Asset management

Securitisation and covered bonds: a European perspective

December 2006

Increasingly smart originators are using securitisation and covered bonds together to get the best of both worlds and to achieve a diversified funding strategy. As mortgage products flourish and lenders pursue new borrower niches, traditional covered bonds may do well to incorporate some of the flexibility of the newer securitisation framework in order not to be marginalised.

Funded securitisation started in the 1970s and is probably the most well-known funding tool within the UK and Europe. Using the securitisation process, assets are transferred to a vehicle that issues notes backed only by those assets. Major advantages of funded securitisations are the (likely) removal of the mortgage portfolio from the bank balance sheet, the reduction in risk and regulatory capital (if the lender is a bank) and the access to relatively cheap, long-term funding. This structure is also common in countries like Spain, Italy, Ireland, the US (especially for 'non-conforming' mortgages) and Australia.

Covered bonds

Traditional covered bonds (CBs), in contrast, are over 100 years old and are the major funding tool in Germany (called Pfandbriefe), France (Obligations Foncieres), Spain (Cedulas Hipotecarias) and Denmark. The lender, necessarily a bank, issues a bond that, unlike unsecured debt, is guaranteed by a specific pool of mortgages. While remaining on the bank balance sheet, this pool would be used to satisfy the covered bond holders before any other creditor in the event of a bank's default. The bond is thus doubly guaranteed by the lender and by a safe residential portfolio, and is thus normally rated AAA.

This differs from a securitisation as there are no lower-rated notes on a covered bond, while in residential mortgage-backed securities (RMBS) it is typical to see AA-, A-, BBB- and unrated notes. Covered bonds pay very low spreads compared to a traditional securitisation, and banks that buy them as an investment are required to keep a very low amount of regulatory capital against their risk of default.

Traditional covered bonds require specific legislation in order to ensure, among other things, that bond holders will have a privilege over the lender's mortgages. This is a crucial point as other categories (e.g. deposit holders) would be at a disadvantage. Therefore covered bonds are highly regulated and some countries, like Australia, have banned them altogether. In order to protect the very high quality perception of covered bonds, legislators often allow only high-quality, low loan-to-value (LTV) mortgages to be included in the pool. This is an issue as LTV levels are on the rise throughout Europe.

Structured covered bonds provide a solution where, in the absence of a specific 'ring-fencing' law, assets are transferred to a Special Purpose Vehicle (SPV) that may then issue a guarantee in favour of the noteholders. These bonds became popular in the UK when HBOS issued the first one a few years ago. The intention was to introduce covered bond benefits into markets where specific covered bond legislation was not in place. Implementation proved difficult, however, as the arrangers had to define a large amount of detail in the investment-offering memorandum, there being no specific legal framework in place for such an offering.

The initiative was successful, and other countries such as the Netherlands, are now looking into introducing their own systems of structured covered bonds. The proposed Italian covered bond law is, in effect, mimicking a structured covered bond. Interestingly, Washington Mutual, a US-based company, recently launched its first covered bond in Europe. Covered bonds have previously been absent from the US scene because the government-sponsored enterprises, Fannie Mae and Freddie Mac, substantially serve a similar function: they buy loans from lenders and, being “sponsored” by the US government, are able to issue AAA securities to fund them.

Covered bonds and securitisation: efficiency compared

In terms of collateral, covered bonds only allow the use of high-quality, low LTV mortgages, while all sorts of assets, including riskier loans, can be effectively securitised.

In terms of the average cost of funding achieved by the originator, covered bonds are a cheaper source with some having a 10-15 basis point advantage. However, while in a securitisation a fixed pool of mortgages is funded, in a covered bond the mortgage pool may or may not be replenished as mortgages are prepaid. When replenishment is not allowed (such as in Spain, where the entire mortgage book backs the issued Cedulas) a much larger initial pool is needed to ensure that - five years down the line - the remaining portfolio will be sufficient to fully back the covered bonds. The extra portion of the portfolio needs to be funded in alternative ways, usually with not-so-cheap subordinated debt, and in the end the overall funding cost of the two methods may actually be quite similar.

Securitisation is also much more flexible than covered bonds with regard to size, with minimum issues in the order of a few hundred million pounds. A covered bond programme, in contrast, usually requires several billion pounds in order to be set up. As lenders consolidate, cheaper covered bond funding will arise. The market should potentially look at introducing multi-originator-covered bonds - however, they have yet to be seen in Europe.

In terms of maturities, securitisation notes hardly exceed seven years, while covered bonds tend to be for longer periods.

Securitisation as a risk transfer/capital relief tool

Funded (cash) securitisation is the most well-known product, providing for both funding and regulatory capital relief as significant credit risk is transferred to noteholders. Another type of securitisation, called 'unfunded' or 'synthetic securitisation', exists with the sole intention of transferring risk and achieving regulatory capital relief. The portfolio is tranched and rated as in a normal securitisation, but it is not sold to an SPV; instead it remains on the bank balance sheet. The different layers of risk are protected by counterparties through either a Credit Default Swap (similar to an insurance contract) or a Credit Linked Note (where the protection provider puts up capital that will be reduced if losses emerge).

While it is not possible to execute a funded securitisation on mortgages used as collateral for a covered bond, synthetic securitisations are a natural complement to covered bonds: as the lender issues more and more covered bonds, its mortgage book gets larger and larger and the bank (which is retaining all the mortgage credit risk) has to dedicate a large amount of regulatory capital to this book. By applying a synthetic securitisation to the mortgage portfolio, the bank can achieve both the low cost of funding typical of covered bonds and the high capital efficiency typical of cash securitisations.

Some implications of Basel II

With only a few months until the introduction of Basel II, a number of key questions have still not been fully answered or will have different implications in each country. Under Basel II, mortgage banks will have to choose between Standardised and Advanced Internal Risk Based (IRB) models (the latter offering more benefits for their deeper understanding of credit risk).

Basel II will also penalise higher LTV mortgages, give credit to unfunded credit protection (such as lenders mortgage insurance), and explicitly recognise synthetic securitisation as a capital relief tool. All this will be an incentive for the ROE-conscious lender to transfer risk to more specialised risk takers who can leverage on highly geographically diversified mortgage portfolios, such as mortgage insurance companies. Mortgages backing covered bonds will absorb regulatory capital in the same way as all other mortgages, exactly as under Basel I.

Basel II will harmonise capital requirements for securitisation tranches across each jurisdiction, while today the most junior portion of a securitisation can absorb between 8 per cent and 100 per cent of regulatory capital, depending on the country.

It still needs to be clarified across Europe when a 'significant' risk transfer to a third party has been achieved in a securitisation, whether funded or synthetic; only when such a “significant” amount of risk has been transferred, will the originator be allowed to calculate its capital on the more favorable basis of the risk weights of the retained tranches and not on the original risk weights of the portfolio that was securitised.

Similarly, while we expect a reduction in capital required because of the lower credit risk weights applied to mortgages (the much talked-about Pillar I), we still need clarification over the amount of additional capital that may be required for operational risk (the not so well-known Pillar II), which will be determined, based in part, on the quality of the bank's internal processes. Several regulators point out that at many banks the benefits of Pillar I may be compensated by Pillar II's additional capital requirements.

Other tools to support CBs and securitisations

In order to increase the “quality” of the assets backing a securitisation and therefore achieve a better tranching by the ratings agencies (that is, have more of the cheaper AAA tranche) and thus reduce the cost of funding, a number of techniques are normally used that could be classified as “internal” or “external” credit enhancements.

Examples of internal credit enhancements for securitisations include: the set-up of a cash reserve to absorb the first level of losses; the trapping of excess spread (meaning that in case of losses the lender may not receive all the interest from borrowers); and the presence of over-collateralisation. Also, the lender usually retains the equity (first loss) piece of a securitisation in order to reduce the average cost of funding of the remaining notes.

External credit enhancements, in contrast, require the participation of a third party. Such tools include:

• Primary mortgage insurance (lenders mortgage insurance) applied to high LTV loans - a very common technique in the US and Australia, where established mortgage insurance companies have a very strong reputation in the capital markets, now also gaining popularity in Europe
• Pool insurance policies - where the insurer will absorb a certain portion of losses up to a maximum threshold, popular in the US sub-prime market
• Financial guarantees
• Wraps - to ensure the performance of a portfolio or a specific tranche.

Of all these tools, covered bonds use only the technique of over-collateralisation. Securitisation, however, can utilise all the above-listed features, making them more nimble and, in many cases, more cost-effective. As the mortgage market becomes more diverse - in terms of product development and being increasingly able to meet the needs of potential homebuyers - the securitisation market has reacted with continuous innovation to ensure that risks and rewards are efficiently traded between originators and investors. The traditional covered bond, with its very established yet very rigid framework, may benefit from incorporating some of the flexibility of securitisation.