Real Estate Finance: Listen carefully
The interplay between covered bonds and RMBS looks set to become more complex going into Basel II, as the risk weighting applied by various bank investor institutions stands to vary considerably. It seems that the new regime will make it less easy to make money, and much easier to make mistakes. William Thornhill reports.
According to Christoph Anhamm, chief covered bond and ABS strategist at ABN AMRO, the approach adopted by the issuing institution under Basel II is not the main determinant of whether it is more attractive to issue RMBS or covered bonds. He argues that to assess capital requirements and commensurate risk weightings it is the approach taken by investors that will be the ultimate driver.
"It depends on what investors you have and the extent to which they are Basel II sensitive. This is essentially a question of how much is placed with [Basel II sensitive] bank investors versus non-banks," he said. And if the paper is placed with banks, the question then turns to which approach the bank investors intend to take.
In essence there are two approaches: the FIRB or Foundation Internal Ratings Based approach, and the Advanced Internal Ratings Based (AIRB) approach. Under FIRB, the probability of default (PD) is calculated while effective maturity and loss given default (LGD) are given, while under the more flexible AIRB approach, an investor can apply different LGD figures.
According to ABN's Anhamm, around 70% of banks are likely to adopt the FIRB approach.
For investors in super-senior Triple A RMBS, all paper is 7% risk weighted, irrespective of maturity, so if the weighted average life is between one and 10 years, it makes no difference. But for covered bonds it is a completely different story.
"If you go to the FIRB approach for covered bonds, you have to calculate the PD, but effective maturity is given at 2.5 years and the LGD is also given," Anhamm explained.
Under Basel II the local regulator may, however, require the investor to apply the real effective maturity for durations between one and five years; anything longer than five years will be considered equal to five years. Bankers generally assume a 2.5-year duration, but once the AIRB approach is adopted, the effective maturity becomes the valid duration input.
In addition, the Capital Requirement Directive (CRD) – the EU's interpretation of Basel II – specifies a number of covered bond criteria before certain LGD levels can be applied. For example, under the FIRB approach, the LGD would be 11.25% for bonds meeting all the criteria. When combining that with the lowest eligible PD of 0.03% (meaning the issuer is rated Double A or higher) under the FIRB approach, an investor could well reach a risk weighting of just 3.6% for covered bonds. This is well below the 10% that currently prevails under Basel I for covered bonds with a legal backing, let alone the 20% that applies to structured covered bonds.
Under the AIRB approach, an investor can use different LGD figures without taking into account differences between covered bonds and structured covered bonds. Since LGDs are hard to estimate, they could be higher or lower than those applicable under the FIRB approach. Nonetheless, in combination with the more flexible maturity regime it is possible that under AIRB the risk weighting for covered bonds could turn out to be much higher than the 7% level applied to Triple A RMBS.
"The general assumption under the FIRB or AIRB approaches, using an LGD of 11.25% or 12.5%, is that there will be a level playing field between covered bonds and RMBS, but that's not true. If you are an investor in covered bonds issued from a A3/A– rated bank, the risk weighting could be anything from 6% to well over 20%, a level that is sure to impact spreads," said ABN's Anhamm.
"It could well be that for borrowers rated in the Single A or Triple B area it is economically more sensible to issue an RMBS for pure funding purposes," Anhamm concluded, adding that it would only make sense to issue RMBS tranches that were rated above the issuing entity.
Deutsche Bank's chief covered bond analyst, Bernd Volk, agrees that for long-dated covered bonds from A3/A– rated issuers it may very well be that RMBS have a lower risk weighting, what their maturity might be. But he noted that list of Double A institutions typically includes many Spanish issuers that would be beneficiaries under Basel II, as their covered bonds will get a lower risk weighting from investors, compared to Single A rated issuers.
Some argue that both covered bonds and RMBS will remain key funding markets for Spanish issuers, irrespective of Basel II.
According to Jose Antonio Trujillo del Valle, president of Intermoney, a large Spanish securitisation management company: "RMBS is costly in terms of servicing and tranching, but rating agencies are concerned that savings banks are coming close to hitting their cedulas overcollateralisation limits, and this is a more important impetus than Basel II."
Deutsche bank's Volk notes that under the FIRB approach, which many German issuers are expected to apply, there is no difference as to whether the covered bond is backed by commercial loans, public sector debt or residential loans – they are all considered the same. This is despite the fact that public sector loans would normally have a much lower LGD.
The large potential jump in the risk weightings of bonds as a result of Basel II is particularly pertinent in Germany, where a large number of issuers are rated low Single A, or less. However, for these issuers recourse to the RMBS market, where less prohibitive risk weighting might apply, is not an option either.
The recently introduced refinancing register, which is aimed at facilitating an economic assignment of mortgage assets to a different (normally larger) entity, should have helped both securitisation and Pfandbriefe markets. However the law, approved on July 8 2005, is still not working properly. S&P has raised a number of questions that remain unresolved.
Adding to the uncertainty is the outlook for spreads – more specifically the spread between covered bonds and RMBS. As of late April, the five-year spread was around 10bp–15bp. But as the two markets converge from an investor's standpoint, the expectation is that the differential will diminish. The fact that covered bonds are more liquid and need significantly less credit work should afford them a modest discount of perhaps 2bp–3bp to RMBS, but certainly no more than 5bp.
According to BarCap research analysts Maddi Patel, the onset of Basel II is expected to result in a gradual tightening of MBS spreads.
"Triple A spreads look good value versus covered bonds, but because implementation will be gradual and the fall in capital requirement has been known for some time, it is unlikely that there will be an immediate lock-step tightening," she wrote in December 2006 in a report titled "Basel II for Investors in Rated ABS".
"Securitisation exposures at lower ratings will be more expensive for banks to hold; therefore demand is likely to shift up the credit curve, leaving investment in these lower-rated notes to be taken up by hedge funds and insurance companies."
As a result, borrowers will issue Triple A RMBS or covered bonds for funding purposes only. They are likely to transfer risk for capital relief only on the most junior piece while retaining the mezzanine tranches, since these offer neither a funding advantage or capital relief (see chart).
The explanation for the continuing large differential between the two products may well depend on the fact that Basel II has so far been only partially implemented. However, given that many deals carry maturities that exceed the end of the 2009 transition period, most banks should in theory be pricing tighter spreads today.
Moreover, covered bond risk weightings could be significantly higher that the 20% level many had assumed would be the ceiling. As recently as November, Fitch published a report regarding the CRD's view of covered bonds. The report suggested that depending on what PD is used, the risk weighting could go as high as 120%. Although it was based on unrealistic assumptions not seen in the last 40 years, the report acted as a wake-up call to any issuers complacent over the impact that PD levels will have on their risk weightings.
And it seems that experienced European bankers are not yet up to speed either. Many continue to use the PD of covered bonds themselves and not the PD of the issuer. This is a fundamental mistake, as Basel II does not recognise the double default approach that favours covered bonds.
"Even experienced people are lost. You have to check and check again that this is this right. It is subject matter that no one really fully understands," said one experienced banker.
With that in mind, DCM syndicate desks will have to assess the best investor base for each issuer to avoid a significant jump in risk weighting and therefore spreads.
"It will become much more of a challenge to organise a proper roadshow, as marketing an Aa2 rated entity will be completely different from an A3 rated entity in three years' time," said ABN's Anhamm.
Given that the CRD leaves 140-plus different items open for regulators to decide on a regional basis, this new regime will require an army of people to get everything under control. Whether this makes the industry any more flexible is open question, but reading between the lines, it seems that Basel II will make it less easy to make money, and much easier to make mistakes.