Sweat the assets
SME covered bonds offer an opportunity to cut funding and score political points. ABS will offer competition, but having made the tough journey from concept to test case the cost saving is clear and more deals are set to follow in Commerzbank’s wake as banks sweat their assets.
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Covered bonds backed by loans to small-sized and medium-sized enterprises are the product of two converging post-crisis trends, but in the last few months both of these have started to reverse.
While regulators prefer covered bonds and banks have to use collateralised funding, SME covered bonds are a natural funding solution. Using SME collateral also provides banks with a reputational quick win – helping SMEs to fund has become as politically important as kissing babies.
But regulators are starting to row back on their preference for covered bonds, as the European Commission works on a scheme to guarantee SME ABS, which holds out the prospect of capital relief – something SME covered bonds cannot deliver. Meanwhile, banks are well funded, with ready access to bountiful central bank liquidity.
Using SME loans as collateral to bring down funding costs should certainly help banks that are prevented from lending to SMEs by skinny interest margins. Banks struggle with elevated post-crisis funding costs, while getting paid rock bottom rates on their floating rate assets.
“Without the financial crisis, SME covered bonds wouldn’t exist. With it, they have to exist for the sake of the European economy”
“Without the financial crisis, SME covered bonds wouldn’t exist,” said Richard Kemmish, head of covered bonds at Credit Suisse. “With it, they have to exist for the sake of the European economy.”
They barely do exist – just one €500m deal from Commerzbank has been issued in Europe, complemented by several from Turkish institutions, often supported by multilateral development institutions. But more could be around the corner.
“It’s not going to be a market of 100s of billions, but I’d say there’s maybe 10 or 15 issuers that could benefit from using this tool,” said David Kim, head of FI securitised products EMEA at Barclays.
To see more issuance though, the asset class has to overcome some natural disadvantages. It is a maturity transformation which runs the wrong way – it allows banks to fund short-dated assets with long-dated funding.
SME collateral itself, being lumpy, high risk and exceptionally diverse, gives a poor advance rate compared to mortgages or public sector collateral. Commerzbank gave its SME programme 21% over-collateralisation (11% mandatory). For its public sector sector programme, it only has 2% committed OC.
Arguably, these factors make ABS a better format for banks to work their SME books. It is maturity matched, and banks can mitigate the low advance rates by selling the bottom of the capital structure.
Kemmish says this view ignores a major strength of covered bonds.
“An overlooked aspect of the ABS v covered bonds debate is that covered bonds are much better at handling constantly changing pools. SMEs are always amending terms, size, security and so on, so what you really want is a structure where they can be readily substituted in and out of a collateral pool.”
“An overlooked aspect of the ABS v covered bonds debate is that covered bonds are much better at handling constantly changing pools”
The existence of specific covered bond legislation, now present in every European country and gathering traction worldwide, is a signal to investors that covered bonds will be treated well in an insolvency, restructuring, nationalisation, resolution or any other conceivable scenario that a bank could find itself in. Most covered bond legal regimes presently exclude SME loans.
Existing covered bond issuers are hostile to any attempt to blur the lines of what a covered bond is.
The European Covered Bond Council, responding to an European Commission consultation on funding the real economy, said: “The ECBC … supports the development of this market segment as long as the fundamental differences between the two products – particularly in terms of recovery values between mortgage or public-sector backed covered bonds on the one hand and dual recourse instruments backed by SME loans on the other hand – lead to a clear differentiation between the classical product and these new types of secured bonds.”
The ECB has made a small gesture towards regulatory backing. After initially assessing the Commerzbank SME covered bond as equivalent to a senior unsecured bond, it has now been switched to a covered bond bucket for haircut at the Eurosystem repo window.
Haircuts are lower than for unsecured debt, but are still higher than for Pfandbriefe, and it is lumped in with structured covered bonds issued before covered bond laws came into effect across Europe.
Italy is also said to be working on amendments to its covered bond law to allow SME deals. Italian banks are short on mortgage collateral, but have plentiful SME books and elevated funding costs.
Is it worth the effort? It remains to be seen if issuers will be able to bring their spreads down by collateralising with SME loans.
For Commerzbank’s deal, the saving was about 50bp when it issued in February. Since then, central bankers have squeezed the opportunity further, as spreads down the credit quality spectrum have compressed.
For peripheral banks, there remains room in the middle – enough of a spread gap between mortgage covered bonds and senior unsecured – but the threat comes from ABS. There is little rating benefit in recourse to a weak bank with a weak sovereign, so peripheral banks remain likely to structure non-recourse ABS to repo at the central bank.
Barclays’ Kim (lead arranger on the Commerzbank deal) said: “The market opportunity for SME covered bonds is really limited to issuers in core European countries, such as Germany, the Netherlands, the UK and Scandinavia. The peripheral issuers will go down the ABS route rather than covered bonds.”
“You have to view the opportunity through the cycle,” said Kim. “We’ve seen issuers shift issuance down the capital structure as spreads have come in, but savvy issuers will want to open new funding markets before the exceptional liquidity environment we’re in right now changes.”
While central bankers have been talking peripheral and bank spreads down, shrinking the space for SME covered bonds, they have also been talking ABS up.
Comments from the EC and the ECB have hinted at a more supportive attitude towards securitisation, particularly to support SME lending. The European Investment Bank recently recommended using EU structural funds to guarantee SME securitisations, which it hopes “would help revive the commercial securitisation market, which would open up new non-bank sources of finance for SMEs that currently depend almost entirely on bank financing”.
So far this has not translated into action, but bringing in a large subsidy for securitisation naturally threatens the nascent SME covered bond market. ABS, unlike SME covered bonds, holds out the possibility of capital relief against SME portfolios – though in this case, at the cost of putting public funds at risk.
“With SME funding, there is a capital problem and a funding problem. SME covered bonds are an answer to the funding problem – the answer to the capital problem may be elsewhere,” said Kemmish. “Just transferring risk from private sector to public sector probably isn’t it.”
Judged on language, at least, holders of senior unsecured can expect to get “bailed-in” to recapitalise a failed bank.
That, really, is the covered bond pitch.
Even structured covered bonds, with no legislative backing, and covered with esoteric collateral such as SMEs, will almost certainly be made whole. If for no other reason, there should be more to come.