Pfandbriefe/Covered Bonds 2005 - UK covered bonds and the FSA
Earlier this year the FSA held a couple of exploratory meetings, to sound out the banking and mortgage industry on the 4% of asset value soft cap to covered bond issuance, along with a UCITS 22.4 compliant regime and the preferential risk-weighting that it entails. William Thornhill looks at the main points discussed.
Progress on the 4% of asset value ceiling to covered bond issuance appears to be gaining ground. The FSA's 4% ceiling was never intended as a hard limit, though the way in which it was initially reported may have given this impression.
The cap appeared draconian in light of the comparison with Germany where borrowers can issue up to 60% of their capital. Sources close to the regulator explained their reasoning: "UK issuers also rely on retail funding while overseas they are wholesale banks – and therefore the issue of depositor protection is less important. UK issuers are much more like universal banks – they are not specialist and therefore the UK is in a unique position."
Other jurisdictions such as Germany are starting to look at how the impact of covered bond issuance would effect unsecured creditors. The new general pfandbrief law – that extends the issuing remit to universal banks with retail deposit bases – will mean that Bafin, the German regulator, is likely to encounter the same issues as did the FSA.
The UK regulator's initial response was nevertheless justified. "The FSA acted on a prudential basis; whether its 4% or 20% is not really the issue, what matters is whether the level and nature of issuance is detrimental to unsecured creditors. Second, they asked at what level does that analysis start … 4% was decided on but the conclusions could be very different – it depends on the individual bank. Two banks may issue the same level of covered bonds but regulatory treatment would differ depending on how their unsecured creditors are affected."
While the 4% level remains intact, it is a flexible one and will vary from institution to institution. Sources familiar with the FSA proceedings confirmed 4% is "a trigger point for a case-by-case monitoring." It is therefore only intended as a point where a "dialogue" with the borrower is opened up with its line manager at the FSA.
The regulator dialogue is likely to focus on three areas. It was noted that, "They are looking at size of cover pool with respect to; 1) total asset size of the mortgage book, 2) total assets on balance sheet, and 3) growth of total assets and mortgage assets expected … they are essentially looking at how good the assets are that are being taken out compared to how bad the assets are that have been left in.
"Even if you had a situation where someone came up against the 4% level but was expected to grow strongly, then they would take that into account in order to consider whether further issuance would require an additional capital injection."
The issuance limit is also likely to be impacted by the overall size of the mortgage book. "If it is a large book and of a high quality, then that is less of a concern … taking all the good mortgages off into cover pool in a small book would have a much more material impact on its unsecured creditors." Second, asset diversity of banks is important: "They have more comfort with banks that have a broad and diverse asset base."
In the event the regulator becomes concerned about issuance levels, the prudential mechanism would be to ask for additional capital. While some issuers are not prepared to inject capital and therefore treat the 4% level as a hard limit, others are still likely to press ahead.
With regard to the rating agencies, the UK authority says the UK structures are principally designed to maintain the rating. So if the cover pool were to deteriorate there would be a substitution of assets into it in order to maintain the high rating.
"Obviously, that substitution would be more detrimental to the main asset pool, so while the FSA is looking at the same things as the rating agency, they are doing so from the opposite side. In a way, the more comfort that rating agencies have with the cover pool, the more detrimental it would be for the lender's overall asset pool," said sources close to the regulator.
Covered bonds help liquidity
One of the UK banking industry's main arguments for covered bond issuance is that an institution usually goes into receivership not because they have run out of capital, but because they have run out of liquidity. It would appear that in principle the regulatory authority agrees with this observation.
The industry argues that covered bonds enable borrowers to weather credit storms and raise money because of the implicit structure and law in which they are enshrined, effectively helping to offset investors' fears of possible credit contagion.
The ability of some of the troubled German real estate lenders to continue accessing the covered bond market for liquidity is a case in point. Though the German law does not afford the same ratings immunity as either the HBOS structure or the other UK structures, German mortgage banks have found investors with relative ease.
The FSA genuinely believes in the logic of the liquidity argument but this is also twinned with other concerns. Aside from the cherry-picking of assets and its effect on unsecured creditors, it is also focussing on how collateral is managed given it has already been pledged.
"The logic is genuine. It will reduce the probability of default (PD), that’s clear – the issue the FSA has is when a default takes place, the loss-given-default (LGD) for unsecured creditors (including depositors) becomes more pronounced. At a low level of issuance, liquidity is improved – and this is good for the covered bondholder and unsecured creditor as PD falls, but there is little increase in LGD.
However, as a bank increases issuance of covered bonds, the increase in LGD will become more pronounced, and at some stage this will more than outweigh any gains from a reduction in PD," said another source familiar with FSA proceedings.
A possible solution is that collateral could be taken out of the pool and substituted with sovereign debt or cash, even though this might prove an expensive exercise to conduct. However, for this to happen, the UCITS 22.4 definition would need to be broadened.
As issuance rises it is likely that the rate of capital injection would initially be small, but this would become "exponentially more material" with the amount of covered bonds that are issued.
On the other hand, the banking industry argues that there would need a "hellish combination" of heavy covered bond issuance, large levels of over-collateralisation plus a big downturn in the real estate market if a material increase in the LGD were to be registered. The banking industry says much higher levels of issuance – that is, well above 4% – would be required before there is a material impact on the LGD.
The FSA has principally concluded the group level exchange process but dialogue is still continuing from both sides. It will be assessing the appropriateness of an interim regime looking both at the level of issuance that triggers a case-by-case assessment and what factors are included in that assessment.
UCITS in time
With the FSA working in the context of Basle 2 and the CAD3 that comes into force in January 2007, a near-term UCITS compliant regime in the UK may not surface as quickly as some might have hoped. Yet some believe a solution could be reached relatively quickly, despite legal opinion which suggests a covered bonds regime cannot be accommodated within the existing bankruptcy framework.
Legal expert Angela Clist at law firm Allen & Overy said the process "is tied up in terms up of the implementation of Basle 2 and CAD-3. In particular, the terms of Article 22.4 may be changed in the future, and the draft Capital Requirements Directive (July 2004) contains a definition of "Eligible Assets" for covered bonds that needs to be amended to cover existing UK covered bonds.
"Not only is the FSA considering its position with regard to the current directives applying to covered bonds, but it is also considering potential changes to the directives in the context of Basle 2/CAD3."
Industry insiders suggested that because the FSA is obliged to undertake a degree of policy analysis, the debate could become a Treasury issue that might need an Act of Parliament, but Clist responded, saying, "I don't think anybody has concluded that there is a need for primary legislation but I think that the FSA has to consider how they are going to implement a regulatory framework – and this means they are involved in policy analysis as well as a technical analysis."
Regarding the risk-weighting, HVB Research's chief covered bond analyst Bernd Volk noted that preferential treatment "is only for covered bonds meeting the CAD 3 covered bond definition. The UK has no framework and would therefore currently not qualify." Despite that, he felt "UK covered bonds offer excellent investor protection," arguing that they "should be risk-weighted lower than UK senior bonds even without any specific legal framework."