Upcoming Brazilian covered bond legislation could create an important funding alternative for Brazil’s mortgage market, according to Fitch, but the rating agency on Friday also identified questions it said must be addressed regarding the ultimate quality of the new instruments.

Fitch noted that the legislation – which was announced by the Brazilian minister of finance on 20 August – is part of the government’s efforts to expand mortgage lending, which, at 9% of GDP, is small compared with developed markets, according to the rating agency.

“Strong covered bond legislation, in tandem with Brazil’s existing RMBS framework could support viable alternative funding sources,” it said.

Fitch said that it will be looking for Brazilian covered bonds to offer stronger investor protection than Chile’s recently-introduced legislation.

“While the Chilean legislation shares some basic similarities with other covered bond frameworks,” the rating agency said, “it has certain weaknesses, notably regarding investors access to the cover pools in a default situation of the issuing bank.”

Fitch noted that Brazilian legislation has traditionally subordinated collateral guarantees in favour of bondholders to labour creditor claims in the event of liquidation, and that this has the potential to undermine covered bondholders’ key priority claim against the underlying collateral. The rating agency noted that eligibility criteria for loans are not yet known, for example any maximum loan-to-value ratio level.

“The ability to rate the bonds above the issuer default rating will depend, among other factors, on the strength of the security and the quality of loans in the cover pool,” said Fitch.

“In addition, clear rules and responsibilities for third parties to effectively manage the collateral in a liquidation event will be crucial,” added the rating agency. “Major RMBS trustees and servicers and institutions acting as custodians in Brazil’s ABS market could ultimately play this role.”

Photo: Guido Mantega, Brazilian finance minister