A basic legislative covered bond framework introduced in Brazil in October needs to be enhanced if the country’s proposed letras imobiliárias garantidas (LIGs) are to achieve greater uplift over issuer ratings, according to Fitch, which cited other challenges facing the instrument.

Legislation to introduce covered bonds, to be called letras Imobiliárias garantidas, was introduced by the Brazilian government via a Provisional Measure on 8 October, Fitch noted in a special report published yesterday (Monday). It said that this is still subject to congressional amendment and approval within 150 days of enactment, which will come in March, and also subject to further legislative action by the National Monetary Council of Brazil’s Ministry of Finance.

“This is imperative to comprehensively address important issues such as segregation of covered assets, minimum asset quality, the availability of liquidity to bridge maturity mismatches between assets and liabilities, cover pool monitoring and administrative roles and responsibilities,” said the rating agency.

Fitch said that the ability for part of the cover pool to be invested in government debt, pass-through amortising structures, and the provision of 12 months’ liquidity protection as common in other jurisdictions could help reduce liquidity risks and permit a larger uplift over a bank’s issuer default rating (IDR).

However, it noted that a minimum 5% overcollateralisation (OC) level result in only a limited uplift and that the legislation does not clarify if contractual OC above this level would be available to covered bondholders. It also noted that the secondary market for mortgage loans in Brazil is very limited and the RMBS market shallow.

“In the absence of a pass-through mechanism or liquidity provision perceived sufficient, Fitch will only rate these bonds above their issuer based on recoveries given default – that is, not based on timely payment,” said the rating agency.

The LIG framework will enable a new source of funding for Brazilian financial institutions, said Fitch. It noted that the retail banks that originate the overwhelming majority of mortgages in Brazil are rated AAA(bra), i.e. triple-A on a local scale, and hence cannot benefit from an uplift on this measure, but that some mid-sized financial institution and mortgage companies could do so.

“Although covered bonds linked to foreign currencies are permitted under the initial legislation, currency mismatches will be an additional key challenge for rating covered bonds above the issuing bank IDR,” added the rating agency.

Fitch said it expects the bulk of issuance to be in local currency and placed in the domestic market, and hence rated on the national scale. It noted that capital gains tax exemptions have been granted to domestic and foreign retail investors and that these are in line with those outlined for RMBS and an unsecured term funding Brazilian instrument, letras de crédito imobiliário (LCIs).

“From a market perspective, it will be challenging for covered bonds to compete with LCIs,” added Fitch. “Banks may issue LCIs of up to the limit of real estate-related assets on their balance sheet, and, while LCIs are not directly secured by these assets, they are covered by the Fundo Garantidor de Crédito (FGC), Brazil’s deposit insurance corporation, up to BRL250,000 per investor.”

Photo: Brazilian finance minster Joaquim Levy; Source: Wilson Dias/Agência Brasil/Wikimedia Commons