Moody’s has warned that because issuers are holding growing shares of their own covered bonds – as they increasingly retain issuance to access central bank funding – they could outvote end investors to weaken protections and hurt investors’ interests.

Intesa Sanpaolo

The rating agency noted that Italy’s Intesa Sanpaolo last week increased its share of its own public sector covered bonds by around 30% after exchanging them for new mortgage backed covered bonds, and that this allowed it to introduce amendments relaxing certain contractual obligations that mitigate counterparty and other risks.

“Relaxing covered bond standards is detrimental to other (final) investors or to the European Central Bank (ECB) when an issuer uses the covered bonds as collateral for loans,” said Moody’s in a report today (Wednesday).

“Relaxed standards hurt final investors,” it added. “When issuers retain the majority of outstanding covered bonds, they are able to outvote final investors and can weaken structural credit features.”

According to the rating agency, Intesa’s amendments would delay the posting of additional collateral, mitigating certain risks such as set-off risk, while in other Italian covered bond programmes amendments have been introduced that reduce haircuts applied to collateral in amortisation tests, thereby lowering the required amount of collateral supporting the covered bonds.

“Issuer approval of these adverse amendments is permissible under the covered bonds’ documentation because of the growing percentage of bonds that issuers retain,” said Moody’s. “In this context, standard governance rules in the Italian covered bond market (such as a quorum or the right of vote allocation) are not sufficient to restrict issuers’ ability to implement adverse amendments.”

Issuers are more likely to exercise their ability to do this when liquidity pressures are high, said Moody’s, as they can issue more and thus raise more funding against the same amount of collateral. However, this conflicts with investors’ interests, it added.

According to Moody’s, while the volume of Italian covered bonds outstanding rose by 45% in the year to the first quarter of 2012, it estimates that the amount of retained issuance tripled. Moody’s said that 35%-40% of outstanding Italian covered bonds were retained as of 31 March, ranging from 10%-100% per programme.

The issue is not confined to Italy, Moody’s said, with retention increasing in other countries where ECB funding is key, such as Spain. In Spain, issuers retain 25%-30% of their outstanding covered bonds, according to the rating agency.

“Relaxation of standards and structural mechanisms by the majority holder are permissible under the bond documents, but not under the law,” said Moody’s. “The potential for standards relaxation varies with the use of contractual agreements (as opposed to legal obligations) in the different covered bond markets.”