From Prussia with love: an undercover bond market
THE demand for covered bonds has been on a steady rise for the last decade. It’s a trend driven both by institutional investors looking to their perceived safety compared to traditional forms of securitisation and their use as collateral in the shoring up of Eurozone credit operations.
Covered bonds are typically seen as especially safe instruments due to a double layer of protection, combined with the fact that in the majority of European jurisdictions, investors in covered bonds are protected by specific covered bond regulation and supervision.
Unlike the securitisation process that passes ownership of pooled mortgages to investors where the investor has no recourse to the issuing bank, the loans backing covered bonds remain on a bank’s books and are ring-fenced, protecting bondholders even in the event of bankruptcy. The measures provide investors with two layers of protection. In the first instance, investors have recourse to the underlying assets (mainly composed of good quality instruments which offer a significant level of over-collateralisation.) In the second instance, investors have recourse to the other un-secured assets of the issuing bank.
RISE IN EUROPEAN BOND ISSUANCE
The first covered bonds – pfandbriefe – were issued by Frederick the Great in 1769 after the Prussian war. These were followed by realkreditobligationer out of Denmark after the fire of Copenhagen. Other European countries such as France, with the credit foncier, and Spain, with the cedulas hipotecarias, followed in the late 20th century. However, a number of countries had no issuances before 2007. The emergence of structured covered bonds in the UK did not happen until 2003.
The graph, left, taken from a European Central Bank report on recent developments in securitisation, shows the significant rise in covered bond funding over the last 10 years. Given its early start, Germany has traditionally been the biggest issuer of covered bonds. With German contributions removed, the rise in issuances is especially notable.
The rise in demand for covered bonds was in large part driven by the fall of the 2008 liquidity crisis. According to institutional research from Dealogic, before
the crash, securitisation made up 30 per cent of bond issuance by EU banks, compared with 23 per cent of covered bonds. In 2010, securitisation accounted for 8 per cent, while covered bonds made up 32 per cent.
According to the report: “The evidence of market-based demand suggests that transparency, simple and tested structures as well as low collateral risk are key factors for investors. This is an indication that investors have learnt some lessons from the crisis and are now scrutinising products more carefully, preferring simple and transparent structures.”
SOLVING BANK FUNDING ISSUES
Unfortunately, not quite. Though you may have been reading the previous five paragraphs enthralled with the concept of covered bonds saving the financial world, unfortunately there is a bit of a roadblock. As with most things with “finance” and “Europe” mentioned in the same breath, these problems revolve around the debt-burdened periphery Eurozone countries and the threat of downgrade by the debt-ratings agencies.
Although most of the countries do already have certain limits in place for the issuance of covered bonds, these have been known to be exceeded by the usual Eurozone suspects.
In theory, Greek covered assets are not supposed to be greater than 20 per cent of total bank assets. In practice, Greece has more than €12bn of retained covered bonds.
According to UBS analysis, the situation in Spain is much more worrying. Figures provided by la Caixa showed that it had €37bn of covered bonds outstanding and the capacity to issue €22bn more. According to the report, if these figures are typical of the levels of covered bonds outstanding then “we believe for many Spanish banks, the picture is a challenging one.”
For the banks with a high level of asset encumbrance, the prospect of further regulation may be a mere quantum of solace.
This article was amended on June 9.