Covered Bonds Roundtable 2009: Part III
IFR: Is there a change in strategy in terms of how you bring a primary deal to the market now?
Cuesta: I don't think so. Mortgage lending is growing less than 2%, in some cases 0%, in Spain. Our funding target is basically to refinance what it's maturing.
Kvist: Which is not a lot.
Cuesta: Which is not a lot. Things could have been tougher in Spain but we tended to issue 10 years, 15, 20 and even 30 years. So we just have at most €2bn–€3bn for the big issuers in maturities every year, which is not a lot.
I have been discussing with originators about what will happen with the Spanish market. In September only three or four issuers came, and some new issuers with issue size that were uncharacteristically big for them, which were new to some investors. If you consider their issuing capacity, €1bn for them is probably more than enough in terms of funding needs. Investors were used to issues from them of around €100m-€200m. I don't think we'll see them issuing regularly.
On the other hand, the ECB has already said they're going to withdraw their liquidity from the market. On July 1 2010 they're not going to be active in primaries or secondaries, but they will be holding €60bn of covered bonds, which will be split among all the central banks in Europe. I don't think covered bonds will widen, in any case, because the market will probably stabilise itself. But, if it comes back to the extreme levels we saw at the height of the crisis, I am sure the ECB will change its strategy. It cannot afford to let the market fail again.
The approach to supporting the market has also been perfect. It has not been supported along geographical lines, with the Bundesbank buying Pfandbrief or the Bank of France buying Obligation Fonciere. All the central banks have shown an interest in the product itself. It's probably the first pan European or European product to be supported in an European way. The rest of the supporting measures have been taken independently by every country, but this is probably the product that has been supported by the euro area, all central banks were coordinated.
So I'm relatively optimistic, I think it will not widen, if there is more supply then some investors will meet that at mid-swaps plus 60s, 70s or 80s – wherever the spread give an opportunity to buy and get back in the market.
Skeet: There are some very substantial redemptions this year, much of it in the Pfandbrief market.
Cuesta: €90bn in the first half and another €90bn in the second half.
Skeet: We tend to forget that. It is a massive level of redemptions.
In the UK – but we're going to see it right the way across Europe – bank liquidity requirements are going to require holding a higher level of liquidity. That means issuers will have to fund much more long term than in the past, and hold a lot more liquid assets. If you're Eurozone it’s fine, these covered bonds will be advantageous to hold, not just from the risk asset weighting perspective but because it is exempt from the large exposures feature of the CRD and is included in the liquid assets definition that SEB has been talking about. But that is not the case in the UK.
Kvist: That's key. The UK example must not be followed because then bank treasury portfolios will no longer be willing buyers for liquidity management purposes. That would suck even more demand away from the investor base.
Skeet: It’s one of the structural issues that has been raised with the UK authorities. They have consistently failed to provide any kind of privileged status to covered bonds, which is going to be a problem for the UK market. That's where you will see plenty of supply ongoing. Over the next few years both sides are going to remain very actively engaged in the two way flow on this market. I think the outlook is good to that extent.
IFR: So that's a spread positive, then, given the redemptions?
Skeet: I think it's going to be spread positive, even once the ECB has gone. This market has a momentum, someone called it the iron lung. The ECB was never an artificial iron lung, it was certainly a turbocharger that sped up the tightening, but the momentum of this market is sustainable now.
If one is a super optimist, you can look into the crystal ball and see the non European markets growing, you can see a lot more of the central banks from outside the Eurozone coming back in, you can see the US market, maybe, third time lucky, springing into life next year. That is a probability, not just a possibility. There are other peripheral markets showing an interest. If you factor all that in, and not just look at it purely in the European context, important though that is, then there are many grounds for optimism.
Cuesta: Apart from the covered bond programme, there are many other variables. We have interest rates close to zero. We have the impact of the improvements in other markets, which are going to be key because some investors – especially banks – have been playing the carry trade: the ECB repo at 1% and a five year transaction paying 3.5%. We know part of this demand has come from this environment, not only because the ECB is buying covered bonds.
It will depend a lot on timing. If you keep it too long it's going to be tough because it will generate bubbles, encouraging people to speculate with the product. But if you adopt an exit strategy too soon that can be a disaster I wouldn't want to be a regulator.
De Bruin: Maybe on the spread movement and on rating agencies there's a tendency to look more at the liquidity situations of the financial institutions. Credit enhancement is improving because of that. That’s a spread positive, right?
Loughney: I think it’s a good thing and maybe a spread positive, but spreads are very tight anyway. You have to do more work on the investor: you have the different jurisdictions, the different rules, more focus on granularity in the analysis, you tend to need more research.
I think the market will equilibrate at wider spreads than seen in the past. That's a positive thing. It will bring new investors into the market, more sophisticated investors bringing more granularity. It will be a better place.
Spreads are a bit too tight at the moment. The ECB won't spend €60bn, they'll start putting the brakes on. We'll see more liquidity, which will probably provide an opportunity for investors like myself to get rescaled in the market and be more comfortable at a better level. Then maybe we can glide along, getting paid for doing the work and staying away from the names that we don't want.
Guire: If the ECB gave the market cause for uncertainty concerning the €60bn and/or July, that would bring out the people who are waiting for the last buck. While they have another €40bn theoretically to spend, that's not all going to new issuance. There's plenty of books holding paper from beforehand that didn't want to sell at plus 200 and don't want to sell at plus 30 now. If the ECB indicates it doesn’t believe it needs to spend €60bn and is happy with the conditions, suddenly plus 30 seems attractive.
That would also bring more issuance to the market straight away. Issuers must be sitting there waiting for the tipping point, past the halfway mark, before they start coming in.
I'd like to see better development in the repo market. The ECB is sitting on €20bn of bonds now. It would be nice if they could somehow release some of that in the repo. That would create some uncertainty in the market. Nobody goes short in this market – or very, very few people will.
Guire: It's very difficult to borrow, to put on an arb trade, even in decent size bonds. Allen, do you see it differently, in terms of repos?
Rad: One of the biggest challenges for improving liquidity are repos. Repos are getting very expensive towards year end. The market knows what bonds are being bought by the ECB and at the moment, it is difficult to find offers so the repo facility is very important.
I don’t think the ECB will sit on the €60bn proposed volume and just roll it down the curve. I think they're going to be opportunistic, responding to demand for bonds with variable pricing and demanding a pick up against the new issue. In other words, acting like a customer at the end of the day. That would be very good.
IFR: How do ECB's secondary purchases operate? Presumably there's a list and you deal with the repo consequences of it depending on whether you trade or not?
Rad: There are a couple of different ways. Every central bank does it differently. Some central banks will only work on an axe basis, such as the smaller central banks while the big ones trade through the electronic platforms. You may show an axe to one of the bigger central banks but you might miss the ticket. They're acting like real customers, which is as it should be. They want the best execution.
Skeet: Next week a bunch of European regulators will meet for a discussion, we could send them a list of points – things we'd like to raise with them – since we have the opportunity to send a few messages. I suppose the repo market is one of them. Is there anything else that's troubling us now that we would like the regulators to be actively thinking about?
Kvist: Wouldn't it be double whammy if the ECB were to discontinue its tender operations at the same time as the purchasing programme reaches its conclusion? That's potentially quite dangerous because bank treasury portfolios have obviously been availing themselves of the cheap tender money. The ECB can’t be keen to prolong those programmes in terms of signalling recovery. We know there is an end date for the purchasing programme, as well. If those two events come too close to each other, I don't think that would be particularly good for sentiment.
IFR: Moving on, how has the methodology used by the rating agency changed?
Settepani: We didn't completely revolutionise our methodology, we changed one specific aspect of it. The general framework of the covered bond methodology we thought was still good and valid, even after the crisis. What we changed is the way we approached the liquidity gap within the covered bond product. We couldn't ignore what happened in the market last year, in terms of complete repricing. So we tried to incorporate this in our methodology.
Every time you have to manage a match between the maturity of your asset and the maturity of your liability, you need to take into account that if the issuer defaults, the administrator of the cover pool may need a refinancing, or will have to sell a portion of the portfolio in order to repay the outstanding covered bonds.
We have incorporated in our methodology a higher refinancing spread and a longer time required to refinance or sell your portfolio. This has a direct impact on the over collateralisation levels that support our ratings. In terms of the D Factor, which basically determines how far the rating of the covered bond can go beyond and above the rating of the issuer, we have put more weight on this liquidity management profile, typically meaning increased D-factors.
We announced the review of our methodology at the beginning of the year. In the second half of the year we reviewed all the D-factors and the levels of support overcollateralisation for all the programmes we rate. We have now almost completed all the review, there are just a few programmes left and in fact not many ratings were really affected in the end.
IFR: From an issuer's perspective, how do you feel about the ratings pressure that we're seeing now, and the over collateralisation?
Cuesta: Most of the rating agencies have probably been as surprised as the rest of us at the events of the last two or three years. They have probably tried to adapt their methodologies to reflect what has happened. But in my experience they try to standardise different markets and different products. That's what it means to have methodology. But sometimes you lose certain factors that are unique to a market or a product, that would lead to a different outcome.
In the secondary markets one probably sets the price and the others follow. It is the same for some syndications: some banks establish the price and the rest, besides the three, four or five big names, don't know or don't have the time to monitor the different markets and different names, so they have to follow.
Certain rating agencies sometimes try to apply general methodologies and forget that certain jurisdictions have their specific features, the market has specific features, that should be contemplated.
Settepani: Of course we have to standardise our methodology. The rating has to be comparable across the issuers and the jurisdictions. But we do put a lot of effort into trying to understand the specifics of each individual country. We have local experts in all the jurisdictions, with local issuers.
Cuesta: We have asked for your ratings, we are pretty comfortable with Fitch. I will not say anything regarding your competitors.
Kvist: Sometimes, as an issuer, you will find that the rating agencies work in mysterious ways. That's just the way things are and I don’t have a problem with that. But I hope that we all now recognise that covered bonds are a credit product, so investors are more discerning and do more credit work themselves, instead of simply looking for a Triple A ‘stamp of approval’ on what was a rates product.
From that point of view I do not think that the covered bond universe will have to be a Triple A universe going forward. If the agencies think they have to downgrade certain issuers, or certain securities, based on a developing methodology, that doesn't have to be the end of the world. In the future there will be more tiering in the market, and I hope investors conclude it's worthwhile for them to make an effort to evaluate these credits themselves.
De Bruin: At F&C we always look at top down aspects of the market, the asset class as a whole. But of course we also look at each single name, cover pools et cetera, before we invest in any bond. This analysis has gained importance. In the past it seems covered bonds were seen by the market as somewhat commoditised, as just another alternative to governments bond. That has changed quite significantly.
If names need to be downgraded, that must be a consequence of something, of not having the right cover pool for example. All issuers should have a good opportunity to at least be Triple A if they fulfil all the aspects on their collateral, on the liquidity gaps, et cetera.
Cuesta: It's really an opportunity for investors. If you are really independent and you feel that that Triple A for that product with a tighter level is offering less value than this product, which is not Triple A, then you will be rewarded for that call if you are correct. That's the market. Investors see that there is still certain value in certain sectors. We don’t all need to be all Triple A. In fact, that was one of the problems in the previous crisis – too much Triple A paper everywhere, not only in covered bonds but in ABS and elsewhere, everything should be Triple A. That is not how it should be.
The question is, do all investors really have the time, the team, and the resources to conduct independent analysis?
Settepani: A rating agency will always encourage investors do their own homework and not buy only based on the rating. We always want to get the investors point of view. The more analysis they do the more transparency we will see in the market as a whole, a result of the collective effort by everybody.
Skeet: It's very exciting trying to work out what you guys are going to do next, it gives us all a little bit of a frisson. Just think, we don't know really know what S&P are doing. Does anyone have any idea when they're coming out with something, or what they're going to do when they come out? I think it's tremendous, it gives you guys something else to jump up and down about!
Actually, there is one area that does trouble me. Here we have an asset class where there's never been a default. Here we have underlying assets where there's a remarkable lack of data. I keep hearing from agencies that you want to stress test everything to the maximum and create over collateralisation levels which run the risk of going through the roof – and I'm talking generically about the rating agencies. You're basing a lot of your calculations on worst case scenarios generated from a market where there is statistical information going back several years, and we happen to be here in the UK where some of the best data is available.
We all know that one of the peculiarities is that different European markets operate in different ways. The problem with the ratings here is if we go on stress testing markets based on worst case scenarios, and data that doesn't fit, in an asset class which has never shown a default, for all of the other mechanisms that exist outside it, can you really justify the methodologies that you're applying? Are you not trying to take a different methodology, applied to a different asset class, and graft it on to something where it doesn't belong? Because I think there is a sense, if I can talk for a lot of issuers I've spoken to, that you guys are trying to be transparent, but the basis of your analysis may be suspect.
Settepani: Of course we disagree with that. I'm not totally sure about the lack of data. There is plenty of data for the underlying collateral.
Skeet: To clarify it’s not the lack of data but the lack of data during a crisis. In other words, in order to stress test you need to look at an example of a market which has melted down, to actually give you something empirical. There’s lots of data on markets that have been working smoothly for ten years but that's not really what you guys need.
Settepani: No. On the credit side it's true that we have gone through quite a benign cycle but now things are changing and we are seeing that the delinquencies are picking up in different portfolios. That's why we're tracking very closely what's happening on that side, to fine tune our asset model on what's really happening in the banks' portfolios. So that's one side of our methodology.
Then there’s the refinancing risk I mentioned before. There we have already had a shock, although I don't know if it's going to be repeated. We are already incorporating that scenario, based on something that really happened. We feel comfortable that the stresses we are incorporating in our analysis on these sides are sufficiently conservative. The real situation that we have never seen is in fact the situation where there is one issuer defaulting and you need to manage, let's say, a transition process where somebody else steps in and starts to manage the portfolio. That's really the final test of the robustness of a covered bond and effectiveness of the legal framework and systemic support.
As for the rest, on the asset side, the RMBS or CMBS methodologies on the portfolios, we think it makes perfect sense. Our stresses are definitely very severe but we're talking about Triple A assets.
IFR: Is it right that we're seeing more securitisation techniques in covered bond ratings?
Settepani: Some banks are interested in putting together a sort of securitisation but with dual recourse, which looks like a covered bond. Sometimes we are asked our views on the inclusion of different kinds of collateral, like unsecured SME loans, in these kinds of products. The market is interested in developing products which are a hybrid between securitisation and covered bonds.
Kvist: If rating agencies focus too much on the concentration risk on the liability side, the funding side, then that will undermine the benchmark issuance, the jumbo issuance format. That is potentially a problem for market liquidity. There's a trade off there that one has to think about. It might end up pushing those of us that are not major issuers in terms of size towards private placements, to deal with the perceived concentration risk on the refinancing side. What are people's views on that?
Settepani: Under our methodology the size of the issuance is important. It affects the result of our analysis – especially as long as you don't have many issues outstanding and you are not very well matched. On the other hand if you are a frequent issuer and have a good match between asset and liabilities probably the size of issuance is going to matter less.
Cuesta: It's an interesting question. We really have to wait to see not only the rating agencies’ view on this but the regulator’s view regarding the liquidity requirements. The FSA has already announced what would happen after the crisis, of course now they cannot do anything because its hands are tied by the recovery process. But we will see new regulation. If for whatever reason an issuer wanted to have extremely short term funding for an asset with 20 or 30 years duration, that's something that probably will be forbidden
I think regulation will change the way we issue. Things will be different to how they were before the crisis.
If the market needs liquidity and you have to issue a €2bn or a €1.5bn transaction, that's going to be tough for certain methodologies given the requirement that issuers have not to concentrate two transactions in the next twelve months. That’s nonsense.
It's going to be tough. We have to take a look at the rating agencies, the regulation, and then the investors, and, as an issuer, decide how to match the three requirements.
Rad: Secondary trading is also very hard. We're expecting opportunistic funding levels, asking for taps for example to get the free flow again. This means that old bonds are automatically becoming illiquid.
Kvist: This could turn into a vicious circle. The agencies could decide the secondary market isn't liquid, proving their perception of refinancing risk is justified. Something else has to give here.
Cuesta: In the worst case scenario, if we don't launch benchmarks transactions, what is the price? Even if you only launch private placements, you always have a comparable issue. But no one will want to be the comparable, so there will be a time when there will be no benchmark. No one will know the price of the private placements.
Skeet: We have the revisions of the CRD coming up and there are one or two technicalities there, like the inclusion of RMBS in the cover pools. We had a derogation (of amount of RMBS units in the cover pool) that was set at having a five year life. This is now up for expiry. As an industry we need to send a clear message to Brussels telling them that some things matter and some things don't. My view is that if the underlying assets happen to be the bank's own assets but in a repackaged format, so what? I don't think we should be hung up by form, we need to be hung up over substance.
There are some clear messages we do need to send to regulators. We should be using the European Covered Bond Council, we should use the newly set up covered bond investor council, which is operating with increasing efficiency and impact, alongside the other mechanisms that already exist across the market, to increase the flow of communications between all market participants and regulators. Therefore we welcome any initiatives on the part of regulators to get a better sense of market views. We are seeing some genuine openness to ideas and better communications channels, the likes of which we never had two or three years ago.