Covered bonds’ possible role in stoking house price inflation came under scrutiny at a covered bond investor conference in Frankfurt on Thursday, with panellists expecting further regulatory focus on the asset class. Asset encumbrance and SME concerns were also discussed.

Ulrich Bindseil, ECB

At the event, organised by the ICMA Covered Bond Investor Council and The Covered Bond Report, investors and a representative of the European Banking Authority (EBA) discussed covered bonds’ position in macroprudential regulation, with Nordic and Spanish experiences colouring the debate.

Georg Grodzki, head of pan-European credit research at Legal & General Investment Management, said that overuse of covered bonds can fuel a rise in property prices — citing Ireland and Spain as examples — and said that it is important “to be honest” about this potential impact. Regulatory authorities are entitled to monitor overall leverage in an economy, and, as a funding tool contributing to this, covered bonds would legitimately come under their focus.

“There should not be a ban on lateral thinking” about the big picture implications of use of an asset class that has many strengths and weaknesses, he said.

“If there is a property bubble it won’t be covered bonds’ fault,” added Grodzi, “but covered bonds are not a guarantee that things will remain under control.”

Claus Tofte Nielsen, head of position management allocation strategies at Norges Bank Investment Management, said that investors should be “relaxed” about the possibility of regulators turning to covered bonds in a bid to try to dampen house prices. However, he noted that politics can also influence how regulators go about tackling overheating property markets and said that investors should be mindful of this, as well as the role played by the availability of sources of cheap funding. He gave as an example the introduction of legislation in Denmark that allowed interest-only mortgages, which, he added, some would say turned out to be a mistake.

Other panellists pointed out that covered bonds are only one piece of the puzzle. Christian Moor, policy advisor, securitisation and covered bonds at the European Banking Authority, said that loose underwriting standards and poor risk management are other contributing factors.

Mónica Trastoy, senior credit analyst at Santander Asset Management, noted that several factors were behind the property bubble in Spain, such as a growing population, high employment and high per capita salaries, and that the growth of the cédulas market only came later.

Meanwhile, Morten Bækmand, head of investor relations at Nykredit Realkredit, gave a mixed prognosis on the wider regulatory front. He said that whereas a previous examination of pending regulations had thrown up 10 potential ways for the group to be put out of business, recent encouraging developments suggested that “we can only be killed three or four times”.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB, said that regulation remained uppermost among issues that investors are grappling with based on his conversations with them.Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (vdp), noted that the regulatory scene was developing.

“Some of the big elephants are out of the room,” he said. “Others are coming.”

He cited mention of covered bond harmonisation in a recent EC green paper on long term finance.

Bækmand noted that a “key” decision would be the final outcome over what assets are eligible as top level LCR assets after the EBA has completed its work on this. Bækmand was optimistic about Danish covered bonds’ fate, noting that the industry had a lot of data to back up its case.

Tolckmitt said that a major issue that needs to be tackled is the way in which European-level regulatory initiatives can be contradictory, and he called for greater examination of the interaction of different regulations. In particular, he said that were covered bonds to become subject to haircuts in the event of a bail-in this would “kill” the idea of covered bonds.

Nykredit’s Bækmand agreed with this, citing two examples. He said that CRD IV induces banks to raise more longer term funding, but that Solvency II penalises insurance companies buying long term assets, and that the authorities want liquid markets but are introducing the Financial Transactions Tax, which Bækmand said “will kill liquid markets”.

Indeed, the transaction tax has many market participants worried, and a trader in the conference audience took the opportunity to ask Ulrich Bindseil, director general, market operations, at the European Central Bank and one of the keynote speakers, for the ECB’s views on the proposal.

Bindseil said the transaction tax needed to be thought about very carefully, and that, as currently proposed, it risks undermining liquidity in the bond markets, including in covered bonds.

Nykredit’s Bækmand warned that such muddled banking regulation would “sow the seed for the next piece of trouble”, which he said was likely to be activity being driven into the shadow banking sector.

Investors also had warnings for regulators. Grodzki criticised a trend of political interventionism and regulatory overreach and inconsistency, saying that this undermines investors’ trust, and that regulators and politicians were playing into the hands of old-fashioned securitisation.

“Regulators should rein in their ambitions to fix the world,” he said. “They are not wiser than the markets.”

Encumbrance, SME preoccupations

Another topic on the investor-driven conference agenda was asset encumbrance, and whether covered bonds were being unfairly singled out as a contributor.

Bindseil at the ECB said that covered bonds have not been a driving factor of intensifying asset encumbrance, but that the issue will become more relevant for the market because of a general trend toward collateralised transactions, in part due to regulatory drivers. There needs to be scope for collateralised and unsecured bank liabilities, he said.

For L&G’s Grodzki, senior unsecured investors should be more worried about depositor preference than asset encumbrance via covered bonds when it comes to their spot in the payback queue and recovery prospects. And Moor at the EBA defended the way covered bonds were dealt with in the EBA’s asset encumbrance reporting consultation, saying that the asset class was not singled out and that the proposed data reporting requirement is “quite reasonable”.

It is right that regulators pay attention to asset encumbrance, which has increased over the years, he added, to determine to what extent it is a real problem or not.

When an investor warned of the implications of changes recently put forward to the proposed EU bail-in framework, Moor said that uncertainty about the fate of covered bonds in a bail-in situation should not be exaggerated, questioning how certain investors can really be about how covered bonds would ultimately fare in an insolvency situation under national covered bond laws.

The conference would not have been complete without a discussion of SME backed covered bonds, as controversially spearheaded by Commerzbank via the launch of the first such deal at the end of February, with use of the “covered bond” term being a major concern for several large investors.

Rainer Mastenbroek, head of covered bond funding at Commerzbank, was once again pressed to explain why the issuer introduced the SME backed programme and why it referred to it as a covered bond.

“We chose the covered bond brand because that it is how people referred to it during the preparation and because it has typical covered bond features,” he said. “It was the natural thing to do to call it a covered bond, and I don’t think the name affected the pricing.”

The latter point was an answer to a question posed by Andreas Denger, senior portfolio manager at MEAG, about how much pricing power could be attributed to the deal being called a covered bond, as opposed to a collateralised SME bond, for example.

He welcomed the innovation and SME funding tool, but said that it is missing traditional covered bond assets as collateral and that is one of the reasons he believes it should not be referred to as a covered bond.

Thorsten Jegodtka, portfolio manager at Union Investment, said that the Commerzbank SME bond came under the remit of the ABS team at Union Investment, and criticised the use of the covered bond term in connection with the deal, saying that it amounted to abuse of a good name for the product.

Mastenbroek played down the take-up of covered bonds backed by alternative assets on a bank’s balance sheet. He said that the SME programme made sense for Commerzbank because it corresponded to one of the bank’s core business areas, and that the issuer wanted all of these to have access to covered bond financing.