Investors shouldn’t count on covered bond standardisation

Issuance is booming in the European covered bond market, giving investors a wider range of products to choose from than ever before. However, the proliferation of national covered bond laws is making comparative analysis much more complicated.

Gone are the days when bonds such as German Pfandbrief could be bought without paying much attention to the underlying structure, and hardly any attention to the issuer name – German investors were heard to say: ‘A Pfandbrief is a Pfandbrief is a Pfandbrief.”

Today investors are having to look at various pros and cons of laws passed in different jurisdictions. And the launch in July 2003 of the first UK structured covered bond by HBOS has clouded the picture even further. The UK has no covered bond law, and instead the HBOS bonds rely upon structuring techniques largely borrowed from the securitisation market.

Meanwhile long delays in Italy over the passage of a law have resulted in a situation where Italian issuers may now follow the UK lead, and go the structured route, while countries such as Portugal, Sweden and Belgium are all about to pass covered bond laws.

EU intervention?

There are some efforts at EU level to set out guidelines in order to protect investors, but bankers expect that covered bonds will remain a national product, and that pan-European standardisation is a long way off.

At present the EU Commission sets out its definition of covered bonds in Article 22.4 of the directive governing “Undertakings for Collective Investment in Transferable Securities”, usually known as the UCITS directive.

Bonds that meet these criteria typically benefit from a 10% risk weighting, though this is at the discretion of individual member states. In contrast asset backed securities (ABS) carry a 20% risk weighting. Since there is no national covered bond law in the UK the HBOS bonds are not compliant with EU guidelines, and so they too carry a 20% risk weighting.

The Commission is now reviewing its guidelines, and in April 2003 it published the Working Paper on the Treatment of Covered Bonds.

Commission project

“The EU is currently working on adapting to the Basel II standards, and putting together its third Capital Adequacy Directive,” explains Alexandra Sleator, co-ordinator for European covered bond ratings at Moody’s Investors Service. “Basel II does not specifically mention covered bonds – the work on covered bonds is a pure EU Commission project.”

According to Ms Sleator, the financial services unit of the EU Commission has announced plans that favourable capital treatment will be awarded to bonds which continue to meet the criteria listed under Article 22.4 of the UCITS Directive, but also meet a number of other parameters, notably dealing with the nature of assets eligible as primary and substitute collateral.

“The primary assets eligible as collateral for covered bonds will be clearly identified as either mortgages or public sector claims, and loan-to-value levels will be indicated for the mortgages,” Ms Sleator says. “With respect to substitute collateral, there will also be specifications as to permissible investments and a limit set on how much of the cover asset pool these substitute assets can represent.”

Keeping up with demand

But the EU appears to be playing catch up with a market which is developing extremely rapidly, as a growing number of banks in countries across Europe want to broaden their investor base by issuing both ABS and covered bonds, and are lobbying for national laws to be passed or amended to help them do this more efficiently.

The next entrant to the market will be Sweden. In the third quarter of 2003 the Swedish Parliament passed a new covered bond act which will come into effect on July 1, 2004. It will introduce directly collateralised bonds, with the underlying assets consisting of mortgage loans and loans to central, regional or local governments located within the European Economic Area. The Loan to Value ratio will be limited to 75% and 60% for residential and commercial mortgages respectively.

“Legislation is being considered in a number of markets, including Portugal,” says Stuart Jennings, managing director at Fitch Ratings in London, who notes that the rating agencies do usually have some input into this process. “Governments have a consultative process in putting together what kind of structural features they want to put into their law, and they do speak to the rating agencies for their views,” he says.

Claudia Vortmueller: ‘Though we are a long way from a common European solution, there is still a certain level of standardisation in the market’

Alexandra Sleator: ‘The EU is currently working on adapting to the Basel II standards. Basel II does not specifically mention covered bonds – the work on covered bonds is a pure EU Commission project’

HBOS impact

In the UK, however, there are no imminent plans to enact covered bond legislation. “HBOS has managed to get a number of covered bond offerings away with reasonable pricing, and without any legislation in place, by structuring within the confines of English law and mimicking the features of other covered bond programmes,” says Mr Jennings. “So I don’t see any immediate move towards legislation, especially if the UK programmes to come prove as successful and create the feel of the UK covered bonds as an established asset class.”

Claudia Vortmueller, structured finance research analyst at Commerzbank Securities, expects to see more European structured bonds similar to the HBOS offerings, which do not rely upon legislation. “In Italy the government has been looking at the possibility of a covered bond law, but if no covered bond law is passed then some Italian banks are likely to proceed via the structured covered bond route, as has been done in the UK,” she says.

Clearly, countries learn from one another. For example, the Irish law drew on the German legislation and developed it further, Ms Vortmueller says. “So, though we are a long way from a common European solution, there is still a certain level of standardisation in the market.”

Healthy competition

According to Cristina Costa, head of the Capital Market Committee at the European Mortgage Federation, such regulatory competition can actually be beneficial as long as it enhances the quality of the bonds. And the Federation believes that the challenges posed by the introduction of new structured covered bonds will trigger a debate on a common European definition of covered bonds, something which the industry views favourably.

As for the underwriters, on their roadshows to sell covered bond deals they are reluctant to spend too much time criticising alternative structures, because the same investment banks that are selling Spanish or German deals will also typically be pitching for business in the UK or Italy.

“You market the strengths of the particular transaction that you are selling,” comments one Madrid-based banker. “For a deal such as one out of Spain, you sell the strengths of the law. But we are also interested in doing UK deals, and there we would sell on the structural strengths. And at the end of the day the rating agencies are satisfied with one or the other, and give it a triple A according to their own judgement.”

Do-it-yourself

The Madrid banker argues that investors will simply have to get used to comparing the features of various national covered bonds, and do their own analysis, just as in the ABS market investors spend a great deal of time picking apart structural features to see which they prefer – even if they are all rated triple A by the rating agencies.

The idea that the European covered bond market is going to standardise to the point where investors are able to say “a Pfandbrief is a Pfandbrief is a Pfandbrief” looks less likely than ever at the present time, as the volume of issuance and number of jurisdictions involved is growing rapidly.