The Polish covered bond market could witness upgrades, lower funding costs and more issuance when long-awaited changes to the country’s list zastawny legislation — including statutory conditional pass-throughs — are enacted. Alex Whiteman reports.

Impending amendments to Polish covered bond legislation, the first to the framework since it was introduced in 1997, are expected to lead to a growth in issuance, with banks, analysts and commentators all characterising the update as the catalyst for a new era in Poland’s covered bond market.

Speaking at an ICMA CBIC-The Covered Bond Report conference in Frankfurt on 15 May, Oliver Koepke, head of treasury at mBank Hipoteczny, said that covered bonds will be an important and established asset class in Poland within the next five years.

This sentiment is echoed by Matthias Melms, covered bond analyst at NordLB, who says he expects outstanding Polish covered bonds to amount to Eu10bn-Eu20bn within a five to seven year timeframe following implementation of the updates.

Such a figure greatly exceeds outstandings, which Koepke says total around 3bn zloty (Eu724m). By 2019, he expects two to three deals a year from up to five issuers.

“Covered bonds will begin to play a much bigger role in funding mortgages and real estate,” says Koepke. “PKO Bank, the biggest bank in Poland, has the potential to become a huge issuer. They’re intending to do a lot of refinancing through a specially created mortgage-backed covered bond bank.”

PKO Bank is the largest commercial bank in Poland, with more than 100bn zloty of mortgage loans. The creation of a mortgage bank, PKO Bank Hipoteczny, would allow it to become the third covered bond issuer in the country.

Rafal Kozlowski, head of the PKO Bank Hipoteczny project, told The Covered Bond Report that the primary purpose of establishing the mortgage bank was for the issuance of covered bonds to provide the bank with improved ALM and a source of long term financing. He said that once the permit to develop the mortgage bank is received from the Financial Supervision Authority (Komisja Nadzoru Finansowego, or KNF), PKO Bank will begin developing its covered bond programme.

“We will then send this for final approval,” added Kozlowski. “We expect the bank to begin operations in early 2015 with the first covered bonds being issued a few months afterwards.”

Long overdue

A desire to improve access to long term funding has been one of the drivers of the legislative changes, according to NordLB analysts.

“The Polish Ministry of Finance is therefore concerned that long term assets are being funded on a short term basis in the local banking sector and recognises that this poses a threat to the domestic financial sector,” they said. “To increase the appeal of long term funding using covered bonds, a proposal was put forward for an amendment to the existing covered bond legislation, which provides inter alia for changes to insolvency and tax law in addition to changes to covered bond legislation.”

Kathleen Tyson Quah, chief executive at financial infrastructure consultancy Granularity, says that an update to Polish covered bond legislation is overdue, adding that it has come at the right time as the pressures of post-crisis reforms in Poland, Basel III, the Liquidity Coverage Ratio, and EU regulations on mortgage legislation begin to take effect.

“The regulator in Poland has taken the step of implementing an LTV cap of 85%, and restricting foreign exchange mortgage loans to borrowers who receive income in foreign currency,” she says. “Before the reforms up to 80% of the wholesale mortgage market used to be financed in euros or Swiss francs and a lot of the retail market also used these currencies.

“Now the banks are being forced to lend and borrow in zloty, which is a less liquid market, and face higher interest rates for wholesale borrowing.”

Tyson Quah says that while related reforms to financial infrastructure should also be focused on, the changes are on the right track.

“Let’s face it, almost all financial crises start with mortgage lending as mortgage lending is the most extreme challenge of maturity transformation and faces the biggest run risk,” she says. “The Polish authorities are very sensibly trying to rebalance the wholesale market to promote macro financial stability.

“Covered bonds provide the perfect vehicle for this if they get reforms right and the banks and investors come together to build a liquid market.”

Koepke acknowledges that work is required if Poland wants to become a bigger player in the covered bond market, noting that the outdated nature of the country’s covered bond legislation, based on a German framework in 1997, is a hurdle it is necessary to overcome.

The latest draft of the proposed amendments was published by the KNF at the end of March, according to Koepke, with a final draft expected imminently.

“It is now going through a process of being discussed by all concerned,” he says. “Our intention is that it is finalised and through the parliamentary process by the end of the year.”

New standards include CPTs

Under the proposals outlined in the draft legislation, issuers would be required to address overcollateralisation and liquidity issues.

NordLB analysts have noted that there is no statutory overcollateralisation under Polish legislation as it stands nor provisions for liquidity lines. The proposed amendments will require issuers to hold 10% overcollateralisation and liquidity to cover 12 months of interest payments.

Meanwhile, a loan-to-value (LTV) limit will be increased from 60% to 80% — this would bring it into line with the maximum allowed under the Capital Requirements Regulation (CRR), whereas it has hitherto matched that in German Pfandbrief legislation.

The composition of cover pools will not be affected by the proposals, with public sector debt and mortgages originated in Poland remaining the eligible assets for collateral.

But perhaps the key point is the creation in legislation of a conditional pass-through (CPT) structure. So far this has only been used within a legislative covered bond framework by the Netherlands’ NIBC — twice since October 2013 — although the structure is not defined in Dutch law. Germany’s Commerzbank also used a pass-through structure on a benchmark SME covered bond launched in February 2013, although that was wholly outside the country’s Pfandbrief Act.

Melms says that should the Polish legislation being discussed get enacted, it would be one of the most progressive in the covered bond market.

“This draft, which is not yet in itself complete, goes much further than any other legislation I have seen,” he said. “This is down to the implementation of the conditional pass-through structure.”

According to NordLB analysts, the maturity of covered bonds extends by law by one year in the event of an issuer insolvency.

“As we understand it,” they said, “the aim of this soft bullet structure is to avoid possible liquidity squeezes as a result of the issuer becoming insolvent. Two tests at predetermined intervals are envisaged following the issuer’s insolvency.

“Firstly, checks will be carried out every six months to establish whether the collateral in the cover register is sufficient to satisfy investors’ claims.”

If this test is failed, they note, all covered bonds become due and the process of realising security begins.

“However, if the test is passed, a liquidity test will be applied every three months, which will check whether the interest and principal claims under the covered bonds can be serviced on time,” said the analysts. “Should the liquidity test not be passed, the payment structure of the covered bonds will be changed from a bullet to a pass-through structure.

“Payment of the nominal amount of the covered bond will then be extended until the final maturity of an item of collateral in the cover pool. At the same time, pro rata redemption on a six monthly basis is also envisaged.”

Koepke says that the pass-through structure outlined in the proposals will be the mandatory structure for legislative covered bonds.

“The only option available to issuers wanting to use a hard bullet, or any different structure for that matter, would be non-legislative, structured covered bond issuance, but this would not make sense and is not our intention,” he says. “We want to solely use the new legislative structure.

“What we want is some sort of transparency, so investors know that each issuer using the legislation has this structure in place.”

He says that the pass-through structure will increase international investors’ confidence in Polish covered bonds.

Despite Melms’ praise for the progressive nature of the legislation, he says that it does not appear to go into sufficient detail.

“Take, for example, the German Pfandbrief law,” he says. “This indicates, who takes control, what happens, and how it works in the case of issuer insolvency.

“These issues are not covered in detail in the draft Polish legislation.”

Market moves pending

NordLB analysts noted that overall the implementation of the proposed draft legislation will result in higher issuance, with the mandatory overcollateralisation likely to help attract foreign investment.

“There is a strong willingness among all involved to get this right,” says Melms. “And I think that it is certainly going to lead to an increase in issuance that will be visible within the first year of the draft’s implementation.”

However, Tyson Quah says that “legislation does not equal market depth or liquidity” and expects changes to market practice and infrastructure will be necessary to increase issuer and investor interest in covered bonds in Poland.

“I’m a big fan of tap issuance for providing deep liquidity,” she says. “Poland is a small market with a less liquid currency. So a tap issuance structure would allow mortgage lenders to build deep liquidity in larger bond issues and increase investor confidence in the secondary market.

“That’s a market rather than statutory measure, but it is probably critical for a non-euro currency, especially as Poland restricts covered bond issuance to narrow mortgage banks.”

mBank has already tapped the euro market, albeit not in benchmark format but in the private placement market, where it is a regular issuer. It recently issued a Eu20m 15 year private placement, for example.

Koepke hopes that implementation of the proposed legislation should lead to a rating uplift for mBank’s covered bonds (see below for more), which would in turn attract greater interest from international investors. In addition, he believes the bank will eventually be able to issue larger bonds.

“The volumes in the cover pool we have are currently too low for benchmarks, so we have to acquire more loans to increase the size of it or transfer loans from mBank into the mortgage bank,” he says. “So from a volume perspective we are not yet ready to issue benchmarks.

“We are not sure when this will happen. We are willing to do benchmarks in the future, both in euros and zloty, but it will take a while to get the cover pool into the necessary shape.”

Alongside mBank (which was formerly BRE Bank and is part of the Commerzbank group), Pekao Bank Hipoteczny — a UniCredit group member — is an active issuer in the Polish covered bond market. Pekao Bank has sold covered bonds in euros in the private placement market, according to an official at the issuer. One such deal was for Eu15m and on several occasions it has placed Eu4.5m deals with one investor, for example.

Recently, however, the bank has held back from issuing as it awaits the impending changes to legislation, says the official. His rationale for holding back is the rating improvements that the legislative update is expected to lead to.

“A better rating would be beneficial in two ways,” says the official. “We will be able to obtain cheaper funding as a result of the rating indicating a less risky option for investors, and more investors will be interested.”

Higher ratings anticipated

The Pekao Bank official expects the update to the legislation to lead to Pekao Bank covered bonds receiving an upgrade.

Fitch rates Pekao Bank covered bonds at A, with one notch of uplift above the issuer rating of A-, and in April the rating agency placed them on positive outlook. Under changes to its methodology to reflect the EU bail-in framework, Fitch considers Pekao Bank eligible for an extra notch of uplift for its covered bonds above the issuer default rating (IDR).

“The A/Positive rating of Pekao Bank Hipoteczny’s mortgage covered bonds may be upgraded once the Bank Recovery & Resolution Directive (BRRD) is passed by the European Parliament and provided the overcollateralisation that Fitch relies upon in its analysis is commensurate with the breakeven level for the new rating,” it said.

Fitch also rates mBank covered bonds at A, in line with the issuer rating of A.

Fitch assigns a Discontinuity Cap (D-Cap) of zero for covered bonds issued by Pekao Bank and mBank. The D-Cap of zero reflects its view that there is no mandatory liquidity provision in Polish covered bond legislation, combined with what it considers “insufficient marketability of the underlying assets” of the covered bonds. As a result, any downgrade of the issuer ratings would lead to a downgrade of the covered bonds.

Pekao Bank covered bonds’ rating incorporates one notch of uplift for recoveries given default, which the rating agency has assessed would amount to more than 51% on the defaulted bonds, according to Rebecca Holter, senior director at Fitch.

“In mBank’s case, the rating agency only receives limited information on the cover pool assets, precluding a full asset analysis, but tested for recovery prospects based on conservative assumptions,” she says.

In May the rating agency determined that in the case of mBank, publicly committed OC of 10% did not provide sufficient stressed recoveries (of more than 51%) to support a recovery uplift.

Agnieszka Tułodziecka, president of the Polish Mortgage Credit Foundation, says that rating agencies were not too confident of what would happen in the case of issuer insolvency under the existing framework. However, she believes that the amendments, as in the draft, would be sufficient to lead to an upgrade.

“The maximum local currency ratings of Polish covered bonds are AAA for Fitch and Aa3 for Moody’s,” she says. “Given the maximum rating levels available, improving the regulatory environment could raise their rating (in local currency) by six (Fitch) or two (Moody’s) notches.

“This should in turn reduce the cost of loan funding by at least 50bp–60bp.”

Speaking at the covered bond investor conference in May, Holter said that if Polish covered bond legislation is amended to introduce a pass-through structure and there are no other obstacles limiting the ratings, such as a lack of an interest rate reserve, Polish covered bonds ratings could potentially reach a higher uplift from the issuer rating than today.

Tułodziecka adds that she hopes Polish banks will use covered bonds as a funding tool and part of their strategy.

Hopes for the future

“If the legislation does lead to an upgrade,” says the official at Pekao Bank, “we can expect more business and smaller spreads. We also offer a nice pick-up compared to others, notably mBank.”

He adds that the plan will be for Pekao Bank to issue in higher volume and increase the size of the cover pool.

“As to how I will proceed, if I can wait to issue I will,” he says. “But this is dependent on how long the legislator takes to put the legislation through.”

Tułodziecka says that it is to assume that amendments will be greeted positively by investors and the market at large.

“Legal changes and new strategies of banking groups could finally change the share of Polish covered bonds on the market,” she says. “Assuming that the current growth of residential lending will be maintained, 20% of the new mortgage production will be funded with covered bonds, and starting from 2014, three banking groups will issue covered bonds.”

According to Tulodziecka, new issuance of Polish list zastawny could amount to 4bn zloty per year, which she believes could lift the share of covered bonds in residential market funding to an estimated 10% (from around 1%), and greatly improve the perception of the Polish list zastawny — from the point of view of both investors and rating agencies.

“It’s a sense of perception, but investors like higher ratings and if we get these higher ratings more Polish banks may be interested in utilising the asset class as they will draw greater investor interest,” she adds. “I expect greater diversification in bank funding, with covered bonds becoming a more present tool, once the legislation in place.”