Amendments to Luxembourg’s covered bond law will strengthen the lettres de gage (LdG) framework by clarifying the consequences of insolvency of an issuing bank and enhancing disclosure requirements, according to Standard & Poor’s.

The rating agency yesterday (Wednesday) said that the changes, which were passed by the Luxembourg parliament on 11 June, are credit neutral and hence have no rating impact. But the rating agency noted that they will also expand asset eligibility criteria and create a new type of covered bond in Luxembourg, namely lettres de gage mutuelles.

S&P said that the amendment clarifies how an issuing bank would be split into two entities upon insolvency: an insolvent entity that would enter a moratorium and liquidation process; and a separate entity that would be excluded from this process and hold the assets registered in the cover pool(s), managing them for the benefit of LdG holders and making payments to them.

“Within this separate entity, the updated legislation creates different compartments to isolate the assets registered in each cover pool,” said the rating agency. “It clarifies explicitly that all payments received on cover pool assets belong to the relevant compartment and not to the estate of the insolvent bank.”

S&P also noted that the law states explicitly that the entity managing the cover pool would retain its banking license.

“We understand that this might allow the entity to participate in central bank repo financing operations, although this would be subject to eligibility requirements and operational aspects,” it said.

However, the rating agency said that the amendment does not fully exclude comingling risk and that the degree of such risk will depend on the operational set-up of individual LdG programmes. It nevertheless said that the amendment provides for a clearer framework for assessing operational mitigants in individual transactions.

Previously only assets located in European Economic Area and OECD countries were eligible as collateral for LdGs, but the amendment expands this to include assets originated in any country with a high sovereign rating, according to S&P, up to an amount that is dependent on the sovereign rating. Up to 50% is allowed if the sovereign rating is “first credit quality step” (equivalent to an S&P rating of AA- or higher) or 10% if “second credit quality step” (at least A-). The rating agency noted that only the first rank are allowed in France’s obligations foncières for countries outside the EEA, while in German Pfandbriefe only exposures to the EEA, Switzerland, US, Canada and Japan are allowed.

“In our view, the expansion of the geographic spectrum will give issuers increased flexibility regarding the assets they can use to maintain overcollateralisation over time, and provides a more risk-based assessment framework for the inclusion of assets from new jurisdictions,” said S&P. “In some cases, this amendment could introduce new risks to the cover pool.”

The rating agency noted that its rating of individual assets could be lower than those of the relevant sovereign. It also said that there could be legal risks associated with new countries, for example if the preferred status of LdG holders under Luxembourg law is not recognised by local courts. S&P noted that in Germany this risk is limited by a 10% cap on Pfandbrief exposures to such countries.

The amendment also clarifies the conditions for the inclusion of securitisations, said S&P, which can be included if their rating is credit quality step 1 and if a portion of the underlying assets would themselves be eligible, with this portion having to be 50% if securitisations make up less than 20% of the cover pool and 90% if not.

The amended law now explicitly states that assets can be transferred as a security for a loan, which was previously possible and had been done, said S&P.

The rating agency said the amendments provide for a regulatory disclosure requirement, which it understands aims to enhance the transparency of cover pool information, in particular within the context of the European Covered Bond Council’s Covered Bond Label project.

Regarding the new lettres de gage mutuelles, which would be backed by exposures to credit institutions that are members of a co-operative banking system, S&P said that it understands these exposures could include, for example, German co-operative banks.

“In our rating analysis, we will assess the level of correlation between members of a same institutional support system, as well as any diversification provided by the cover pool assets,” it said.