Covered bonds: Fund-starved banks risk collateral damage

Covered bonds are having a good run, despite the crisis. The hiatus in senior unsecured issuance since the summer has focused many issuers’ minds on the instrument, and issuance for the first three quarters of the year has reached €262.6 billion, up from €248 billion for the same period last year.

However, as banks turn to covered bonds to plug the gaps in their funding strategies, the thorny issue of encumbrance has come to the fore.

Covered bonds now make up a larger share of the funding mix, but their collateral demands on the balance sheet could start to worry senior unsecured investors. Holders of covered bonds have priority over such creditors in an insolvency, so the more of a bank’s funding is done through covered bonds, the less likely an unsecured creditor is to recoup its investment if things go wrong.

Yet market specialists are irritated by the focus on covered bond encumbrance, arguing that the transparency of the product means critics are missing the point. "Covered bonds are probably the form of encumbrance to least be worried about," says Tim Skeet, managing director at RBS. "As the most visible form [of encumbrance], they’re also the one you can plan best for."

This focus on covered bond encumbrance has highlighted just how opaque true balance-sheet encumbrance really is. Banks acting as their own swap counterparties or entering into bilateral agreements all place a burden on the balance sheet, but are far harder to quantify. "The liability structure in the larger banks is complex and not transparent," says Bridget Gandy, managing director in Fitch’s financial institutions group. "When you’re talking about encumbrance, covered bonds are only part of the story. You have to look at other forms of encumbrance: things such as asset swaps and bilateral agreements with insurance companies all encumber assets, but are harder to detect."

It is this lack of transparency regarding other forms of encumbrance on a bank’s assets that has focused attention on covered bonds. Determining how encumbered a bank is by, say, asset swaps is far harder than looking at covered bond issuance. "It would take a long time to get the full picture on other forms of encumbrance," admits Helene Heberlein, head of covered bonds at Fitch.

One of the more prominent examples of alternative asset encumbrance stems from banks acting as their own swap counterparties. This has become popular among some of the larger banks, as it removes the cost of an external counterparty and cheapens issuance.

However, when acting as their own swap counterparty, the banks need to allocate collateral – tying up more of their balance sheet. There is also a concern that, should the bank be downgraded, then both the swap issuer and the counterparty have been, in effect, downgraded. This adds an extra element of risk to the process, something that has been recognized by the ratings agencies.

"We do penalize acting as one’s own swap counterparty in a transaction," says Heberlein. "We differentiate because if a bank is acting as its own swap counterparty, it becomes more vulnerable to issuer downgrades."

THE PREVALENCE OF OTHER FORMS OF ASSET encumbrance was recognized by the Reserve Bank of New Zealand during the consultation process before the enactment of New Zealand’s covered bond legislation in June 2010.

The central bank felt that an asset encumbrance level of around 20% was the point at which bank ratings might come under threat. However, the bank chose to set the encumbrance cap at 10% – partially based on the existence of other forms of asset encumbrance, particularly RMBS.

The halving of the cap by the Reserve Bank of New Zealand recognizes that non-covered bond encumbrance could represent half of the encumbrance on a bank’s balance sheet. This calls into question the focus on covered bond encumbrance, and suggests that investors should be paying an equal amount of attention to what else is tying up the bank’s assets.

So far, the market’s response to banks’ growing level of asset encumbrance has been surprisingly muted. The ratings agencies have yet to express concern at the rising level of asset encumbrance from covered bonds, seeing other dangers as more pressing. Certainly, there is little sense in the markets that the agencies are worried about a threat to unsecured creditors in the instance of a default. "The ratings agencies don’t seem concerned about current levels of covered bond issuance," says Anthony Whittaker, head of UK bank ALM and origination at Natixis.

He argues that the increased issuance of covered bonds is a benefit for unsecured creditors. As the issuance of further senior unsecured debt is now unfeasible for many banks, due to aggressively elevated spreads (see Funding freeze pushes banks closer to the edge Euromoney November 2011), even if they are left subordinated, at least the funding obtained through covered bond issuance reduces the chances of the bank’s insolvency in the first place. "Unsecured creditors should react well to higher covered bond issuance," says Whittaker. "It means more funding for the banks and less chance of insolvency. It’s healthy for issuers to seek the most cost-effective funding measure."

The ratings agencies are also confident in their ability to keep covered bonds the sole preserve of stable financial institutions. "Given that you need to be a certain rating to issue a covered bond, I don’t think we need to be worried about the issuers going into liquidation and senior unsecured creditors taking a hit," says Fitch’s Gandy.

The agencies also give credit to the likelihood that the sovereign will stand behind the issuer. "Even if we see the insolvency from a major issuer, governments are likely to intervene to protect creditors from taking a loss," says Gandy. The extent to which their ability to do so has been impaired by the eurozone sovereign debt crisis is another matter.

Not all investors share Whittaker’s view. While there is a balance to be struck between the acquisition of funding and the subordination of existing creditors, the unsecured creditors might understandably be concerned that issuers are putting too much focus on the former. "Investors are more discerning in terms of asset encumbrance these days," reckons Ted Lord, head of covered bonds at Barclays Capital. "They do not feel comfortable if most of a firm’s high-quality assets are pledged. This makes an issuer more vulnerable in their opinion. Although covered bond asset pools are ring-fenced in the case of an insolvency, nobody wants to have this conversation with their boss."

SUBORDINATION IS NOT AN ISSUE that exists across the whole covered bond universe. In Denmark, the third-largest market for covered bonds in Europe, most covered bonds are issued by specialized mortgage banks. These are prohibited from taking deposits and rarely issue senior unsecured credit. This means that subordination issues are unlikely to arise.

"Dividing between mortgage banks that can issue covered bonds and general-purpose banks that can’t is a good model," says Morten Bækmand Nielsen, first vice-president at Danish mortgage bank Nykredit. "You avoid worries about subordination; you can get a very strange funding structure in general-purpose banks that rely heavily on covered bonds as a source of funding."

The German Pfandbrief market used to be subject to similar restrictions, with only certain institutions being permitted to issue Pfandbriefe, but the system was changed by the Pfandbrief Act of 2005.

However, this system has not been adopted elsewhere and investors have not shown a preference for it. "The Danish system works in Denmark, but so far international investors have not embraced the domestic Danish model, although they have supported the traditional style of covered bond," says RBS’s Skeet.

Investors continue to sit on their hands in the senior unsecured market, but asset encumbrance is something they will have to get comfortable with as banks turn to covered bonds instead. The attractions for investors are considerable: their dual-recourse nature offers an increased chance of recovery in the case of insolvency. Furthermore, holders of covered bonds are safe from the possibility of any future regulator-enforced bail-ins.

Covered bonds used to be a last resort rather than a first – the preserve of banks that had exhausted other sources of funding – but the financial crisis has changed the rules. "Traditionally, covered bonds were meant to be used when you couldn’t get funding in other ways," says Christoph Anhamm, head of covered bond origination at RBS. "We’ve drifted away from that. It’s now seen as an instrument that gets high ratings."

RBS issued a €750 million benchmark on November 17, priced at 150 basis points over mid-swaps. Books closed with orders over €800 million, despite a surprisingly low German participation of 6%. The deal was led by Citi, Credit Suisse, Danske Bank, HSBC, Natixis and RBS.

Covered bonds’ role as a safe option amidst unprecedented market volatility has seen investors prepared to take a lower coupon for the extra security, even though covered bond spreads have risen sharply in tandem with the senior unsecured market, but the gap in funding costs between the two instruments has increased vastly in recent years.

"The spread between comparable senior unsecured issuances and covered bond issuances has widened dramatically," says Jeremy Walsh, head of covered bond syndicate at RBS. "Whereas 8bp used to be the norm, now it’s more like 250bp. We’re seeing covered bonds become the norm; senior unsecured has fallen off a cliff."

If they do become the norm, there will be implications not only for collateral encumbrance but also collateral quality. "Banks have to work harder for funding and that’s leading them to look at asset classes that are ineligible under some jurisdictions’ covered bond legislation," says Fitch’s Heberlein. "We’ve seen covered bonds issued in France backed by non-mortgage housing loans backed by mutual funds. While this isn’t an exotic asset class, it is out of the ordinary for covered bonds."

One of the more unusual examples of this is the €250 million July deal from Sekerbank, the first covered bond issued by a financial institution in Turkey. The issue, which was rated A3 by Moody’s, was backed by a pool of 15,000 SME loans. The deal was arranged by UniCredit and was sold to four multilateral agencies, including the IFC and the Financierings-Maatschappij voor Ontwikkelingslanden (FMO). The tranches were priced at between 200bp and 250bp over Libor. The trade was unusual, however, in that it incorporated some structuring from the ABS market and is essentially a hybrid of a covered and a structured covered bond. As such it would probably not be palatable to traditional covered bond investors, as the pool will have different dynamics than mortgage or public sector pools and different maturity profiles.

Given the risky nature of the collateral, the Sekerbank deal illustrates the extent to which issuers have sought to expand the universe of collateral to back covered bonds. This is an issue that is likely to concern conservative investors perhaps more than that of asset encumbrance. "There are cases where the collateral is more or less worthless," claims one.

The banks that have turned to covered bonds to ease their funding woes would like to think that reliance on covered bonds is sustainable and poses no threat to the banks’ unsecured bondholders. Perhaps that’s true if you look at covered bond issuance in isolation. However, until there is greater clarity on other sources of encumbrance on bank asset books, and while there are concerns over the quality of collateral, senior unsecured creditors are going to look at soaring covered bond issuance with justified concern.

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