Friday, 21 September 2018

Pfandbriefe/Covered Bonds 2007: Light at the end of the tunnel

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With the Republic of Italy being one of the few remaining large eurozone countries without a full-scale covered market, the arrival of a new covered bond law has been eagerly awaited. It has also been a very long time in the making. But could the wait now be over for Italy's long-suffering banking industry? Rachelle Horn investigates.

After years of intense lobbying by the Italian banks, Italy's covered bond law finally appears to be nearing fruition. Tommaso Padoa-Schioppa, the Italian finance minister, has reportedly signed the final decree of the secondary law relating to the supervisory capacity of the Bank of Italy.

The statutory order for Italian covered bonds, or Obbligazioni Bancarie Garantite, was authorised back in December 2006 following the amendment of Securitisation Law 130 in May 2005. However, it is the all-important secondary law that has been halting the progress, with the vested interests of the Italian central bank and the private banking industry struggling to find some middle ground.

Until now, the only issuer of covered bonds in Italy has been the Cassa Depositi e Prestiti (CDP), which benefits from a special legal regulation allowing the institution to collateralise public sector assets. As such, the Italian commercial banks have, until now, suffered from a lack of a legal framework for the issuance of covered bonds.

Following a number of false starts, final approval from the Bank of Italy will reportedly be published in the Gazzetta Ufficiale in a matter of weeks. If this transpires to be the case, Italian banks will finally be able take advantage of the low-cost funding already enjoyed by many of their European counterparts.

But it has been no secret that the Bank of Italy, in contrast to most European central banks, has maintained a preference to limit the amount of covered bonds issued. Its secondary legislation reportedly hit its first stumbling block after the draft, when reports emerged that it was looking to impose a limit on issuance set at 5% of an issuer’s balance sheet. On that basis, bankers allege that the larger borrowers would only be able to issue a total of three or four benchmarks per year. “The worry over this is that the quality assets are shifted to the cover pool, thus leaving senior unsecured debtors with fewer assets on the balance sheet,” explains José Sarafana, an analyst at Societe Generale Corporate & Investment Banking.

As such, the Bank of Italy's limiting approach to the covered bond market raises concerns among issuers that setting up a covered bond programme may not be economically viable. Analysts suggest that such restrictiveness would impact the depth and liquidity of the market.

Sarafana emphasises the importance of the Bank of Italy’s secondary framework: "This fixes the possible size of the Italian covered bond market," he explains.

The Bank of Italy's supervisory regulation covers the following areas; the issuing bank requisites in terms of minimum regulatory capital and total capital ratio, covered bond issuance determined as a percentage of the bank’s eligible assets, asset integration constraints and duties of the issuing bank and asset monitor.

Central Bank retreat

The latest market rumours suggest that the minimum total capital ratio in the secondary legislation may have been reduced to 9.5%, instead of the previously discussed 10%.

Should this be the case, Sarafana predicts that Italy’s potential issuance could to rise to just below €170bn, instead of the €99bn estimated under the old restrictions of 2006. “This demonstrates a marked relaxation of conditions by the Bank of Italy,” he comments. However, he points out that the volumes remain significantly lower than current outstanding Spanish and German issuance, which account for more than €200bn and €300bn, respectively.

The limitations for covered issuance are said to have stayed at 25% of eligible assets for thinly capitalised issuers, 60% for intermediaries and with no limitation for issuers with a comfortable capitalisation.

However, Florian Hillenbrand, a covered bond analyst at UniCredit takes the following view. "It is rather obvious that reducing the total capital threshold to 9.5% from 10% and reducing the Tier I threshold from 6% to 5.5% would probably not make much of a difference. In particular when noting that the 10% and 6% combination is just an admission ticket to the covered bond world and allows the issuer to employ 25% of its eligible assets," he says.

So, the obvious question being asked is which bank can be expected to be first to tap the market, the most widely rumoured candidates being Intesa Sanpaolo and UniCredit. And while speculation cannot rely on capital ratios alone, the featured table gives an indication of Italian issuance capacity. (Banca Intesa and Sanpaolo IMI have been treated separately, as no common total capital ratio has been published for the merged entity).

Demetrio Salorio, head of DCM financial origination at SG CIB, highlights the fact that the Italian banking industry is quickly consolidating. As such, "this should create a further need for benchmark funding and covered bonds will represent a very effective tool for their long-term financing," he explains. Salorio predicts that the market could expect six to 12 benchmark transactions per year from Italy.

For those smaller banks left out of the consolidation phase, there is still light at the end of what has been a very long tunnel. The Italian law foresees the possibility of multi-seller issues, a technique that has been undertaken very successfully by the Spanish Cedulas issuers. In fact, the majority of financial institutions in Spain are involved in issuing covered bonds, in many instances thanks to multi-seller pooling vehicles such as the AyT Cedulas Caja programme. This is a stark contrast to the smaller German savings banks, which continue to struggle to access Pfandbrief funding.

Indeed, the Italian law states that the bank originating the collateral assets, the bank issuing the bonds, the bank granting the loan to the SPV and the entity owning the SPV can all be different institutions, giving the Italian banks a flexible framework for structuring their covered bond issues through multi-seller vehicles.

OBGs versus BTPs

Another interesting case point will be where the new Obbligazioni Bancarie Garantite paper will trade compared with Italian government bonds, especially in light of the fact that the covered bonds are anticipated to be awarded top ratings by all three agencies, as opposed to the Republic’s Aa2/A+/AA- rating.

While the new OBGs will initially have to pay a premium over Italian government bonds, some analysts have in the past suggested that they could, at some point, trade flat or even through government on a Libor basis. However, with 10-year BTPs currently trading around 22.5bp over Germany, or 4bp–5bp through Libor, the general consensus remains that a sovereign ceiling is seldom a topic worth raising in an EU country.

This sentiment was echoed by one covered bond trader. "I think OBGs trading through the BTP curve is a long shot, but it's not impossible," he said. "In the short end of the curve Italy is quite skewed and trading quite expensively, but the longer end is up for discussion," he added.

The clear consensus among covered bond professionals is that the outstanding CDPs should be the ceiling. "The current pick-up of the CDPs to the BTPs is just around 10bp-12bp, and this should be the target long-term spread level for the new Italian covered bonds," says UniCredit's Hillenbrand.

The only situations he envisages that could change this picture are a widespread diversification of portfolios into covered bonds, a general significant pick-up of interest in Triple A products, or unexpectedly strong demand from the domestic investor base. Furthermore, CDP has applied for a banking license and intends to start issuing OBGs (the general form of Italian Covered Bonds) instead of using its own statute for issuance. This could result in a reduction of its 20% risk weighting to 10% and should be reflected by a tightening of around 1.5bp–2bp, estimates Hillenbrand.

Most expect that the Italian covered law will match the quality its European counterparts and, as such, it is widely thought that the spreads of the new Italian covered bonds will quickly match those of their European counterparts such as Portugal or Sweden.

Looking at the differential of senior debt across jurisdictions, according to SG's Salorio, Italian banks currently fund at spreads that are very much in line with their European peers of the same rating category.

Italy has the smallest mortgage market in Western Europe, with a mortgage debt of approximately 16% of GDP as of 2005, compared with an EU average of 34%, according to research from ABN AMRO. Bank of Italy figures put the level of outstanding mortgage debt as of June 2006 at €600bn.

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