The common understanding is that covered bonds are low risk instruments, but this is a misnotion. Lately, S&P has come with several reports, webcasts etc.on covered bonds risks emphasizing that characteristics and performance of covered bonds are dependent on the asset liability mismatches, credit enhancements and collateral performances which are diverse and vary.

15th September, 2011: Australia introduces Covered Bonds legislation

Banking Amendment (Covered Bonds) Bill, 2011 has been introduced today by Treasurer Wayne Swan to the House of Representatives, Australia to amend the Banking Act, 1959 facilitating financial institutions to issue covered bonds and is expected to generate a sale of A4130 billion in coming years.

15th August, 2011: Risks in Covered Bonds - S&P director speaks

Standard & Poor's director Sabrina Miehs, of the Covered bond rating group, on credit matters show, discussed the wide range of collateral types and diverse risk underlying different covered bond program and the misnotion people carry that covered bonds are risk free.

28th July, 2011: Turkey’s first covered bond issuance
5th May, 2011: Covered Bonds Bill considered again to promote covered bonds in US
6th April, 2011: Australia's draft Covered Bonds bill
06 April, 2011: Turkey's maiden Covered Bonds issue
April, 2010: Covered Bond Act in US

S&P reports warn on covered bonds risk

While Covered Bonds markets are booming globally and have been well received by the investors, regulators and issuers, covered bonds aren’t risk free.

The common understanding is that covered bonds are low risk instruments, but this is a misnotion. Lately, S&P has come with several reports, webcasts etc (see our news here) on covered bonds risks emphasizing that characteristics and performance of covered bonds are dependent on the asset liability mismatches, credit enhancements and collateral performances which are diverse and vary. In a report titled ‘Never underestimate Credit Risk in Mortgage covered bonds’ and another report titled ‘Credit Risk plays an important role in mortgage covered bonds,’ issued on 14^th September, 2011, analysts state that credit risk associated with underlying pool is critical in covered bonds as the pool’s characteristics also impact the credit worthiness of the bonds.

[Reported by: Nidhi Bothra]

Australia introduces Covered Bonds legislation

The bill includes a regulatory cap on the amount of covered bonds an institution can issue, with the pool of assets used to secure issuance no greater than 8 percent of an institution's assets. The cap shall limit the claim of the covered bondholders over the assets of the depository institutions protecting the claims of the unsecured creditors such as depositors arising from the preferred claim of covered bondholders over the assets of ADIs. The eligible assets to form a part of the cover pool are high quality assets such as residential mortgages and the value of the assets in the cover pool should be 103% of the value of the outstanding covered bonds.

There have been concerns over offshore entities issuing covered bonds in Australia and tapping on the savings while the banks tried to deal with the global financial turmoil. The legislation is expected to reduce the dependence of banks on overseas funding markets, provide alternative and cheaper means of accessing funds and diversifying funding base.

Both houses are expected to pass the law by the year end. The text of the bill is available here.

[Reported by: Nidhi Bothra]

Covered Bonds not risk free – S&P Covered Bond Ratings Director speaks

Covered Bonds recently have been well received by investors and have seemingly gained a high profile with issuers and investors. Standard & Poor's Director Sabrina Miehs, of the Covered Bond Ratings Group, on Credit Matters show, discussed the wide range of collateral types and diverse risks underlying different covered bond programs.

Some of the risks attached to covered bonds are, the asset type in the pool, jurisdiction in which they are issued, structural risk, asset liability mismatches, counterparty risk and over-collateralisation in the pool and so on. The methodology adopted by S&P for rating such covered bonds is typically looking at the cashflows from the underlying assets, the timely and full payment of interest and principal and the loan pools backing the covered bonds are monitored on a regular basis, whereas other rating agencies approach is looking at the sum of expected losses, ALM, interest rate risk and foreign exchange risk.

Further she mentioned that the general misnotion is that the issuer downgrading would impact the rating of covered bonds as well however issuer downgrading may or may not be affecting the rating of the covered bonds at all. It is also believed that covered bonds are vanilla products and are almost risk-free. The view however is incorrect as there lot of credit risks attached to the product.

(Reported by: Nidhi Bothra)

Turkey’s first covered bond issuance

SME loan based pool indicates a new opportunity for emerging market issuances

28 July, 2011:

Turkey’s Sekerbank has come up with Turkey’s first covered bond issuance. The transaction should receive immense attention being one of the first transaction from an emerging market country, and that too, from the traditional domain of residential mortgage loans with which covered bonds have usually been associated.

Turkey has a law dealing with covered bonds but this law is limited only to mortgage loans. It appears that there is another law on asset-backed covered bonds which deals with non-mortgage-backed assets. The law provides for ring-fencing of the assets in the cover pool in the event of bankruptcy of the issuer.

The present transaction has an over-collateralisation of 25%. There is a liquidity facility covering 9 months’ interest, and there is also a provision for appointment of a replacement servicer.

Despite Turkey’s sovereign rating of Ba2, the transaction attained a rating of A3, one notch below the bank’s domestic rating.

Since the assets in cover pool can only be used to repay the covered bonds, the transaction is almost like a revolving pass-through transaction.

[Reported by: Vinod Kothari]

Also see our news dated 6th April 2011 on Turkey's maiden Covered Bond issue. Click Here

Covered Bonds Bill considered again to promote covered bonds in US

5 May, 2011: Covered Bond Bill introduced by Rep. Scott Garrett and Rep. Carolyn Maloney in March, 2011 for the development of covered bond market in the US and was considered and approved by a sub-committee of House of Representatives recently. The Bill will be put up for consideration before the House Financial Services Committee. The Bill has been several times before put up for consideration (see our news here). Some of the salient features of the bill are:

The Bill provides requirement of eligible issuer, single cover pool for issuance, eligible assets etc.
Covered bond regulatory oversight program to regulate the covered bonds issued and the covered bond regulator shall apply the standards established by the Secretary to evaluate the covered bonds to be issued by an eligible issuer for approval. The Secretary is to maintain a registry that would have a record of all the approved covered bonds.
The regulators may establish minimum over-collateralization requirements for covered bonds backed by eligible asset classes.
The Bill places requirement for monthly reporting to the Secretary, covered bonds regulator, indenture trustees, the bondholders and independent asset monitor.
Covered bondholders to retain claim against the issuer for any deficiency with respect to the covered bonds or related obligation and the obligation of the issuer shall remain absolute.
In case an uncured default occurs, before the issuer enters conservatorship, receivership, liquidation or bankruptcy, an estate shall be created separate from the other assets of the issuer for the affected covered bonds.

The Bill intends to create a new market for financing mortgages and help revive the housing markets in US. The text of the Bill is available here.

[Reported by: Nidhi Bothra]

Australia’s draft Covered Bonds bill

6 April, 2011: After much consultation between the Australian Treasury and industry participants on the preferred legislative framework for the issuance of covered bonds by ADIs, the Australian Federal Government has released an exposure draft of the Banking Amendment (Covered Bonds) Bill 2011.

As a part of the commitment under the Competitive and Sustainable Banking Package, where the Australian government had announced a measure to allow issuance of covered bonds by Australian banks, credit unions and building societies, the Treasury released the exposure draft Bill and the draft explanatory memorandum providing legislative support for issuance of covered bonds by ADIs in March, 2011.

The Australian Prudential Regulation Authority (APRA) had prohibited the issuance of covered bonds by financial institutions as it was of the view that in the insolvency of an ADI issuer the covered bondholders would take priority over other creditors, so covered bonds would contravene the depositor protection standards set out in the Banking Act. By now amending the Banking Act by the Government is allowing financial institutions to access cheaper, more stable and longer duration funding in the wholesale capital markets. However measure to allow issuance of covered bonds will have no impact on the rights of the depositors. Salient features of the bill are:

ADIs can issue covered bonds with a cap of 8% on the value of the cover pools of the assets, preventing the covered bondholders having claim over more than 8% in the assets at the time of issuance of covered bonds.
Australian Prudential Regulation Authority shall regulate the issuance and shall have the authority to restrict the issuance of covered bonds that are non-compliant with the legislations.
The cover pool would be held and owned by a special purpose vehicle separate from the ADI issuing the covered bonds and the ADI shall transfer additional assets or maintain the cover pool in order to meet its obligations.
The ADI is required to appoint a cover pool monitor to monitor the value of the cover pool and report on the status of the cover pool.
Assets eligible to form a part of the cover pool, as specified in the Bill include
- cash,
- government debt instruments, not greater than 20% of the value of all the assets in the cover pool at any time
- a loan secured by a first ranking mortgage over residential property provided that the sum of the principal amount of the loan when it is issued and the total value of all other debts and other obligations secured against the residential property must be no greater than 80 per cent of the value of the residential property;
- a loan secured by a first ranking mortgage over commercial property provided that the sum of the principal amount of the loan when it is issued and the total value of all the other debts and other obligations secured against the commercial property must be no greater than 60 per cent of the value of the commercial property
- a derivative (within the meaning of section 761D of the Corporations Act 2011) used to hedge movements in exchange rates or interest rates relating to the special purpose vehicle’s liabilities

In the event of default of the ADI, though the covered bondholders would have priority of claims in the cover pool over the depositors as well, the depositors would be protected by the Financial Claim Scheme. However any claim of the covered bondholders over the cover pool would represent unsecured claims on the ADI.

The draft bill shall remain open for public consultation till 22 April, 2011. Get the text of the exposure draft and explanatory memorandum here.

[Reported by: Nidhi Bothra]

Turkey’s maiden Covered Bond issue

6 April, 2011: Sekerbank of Turkey is ready for its maiden issue of Euro 200 million Covered Bonds with a five years maturity. The cover pool consists of SME loans, in which the bank is considered to specialize. Issuance will be in four tranches one sold to private investors, one guaranteed by European Investment Fund and other two bought by IFC and Dutch Development Agency FMO. This would also be the first issuance where the cover pool denominated in Turkish Lira would back the foreign currency bonds. The pricing of the bonds is through bookbuilding. Covered Bonds was facilitated by the Capital Markets Board of Turkey in 2007, allowing securitization and covered bonds issuances.

[Reported by: Nidhi Bothra]

Covered Bond Act in US

April, 2010: To add liquidity and to develop a robust capital market through new and innovative solutions, Rep. Scott Garrett, R-N.J., introduced the U.S. Covered Bond Act, 2010 with Rep. Paul E. Kanjorski, D-Pa., and Financial Services Committee Ranking Member Spencer Bachus, R-Ala. The Act is similar lines to the European covered bonds.

Covered bonds have been a major source of liquidity for many European nations’ mortgage markets. The Covered Bond Act, establishes the regulatory oversight of covered bond programs, subjects covered bonds to appropriate securities regulations by federal regulators and provides several provisions in case of default and insolvency of covered bond.The Act includes the following:

Covered Bonds have been defined as senior recourse debt obligation that has an original term to maturity of not less than 1 year, issued by an eligible issuer and secured by a perfected security interest in a cover pool of assets which is owned directly or indirectly by the issuer of the obligation. Is not a deposit as defined under section 3 of the Foreign Deposit Insurance Act.

Procedure:

· The covered bond regulator sets up the covered bond regulatory oversight program

· The covered bond program is approved by the regulator. The regulator being the Secretary of the Treasury or any other officer of the Department of Treasury as may be authorized by the Secretary in this regard.

· Before approving the covered bond program the regulator has to consult the primary Federal regulator.

· Covered Bond regulator shall maintain a covered bond registry for all approved programs

.The eligible assets are:

Residential Mortgage Asset Class which include first-lien mortgages secured by 1 to 4 family residential property, mortgage loans insured under the National Housing Act, loans guaranteed, insured or made under Chapter 37 of Title 38 of the United States Code and residential mortgage-based securities ("RMBS") of the same asset class.
Home Equity Asset Class would include home equity loans secured by 1-to-4 family residential property and asset-backed securities ("ABS") of the same asset class.
Commercial Mortgage Asset Class would include commercial mortgage loans and commercial mortgage-backed securities ("CMBS") of the same asset class.
Public Sector Asset Class would include investment-grade securities issued by one or more states or municipalities, loans made to one or more states or municipalities and loans, securities or other obligations that are insured or guaranteed, in full or substantially in full, by the full faith and credit of the United States.
Auto Asset Class would include auto loans or leases and ABS of the same asset class.
Student Loan Asset Class would include student loans (whether or not such loans are guaranteed) and ABS of the same asset class.
Credit or Charge Card Asset Class would include credit or charge card loans and ABS of the same asset class.
Small Business Asset Class would include loans made under a program established by the Small Business Administration (whether or not such loans are guaranteed) and ABS of the same asset class.

Salient features of the covered bond program:

· In a cover pool there will not be more than one eligible asset class

· For each covered bond program there is a need to establish minimum over collateralization requirement from time to time based on credit, collection and interest rate risk; established by the covered bond regulator

· The covered bond issuer will have to appoint an indenture trustee (unaffiliated entity) to monitor the cover pool.

· The cover pool securing the covered bonds shall have to satisfy an asset coverage test. This test is to be conducted every month by the issuer and the test would measure whether the assets in the cover pool satisfy the minimum collateralization requirements. The results of the monthly test are to be disclosed to the primary Federal regulator, if any, covered bond regulator and the bondholders.

· In case the covered bond fails to satisfy the asset coverage test and the failure is not cured within the time specified in the transaction documents; it would amount to default and would result in the creation of an estate. The issuer shall submit the schedule of the eligible assets and substitute assets to the indenture trustee on monthly basis

Creation of estate in case of event of default: The estate created shall be not be taxable as a separate entity and no assets and liabilities shall be a taxable event

1. In case of default and before issuer enters conservatorship, receivership, liquidating agency or estate in bankruptcy

All the applicable assets of the cover pool shall be released to and held by such estate, free from any right, title, claim of the issuer, conservator, liquidating agent, receiver or bankruptcy trustee of the issuer
In case the assets of the cover pool are inadequate to fulfill the obligations, the bondholders will have claim against the issuer for the deficiency with respect to such covered bond or related obligation
The issuer shall have the residual interest in the estate (if any)
Covered bond regulator shall act as the trustee of the estate and appoint and administer one or more servicer or administrators of the pool. The administrator will:

o Collect, realize the assets of the pool

o Borrow, procure funds for the benefit of the estate

o Invest or use the proceeds for making payments for the covered bonds

o Provide liquidity support if need be

Fees of the servicer, administrator is paid from the estate as approved by the covered bond regulator

2. Default on conservatorship, receivership, liquidating agency or estate in bankruptcy:

In case FDIC is the conservator/ receiver, the Corporation shall have the right to transfer the cover pool along with the covered bonds and related obligation secured by such a pool to another eligible issuer that meets all the conditions and requirements specified in the transaction document, within 15 days from the date for such appointment. The transferee shall become fully liable for the covered bonds upon such transfer
In case no transfer takes place within 15 days an estate shall be automatically created. In such a case the issuer will continue to service the pool for 120 days from the date of creation of the estate for a fair market value fee

Before this present Act, in 2008, FDIC had issued the first formal guidance on covered bonds, the "Final Covered Bond Policy Statement" later, in the same year, the Department of the Treasury published "Best Practices Guide for US Residential Covered Bonds." This Act is the legislative follow-up to Garrett’s original legislation, The Equal Treatment for Covered Bonds Act, which was first introduced in 2008. The Covered Bond Act, 2010 has been welcomed by the industry players and is hoping to be the alternative investment solution for the markets

[Reported by: Nidhi Bothra]

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