 22/2003 on Insolvency Law

iii. Act 41/2007, which modifies Act 2/1981 and other rules of

the mortgage and financial system

iv. Royal Decree 716/2009, whereby certain aspects of Act

2/1981 and other rules of the mortgage and financial

system are developed

One of the key features of the Spanish mortgage covered bonds is

determined by Article 12 of Act 2/1981, which provides that the

35 European Mortgage Federation, Mortgage info (September, 2010).36 Please note that there are two other types of covered bonds called“cédulas territoriales”, a relatively recent instrument where the cover-poolconsists of loans to public sector entities, and “bonos hipotecarios”,which are covered only by specific mortgages as collateral and not thewhole portfolio. However, their use is by far lesser than “cédulashipotecarias”.

31

capital and interests of the cédulas hipotecarias37 are secured by the

entire mortgage loan book registered in favour of the issuer,

except for those loans already acting as collateral for mortgage

bonds. The issuer is required to hold at all times the mortgage

loans serving as collateral on its balance sheet, thereby not

being possible to transfer the assets to a separate legal

entity.

In the event of bankruptcy on the issuer (a credit institution),

Act 2/1981 will supersede the general insolvency law, and

holders of cédulas hipotecarias will have special privileged claims38

against the insolvency estate covering all the amounts

corresponding to the repayment of the capital and interest of

the cédulas hipotecarias and, if appropriate, to the substitution

assets which backup them and the economic flows generated by the

financial instruments linked to the issuances39. The outstanding

amounts shall be paid by the insolvency administrators on their

respective due dates without delay of payment, irrespective of

the status of the bankruptcy proceedings.

37 Cédulas hipotecarias compliant with the abovementioned legal scheme areconsidered UCITS-compliant covered bonds. They are also eligible forrepo transactions with the Spanish Central Bank and the EuropeanCentral Bank.38 This privileged claim shall be understood without prejudice to theunlimited universal nature of the liability of the issuer.39 According to Articles 15 and 17 of Act 2/1981, cédulas hipotecarias canbe backed up to a limit of 5% of the issued capital by fixed incomesecurities such as securities issued by the State and other EU MemberStates, or by mortgage securitisation funds, etc.

32

In case that the cover-pool assets are insufficient to meet the

payments for the cédulas hipotecarias, such payment shall be done on a

pro rata basis, whatever their date of issue.

The issuance of cédulas hipotecerias is restricted to credit

institutions compliant with the Spanish mortgage market legal

framework such as commercial banks, savings banks and

cooperative banks. Although there is no legal provision

regarding the currency of the cédulas hipotecarias, there is a market

practice to denominate them in Euro if the currency of the

cover-pool assets is the Euro in order to mitigate, where

possible, foreign exchange risks.

Another distinctive feature of the mortgage covered bonds market

in Spain is a market practice denominated the “club funding”,

whereby small credit institutions, aiming at raising funds

abroad at favourable rates by gaining access to international

capital markets (typically only available to medium or large

financial institutions), undertake a joint issuance of

securitisation bonds through a special fund without a separate

legal personality, those bonds being backed by the cédulas

hipotecarias of the different issuers. This way, the bond holders

will bear the risk of default on the cédulas hipotecarias but at the

same time they will enjoy further credit enhancement as a result

33

of a higher degree of risk diversification of the underlying

mortgage portfolios.

Although no specific requirements are directly established by

law for mortgage loans to constitute the cover pool, there is

ultimately an eligibility criterion of mortgage loans for the

calculation of the maximum amount of cédulas hipotecarias issued and

outstanding for a particular issuer:

i. The object of the mortgage loan must be the financing of

residential and commercial properties, which are wholly

owned by the mortgagors.

ii. Mortgages which guarantee the loan must be a first-ranked

mortgage with loan-to-value capped at 80%40 and 60% for

residential and commercial mortgages respectively

iii. The value of the mortgaged property has to be previously

determined by specialised entities or by the valuation

services of the issuer licensed by the Bank of Spain

iv. Mortgaged assets must be fully insured

v. Only property in Spain may be used to secure loans (as all

mortgage loans need to be registered in the national land

register).

In terms of asset-liability management requirements, the volume

of cédulas hipotecarias issued and outstanding cannot exceed 80% of

40 This limit can be further exceeded up to 95% if the mortgage loan isguaranteed or insured by a credit institution other than the issuer.

34

the issuer’s cover pool at any time, and a minimum level of 25%

overcollateralization is required by law.

Other typical feature of the Spanish covered bonds is the

transparency of the cover-pool assets. For this purpose, instead

of any possible obligation to appoint a cover pool monitor,

issuers are obliged to keep a special accounting register of the

loans that serve as collateral and, if any, of the replacement

assets as well as any derivative instruments (for instance, to

hedge the interest rate risk) linked to each issue.

Additionally, issuers have to comply with a general duty of

periodic disclosure of information in relation to the cover-pool

assets to the supervisory authority, the Bank of Spain, without

prejudice of other surveillance and monitoring powers of the

National Stock Market Commission, the Commission National del Mercado

de Valores (i.e. issuers have to elaborate a monthly cover pool

report).

VI. Relationship between covered bonds and securitisation:

differences and similarities41

To some extent, both covered bonds and securitization are

financial instruments designed with the purpose of, amongst

others, protecting investors in the event of default on the

issuer. Covered bond transactions achieve this through ring-

fencing or by statutory provisions, whereas in securitization41 See Table 1 infra.

35

transactions, the company originating the receivables (the

“originator”) transfers such receivables in a true sale, tested

under bankruptcy laws, to a bankruptcy-remote special purpose

vehicle.

However, behind that similar goal, it should be noted that

covered bonds, as opposed to securitisation, do not involve the

transfer of the credit risk to the secured investors.

The difference is of great significance in terms of financial

stability42 as the issuer of covered bonds consequently incurs in

a capital charge against such credit risk, and it also helps to

minimise moral hazard and adverse selection as it can be assumed

that the issuer will have stronger incentives to conduct proper

credit evaluation and proper monitoring of borrowers when

granting loans than in originate-to-distribute securitisation.

Absent credit risk transfer, covered bond holders have full

recourse against the issuer in the event of a collateral

deficiency (the so-called “dual-recourse”). In securitisations,

by contrast, investors have specific-asset recourse, that is,

solely to the underlying collateral (i.e. the cash flows from a

securitised portfolio of assets), and the originator typically

does not guarantee the performance of the securitisation.

42 In this regard, it should be noted that covered bonds represent animportant funding source for mortgage lending in several countries.Since covered bonds are, as dual-recourse instruments, less risky thanmost other bank securities and have proven themselves relatively moreresilient during the market turmoil, the preservation of the properfunctioning of covered bond markets is considered as of great interestto both market participants and regulators.

36

Therefore, if the cash flows from the securitised portfolio are

insufficient to make payments on the securitisation units as

they fall due, investors would generally have no further claim

against the originator. At the same time, the originator is

generally not compelled to substitute assets which either mature

or enter into default after they have been included in the

securitised portfolio and transferred to the special purpose

vehicle. As a result, if defaults in the securitised portfolio

are higher than anticipated when the securities were issued, the

burden of the resulting losses will be borne by the investors

rather than by the originator.

Another distinction is that the cover-pool assets typically

remain on the issuer’s balance sheet for accounting purposes

whereas, in securitization transactions, the transfer of assets

from the originator to the special purpose vehicle is accounted

as a sale, thereby exiting the balance sheet, and allowing the

originator to raise capital without increasing its leverage. As

a result, however, less transparency arises in the

securitisation model.

Notwithstanding the former, certain features of covered bonds

could be either similarities or distinctions, depending on the

particular transaction at which it is looked. For instance,

covered bonds are typically bullet instruments with no

37

prepayment risk, whereas in securitisations defaults and early

repayments are usually fully passed through to investors.

However, in securitization transactions prepayment risk can be

contractually limited through swaps agreements and guaranteed

investment contract accounts or the issuance of multiple

tranches of securities against a pool of assets.

Another distinction that can also turn into a similarity is the

nature of the cover-pool assets. Where cover-pool assets in

legislative regimes have to meet certain eligibility

requirements, in structured regimes, as it happens with

securitization, there is more flexibility to select the assets

to cover the bonds, although such flexibility is ultimately

limited in practice by the close scrutiny of the rating

agencies.

Generally, regulation and financial supervision give covered

bonds more transparency in terms of liabilities, quality of the

cover-pool assets and rights of their investors than

securitisation transactions, the majority thereof normally

taking place outside the ambit of financial supervision.

Additionally, the ongoing obligation of the issuer of covered

bonds to maintain sufficient assets in the cover pool during the

38

term of the issuance is considered by rating agencies and

investors as a sort of credit enhancement to the issuer’s

creditworthiness.

As per example, assets which either mature or no longer meet the

requirements of the covered bond issuance have to be replaced by

the issuer43, thereby ensuring that there is enough cover for the

outstanding covered bonds at all times (“dynamic” versus the

“static” nature of assets underlying securitisation notes). A

common feature, however, has to do with the residual value of

the collateral once secured investors have been paid in full,

which returns to the issuer/originator for the benefit of other

unsecured creditors.

Most experts and associations would manifest that these

essential features clearly distinguish covered bonds from

securitisation and effectively help their market access in times

of stress44. However, according to Steven L. Schwarcz45, “there is

great confusion about the nature of covered bonds and their relationship to secured

bond financing and securitization”.

43 Refusal to do so may entail the reflection of the assetdeterioration in the issuer’s prudential ratios.44 A representative example of this is the fact that central banks, intheir function of supplying liquidity to the financial system throughloans to credit institutions, see in covered bonds high-qualitycollateral.45 Steven L. Schwarcz, ‘The Conundrum of Covered Bonds’ (September2010):< http://ssrn.com/abstract=1661018> (20 Sept 2010) at 1.

39

As per Schwarcz:

“covered bonds should be classified within the broader category of

structured finance as they incorporate fundamental financial and legal

elements of both securitization and bond finance generally (for

instance, securitization can be treated for accounting purposes as

either an off-balance sheet sale of receivables or an on-balance-sheet

transfer while still performing its key fundraising and risk transfer

functions. It is possible to structure a securitization as a true sale for

bankruptcy purposes, but not necessarily for accounting purposes,

allowing the originator to raise funds and transfer credit risk while

retaining the securitized assets)”.

Indeed, prior to the credit crunch, there was a market

perception that the boundaries between covered bonds and

mortgage-backed securities were becoming blurred. For instance,

in some jurisdictions mortgage backed-securities were eligible

as collateral for covered bonds, when at the same time, covered

bonds were being used as collateral in synthetic securitisation

transactions. While this is true, it should be noted that the

possible similarities are primarily referred to structured

covered bonds which, as previously mentioned, replicate the

40

essential features of covered bonds in legislative regimes

through securitisation techniques.

Table 1 - Main characteristics of covered bonds and asset-backed

securities46

Characteristics Covered bondsAsset-backed

securities

Motivation of

issuer

Refinancing

Risk reduction,

regulatory

arbitrage,

refinancing

Who issuesGenerally originator of

loans

Special entity

Recourse on

originatorYes

Generally no

Structure

Assets generally remain on

balance sheet, but are

identified as belonging to

cover pool

Assets are

transferred to

special entity

Impact on None Reduction

46 Frank Packer, Ryan Stever & Christian Upper, ‘The covered bondmarket’ in BIS Quarterly Review (September, 2007) at 45.

41

issuer’s capital

requirements

Legal

restrictions on

issuer or

eligible

collateral

Yes (if issued under

covered bond legislation)Generally none

Management of

asset pool

Generally dynamicPredominantly

static

Transparency of

asset pool to

investors

Limited (but quality

regularly controlled by

trustees or rating

agencies)

Limited

Prepayment of

assets

No pass-through as assets

are replaced

Generally full

pass-through

Tranching None Common

Coupon Predominantly fixed Predominantly

42

floating

VII. Operational and legal risks of covered bonds

Although features such as the eligibility requirements and the

obligation of maintaining sufficient assets help effectively to

mitigate risks, covered bonds issuances still involve different

types of credit and financial risks, which can affect

significantly the value of the collateral (for instance, the

type and quality of the assets) and the cash-flows during the

term of the issuance (for example, mismatch risks).

It can happen that certain assets within the cover pool

deteriorate, the issuer not being able to replace them at such

particular moment. Special-law based regimes require for a

prescribed level of overcollateralization in these cases so as

to ensure that proceeds obtained by the cover pool are

sufficient to satisfy bond holders’ right under any

circumstances47.

47 In this regard, Spanish legislation is considered the mostprotective as it imposes a minimum overcollateralisation of 25% forcovered bonds secured by residential mortgages and of 43% for thosesecured by public sector debt.

43

The average duration of cover assets (mainly residential

mortgage loans whose maturity may range from 10 to 30 years, if

no more) is usually longer than that of the outstanding covered

bonds (typically 5 to 10 year48). Therefore, the risk of

mismatches between the differing amortisation profiles of cover-

pool assets and outstanding covered bonds has to be managed by

the issuer. Furthermore, the cash-flows of assets and

liabilities may differ substantially, resulting in temporary

deficits or excesses of liquidity within the cover pool.

The European Central Bank proposed two different approaches as

to manage maturity mismatches:

1. By imposing restrictions on the financial features of both

assets and covered bonds issuances, so that a close

correspondence between them is ensured.

2. By allowing derivatives with high-rated banking

counterparties for hedging risks such as prepayment risk,

currency risks or interest rate risks. The use of

derivatives is limited quantitatively and the protection

that they provide will ultimately be effective only to the

48 According to the ECBC, the trend towards longer maturities hastemporarily reversed during the financial crisis and shortermaturities (from 2 to 5 years) are present in the markets as well.

44

extent that the counterparties providing such hedges

honour their obligations.

Despite the fact that the possibility of default in covered

bonds (at least if issued under special covered bond

legislation) is very remote -mainly because the intrinsic idea

behind covered bonds is that of a financial instrument which is

delinked as much as possible from the issuer and the credit

rating thereof-, such risk shall also be borne in mind as it has

been demonstrated by the financial crisis and, lately, the

current proposal for regulatory changes within the scope of the

Basel Accords, relating to liquidity buffers, leverage limits,

reserve requirements and valuations of credit institutions.

In legislative regimes, special regulations have been designed

to maintain investors’ expectation that their investment will

not accelerate in the event of default by the issuer, thereby

establishing that the terms of payment for both capital and

interests shall remain as initially agreed in the programme at

the time of issuance49.

49 For instance, through provisions that allow derivatives to becomepart of the cover pool for hedging purposes, transferring the bondholders’ claims against the issuer’s estate to the derivatives’counterparties, which will rank pari passu with other unsecuredcreditors.

45

The senior position of covered bond holders on the cover-pool

assets against all other unsecured creditors, if not guaranteed

under special-law based frameworks, is otherwise achieved by

asset segregation, whereby the issuer transfer the assets to a

wholly-owned special purpose vehicle. Therefore, the bankruptcy

remoteness of the latter (that is, the possibility of the

special purpose vehicle to enter into a bankruptcy procedure

should the parent company –the issuer- files for bankruptcy) is

of great importance in terms of risks.

All major rating agencies will primarily look at the quality of

the underlying collateral and its liquidity when assessing the

credit risk of covered bonds (i.e. whether the collateral

encompasses first rank mortgages with a particular loan-to-value

ceiling, any credit enhancements, etc).

Outside the cover pool, they will also contemplate the

creditworthiness of the issuer and its own rating as a key

analytical factor, however the isolation of the cover-pool

assets is achieved, and some other external criterions such as

the legal framework under which the issuance will take place

(i.e. enforceability of investors’ protections, collateral

eligibility criteria, quality of prudential supervision,

46

mandatory overcollateralization, insolvency treatment, asset-

liability management requirements, etc).

VIII. Impact of the credit crunch on covered bonds

The impact of the recent financial crisis on covered bonds

issuances has been considerably to a lesser extent than for

single-recourse instruments such as unsecured senior bank debt

or asset-backed securities in terms of both disruption to

issuance and spread widening.

Market observers have pointed out that, until mid-September

2008, when the collapse of Lehman Brothers occurred, the

performance of covered bonds, as dual-recourse instruments,

illustrated that they were relatively more resilient than other

wholesale funding instruments. However, as the financial turmoil

intensified in early 2009, increased risk aversion on investors

widened spreads in secondary markets, ultimately hitting covered

bonds50.

The spread widening, however, did not affect all markets equally

and thus it has highlighted investors’ concern about the

different covered bonds markets, in terms of types of50 According to the ECBC, where new issuance of EUR benchmark coveredbonds declined by 45% in Q1 2008 versus Q1 2007, the market formortgage-backed securities was almost completely closed.

47

collateral, jurisdiction of issuance and legal frameworks, and

their investor base -domestic versus international-.

According to the European Central Bank, some of the factors

behind the different performance of covered bonds are the

following:

a) Developments in real estate markets, which have raised

investor special concerns about the credit risk inherent

in covered bonds backed by mortgage loans issued in

countries in which the real estate market was rapidly

developed in the years preceding the financial crisis due

to several factors such as favourable macroeconomic

conditions, low interest rates and low demand for

corporate debt

b) Downgrades of ratings of some issuing credit institutions

c) Adverse market conditions for issuers

d) The investor base: the drying up of international investor

demand has made a stable investor base crucial. Hence,

traditional issuers have changed their funding strategies,

making private covered bond placements in the primary

48

market, using taps on already outstanding covered bonds,

thereby potentially leading to a reduction in the market

share of jumbo covered bonds in the secondary market, or

shortening the maturity of their assets to obtain more

favourable market access conditions.

In addition, the ECBC have highlighted that the financial crisis

has showed that the covered bonds market was effectively only

open to issuers out of jurisdictions that were untainted by the

crisis, to such a degree that one of the two ways that the Basel

Committee and the European Union have set forth to measure

covered bonds risk weightings is, indeed, the credit rating of

the home country sovereign of the issuer.

In fact, sovereign spreads, particularly remarkable this year,

have widened strongly and such have led to a very strong spread

difference between covered bonds issued in different countries,

even when they relate to the same issuer. Additionally,

sovereign creditworthiness is directly linked to that of their

relevant banks since the latter will normally hold large amounts

of the national debt in their portfolios.

Although most experts consider covered bonds as a viable

replacement for off-balance sheet securitisation, the rescue

49

measures announced by governments across Europe in response to

the intensification of the financial turmoil, and in particular

the increase in issuances of government guaranteed instruments

provided for new issues of banks’ debt, may also have

implications for the covered bond markets in the period ahead in

terms of competition.

In addition to this, the macro-financial environment shall also

be taken into account as it could lead to redemption calls from

investors and thus a low demand for covered bonds from domestic

banks and investment funds in jurisdictions where there is great

pressure.

In response to the financial crisis, the Basel Committee on

Banking Supervision (BCBS), aiming at developing a review of the

Basel Accords, which provide an international regulatory

framework for capital and banking activities, published two

consultative papers in December 2009, presenting its “proposals to

strengthen global capital and liquidity regulations with the goal of promoting a more

resilient banking sector, … improving the banking sector’s ability to absorb shocks

arising from the financial and economic stress, … thus reducing the risk of spill-over

from the financial sector to the real economy”51.

51 BCBS Consultative Proposal, ‘Strengthening the resilience of thebanking sector’: <http://www.bis.org/publ/bcbs164.htm> (15 Oct 2010).

50

In particular, one of the consultation papers relates to the

“International framework for liquidity risk measurement, standards and monitoring”.

While final rules are expected to be published by the end of

this year, the BCBS, after the end of the consultation period

last April, has lowered certain requirements for banks’ capital

and liquidity buffers.

Basel III defines minimum short-term and long-term liquidity

levels for banks by introducing a liquidity coverage ratio and a

net stable funding ratio. Where the liquidity coverage ratio

measures short-term liquidity by the ratio resulting from a

prescribed stock of high quality assets52 to meet the net cash

outflows over a 30-day time period, the net stable funding ratio

establishes the required amount of stable sources of funding

employed by a bank relative to the liquidity profiles of its

assets and the potential liabilities arising from off-balance

sheet obligations over a year-time period.

This required amount is dependant on the quality and maturity of

the assets in question and each asset class is assigned a

Required Stable Funding (RSF), which defines the minimum amount

of stable funding for each particular asset class.

52 Such assets can be neither pledged explicitly or implicitly in anyway to secure, collateralise or credit enhance any transaction, norheld as a hedge for any other exposure.

51

The Basel Committee has introduced two levels or tiers of high

quality liquid assets. The first level includes cash, central

bank reserves and securities representing claims on or

guaranteed by sovereign debt. The second level assets, which can

make up to 40% of the total liquid assets of the credit

institution, can be composed by 20% risk-weighted debt from high

quality covered bonds and corporate debt rated AA- or higher and

from government and other public sector entities’ debt.

In the opinion of the ECBC, while they celebrate the lowering of

the rating limit for high quality bonds if comparing with the

original proposal (from AA to AA-), they regret the removal of

lower rated bonds from the eligible assets, and argue that

within level 2 assets, triple-A and double-A rated covered bonds

should not be in the same “bucket” as single-A rated public

sector debt as the assessment shall be made from a liquidity

perspective, not from a return-profile one.

For qualifying as level 2 assets, covered bonds must also fulfil

the following requirements:

i. Central bank eligibility for intraday liquidity needs or

overnight liquidity shortages in relevant jurisdictions

ii. Not issued by the bank itself

52

iii. Traded in large, deep and active markets characterised

by a low level of concentration

iv. Proven record as a reliable source of liquidity in the

markets even during stressed market conditions

Another area for improvement has to do with transparency and

market efficiency. The secondary market for covered bonds is

currently dominated by OTC trading. The lack of transparency in

this market has been cited as reason for market making

difficulties. Market-driven initiatives aimed at moving the

trade in covered bonds to a trading platform on a request for

quote basis have already been launched (i.e. an increasing

importance of electronic trading platforms like EuroCreditMTS).

IX. Conclusions: future of covered bonds

Although covered bonds have also suffered from the financial

crisis especially in late 2008 and early 2009, market observers

have noted a significant return in terms of spreads and issuance

volumes as well as investors’ confidence. According to the

numbers published by the ECBC by the cut-off date for this

paper, a new issuance record of EUR benchmark covered bonds of

almost €100 billion have been achieved while residential

mortgage-backed securities volumes still remain low.

53

Despite the fact that the credit crunch has rescued government

guaranteed banks bonds as a substitute wholesale funding

instrument, these are by definition of temporary availability.

The likelihood of deposits becoming a steady funding source for

credit institutions is also remote as the financial crisis has

intensified the competition in this market, thereby making them

a more expensive funding instrument. Therefore, a worldwide

increase in the use of covered bonds is expected.

In the near term, however, the outlook for covered bonds, as for

other wholesale funding instruments, is likely to remain

challenging as long as funding markets continue to be disrupted.

As per Ralf Burmeister, although “the progress towards a return to

normality will continue to be long and slow, for the economy in general and

accordingly also for the covered bond market, … covered bonds demonstrated an

ongoing positive performance throughout the crisis and are also expected to do so in

the future”.

Burmeister also raised “two major arguments for this positive market

perception. Firstly, the industry remains committed to the market and is working on

further improvements” in terms of “transparency of cover pool data as well as

progress in the liquidity and trading issue of covered bonds”. Secondly, “the

54

market has been strongly supported by the European Central Bank”, and it will

continue to do so in the aftermath of the ECB covered bond

purchase programme53.

It is the view of the European Central Bank that covered bonds

are likely to recover its important segment within the privately

issued bonds market once general investor confidence returns and

dislocations in funding markets ease substantially54. The

European Central Bank also stated that the European Union

covered bond model is a valuable alternative to the US mortgage

backed security model, proven to be more susceptible to market

disruptions.

With regards to the ECB covered bond purchase programme, its

President, Jean-Claude Trichet, has stated that the motivation

for choosing covered bonds rather than any other asset class

responds to two aspects. Firstly, the ECB considered that the

programme would give “access to funding of a longer-term nature than the ECB’s

refinancing operations” which in turn will facilitate the access to

credit for the non-financial sector. Secondly, “covered bonds do not

involve the transfer of credit risk implied by underlying assets from the issuer to the

53 European Covered Bond Council, European Covered Bond Factbook (5th ed,2010).54 Indeed, covered bonds were one of the first non state-guaranteedfunding instruments for credit institutions to resume issuanceactivity after the credit crunch.

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investor…-staying the credit risk- with the originator, preserving the

incentives for prudent credit risk evaluation and monitoring”.

The key objectives of the ECB covered bond purchase programme

were (i) to promote the ongoing decline in money market term

rates; (ii) to ease funding conditions for credit institutions

and companies; (iii) to encourage credit institutions to

maintain and expand their lending activities; and (iv) to

improve market liquidity in the covered bond market.

The asset class has demonstrated itself to be a solid and

reliable long-term funding tool which enables banks to access to

an alternative stable, relatively cheap funding source in an

environment of increasing reliance on wholesale funding as

opposed to a core deposit base capitals.

Furthermore, the safety features and resilient performance of

covered bonds, particularly relative to other asset classes, has

continued to attract a broad, stable investor base, helping to

maintain lending to the real economy.

From the perspective of funding liquidity risk, the current

turmoil has also highlighted the importance of diversified

funding structures both in terms of amortisation and

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geographical diversification. In this respect, covered bonds can

provide diversification benefits for banks in the liquidity

management, as they provide a medium to long-term financing

resource and are well-suited to fund a bank’s fixed rate

mortgage loan portfolio. Issuing covered bonds enhances a bank’s

ability to match the duration of its liabilities to that of its

mortgage loan portfolio, thus enabling a better management of

its exposure to interest rate risk.

Nevertheless, the crisis brought also into focus areas which

need further improvement not only in terms of transparency,

quality and liquidity and the general impact on financial

stability, but also in terms of harmonisation.

Although integration in the European covered bond market has

made progress since the introduction of the euro, markets

continue to be, however, considerably fragmented, and investors

still show a significant home bias. According to the ECB, there

is still considerable scope for further integration of the

covered bond market, in particular by increasing the degree of

homogeneity between the different legal frameworks.

Various markets-led initiatives are underway to pursue the

development of common standards in terms of nature of the cover

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pool, yields and maturity as a crucial step towards a broadening

of the investors’ base of a clearly defined and transparent

financial instrument.

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Bibliography and reference materials

European Covered Bond Council, European Covered Bond Factbook (5th

ed, 2010).

European Mortgage Federation, Mortgage info (September, 2010).

Bank of America - Merrill Lynch, Covered bond primer for the

uninitiated (2009)

Steven L. Schwarcz, ‘The Conundrum of Covered Bonds’

(September 2010): < http://ssrn.com/abstract=1661018> (20

Sept 2010).

European Central Bank, Covered bonds in the EU financial system

(December, 2008).

JJ de Vries Robbé, Structured Finance: On from the Credit Crunch – The Road

to Recovery (2009)

European Central Bank, The implementation on Monetary Policy in the Euro

Area (November, 2008).

European Central Bank, Financial Integration in Europe (April, 2010).

European Central Bank, EU Banks’ Funding Structures and Policies (May,

2009)

European Covered Bond Council, ‘ECBC Response to the Basel

Committee on Banking Supervision’s Consultative Document

Entitled “International framework for liquidity risk

measurement, standards and monitoring” (April, 2010)

Verband Deutscher Pfandbriefbanken, ‘Refinancing Real Estate

Loans – Lessons to be Learned from the Subprime Crisis’

(Berlin, 2009).

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Renzo G. Avesani, Antonio García Pascual & Elina Ribakova,

‘The Use of Mortgage Covered Bonds’ in International Monetary

Fund Working Paper (January, 2007)

Landesbank Baden-Württemberg, ‘Overview legal frameworks on

the covered bond market’ (August, 2009)

Hyun Song Shin, Financial intermediation and the post-crisis financial system

(8th BIS Annual Conference, June 2009)

Bill Allen, Ka Kei Chan, Alistair Milne & Steve Thomas,

‘Basel III: is the cure worse than the disease?’ Cass

Business School – City University London

Centro del Sector Financiero de PwC e IE Business School,

Basilea III y los retos de la banca

Reference websites

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