Germany is the progenitor of the covered bond. Pfandbrief were established under Frederick the Great in 1769, originally as a means of giving estate owners access to credit. France followed with obligations foncières in 1852, while in Spain, cèdulas hipotecarias was introduced in 1981.
The first UK covered bond was not issued until 2003 and the legislative framework for regulated ones only arrived in 2008. The laws governing covered bonds vary from country to country; some European countries have regulatory frameworks that stipulate what kind of loans can go into the pool that covers bonds and what happens if the issuing bank becomes insolvent. There is a statutory monitoring process and regular independent annual audits.
The financial institution that issues them – usually a bank – usually needs a licence to do so. To be registered, covered bonds must stay on the issuer’s balance sheet. This government oversight and greater security contrasts with mortgage-backed securities, where no statutory rules control what goes into cover pools or their monitoring.
Moreover, lenders remove the loans backing CMBS or RMBS issues from their balance sheets by selling them into special-purpose vehicles that issue bonds. The loan pools that back covered bonds are not fixed; as some loans are repaid, they can be replaced by new loans. Thus issuers are responsible for administering the pools to ensure that the bonds can meet their obligations to investors. In the UK, banks must provide quarterly data to the Financial Services Authority.
The FSA has a team of risk specialists who model cash flows to ensure that covered bonds are on track to pay investors on time, and that the programmes are matching assets with liabilities. The valuation method used on properties and a maximum loan-to-value level are also legally stipulated.
“Unfortunately we don’t have a global or European binding approach; each country’s legislators find different ways of valuing collateral,” notes Barclays Capital covered bonds analyst Leef Dierks. “It not only differs on a country-by-country basis, but in the UK, for example, different issuers use different house price indices.”
German and French valuation rules and loan-to-value limits are very conservative. Loans are based on the assets’ ‘mortgage lending value’, which is not market value, as it ignores peaks and troughs, while only 60% of the LTV is eligible for a cover pool. In contrast, UK and Spanish covered bonds are based on property entered at market value, and the UK legal maximum LTV for covered-bond loans is 80%. But UK issuers are free to set LTV limits, as long as they do not breach the statutory maximum.
In the UK, eight banks have registered their covered bond programmes with the FSA. Although the legislation allows commercial real estate loans to be used for collateral, the FSA does not yet allow them to be used in its regulated programmes. The geographical spread of loans allowed in cover pools also varies from country to country, and many permit international collateral.
Tobias Ilgen, head of treasury at WestImmo, says: “Investors prefer pfandbrief with a higher percentage of domestic real estate in the cover pool, and that is reflected in the price. You can issue pfandbrief with international real estate in the cover pool, but at, say, five basis points higher. We are able and optimistic that we can do international business that is eligible for the cover pool, and to refinance it with covered bonds.”
Ilgen would like to be able to hedge his cover pools by issuing pfandbrief in other currencies. “The asset side is mostly in euros, but also in US dollars, Swiss francs and British pounds, while the liability side is denominated in euros. My goal would be to issue a pfandbrief in a foreign currency, but the market isn’t there for it. That is for the future, I’m afraid.”
Investors can choose from a wide range of maturities and because the bonds are considered lower risk, they are given special treatment under European Union law. Investment funds (UCITS) and insurance companies are allowed to hold a higher proportion of bonds from a single issuer.