The Capital Requirements Directive has for several years limited the use of MBS in cover pools, with 2010 amendments reducing the limit from 20% to 10%, but the limit has been accompanied by a periodically extended waiver for self-originated MBS.

The most recent extension of the waiver, which allows unrestricted use of internal MBS, took place in 2010 and runs until the end of 2013.

However, according to a Council of the EU Presidency CRD IV addendum from 13 February that was seen by The CBR last week, the waiver is intended to be prolonged once again, this time until 2017.

A covered bond banker suggested it is time for the derogation to be made permanent so that other issuers with complex legal covered bond set-ups could start structuring programmes without a 2017 deadline “hanging over them like the sword of Damocles”.

As previously reported by The Covered Bond Report (see article here), some Member States were keen to make the waiver permanent but after some intense debate it was agreed to prolong the waiver, but made subject to further review.

According to a progress report from the Cyprus EU Council Presidency published on Thursday, provisional agreement has been reached by the Presidency, the European Commission and the European Parliament on several elements of the legislative package.

“Significant progress has been made since the last Presidency report to ECOFIN of 13 November 2012 on the CRD4/CRR legislative package given the constructive approach adopted by all parties to the inter-institutional political negotiations,” said the report.

According to Wolfgang Kälberer, head of EU affairs at the Association of German Pfandbrief Banks (vdp), there were two main areas of concern at the Member State level with respect to the treatment of covered bonds, namely the eligibility of MBS as cover pool assets and transparency requirements – although he noted that the discussions about these matters were constructive and ultimately more of a technical nature.

“The main challenge to covered bonds under CRD IV was the delinkage of the issuer and the covered bond ratings, and that was resolved last year,” he said. “The more recent discussions were add-ons with less systemic relevance.”

The Capital Requirements Directive has for some time included a waiver regarding a limit on the inclusion of senior tranches of self-originated securitisations in cover pools, with this waiver having been periodically extended.

Some EU member states were keen for the waiver to be made permanent, according to Kälberer, but after some intense debate it was decided that the waiver will be prolonged, but made subject to further review.

CRD IV will for the first time introduce transparency requirements for covered bonds, but these will not be on a loan-level basis as is the case for securitisation, as some had pushed for.

“It was recognised that copying ABS requirements over to covered bonds would not be best practice because the products are very different,” said Kälberer, “so the Member States agreed a compromise.”

The study, “Are Covered Bonds a Substitute for Mortgage-Backed Securities?”, was written by Santiago Carbó-Valverde and Francisco Rodríguez-Fernández, of the University of Granada, and by Richard Rosen, at the Federal Reserve Bank of Chicago, and published last month.

The authors identify as their premise the suggestion that covered bonds, because they are similar to MBS in allowing banks to finance mortgages using duration-matched bonds, could be a good substitute for MBS.

However, they found no evidence that covered bonds and MBS were being used for similar reasons before the financial crisis, and said that the different reasons for using one or the other are related to differences between the types of debt.

“Both types of SMS [secondary mortgage securities] seem to increase profit, although only weakly in the case of MBS,” they said. “But, our results are consistent with liquidity improvement being a primary benefit of covered bond issuance, but not of MBS issuance.

“There is some indication, albeit indirect, that banks used MBS when they were attempting to reduce risk. Finally, agency problems may have pushed banks to issue MBS as there is evidence of herd behavior in their issue. The same is not true for covered bonds.”

The authors believe that their results strongly suggest that liquidity increases when covered bonds are issued, but not when MBS are issued, but note that while structural differences between MBS and covered bonds are consistent with results showing greater use of MBS for risk management, it is more difficult to come up with a reason why covered bonds but not MBS are useful for liquidity.

“Issuing a SMS can add to liquidity by bringing forward future revenues or by financing mortgages with long term bonds (those backing the mortgage pool) rather than with deposits,” they said. “Both of these are available whether the SMS is covered bonds or MBS.”

However, they said that while covered bond issuance is associated with liquidity increases banks that issue MBS are reducing risk and may be taking advantage of agency problems. This reflects a key difference in the structures of the two types of debt, namely that MBS offer an opportunity to transfer risk that covered bonds do not. The authors note that the transfer of risk from banks to bondholders is more complete with MBS than with covered bonds.

“This ability to shed risk also makes moral hazard problems more severe,” they added. “A bank that ‘fools’ investors by putting mortgages that are riskier than the market thinks into a covered bond pool gets little benefit from this because if the mortgage holders default, the bank must replace the defaulted mortgages with new ones.

“However, once mortgages go into the SPE [special purpose entity] backing MBS, all risk is borne by bondholders.”

The authors also noted that agency problems may have pushed banks to issue MBS as there is evidence of herd behaviour.

“Faster growth in MBS issuance in a country was positively associated future more MBS issuance by banks in that country but faster covered bond growth in a country had no significant impact on future covered bond issuance in that country,” they said.

They said that banks may have decided to securitise loans because securitisation markets were “hot”, which may mean that bankers can take advantage of bond buyers (or the principals of the buyers) by issuing bonds at interest rates below their steady state (or fair) value, perhaps because bond purchasers are not paying close attention to markets.

The authors also examined whether banks that issued MBS or covered bonds were more vulnerable during the financial crisis, and found that, even after controlling for size, issuing MBS during the final years before the crisis (2006-2007) made a bank more likely to have been bailed out during the crisis. They said this does not hold true for banks that had issued covered bonds during those years, which suggests that banks involved in MBS were among those that took excessive risk.

Securitisation proponents have argued that there has been an overreaction against the technique because of problems in the US that are not necessarily relevant to the asset class in general. The paper’s authors noted that in four of the six countries in their sample there was at least one, and that while there was only one in Germany, the technique was not rare in Italy, Spain and the UK. They nevertheless acknowledge that securitisation was most prevalent in the US.

Wellink, president of De Nederlandsche Bank, made the comments while discussing the impact of Basel III on the financial markets at an ING conference in Amsterdam.

“The LCR [Liquidity Coverage Ratio] will change the relative preferences for banks to hold certain asset classes,” he said. “It will make assets that are considered as liquid under the new regulation more popular, and assets that are not considered as liquid assets less so.

“This can shift demand to sovereign bonds, covered bonds and high quality corporate bonds and away from less liquid assets, such as other bank bonds, securitised assets and lower quality corporate bonds. All this can have implications for credit spreads and investors’ returns on particular market segments.”

Wellink said that the prospects for term funding could improve if the liquidity of long term paper improves relative to short term paper.

“This could be stimulated by transparent, collateralised and straightforward asset structures,” he said. “For these reasons covered bonds have become popular recently, although we are not sure on the precise impact on unsecured investors. In the first quarter Eu100bn of covered bonds was issued in Europe and observers expect this asset class to grow further.

“The recognition as liquid assets in the LCR supports the issuance of covered bonds.”

He then raised the prospect of MBS in the future being included in the LCR.

“As you probably know, MBS securities are not recognised in the LCR buffer,” said Wellink. “Increased transparency and market liquidity, for instance through market quotation, would increase the likelihood that MBS securities would be recognised as liquid assets.”

The shortfalls in liquid assets that some countries are facing were also addressed, with Wellink highlighting how “tailor-made” solutions were allowed by the new liquidity regulation.

“For instance, the Reserve Bank of Australia has established a liquidity facility to help local banks meet the LCR requirement,” he said, “while Denmark intends to give special treatment to covered bonds; the possibilities to do so will be fleshed out over the observation period.”

Wellink also discussed how the Net Stable Funding Ratio will under Basel III affect supply of, as well as demand for, covered bonds.

“To limit funding costs, banks will pursue different strategies in their liquidity management. They will try to raise more retail deposits,” he said. “However, the supply of retail savings is limited, in particular in the Netherlands where banks have to compete with insurance companies and pension funds.

“Alternatively, banks could issue more secured funding, for instance covered bonds, or issue more long-term unsecured bonds.”