Preferential regulatory treatment of covered bonds is overdone and RMBS strengths are insufficiently appreciated, potentially “setting ourselves up for a fall”, according to some panellists at an S&P covered bond event for investors last Wednesday (25 January).

During a panel discussion on “Covered bonds vs. RMBS”, Neil Calder, head of the investments credit desk, European Bank for Reconstruction & Development (EBRD), and Rob Ford, partner, portfolio manager, TwentyFour Asset Management, said that they would rather hold a residential mortgage backed securitisation (RMBS) than a covered bond in the event that an issuer finds itself in financial distress or is in default.

Calder said that what he described as recent legislative developments in covered bonds showed an increasing emphasis on “almost RMBS-light” structural enhancements, such as asset coverage tests, eligibility criteria and minimum loan-to-value levels, but suggested that “hard wired” mechanisms in RMBS provide more protection for investors than covered bonds “when things don’t go quite as expected”.

Ford agreed.

“If it was a doomsday scenario, I think I’d definitely prefer to be in the RMBS camp than in the covered bond camp,” he said.

Gareth Davies, head of European ABS and global covered bond research, JP Morgan, suggested that an investor’s preference for one or the other asset class would depend on the circumstances and whether a covered bond is being viewed as a rates or a credit product, with an emphasis on either collateral or regulatory support, for example, differing accordingly and likely to influence an investor’s choices.

However, he contrasted what he said was certainty provided by documentation underpinning RMBS with the situation in covered bonds, where “you can pretty much drive a bus through the legislation”.

He said that in covered bonds “what really happens when something goes wrong” is less clear-cut than would be the case in the asset-backed securitisation market, likening covered bonds to “ABS 2007”, when the possibility of something going wrong was not contemplated.

Regulatory support for covered bonds is leading to the asset class being “overpromoted” to the danger of the European banking system, added Davies. He said that there needs to be a diversity of funding routes available to ensure the European banking system is “as widely funded as possible”.

He said that covered bonds and RMBS should be treated differently and that the dual recourse feature of covered bonds should be recognised, but that the “playing field is so skewed to one over the other that we could be setting ourselves up for a fall”.

EBRD’s Calder said that covered bonds are seen as being safe and simple, but that, from the perspective of a credit investor, it is wrong to perceive them as a rates product.

A sense of familiarity makes them more naturally a liquid product than RMBS, he added, with regulatory support and a growing investor base also contributing towards an overall impression of covered bonds being a more liquid and therefore more attractive asset class.

However, he said that the focus on covered bonds, if taken to an extreme, and the focus on “fighting the last crisis” via deleveraging could lead to the financial system being insufficiently flexible, although better equipped in terms of liquidity.

Ford said that the argument that covered bonds have a structural simplicity is valid and that this arguably should be recognised in their regulatory treatment. However, he said that the support mechanisms in an RMBS also needed to be appreciated.

“I’m not saying that one should balance the other out exactly,” he said, “but the difference is so enormous at the moment that it doesn’t make sense.”

However, not everyone was convinced by the opinions of the panellists. A delegate at the S&P event afterwards told The Covered Bond Report that he was disappointed by what he described as “the whining of the MBS issuers and investors about the unfair treatment by the regulators”.

He said that MBS are less liquid than covered bonds and that MBS issuers have to accept that their investor base has probably halved “when the SIVs [structured investment vehicles] were dying.

“They just failed to ensure a more stable investor base,” he said.

In addition, he said that comments about the weakness of covered bond legislation show a lack of understanding of the product.

“Many covered bonds such as the Dutch, the UK, the Canadian, and many of the French come from the structured side and offer the same legal protection as MBS, plus investors benefit from a claim against the issuer,” he said.

He also said that the panellists did not mention that it is an issuer’s responsibility to ensure that a cover pool is big enough to cover all outstanding covered bonds.

“Hence as long as the issuer is solvent, you don’t care too much about the collateral – something you can’t say about MBS,” he said.