Sunday, 23 September 2018

Tidying up

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Regulatory changes governing French covered bonds are expected to be introduced over the next few months that will pull the market in line with other major issuing countries in Europe. The specific legal framework will provide better protection for both investors and issuers. Han-nee Tay reports.

In recent years, several European countries – including the UK and the Netherlands – have drawn up specific legal frameworks for their covered bond markets. In the wake of the credit crisis, such a move seemed pertinent, and it was deemed important both to assuage investor worries and to protect issuers in the midst of a squeeze on liquidity.

France, being a key player in Europe, with nearly a quarter of the market share in terms of issuance, is the latest to rethink the boundaries of its existing covered bond market. It is expected to introduce a new law that will better reflect the French mortgage market and also the new post-Lehman reality. Work had been in progress on this front for nearly a year. While a draft law has yet to be circulated in the market, it is widely expected that the French governing bodies will announce changes within the next few months.

“There was a real need to create a covered bond that could compete with the German Pfandbriefe,” said Herve Touraine, finance partner at law firm Freshfields Bruckhaus Deringer, an active participant in the market. “That was the state of play before the financial crisis. During the crisis, the French treasury and the credit associations of various banks created a little group to think about how to improve this market, how to benefit French banks and investors and the refinancing market of residential mortgages in light of the financial crisis. They came up with a new vehicle called the societes de financement de l’habitat.”

Not quite working

The SFH will be an issuing vehicle under the new regulations, designed to tighten the market in France which currently has two types of covered bonds – ones issued under a special vehicle called the societe de credit foncier and ones issued as contractual covered bonds. Covered bonds issued under the SCF are governed by a specific covered bond law. Contractual covered bonds are bilateral agreements governed only by the national bankruptcy law.

The SCF has, to a large extent, been a well-functioning vehicle for the covered bond market. However, there is a major glitch in the law that governs it that makes it incongruous to the way the French mortgage market works: SCF covered bonds (obligations foncieres) can only hold up to 35% of guaranteed residential mortgages as collateral.

This is a problem because the French mortgage market is made up of up to 70% guaranteed loans. In the French mortgage system, the lender acts as a guarantor for the borrower in the event of default for a fee. Even though the threshold for such loans to be used as collateral for obligations foncieres was raised to 35% from just 20% a few years ago, there was still a perceptible gap between the way the mortgage market actually operates and what is allowed under existing covered bond regulations.  

To get around this glitch, the market came up with the contractual covered bond. It has no ceiling on how much the cover pool can comprise of guaranteed home loans, better reflecting the workings of the mortgage market. The problem in this case however, was that as the contractual covered bond was not governed by any specific legal framework, it did not comply with European Union directives on investment schemes within the region (otherwise known as the undertakings for collective investments in transferable securities or UCITS). This meant that UCITS funds were only able to invest up to 5% of their assets in French contractual covered bonds. Were such instruments governed by a specific national law the figure would be 25%.

Once made the official issuing vehicle, the SFH will correct these anomalies in the market. Under the new vehicle, there will be no limit on the amount of guaranteed residential mortgages that can be incorporated into the cover pool. Because it would fall under a specific law, covered bonds issued under SFH will be UCITS-compliant and hence, will attract a wider investor base, market participants said.

“The SFH took the best of the SCF and the contractual covered bond and put it all into a law,” said Freshfields’ Touraine. “It will increase security for the investor, and secondly, it will increase liquidity for the market for the benefit of the sponsors or the banks and thirdly, it will expand the investor base as well. Clearly, these objectives are partly driven by the financial crisis.”

Much ado about nothing?

But market participants also said that while bringing the French market in line with other major issuing jurisdictions is a good thing, they do not expect these well-flagged changes to cause major movements in the market. French covered bonds have always been seen as a high-quality, safe investment.

“The fact that they didn’t have specific laws governing all of the covered bonds coming out of France didn’t seem to worry anybody,” said Tim Skeet, head of covered bonds at Bank of America Merrill Lynch. “It certainly didn’t seem to worry the German investors either. It’s all become a bit more of a hot topic because of the latest attempts by the European Central Bank to get everything labelled. The feeling was that you needed to get everything on the same basis. Therefore they are adjusting the covered bond law to allow definitions of those assets to be included.”

The key elements of the new regulations do reflect characteristics specific to the French market that needed amending. But on a wider level, other elements of the new legislation will also reflect lessons gleaned from the recent financial crisis. One such element to be introduced under the new law is the 180-day liquidity buffer, already included in the German Pfandbriefe. This liquidity buffer – that requires issuers are to hold liquid cash or equivalent assets to cover the next 180 days – will serve as a safety net for both issuers and investors in the event of another credit crunch.

“The crisis has taught us that liquidity, even in high-quality assets, doesn’t come free,” said Florian Hillenbrand, senior covered bond analyst at Unicredit. “A 180-day liquidity buffer will avoid the risk of issuers having to raise liquidity against the cover pool quickly in the event of default. In such a distressed scenario, even high quality assets might not be sold as quickly as originally planned or the haircut will be too drastic.”

Also, to cover for extraordinary circumstances of distress in the market, issuers will be allowed to issue new bonds, repurchase them in the market and then use the bonds as collateral to borrow from the ECB under the new legal framework. Currently, French law requires any issuer that repurchases its own bonds in the market to cancel the paper. The new rule means that should liquidity dry up in the capital markets like it did during the worst days of the recent credit crunch, issuers have another avenue through which to fund themselves, albeit, likely at a premium.

When the new law is passed over the next few months, market participants said they expect eight to 10 existing contractual covered bond programmes to be either modified to fit under the new rules or be phased out. But as covered bonds issued under the SFH can only be collateralised by residential loans, covered bonds issued under the SCF will continue to exist, where the collateral will consist of commercial mortgages or public loans, for example.

“The SCF will survive and the SCF has a legal purpose which is much wider than the contractual covered bond,” said Freshfields’ Touraine. “Contractual covered bonds were in practice composed of residential mortgages because the SCF framework was not flexible enough in some respects. As the SFH will be limited by law to residential loans as well, the SCF has a much wider object because it can take commercial real estate assets and public assets.”

Market talk has it that some French banks have already engineered SFH vehicles in place for when the regulators give them the green light. But in real terms, issuance level is not likely to be affected by the new regulations.

Regardless, the French covered bond market is expected to continue to grow. Since the credit crunch, the market has been on the rise, with issuance this year set to exceed the peak of the market in 2007. At the end of May, the market had already seen 33 issues at a total of US$32.36bn, compared to a total of just US$54.62bn for the whole of 2007, according to data from ThomsonReuters.

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