Pfandbriefe/Covered Bonds 2005 - Cover pool scrutiny
The Irish system for asset coverage monitoring is held up as an exemplary model that would seem to offer investors superior protection. William Thornhill outlines the main features and how this compares with other jurisdictions.
Such is the standing of Ireland's asset cover pool monitor that other jurisdictions – notably the German pfandbriefe sector – look set to emulate some of its basic principles.
Dera McLoughlin, auditor at Mazars which is charged with overseeing the Bank of Ireland's collateral pool, explained that "ISRA, the Irish supervisory authority, devolves power to Collateral Asset Monitor (CAM) – which effectively means it assumes more of a regulatory role. This compares to Germany where current monitoring of the asset pool is in the hands of a trustee – a relationship which is much more hands-off and usually undertaken by a retired banker, lawyer or judge."
By comparison with Germany, McLoughlin emphasised that the CAM's duties are far more pro-active and carried out on a week-by-week basis. This "intensive interaction" enables the CAM to act in a very precise way.
Among other factors, the CAM is charged with administering the matching of interest rate risk, duration risk, currency matching, solvency and the eligibility of assets with regard to their prudent market valuation, location and nature. The level of over-collateralisation, which is initially agreed between the borrower and investors, must then be adhered to.
In common with most jurisdictions, the borrower is unable to alter the cover pool in any way unless it has been signed off by the CAM.
Detractors would argue, however, that the role of auditors has been somewhat tarnished in the wake of Enron and Parmalat. Those affairs questioned the willingness of auditors to prevent fraud because the will to raise the alarm may have been diluted by a prospective loss of fee income.
While the Irish system cannot provide a foolproof recourse to this argument, it does ensure a sound degree of candour. The CAM cannot simply be chosen by the borrower but needs to be first approved by the Irish regulator, ISRA.
Furthermore, the Irish law stipulates that the borrowing bank can not let go of its CAM without first gaining the regulator's approval. In this way, the CAM would not be economically bound to protect the borrower as its role would probably be safeguarded, even if it was the messenger of bad news.
Sources familiar with these concerns nevertheless felt there was a potential source of conflict of interest in other jurisdictions where a single firm could potentially act as both the CAM as well as the auditor that signs off year-end accounts. They felt that the role of the CAM would need to be completely independent to that of the year-end auditor. Aside from this, the role of the Irish CAM does not simply stop at the collateral
assets but extends to computer systems-monitoring. "Being able to ring-fence around 24,000 assets involves considerable work, so we audit the Information Technology system first," said Mazars' McLoughlin.
German role beefed up
While the present system in Germany does not stand up well to scrutiny, the role of the collateral monitor – or trustee, as it is locally known – will be significantly beefed up with the introduction of the general pfandbrief law this July.
The draft law suggests a person, not a company, will assume this role. However, it says this person must be qualified and experienced, suggesting a certified auditor. This specialist is appointed by Bafin, the local regulator which also has the power to dismiss the trustee.
The German trustee must check that the securities and derivative claims are in line with regulations giving regard to coverage of the Loan To Value, the Net Present Value of collateral, as well as the ability to trace and audit collateral in the pool. As with Ireland, the trustee must be made aware of – and approve – any changes regarding the flow of money into or out of the pool.
In order to offset concerns about a potential conflict of interest, the trustee and his deputy are both paid not by the borrower but by Bafin itself.
The weight of surveillance is outlined under Articles 27 and 28 of the draft law. These articles deal with risk management and transparency obligations. The trustee is obliged to identify and evaluate all relevant risks regarding interest changes, currency, liquidity, maturity and operational risks. The clustering of certain types of risk, and the setting up of an early warning system, are all dealt with.
Risk management systems should be extensive, understandable and checked annually, and risk reports must be produced on a quarterly basis.
France precursor to Ireland
In France, a precursor to the Irish system has been in place since the introduction of the obligations foncieres law in 1999. The monitoring role is known locally as the Specific Controller. The key responsibility centres on making sure the ratio of assets and over-collateralisation is in line with levels defined by the Bank of France. The eligibility of assets is checked, along with interest rate, currency, liquidity and duration matching risks. The auditor is obliged to report its findings to the board and the central bank.
To avoid a conflict of interest, the Specific Controller cannot be the same as the external auditor – or the same as any auditor in any other part of the banking group.
In Spain there is no dedicated monitor as the borrower's collateral pool is overseen by the Bank of Spain (BOS) at least once a month. If it wishes, it can check at any time on an ad hoc basis. The borrower can only issue to the maximum of the eligible loan pool with the whole mortgage book acting as collateral. Since cedulas holders have a preferential claim on non-eligible assets, the BOS takes account of the entire mortgage portfolio.
The borrower is also obliged to undertake statistical risk provisioning, so if lending grows, then risk provisioning must increase. The rate of provisioning varies from 0% to 100%, depending on the loan rating.
Since 90% of all mortgages are floating-rate, there is very little interest rate risk. There is no currency risk as the mortgage book is all in euros. Furthermore, because of the high degree of over-collateralisation, cashflows are enormous.
Nevertheless, the fact that S&P does not use a de-linked rating approach for Spanish cedulas reflects their concerns that cedulas holders could be exposed to post-insolvency liquidity shortfalls.
UK borrowers differ
The absence of legislation in the UK means there is no obligation for borrowers to employ a collateral pool monitor. But since the UK's FSA is working on drawing up a UCITS compliant framework this could soon change.
In the case of HBOS, the dynamic cover pool is internally monitored. Collateral pool information is transparent, comprehensive and timely, leading DrKW Research to say information compares more favourably with other established jurisdictions.
The structure achieves Triple A ratings partly because of the stringent asset coverage test (ACT). This includes haircuts and risk set-offs, amongst other things. The pool is monitored externally once a year – or more frequently if ratings have fallen.
In contrast, Northern Rock employs a cover pool monitor which conducts annual audits to confirm compliance with the ACT. This is designed to protect bondholders, ensuring the adjusted value of mortgages, cash and substitution assets is greater than or equal to the outstanding principal on the covered bonds.
The indexed valuation that is applied in the ACT is updated on a quarterly basis, and gives credit to 85% of house price increases but takes the full measure of house price decreases. The valuation applied is 75% of the index value. For loans that are three months or more in arrears, 40% is applied where the LTV is less than or equal to 75%, and 25% is applied on those loans where the LTV is over 75%.
In Luxembourg a special auditor is employed to examine the registered cover assets prior to each lettre de gage (LdG) issue, to ensure legally required coverage is met. It must also check that the pool corresponds to the net present value coverage ratio.
Helene Heberlein, senior director at Fitch, explained that "no asset can be removed from the register without the prior approval of the special auditor, which would be granted only if the regulatory coverage ratios continued to be satisfied post-removal."
The borrower is obliged to send data relating to the nominal, interest rate and net present value coverage ratios on a monthly basis. The special auditor does not produce its own independent calculations, but relies on borrowers' systems as approved by its statutory auditor.
Legal framework cannot be relied upon
Fitch's Heberlein pointed out that apart from the role of the cover asset monitor, there were in fact several levels of surveillance. Regarding eligible assets, she pointed out that rating agencies, like auditors, rely on the information provided to them by the issuer.
Heberlein went on to say that, ultimately, issuers are free to make their own decisions within the framework of the law. "Banks are inventive, and there is nothing to stop them altering the asset pool provided they stay within the legal framework."
For example, DexMa follows an especially prudent approach, hedging everything and leaving little exposure – which is well beyond what the law stipulates. Heberlein argued that investors should study issuer guidelines rather than relying on the legal frameworks.