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EU covered bond harmonization could bring change, savings for Spanish issuers

An initiative to harmonize the framework for the EU's €2.1 trillion covered bond market could lead to big savings for issuing banks, particularly in Spain.

The European Commission has set out plans for an EU regulatory framework governing covered bonds, which in Europe are primarily backed by mortgages and which are seen as a stable source of relatively cheap funding for the continent's lenders. More than 80% of European covered bonds are used to refinance mortgages, and covered bonds financed roughly 30% of the €7 trillion in outstanding EU mortgage lending in 2015, according to the EC.

The EC aims to propose legislation in the first quarter of 2018, as part of its wider effort to create a capital markets union within the bloc. Objectives include establishing common requirements allowing for the "safe use of an EU covered bond label" across its single market, and justifying preferential capital treatment for covered bonds, while options for implementing the reforms include allowing the market and national regulators to take the lead or a full harmonization of rules such that only bonds complying with them would qualify for preferential treatment.

The proposed changes could require a significant overhaul of Spain's covered bond market, which has some 40 programs, according to EC estimates. Based on a new program startup cost of €2 million, a "start from scratch" approach in complying with harmonized rules would cost about €80 million.

But the EC said a lowering of covered bond premiums of a single basis point would generate savings of roughly €130 million for Spanish issuers. And overall, the EC says "it is clear that the benefit of increasing investor confidence alone would far outweigh any costs identified" and generate "multiple basis points of savings," with each basis point worth about €1.5 billion in terms of the entire volume of outstanding covered bonds, and €221 million for an average year's issuance.

Big changes ahead for Spanish market

In the case of Spain, Natixis credit analysts led by Thibaut Cuillière said in a note June 8 that the new rules could mean more protection for bondholders, lower cost of borrowing and more efficient usage of collateral. A package of reforms recommended by the European Banking Authority in December 2016 included a framework to ensure that covered bond assets are appropriately segregated and protected should the issuer fall into insolvency or resolution, a process that does not take place in Spain at present.

Instead, Spanish covered bonds, or Cedulas hipotecarias, are backstopped by the issuer's entire pool of mortgage assets, Moody's noted in a May 25 report.

The agency identified several aspects of pan-European harmonization that could be credit-negative for Spanish covered bonds, including that the creation of segregated cover pools would actually reduce the level of so-called overcollateralization — the extent to which the assets backstopping covered bonds exceed the issuance amount. Because Spanish covered bonds are collateralized by an issuer's entire loan book, the market as a whole is 127.4% overcollateralized, compared to between roughly 30% and 50% in most of the rest of Europe, Moody's observed.

By contrast, the EBA has proposed a minimum overcollateralization of just 5%, well below the 25% minimum required under Spanish law for mortgage covered bonds, Moody's noted.

The EBA proposals would also mandate "soft" limits on loan-to-value ratios within a cover pool, Moody's noted. Soft limits define the portion of a loan that can be used to collateralize a covered bond, to 80% in the case of residential mortgages, even if the loan has a higher LTV ratio than that.

By contrast, Spain imposes a "hard" LTV limit of 80% to determine the amount of covered bonds that can be issued, meaning that loans with a higher ratio are ineligible.

"This will definitely have some impact," Natixis credit analyst Jennifer Levy said of the LTV proposal.

Added Moody's: "If the EBA's proposals were implemented, the pool of eligible assets in Spain would increase and banks could issue more covered bonds backed by loans of less quality, all other things [being] equal."

However, the proposed changes also carry a number of potential credit-positive implications for Spanish covered bonds, Moody's said, including more stringent requirements around the availability of liquid assets; a mandate to appoint independent cover pool monitors and administrators; and enhanced reporting on market and liquidity risks in the covered bond program and data on the cover pool.

Enhanced transparency

The proposed changes in the framework will also increase transparency for investors, which will have a significant impact on the covered bond markets, Levy said.

Smaller markets should see an increase in issuance as a result of harmonization, as it allows investors who are more familiar with covered bond rules in bigger markets to incorporate new bonds into their purchase program, Gordon Kerr, senior vice president and head of EU research on global structured finance at rating agency DBRS, said in an interview.

The EC said harmonization "would reduce the burden of due diligence for investors when they invest in covered bond markets across borders. It could reduce costs and time currently needed to undertake separate analysis for the covered bonds of each member state based on their different legal frameworks. Such costs create barriers to entry for smaller or less sophisticated investors and inhibit issuance in member states where the market is smaller."