EC President José Manuel Barroso

Fitch downgraded as many covered bond programmes in the first half of the year as it did in all of 2010, reflecting the damage the euro-zone debt crisis has caused the asset class. Regulatory developments have also picked up speed, the rating agency noted yesterday (Thursday).

The 33 downgrades were confined to Portuguese, Greek, Spanish, Irish and Cypriot financial institutions or their affiliates, said the rating agency in an EMEA structured finance snapshot report.

“The vast majority resulted from sovereign rating downgrades and/or downgrades of the relevant issuer default ratings,” said Hélène Heberlein, managing director of covered bonds at Fitch. “In fewer cases, the decision was motivated by insufficient overcollateralisation, liquidity and comingling issues.”

And she said that the unfolding sovereign crisis is obstructing access to the capital markets for covered bonds from those countries affected.

However, the doubling in the rate of downgrades did not stop covered bonds from achieving a record breaking year, hitting Eu215bn of new issuance in the first half of 2011, according to the rating agency.

Heberlein highlighted the attractions for issuers and investors that have been driving the supply surge.

“A competitive cost of funding would certainly be the first argument cited by bank treasurers,” she said. “Although covered bond spreads rose substantially since the onset of the global financial crisis, they were on average subject to lower spikes than those witnessed in the senior unsecured debt and securitisation markets.

“On the other hand, investors’ appetite is fuelled by risk aversion and regulatory incentives. Historically, legislative covered bonds have attracted a low capital charge at EU investing banks. Also preferential eligibility criteria as well as haircuts have been applied for central bank repo operations. Additionally, some covered bonds qualify for banks’ future mandatory liquidity coverage ratios, and the debt instrument is widely expected to be exempted from banks resolution regimes.”

She added that the rest of the year could be quieter given that some issuers took advantage of the buoyant first half to meet their funding needs “to a large extent”.

Regulation becomes de rigueur

Fitch highlighted a trend towards covered bonds based upon dedicated legislative frameworks rather than contractual issuance, noting that whereas two-thirds of the programmes it rated were legislative based in 2009, three-quarters are today. Among developments contributing to this was the introduction of obligations de financement de l’habitat in France in March.

The rating agency noted that Canada and New Zealand, where issuance is already established on a contractual basis, have launched consultations regarding introducing legislative frameworks – but that in some of these younger jurisdictions regulators were also looking more closely at the wider impact of covered bond issuance. Fitch pointed out that the Reserve Bank of New Zealand has set a 10% limit on the amount of assets that can be encumbered by covered bond issuance, while Canada’s Department of Finance has proposed a maximum overcollateralisation level of 10%.

But while Heberlein noted further developments in Australia, for example, she was cautious about prospects in the US.

“Disagreement between stakeholders persists on the allocation of overcollateralisation in the event of an issuer default,” she said.

The Federal Deposit Insurance Corporation continues to have objections to an initiative to introduce covered bonds by Republican Congressman Scott Garrett, who nevertheless saw the United States Covered Bond Act of 2011 passed by the House Financial Services Committee in June.