CreditWeek ® The Global Authority On Credit Quality | November 2, 2011 Trustee-Like Roles Come In Many Guises Covered Bonds’ Role In Latin American Housing Issuer Rating Changes And Covered Bonds Never Underestimate Credit Risk CreditMatters | Multimedia Edition SPECIAL REPORT Global Demand For Covered Bonds Is Growing Covered Bonds Evolve And Spread Around The World By Sabrina Miehs, Frankfurt Covered bonds—bank-issued debt secured by mortgage loans or public sector assets—are expanding into new countries to meet growing demand for long-term funding. We believe that demand in countries that already have covered bonds is growing as new investors shift away from senior unsecured bank debt, and as insurance and bank regulators give covered bonds preferential treatment in their tightening capital and liquidity rules. 2 www.creditweek.com 8 Covered Bonds—A Primer On The Top Five Global Jurisdictions By Sabine Daehn, Frankfurt Five countries—Germany, France, Spain, Denmark, and the U.K.—dominate the covered bond market. In fact, these countries collectively account for about 80% of outstanding covered bond issuance in the €2.4 trillion global market. In this report on the top five countries, we illustrate some important distinctions between programs and jurisdictions, highlighting how no two covered bond programs can be considered the same. 20 Covered Bond Trustee-Like Roles Come In Many Guises By Sabine Daehn, Frankfurt All covered bond programs—whether they are structured or legislation-enabled—benefit from trustees or entities performing trustee-like roles, who are appointed to safeguard bondholders’ interests. However, the names, nature, and scope of these roles vary significantly by jurisdiction. Depending on the jurisdiction, a covered bond trustee may have anything from a rather passive to a highly active role in the operation of a covered bond program. 25 Never Underestimate Credit Risk In Mortgage Covered Bonds By Sabrina Miehs, Frankfurt Over the past five years, issuers from an increasing number of countries have turned to covered bonds to refinance their mortgage lending, while issuance of public sector loan-backed covered bonds has fallen. The common perception of mortgage covered bonds as a homogeneous and universally low risk product is misleading. In fact, the characteristics of individual mortgage covered bonds are not only diverse, but also can change over time. 32 Covered Bonds—Is The Next Stop A Move Away From ‘AAA’? By Sabrina Miehs, Frankfurt The covered bond market is feeling the impact of the sovereign crisis, the diminishing trust in banks, and bail- in discussions. Investors in senior unsecured debt are worried that their potential recoveries could suffer if banks increasingly use covered bonds for funding because the bank would be using more of its collateral for covered bonds. Issuers are concerned about the quality of covered bonds as certain asset types are finding their way into the cover pools. contents 4 November 2, 2011 | Volume 31, No. 42 Special Report 36 Scenario Analysis: How Sensitive Are Covered Bond Ratings To Changes In Issuer Ratings? By Andrew South, London Ratings on covered bond programs are mostly linked to the underlying issuer credit rating (ICR). But many covered bonds that we rate ‘AAA’ would keep those ratings, even if the underlying ICRs were notches lower. Some would keep their ‘AAA’ ratings if we lowered the ICR by as much as four notches. Moreover, the minimum level of overcollateralization that we view as commensurate with a ‘AAA’ rating on a program doesn’t change if the ICR falls. 41 S&P Discusses Canada’s Proposed Legislative Regime For Covered Bonds By Karlo Fuchs, Frankfurt Without dedicated covered bond legislation in Canada, these programs follow existing structured finance techniques for segregating assets, and they operate as contractual covered bonds. The Canadian Department of Finance’s consultation paper outlines the ability of those existing contractual covered bond programs to become registered programs under a legislative regime, subject to approval and compliance with the then-published law. 45 Could Covered Bonds Help Reduce Latin America’s Housing Deficit? By Eric Gretch, New York Latin America has long struggled with finding new sources of liquidity to close the massive gap in its housing deficit. To keep up with the soaring demand for residential mortgages, governments are busy writing legislation, reforming their mortgage markets, and considering alternative financing options that weren’t feasible in the past. Mortgage lenders have also joined the effort and are pushing for greater access to the capital markets. Standard & Poor’s CreditWeek | November 2, 2011 3 Video: Standard & Poor's Covered Bond Rating Methodology Addresses Market Value Risk One of the key differences between covered bonds and RMBS is the potential exposure to market value risk, as the assets backing the covered bonds typically have longer maturities than the covered bonds themselves. In Standard & Poor's previous covered bond methodology update, we highlighted the analysis of this particular risk. New U.S. legislation may lead to the development of a covered bonds market in the U.S., but investors would need to be comfortable with the credit risk of issuing banks and the assets securing the covered bonds. In this CreditMatters TV segment, Standard & Poor's Managing Director Karen Naylor and Senior Director Ernestine Warner discuss the mechanics of the covered bond market and what would be necessary for a market to develop in the U.S. Other Multimedia In This Special Report 8 Podcast: Covered Bonds: A Primer On The Underlying Risks 25 Video: Covered Bonds: Not All Are Created Equal 37 Issuer Do wngrades? Multimedia Video: How Sensitive Are Covered Bonds To 4 www.creditweek.com features special report Standard & Poor’s CreditWeek | November 2, 2011 5 W ith a deep and storied history in Europe dating back centuries and $3 trillion in outstanding issuance today, covered bonds continue to stretch across the globe and into new territories—most recently in Australia and Turkey, with growing potential in Latin America and the U.S. Covered Bonds Evolve And Spread Around The World ■ Covered bonds continue to stretch across the globe and into new territories—notably Australia and Turkey, with growing potential also in Latin America and the U.S. ■ But, the market hasn’t escaped the effects of the sovereign crisis and evaporating confidence in banks. ■ The question for issuers, investors, and regulators is how to determine which bonds will be the strongest during times of market volatility—and whether a ‘AAA’ rating is the only measure. ■ We believe that demand in countries that already have covered bonds is growing and we expect the overall growth of the covered bond market to continue, both in terms of issuance volumes and geographic reach. Overview Covered bonds—essentially bank-issued debt secured by mortgage loans or public sector assets—are expanding into new countries to meet growing demand for long-term funding. Standard & Poor’s Ratings Services believes that demand in countries that already have covered bonds is growing as new investors shift away from senior unse- cured bank debt, and as insurance and bank regulators give covered bonds preferential treatment in their tightening capital and liquidity rules. Covered Bonds Continue To Evolve As Market Volatility Rises Even as demand for the funding tool grows, the market hasn’t escaped the effects of the sovereign crisis and evapo- rating confidence in banks. On the other hand, talk of private sector creditors shouldering bigger losses if banks fail has caused banks to address investor concerns by focusing on secured funding alterna- tives, such as covered bonds. These crosscurrents between increasing demand and the covered bond market’s continuing evolution have got the market—more than 200 banks issuing covered bonds in about 30 countries worldwide—focusing on how to maintain its credibility. For starters, investors in senior unsecured debt worry about smaller recoveries if banks increasingly tap covered bonds for funding, because the bank would encumber more of its asset base to provide ring-fenced collat- eral for the covered bonds. Some issuers are concerned over the perception of cov- ered bond quality if others begin to include assets such as loans to small and midsize enterprises, credit card receiv- ables, and auto loans in cover pools. More broadly, as the global covered bond market continues to evolve, we have found increasing evidence to support our belief that not all covered bonds are cre- ated equal. The common perception of covered bonds as a homogeneous and uni- versally low risk product is misleading. In fact, the characteristics of covered bonds are not only diverse, but can change over time. Credit enhancement levels, the degree of asset-liability mismatch, and col- lateral type and performance all vary. The question for issuers, investors, and regulators, then, is how to deter- mine which bonds will be the strongest during times of market volatility—and whether a ‘AAA’ rating is the only measure. Most of the covered bond market remains ‘AAA’, though we’re assigning lower ratings to more and more covered bonds. In fact, all covered bonds for which we’ve assigned the highest possible rating over that of the issuer have overcollateralization that is, in our view, sufficient to protect against all asset default-related risks in a ‘AAA’ stress scenario—even if the covered bond rating is below ‘AAA’. Covered Bonds Open New Frontiers Australia is the latest entry in the cov- ered bond market. Once the govern- ment has fully implemented the legal framework, Australian financial insti- tutions—even with an issuance cap of 8% of their total assets—could have the potential to issue up to A$150 bil- lion. This would effectively propel this relatively infant market into the top 10 countries in terms of global issuance outstanding. With the fate of the U.S. private-label residential mortgage-backed securities (RMBS) market still unclear, there’s new hope that covered bonds might finally provide another needed source of long- term liquidity—rather than an RMBS replacement—to finance home mort- gages. Legislation has been written, hearings have been held, the U.S. Treasury has cited it as another poten- tial funding source, and the Federal Reserve has given covered bonds their own collateral category. Still, despite that momentum, develop- ment has lagged because of the Federal Deposit Insurance Corporation’s (FDIC) desire to have recourse to covered bonds’ asset cover pools—as is the case for other balance sheet assets—to avoid lower recovery prospects. This stance reflects the FDIC’s mandate to protect bank depositors. Furthermore, we believe that market participants can only fully assess the fate of covered bonds in the U.S. once policymakers identify the 6 www.creditweek.com features special report future role of the government-sponsored enterprises (Fannie Mae and Freddie Mac), and the Federal Home Loan Banks for mortgage financing. However, we believe that this is not likely to happen anytime soon given politicians’ focus on the upcoming 2012 U.S. presi- dential election, despite the U.S. Covered Bond Act enjoying significant bi-partisan support. Most observers have now pushed backed estimates for the passage of U.S. covered bond legislation until after the 2012 presidential election. A number of Latin American coun- tries have already passed, or are in the process of passing, covered bond laws: Argentina enacted a law in 1995 for securitizing mortgages (“letras hipote- carias”) that closely resemble the tech- niques used with covered bonds; Mexico and Peru have both introduced legislation. Brazil, too, passed a law in 1997 to issue a similar financial instru- ment, called “letras de credito imobil- iario,” or LCIs, which were structured to stay on banks’ balance sheets. Still, despite the appeal covered bonds may have for providing liquidity to help reduce the region’s housing deficit, the viability of the financing tool in Latin America depends on many factors, including the speed of regulatory reform, the legal strength of the security interest over the assets, as well as the emergence of a secondary mortgage market. What Next For Covered Bonds? Covered bonds continue to spread around the globe. As their expansion continues, however, it is important that misconceptions are resolved and that various market stakeholders begin to provide greater transparency, rather than just acknowledging the need for it. As investors have different risk prefer- ences, knowing the full range of risks that exist in any covered bond program and how these risks are addressed— from overcollateralization levels to liq- uidity coverage—clearly is essential to make an educated investment decision. As the covered bond market is growing fast on heavy demand for alter- native investments, more “oppor- tunistic” investors as well as issuers have joined the predominant pool of traditional covered bond stakeholders. In our opinion, this could potentially be negative for the market if their commit- ment turns out to be short-lived. However, we believe that rising demand for covered bonds will see the market expand further, both in terms of issuance volumes as well as geographic reach. In our view, the covered bond market will only maintain its track record as a high credit quality product—with no defaults—if both issuers and investors work together. CW Related Criteria And Research ■ Global Covered Bond Characteristics And Rating Summary Q3 2011, Oct. 18, 2011 ■ Revised Methodology And Assumptions For Assessing Asset-Liability Mismatch Risk In Covered Bonds, Dec. 16, 2009 Standard & Poor’s CreditWeek | November 2, 2011 7 It is important that misconceptions are resolved and that various market stakeholders begin to provide greater transparency… Analytical Contacts: Sabrina Miehs Frankfurt (49) 69-33-999-304 Andrew South London (44) 20-7176-3712 Karlo Fuchs Frankfurt (49) 69-33-999-156 Karen Naylor London (44) 20-7176-3533 For more articles on this topic search RatingsDirect with keyword: Covered Bonds 8 www.creditweek.com features special report C overed bonds have enjoyed significant investor demand throughout 2011, with more than €300 billion in benchmark issuance globally and further growth expected from a geographically diverse set of issuers. Five countries— Germany, France, Spain, Denmark, and the U.K.—dominate the covered bond market. In fact, these countries collectively account for about 80% of outstanding covered bond issuance in the €2.5 trillion global market, according to data from the European Covered Bond Council. Covered Bonds In this report on the top five countries, Standard & Poor’s Ratings Services illustrates some important distinctions between programs and jurisdictions, which mean that no two covered bond programs can be considered the same, in our view. We provide an overview of the legal frameworks, supporting collat- eral, currency, interest rate, and matu- rity mismatch risks, highlighting the extent to which these may differ between programs and jurisdictions. Germany Covered bond type The German Pfandbrief sector is the largest, most established global covered bond market, with 57 issuers who have Pfandbriefe outstanding. The share of mortgage covered bonds is increasing, with public sector covered bonds decreasing in significance, as banks reduce their public sector lending or fund it by other means. There are two types of bond issuances in Germany: “Namenspfandbriefe,” which are registered, and “Inhaberpfandbriefe,” which take the form of bearer notes and rank pari passu with each other (see table 1). Cover pool assets backing covered bonds remain on the issuer’s balance sheet, documented in a special cover reg- ister, and a cover pool trustee (“Treuhänder”) supervises these assets. Legal framework German covered bond legislation dates back over a century but is now based on the Covered Bond Act (Pfandbriefgesetz), first established in 2005. The legislation has since been updated several times, with the latest amendment in 2010. German financial institutions that use covered bonds for funding issue the bonds directly, and bond holders have a priority claim on the cover pool assets if the issuer becomes insolvent. Bankruptcy proceedings related to the issuer do not lead to acceleration or forced restructuring of the covered bonds, and any hedging agreements also survive the issuer’s insolvency. The issuer establishes cover registers, which document the assets assigned to secure the covered bond obligations and if the issuer becomes insolvent, this register segregates the cover pool assets from the insolvency estate. Furthermore, in an insolvency, the cover pool administrator (“Sachwalter”)— appointed by the German Federal Financial Supervisory Authority (BaFin) Standard & Poor’s CreditWeek | November 2, 2011 9 A Primer On The Top Five Global Jurisdictions to oversee the management of the cov- ered bonds—has the right to generate additional liquidity via asset sales or additional borrowing, to mitigate any maturity mismatches between cash inflows from the cover pool assets and the liabilities falling due on the covered bonds. Should cover assets ever prove insufficient to redeem any bonds falling due, the bond holders also have a claim against the issuer’s estate that is pari passu with senior unsecured creditors. Assets The German Covered Bond Act defines which types of assets are eligible to be included in the cover pool for different types of covered bonds, i.e., mortgage loans, loans to public sector entities, or shipping- and aircraft-secured loans. The issuer must maintain a segregated cover pool for each asset category, and meet matching and management requirements separately for each type of asset pool. Furthermore, a covered bond issuer must publicly disclose key risk indicators for each cover pool at least quarterly. These include the cover pool’s composition, according to certain standardized criteria, and overcollater- alization levels—based on both a nom- inal, a net present value (NPV), and a stressed NPV basis. The composition of cover pools securing German covered bonds varies significantly from program to program. For example, pools backing some mort- gage covered bonds consist solely of res- idential loans, while other programs’ pools may contain only commercial real estate loans. We have also observed that the diversity of geographic exposures in cover pools—both within Germany and across other European countries— varies significantly from issuer to issuer. Pools with a higher proportion of com- mercial real estate exposures tend to have wider geographic diversity across Europe, whereas pools with primarily residential mortgage exposures are more likely to have a domestic focus. Indeed, domestically-focused covered bond programs often even have some concentration in the regions where the originating bank has its historical cus- tomer base. Public sector covered bonds exhibit equally diverse characteristics, with domestic exposures ranging from only 40% of the pool to nearly 95% in some programs. Structure Many German covered bonds feature a bullet maturity that can create a matu- rity mismatch between the bonds and the cover assets, which are typically amortizing. However, issuers with large, long-established programs are able to manage this risk by ensuring that the maturity profile of the various bond issuances outstanding in aggregate closely matches the expected amortiza- tion profile of the underlying assets. The Covered Bond Act also addresses liq- uidity risk by requiring that the cover pool can be expected to generate cash flows that meet the program’s maximum liquidity need for a period of 180 days. 10 www.creditweek.com features special report Covered bond type Issuer Legislative framework Balance sheet treatment Asset types Öffentlicher Pfandbrief Financial institution Pfandbriefgesetz On issuer’s balance sheet, Public sector exposure and (public sector covered bond) (German Covered Bond Act) recorded in cover pool register substitute collateral up to 10% Hypothekenpfandbrief Financial institution Pfandbriefgesetz On issuer’s balance sheet, Mortgage loans (up to 60% LTV (mortgage covered bond) (German Covered Bond Act) recorded in cover pool register can be included in the pool) and substitute assets up to 20% Schiffspfandbrief and Flugzeugpfandbrief Financial institution Pfandbriefgesetz On issuer’s balance sheet, Shipping or aircraft (shipping and aircraft covered bond) (German Covered Bond Act) recorded in cover pool register finance loans OC—Overcollateralization. LTV—Loan-to-value (based on prudent lending value not market value). Germany Table 1 Covered bond type Issuer Legislative framework Balance sheet treatment Cédulas hipotecarias (CH) Credit institution Several laws from 1981, On issuer’s balance sheet 2003, 2007, and 2009 Cédulas territoriales (CT) Credit institution Several laws from 1981, 2003, On issuer’s balance sheet 2007, and 2009 Bono hipotecarios (BH) Credit institution As CH, specifically the On issuer’s balance sheet, registered assets amendment from 2007 Multi-cédulas Special entity— Spanish securitization legislation Loan collateral on CH/CT issuers’ balance sheets; Fondo de Titulización and laws applicable to CH/CT CH/CT on balance sheet of fund that issues multi-cédulas de Activos OC—Overcollateralization. LTV—Loan-to-value. EU—European Union. Spain Table 2 [...]... RatingsDirect with keyword: Covered Bonds Analytical Contacts: Sabine Daehn Frankfurt (49) 69-3399-9303 Karlo Fuchs Frankfurt (49) 69-3399-9156 Never Underestimate Credit Risk In Mortgage Covered Bonds Overview ■ ■ ■ Asset-liability mismatch is the most important risk for covered bonds, followed by the credit risk that is present in the cover pools Credit risk factors in mortgage covered bonds may vary significantly... 2, 2011 25 special report features tics, although full details may not always be clearly reported We believe this is reflected in recent demands for greater transparency on covered bond programs and their associated risks To help investors evaluate the risks underlying mortgage covered bonds, in this report we discuss some of the key considerations We detail the range of program characteristics using...As highlighted in our published criteria, potential asset-liability mismatch (ALMM) is a key factor in our rating analysis for covered bond programs (see “Credit FAQ: Standard & Poor’s Explains Update To Criteria For Assessing Asset-Liability Mismatch Risk In Covered Bonds, ” published Dec 17, 2009, on RatingsDirect, on the Global Credit Portal) For the German covered bond programs that we rate,... liquidity risks have to be limited according to the principle chosen by the issuer for the respective capital center or cover register This decision does not depend upon the type of covered bond issued and can only be amended by notice to investors Assets The asset pools that back Danish covered bond programs revolve However, for most capital centers, once a mortgage loan is registered for a specific issuance... Danish covered bonds Mortgage banks have favored this type of covered bond as a major funding tool due to their exclusive focus on granting loans and issuing bonds (these banks cannot take deposits) The special banking principle restricted other banks from using this funding source until 2007, when SDOs were introduced Issuers require a licence from the Danish banking authorities to issue covered bonds, ... spurred downgrades on covered bonds, has been that covered bond spreads have become more volatile, at some points reaching historical highs The spread correlation between government bonds and covered bonds also collapsed in some peripheral European countries (such as Portugal and Italy), with covered bonds even trading below government bonds Panelists hoped that covered bonds in core issuing areas (such... collateral for the series of bonds issued out of this capital center Eligibility of such loans requires them to be registered in the land registry at Danish district courts If an issuer becomes insolvent, the capital centers freeze at their then-current state, repay claims under the covered bonds, and satisfy derivatives counterparties after paying fees and expenses Should the assets registered in... on the covered bonds, the cover pool administrator has the right to liquidate cover pool assets, borrow money, or issue new covered bonds ranking pari passu with existing bonds Subject to the regulator’s approval, the administrator may also transfer some or all of the covered bond program’s assets and liabilities to another covered bond issuer Both the cover pool monitor and the cover pool administrator... program-specific data from our quarterly report on the sector (see Global Covered Bond Characteristics And Rating Summary Q2 2011,” published July 19, However, Standard & Poor’s Ratings Services believes that the common perception of mortgage covered bonds as a homogeneous and universally low risk product is misleading In fact, the characteristics of individual mortgage covered bonds are not only diverse, but... property’s value The total whole loan LTV ratio of this one loan in this example is therefore 100% This split allows the lender of loan part I, which has an LTV that is eligible under the local covered bond law, to refinance this part by issuing covered bonds and by assigning various risk margins to the various loan parts The lender of loan part I, which is prior-ranking, and loan part II do not need to . Risk CreditMatters | Multimedia Edition SPECIAL REPORT Global Demand For Covered Bonds Is Growing Covered Bonds Evolve And Spread Around The World By Sabrina Miehs, Frankfurt Covered bonds bank-issued. if banks increasingly use covered bonds for funding because the bank would be using more of its collateral for covered bonds. Issuers are concerned about the quality of covered bonds as certain asset. coverage—clearly is essential to make an educated investment decision. As the covered bond market is growing fast on heavy demand for alter- native investments, more “oppor- tunistic” investors as well as issuers have