Last week’s move follows the publication of a draft law on 25 June, which was followed by a consultation period.

Although a reduction from the high overcollateralisation (OC) levels seen in cédulas thus far had been seen as inevitable, a zero percent OC requirement for cédulas hipotecarias proposed in the draft had met with concern among market participants, even if other changes were seen as strengthening Spain’s framework.

A 5% minimum OC level is now included for cédulas. Although this is weaker than the current 25% for mortgage covered bonds and 43% for public sector and export finance covered bonds, the change from zero to 5% in the law is positive, according to José de Leon, senior vice president and manager in Moody’s covered bond group.

“Previously, there was a provision that further OC could be added through new laws, or contractually agreed to by the issuer,” he told The CBR. “Now, the legislator has made a cross-reference to CRR to impose a minimum statutory level in relation to mortgage, public sector and export finance cédulas.

“The law retains the possibility for issuers to commit to higher levels,” he added.

A 5% OC level is necessary for covered bonds to achieve the European Covered Bond (Premium) designation under the directive, although this can be achieved either through legislation or on a contractual basis.

De Leon noted that the 5% minimum OC in the new Spanish law does not apply to the country’s three types of static-pool secured bonds (bonos).

The new text also introduces a provision for liquidation in the event of an asset shortfall, something which had been absent from the previous draft. However, Moody’s said that the wording of the planned asset coverage test in the law – with assets having to be higher than OC, including “voluntary” and contractual OC, and the liquidity buffer – means there is a risk it will always be failed, given that all OC is arguably voluntary.

“This would effectively leave Spanish covered bonds with high acceleration risk compared to elsewhere,” said Jane Soldera, senior vice president at Moody’s. “As these provisions are very technical, we expect the market will hope for clearer confirmation of the legislative intention.”

Issuers will be required to update property valuations for mortgage loans at least annually, in line with EU requirement, and the new text builds on the draft by requiring that the valuation-driven part of LTVs be floored at the level it was upon entering the pool. Soldera said the flooring requirement is credit positive.

With Spain’s covered bond market experiencing the biggest upheaval in aligning with the EU directive, banking industry representatives had expressed concerns about hitting the 8 July 2022 implementation deadline.

The law has, however, been presented as a Royal Decree Law, an accelerated legislative process in Spain that could see it coming into force after 30 days, albeit subject to amendments and a potentially longer passage.

“This is likely due to the urgency to comply with the deadlines,” said de Leon, “and to give time for Spanish banks to start carrying out the changes necessary to comply with the law.”

The Royal Law Decree, in Spanish, is available here.

In a report published today, Fitch said covered bond market participants may be overlooking the role of OC in providing dependable protection for investors and suggested there may be too much reliance on issuers maintaining collateral levels in harder times to ensure their covered bonds remain low risk.

“We see evidence of this in the very low levels of OC that Moody’s deems to be compatible with its highest covered bond ratings and which reflect issuer default risk rather than credit and market risk,” said the rating agency.

Hélène Heberlein, managing director at Fitch, told The CBR that the rating agency felt the differences in the two approaches deserved explanation.

“We know that, in meetings between issuers and investors, some market participants ask why the same programme has, for example, next to 0% OC for Moody’s Aaa and 10% for Fitch AAA.” she said. “We felt it was up to us to explain the difference and where it comes from.”

Heberlein noted that the rating agencies in their analyses assess the same risks and that often Moody’s judgement of the risks which arise when recourse against the cover pool is enforced is more severe than that of Fitch.

“But because it is weighted by the probability of the issuer defaulting, the calculation leads to a low level of OC in Moody’s approach if that probability is low,” she said. “For Fitch, the breakeven OC for a given covered bonds rating is much less dependent on the issuer rating and doesn’t rely as much on issuers to top up OC over time.

“We think this is a less cyclical approach.”

Moody’s was unable to comment by The CBR’s deadline.

According to Fitch, across the 51 mortgage covered bond programmes rated triple-A by both Moody’s and Fitch as of the end of the first quarter of 2017, on average the amount of total cover pool losses factored into Moody’s analysis (17.9% of the cover pools) exceeded the Fitch AAA breakeven OC (14.7% of the covered bonds). However, Moody’s determines substantially lower OC to be consistent with its Aaa ratings, with an average of just 5% for the same sample.

On average over the sample, Fitch said that the OC considered commensurate with a Moody’s Aaa rating only covers about a quarter of the OC that would offset Moody’s estimated total cover pool losses. For almost 30% of Moody’s Aaa rated covered bonds programmes, 0% OC was declared consistent with the rating, while Fitch notes that only the covered bonds guaranteed by AAA rated entities have a 0% AAA breakeven OC under its approach.

In a summary of its fellow rating agency’s methodology, Fitch says that Moody’s OC requirements for a given rating are derived from the weighting of anticipated total cover pool losses by the probability that an issuer ceases to pay, calculated for each month and discounted to their present value. The probability of default is small for a highly rated issuer, and OC is expected to increase as the issuer’s credit quality deteriorates.

In contrast, Fitch’s OC requirements are largely independent of the issuer rating, it said. When the covered bond rating is significantly above the issuer rating – in practice, more than four notches – Fitch assumes that the issuer has a 100% probability of default when setting the breakeven OC requirement, which, it says, addresses the risk of an issuer “jump-to-default” risk.

Fitch added that while the vast majority of programmes currently have large OC buffers, there is no certainty that these buffers will be maintained over the life of the bonds in the absence of an issuer commitment.

“We believe this is the appropriate stance because, despite their best intentions, issuers may be unable to post more OC when facing financial stress,” it said. “Available collateral may increasingly be pledged for other purposes and institutions with already high encumbrance levels may be forced to raise other debt to finance additional OC when funding costs are rising.

“In short, we think that overreliance on issuer creditworthiness creates the risk that OC is not topped up before it is too late.”

An increased likelihood of undercollateralisation in programmes could affect the regulatory treatment of covered bonds in the event of a bank resolution, Fitch warns. Lower OC protection also leaves programmes more exposed to the impact of rising interest costs and property market corrections, it said.

While some jurisdictions feature legal and regulatory provisions that mitigate such risks, Fitch added that regulatory OC minimums, which range between 0% and 10% depending on the jurisdiction, with the exception of Spain, are not necessarily designed to sustain extreme stresses associated with high rating scenarios.

“We believe vigilance regarding OC is merited to avoid complacency that could ultimately weaken investor protection,” said Fitch.

Market participants were surprised at Fitch’s questioning of Moody’s approach, saying it is rare for one rating agency to criticise another’s approach directly and in public.

“It’s a bit unusual in my experience to see one agency calling out another by name on their approach,” said a banker.

Jörg Homey, covered bond analyst at DZ Bank, said the contrasting approaches represent the key difference between the rating agencies – that Fitch and S&P are more cashflow driven in their OC analysis, while Moody’s puts a stronger emphasis on the creditworthiness of the issuer.

“You could argue that Moody’s approach is super-linked to the issuer’s creditworthiness,” he said, “But from a historical perspective, 10 or 15 years ago Moody’s used a notching approach, so if you look from a continuity perspective they have simply stuck to their convictions.

“It is a matter of perspective – do you perceive a covered bond more from a structured finance perspective, in which case you can emphasize the cashflow aspect, or do you perceive it as a secured bank bond, in which case it is fair in my perspective to link it more strongly to the issuer’s creditworthiness. There are good arguments for both.”

While publishing its latest quarterly covered bonds surveillance snapshot yesterday (Thursday), Fitch said OC available in the vast majority of covered bond programmes it rates “generously exceeds” the rating agency’s breakeven OC for the programmes’ given ratings and are also well above regulatory minimums required by respective legislative frameworks.

“In general, issuers maintain safe OC buffers to facilitate management of their assets and liabilities, for instance registering extra assets in their cover pool in anticipation of future issuance,” said the rating agency. “In Fitch’s view, this reflects market discipline behind an already highly regulated instrument.”

According to Fitch, weighted-average nominal OC for Fitch-rated programmes ranged between 20% and 60% in most markets.

It noted these levels are much higher in Spain – where cédulas are backed by the issuer’s entire mortgage book – and Singapore and South Korea – where issuers are building up collateral for future issuance.

“At the other extreme are the Canadian and Australian programmes, whose capacity to distribute voluntary OC to covered bondholders is limited by regulation,” added the rating agency.

However, Jörg Homey, covered bond analyst at DZ Bank, questioned whether current OC levels are a useful indicator of how issuers would act in harder times.

“It was proven in the crisis that when push comes to shove, issuers will do what is legally permitted,” he told The CBR. “Rating agencies look at actual OC at a certain point in time, and of course that can be helpful, but I think it is more informative to look at the legal minimum requirements.

“I would even expect that if times of crisis would return, issuers would do whatever they could to drive OC requirements down with structural enhancements, like switching to conditional pass-through structures, for example.”

In December, the Basel Committee published amended risk weights for covered bonds, effective from 2022, which rule that covered bonds must meet a minimum 10% nominal OC requirement to be eligible for 10% risk weight treatment, among other requirements.

Fitch noted that of the 108 covered bond programmes it rates, only 15 had available OC of or below 10%, as of 1 January. All European programmes exhibited OC above 5%, the minimum level put forward by the European Banking Authority (EBA) in proposals expected to inform the European Commission’s awaited Directive to create a harmonised EU covered bond product.

In its year-end survey, Fitch found that 42% of respondents believe regulatory OC is sufficient to cover all credit risk.

“This is contrary to our view that mandatory minimum OC set by most legislative frameworks is too low to sustain large stresses, including cover pool losses and maturity mismatches, as well as interest rate and currency mismatches,” said the rating agency.

DZ’s Homey is sceptical of the effectiveness of a “one size fits all” OC requirement.

“We have in different countries different credit profiles, so to set a regulatory OC requirement that fits the credit profile you would have to analyse country by country, and even issuer by issuer,” he said. “It is a moving target anyway, because there are credit cycles and at one time 5% might be appropriate and at another time not.

“It is not a bad thing to implement, but it is not a silver bullet.”

As part of a 2017 update to the Canadian Registered Covered Bond Programs Guide in June, Canada Mortgage & Housing Corporation (CMHC) introduced the new regulatory minimum OC requirement of 103%.

Previously, the Canadian framework – which is administered by CMHC – required issuers to establish contractual minimum and maximum OC levels, or a ratio of covered bond collateral to covered bonds outstanding by adopting a minimum and maximum value for an asset percentage.

“We think that this legal enhancement is aligned with global best practices, and also facilitates better comparability between issuers’ programmes,” said Lily Shum, covered bond specialist at CMHC (pictured), speaking at a European Covered Bond Council (ECBC) plenary in Barcelona on Wednesday, where EU harmonisation and transparency were key items on the agenda.

In advice to issuers, CMHC said the nominal 103% regulatory OC minimum is aligned with the OC requirements of certain other covered bond jurisdictions and, it said, “supports the prospect for achieving common global standards, should a harmonised covered bond framework develop”.

The new requirement will take effect on 1 January 2018, although CMHC noted that the current level of OC in all Canadian registered covered bond programmes meets or exceeds the minimum level. Issuers will be required to disclose the level of OC in their cover pools monthly.

Shum noted that four of the seven established Canadian covered bond issuers had joined the Covered Bond Label this year.

“We think that the Label complements our framework, which has focussed a lot on transparency and disclosure,” she added.

The next ECBC plenary will be held in Vancouver on 18 April and Wojciech Zielonka, CFO and senior vice president, capital markets, CMHC, noted the plenary will be the first to be held outside Europe.

“So it is very meaningful, in that it is an indication of the success of the work that Luca [Bertalot, EMF-ECBC secretary general] and the ECBC secretariat have done in terms of making this a truly global product,” he said.

Describing Canada as a bridge between Asia, North America and Europe, Zielonka said the next plenary will be a great opportunity for issuers and investors to see “a different side” of the covered bond market.

“We look forward to seeing everyone in Vancouver.”

In a study published on Tuesday, Fitch found that such an OC level would not cover expected losses in cover pools in a ‘B’ rating scenario for 10 of the 98 programmes analysed, with the ‘B’ rating scenario representing a mild stress (and not that which is the expected case scenario for the rating agency). A ‘B’ portfolio loss rate (PLR) of more than 4.76% would reduce a programme’s collateralisation from 105% to 100%, whereas the ‘B’ PLR for the 10 programmes range from 6.8% to 14.3%.

“The high PLRs for programmes in Cyprus, Greece and Spain reflect both the impact of the sovereign debt and financial crises on those peripheral Eurozone economies and the cover pool composition,” said Fitch. “Notably, Spanish cédulas hipotecarias are secured against an issuer’s entire mortgage book, including riskier SME loans and loans to real-estate developers.”

2017 Average ‘B’ PLR – by Country and Programme Type

MO: Mortgage, PS: Public Sector; Source: Fitch

DBRS yesterday (Monday) echoed this, saying that in many cases a 5% nominal OC is unlikely to generate a sizeable uplift from the rating of an issuer.

“It could create a false sense of comparability across jurisdictions and programmes, as the same nominal OC level does not translate into the same protection for investors,” it added. “National regulators should maintain strict control over the general quality of the cover pool and covered bonds and, if necessary, set higher OC minimum level on a case-by-case basis.”

The rating agency noted that a minimum OC recommendation also features in an ICF study for the Commission, while a 2% minimum OC is included in EMIR eligibility criteria.

DBRS also, on Thursday, queried the EBA’s advice relating to maturity extensions, again arguing against a one-size-fits-all approach, saying the recommendations could cause more problems than they are intended to solve.

In its December report, the EBA proposed that in order for soft bullet and conditional pass-through (CPT) covered bonds to qualify as covered bonds eligible for preferential regulatory treatment any decision to extend the maturity of a soft bullet or conditional pass-through (CPT) structure should not be at the absolute discretion of the issuer. It recommended that a maturity extension can only be effected upon two triggers that must occur cumulatively: (i) that the covered bond issuer has defaulted; and (ii) that the covered bond breaches pre-defined criteria/a test indicating a likely failure of the covered bond to be repaid at the scheduled maturity date.

The question of the extent to which the EBA’s draft proposals adequately dealt with different types and models of issuers was already raised at a public hearing before the recommendations were delivered to the Commission.

According to DBRS, the final version remains at odds with some existing business models, notably Denmark, where in 2014 regulation was passed to allow for the extension of covered bonds when they cannot be refinanced at a reasonable rate or in the case of a refinancing auction failure. The rating agency said that the EBA may have left room for a carve-out of such a procedure, but if not, enactment of the regulator’s recommendations could push Denmark down a “perilous path”.

European authorities have hitherto proven willing to make allowances for Denmark’s unique model, most recently regarding an MBS waiver.

DBRS also noted that not all current covered bond maturity extensions have the default of the issuer as a necessary trigger.

It said that overall, the EBA’s recommendations: discount the value of oversight provided by national regulators, assume a level of harmonisation of national bank liquidation processes yet to be implemented; and appear to be more focused on the risk of extension borne by investors than on mitigation of credit risk caused by cover pool/covered bond maturity mismatches.

In a sector comment published on Monday, Moody’s noted that German covered bond issuers are required under the Pfandbrief Act to maintain a minimum 2% overcollateralisation (OC) level in present value terms under pre-determined stressed interest rate scenarios, which may include scenarios where interest rates are 2.5 percentage points higher and lower than actual interest rates, in order to protect investors against changes in interest rates that reduce the present value of cover assets.

However, the stressed interest rate that is used to calculate the stressed present value cannot be less than 0% – a floor set by the Pfandbrief Act.

“In the current low interest rate environment, actual interest rates are close to 0% or even below 0%,” said Moody’s analysts. “Therefore, there is little difference between actual interest rates and the 0% rate that is used to determine the stressed present value OC requirement in a scenario of declining interest rates.

“As such, the protection offered to investors by the stressed present value OC requirement in scenarios where interest rates decline is limited.”

The rating agency said that commercial mortgage-backed Pfandbrief with high proportions of floating rate assets are the most affected, noting that German Pfandbrief programmes have on average more floating rate assets than floating rate liabilities and that interest rate risk is either not hedged or not fully hedged.

“Therefore, for the calculation of the stressed present value OC, scenarios involving a decline in interest rates determine the amount of assets needed to meet the 2% statutory OC requirement for most Pfandbrief programmes,” said the rating agency.

“While the proportion of fixed rate Pfandbriefe is high and similar across most issuers, the proportion of fixed rate assets is lowest for programmes with a majority of commercial mortgage loans in the cover pool. Therefore, the protection provided by the stressed present value OC requirement is lowest for such programmes in the current low interest rate environment.”

Moody’s covered bond ratings are not affected because it determines the level of OC consistent with the current covered bond rating on either an unstressed present value or on a nominal value basis.

Norway has been moving towards introducing a 2% minimum overcollateralisation (OC) level since criteria laid down by the European Securities & Markets Authority (ESMA) required a “legal” collateralisation level of 102% in October 2014, with the standard needing to be enshrined in legislation or regulation and not contractually-based. Sweden’s FSA introduced such a regulation last year.

Some market participants have over time complained about both a lack of clarity in the nature of OC requirements and a lack of consistency across different pieces of EU legislation. When LCR rules were announced in October 2014, it was not immediately clear how OC criteria were to be interpreted.

Norway’s move now comes as the European Banking Authority (EBA) has proposed a higher OC requirement, 5%, for covered bonds to be eligible for preferential risk weight treatment under the Capital Requirement Regulation (CRR), but one that does not have to be enshrined in legislation. In its recommendations to the European Commission, published in December, the regulator said:

“The EBA considers that, while all covered bonds should comply with the general coverage requirement, only those complying with the minimum effective level of overcollateralisation should be eligible for preferential risk weight treatment (irrespective of whether or not the overcollateralisation requirement is anchored in the national legal/regulatory framework).” (The CBR emphasis.)

An EBA official has said that a Directive based on recommendations in “Step I” of its recommendations should form “a sort of single point of entry” for prudential regulations. However, the EBA’s minimum OC requirement would not be included in such a Directive, being part of “Step II” recommendations that are only necessary for CRR treatment.

Moody’s meanwhile today (Monday) described the Norwegian government’s move as credit positive and said it will allow issuers to continue to use interest rate and currency swaps to manage fixed and floating rate exposures and cross-currency risks between cover pools and covered bonds.

“Swaps are particularly important for Norwegian issuers since the mortgages in the cover pools are floating rate and denominated in Norwegian kroner, but issuers rely to a significant degree on an investor base that prefers fixed-rate euro-denominated investments,” said the rating agency.

It noted that actual OC levels in the Norwegian covered bonds it rates exceed 2% on a nominal basis.

Turkish ratings have been under pressure since an attempted coup in July and on 26 September Moody’s downgraded several Turkish covered bond programmes, including that of VakıfBank (Türkiye Vakıflar Bankası), after lowering the sovereign ceiling to Baa1.

VakıfBank’s mortgage covered bond rating was left on review for downgrade, with Moody’s saying that a higher level of overcollateralisation (OC) – 22.5% versus 20% already committed – was necessary for the Baa1 rating to be maintained, all other things being equal.

VakıfBank announced yesterday (Thursday) that it had on Tuesday informed Moody’s that it has increased the Required Overcollateralisation Percentage under the programme’s terms to 22.5% as of Tuesday.

Under EMIR, covered bonds are exempt from central clearing requirements as long as they meet criteria laid down by the European Securities & Markets Authority (ESMA). These include a requirement for a “legal” collateralisation level of 102%, and changes to frameworks in countries, such as Sweden, where this is not already included in legislation had been anticipated.

The Association of Swedish Covered Bond Issuers (ASCB) said that the change to legislation will enable Swedish issuers to fulfil the OC requirement, but it is not expected to entail any increase in costs for them since they already have a significant level of OC far above what the amendment will require.

“This is a positive step for the Swedish covered bond issuers who can continue to use derivatives for hedging purposes as before,” said Martin Rydin, chairman of the ASCB.

According to Jonny Sylvén, senior advisor at the ASCB, the proposal is now being consulted upon and will then be put to parliament, with the government planning to have it effective on 1 May 2016, well ahead of when clearing obligations are expected to come into force.

The rating agency noted that the Polish Ministry of Finance published the detailed proposals in July and that, if implemented, they will limit the risk of time subordination among bondholders and reduce refinancing risk.

Moody’s said that under the prevailing legislation acceleration of individual covered bonds upon a missed payment of a specific series could lead to an early acceleration, thereby creating a risk of time subordination among bondholders. The possibility of this happening will be limited under the proposals and is seen as credit positive.

The proposals foresee an automatic 12 month maturity extension of all outstanding covered bonds at the time of issuer insolvency, reducing any immediate refinancing risk, said Moody’s.

After an issuer insolvency, semi-annual and quarterly tests will be conducted to see if cover assets and liquidity, respectively, are sufficient to cover payments under the proposals. Should either test be failed, repayment will switch to a pass-through structure whereby the maturity of all bonds will be extended to the longest dated asset plus three years and all bondholders treated pari passu and pro rata for principal payment.

“Although we are still waiting for the final law for more details on how the two tests will operate, the implementation of liquidity and asset coverage tests together with the pass-through scenario they trigger should improve timely payment for bondholders,” said Moody’s.

The rating agency also noted that mortgage pool eligibility criteria are being relaxed through higher permitted loan-to-value (LTV) levels, but that at the same time a commitment to higher minimum legal overcollateralisation (OC) requirements is envisaged in the proposals.

Moody’s highlighted the LTV changes, whereby the LTV threshold is increased from 60% to 80% for residential mortgage loans, as a credit negative aspect of the proposals.

“This will bring the LTV threshold in the Polish covered law more in line with international peers,” it noted, “but increases the possible amount of covered bonds that can be issued against a certain pool of assets.”

The proposal for a minimum OC requirement (based on nominal values) envisages a level of 10%, according to Moody’s.

“This is a credit positive for Polish covered bonds as it adds a reliable minimum level of protection for covered bondholders against remaining refinancing risk and other risks including credit risk and currency and interest rate mismatches,” said the rating agency.

Photo: The lower house of Poland’s parliament (Sejm); Source: Kpalion, Wikimedia Commons