Overview Of The CBA

Finnish covered bonds are issued under the CBA, which entered into force on July 8, 2022, and implemented the EU Covered Bonds Directive. It repealed the MCBA. The MCBA continues to apply to covered bonds issued before July 8, 2022--unless otherwise provided in their terms--including any related tap issuances under certain conditions.

The issuer of Finnish covered bonds can be a universal bank or a specialist mortgage bank, subject to a license from the Finnish Financial Supervisory Authority (FIN-FSA) to engage in mortgage credit bank operations.

The covered bonds are direct, unconditional, and unsubordinated obligations of the issuer and rank pari passu among themselves and with related derivative contracts and management costs connected to a cover pool. Creditors of the aforementioned receivables have dual recourse to receive payments (i) from the issuer while solvent and (ii) from the cover pool assets in the issuer's insolvency. If any of the creditors' claims are not paid from the cover pool assets, the residual claims will rank pari passu with the issuer's unsecured and unsubordinated obligations.

Under section 19 of the CBA, issuers can have more than one cover pool. Pursuant to section 27 of the CBA, issuers must maintain a separate register for each cover pool, allowing for identification of the covered bonds issued thereunder and the associated cover pool assets. Assets included in a cover pool can only be used to pay obligations--including (i) all principal and interests of covered bonds the pool covers, (ii) obligations based on derivative contracts associated with covered bonds, and (iii) administration and liquidation costs--relating to covered bonds collateralized by that cover pool.

Cover pool assets are held on the issuer's balance sheet and/or the balance sheet of an intermediary loan debtor. Pursuant to the CBA, a covered bond issuer can grant an intermediary loan to a credit institution, provided that it belongs to the same consolidated group or amalgamation of deposit banks (group members) as the covered bond issuer. Under the intermediary loan process, the issuer channels the covered bond issuance proceeds via intermediary loans to group members. The group members must pledge eligible cover pool assets from their balance sheets to the cover pool as security for the covered bonds. The issuer must record these collateral assets in the cover register, together with the associated intermediary loan, and must ensure the cover pool continuously complies with the CBA and the contractual terms of the covered bonds. The CBA requires the intermediary loan's contractual terms to determine procedures to ensure the cover pool continuously complies with the requirements of the CBA.

The issuer monitors the cover pool and must at least quarterly report to the FIN-FSA. The FIN-FSA is responsible for overall supervision, covered bond licensing, issuing regulations, and compliance with the law.

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The EU Covered Bonds Directive

Finland implemented the EU Covered Bonds Directive by enacting a new legislation--the CBA--which repealed the MCBA.

The main changes include:

• A regulatory overcollateralization requirement of 2% of net present value (NPV) or 5% of NPV if the requirements of article 129 (3)(a) subparagraph 3 of the Capital Requirements Regulation (CRR) are not met.
• Loan-to-value limits of 80% of the market value of residential properties (previously 70%) and 60% of commercial properties when calculating the cover pool's total value, while covered bondholders' priority of payment right extends to 100% of the market value. The MCBA limited such priority right to 70% and 60% of the value of residential and commercial properties, respectively.
• Determination of the terms triggering a 12-month maturity extension of the covered bonds. FIN-FSA's approval for such an extension added.
• A liquidity buffer requirement covering 180 days of net outflow of the cover pool cash flows.
• Specification that eligible collateral needs to fulfill CRR article 129 requirements.
• The definition of eligible collateral includes received collateral under derivatives and receivables based on insurance claims relating to the cover pool assets.
• Public mandatory transparency (website information).

The implementation of the EU Covered Bonds Directive into Finnish legislation enhances the previous legal framework and does not materially affect our analysis. We believe the CBA addresses the main legal aspects we assess under our covered bonds criteria, specifically the cover pool assets' isolation from the risk of an issuer's bankruptcy or insolvency, so that covered bond payments continue on their scheduled dates (see "Covered Bonds Criteria," published on Dec. 9, 2014). This allows us to rate Finnish covered bonds higher than the rating on the issuer, subject to a review of each program's structure, documentation, and specific features, in accordance with our covered bonds criteria.

Five Key Factors In Our Assessment Of Finnish Covered Bond Programs

When assessing a covered bond program's underlying legal framework, we focus primarily on the degree to which the cover pool assets are isolated for the covered bondholders' benefit from the risk of an issuer's insolvency, and whether the insolvency is likely to restrict the full and timely payment of the covered bonds. Under our covered bonds criteria, if we conclude that an issuer's insolvency is unlikely to impede full and timely payments on the covered bonds, we may rate a covered bond higher than the issuer.

Below we outline how the CBA addresses the five key factors set out in our covered bonds criteria.

1 – Segregation of cover pool assets and cash flows

In assessing this factor, we examine whether the cover pool assets are fully available to meet the obligations under the covered bonds.

The CBA requires issuers to enter eligible collateral into a cover pool register and maintain such register. The covered bondholders and derivative counterparties have a priority right to the cover pool, which overrides the interests of general creditors and effectively segregates the assets recorded in the cover pool register from the issuer's general insolvency estate.

Under section 40 of the CBA, when an issuer or intermediary loan debtor has entered liquidation or bankruptcy proceedings, a cover pool supervisor appointed by the FIN-FSA oversees the cover pool's administration to ensure that contractual payments to bondholders and derivative counterparties are fully honored. The bankruptcy administrator/liquidator will manage the cover pool, but the cover pool supervisor oversees, directs, and approves their actions relating to the cover pool's management, safeguarding the covered bondholders' interests. The cover pool supervisor works together with the FIN-FSA and, where applicable, the resolution authority.

Under section 20 of the CBA, the cover pool operates as security for payments due under (i) covered bonds, (ii) registered derivatives, and (iii) the cover pool's administration and liquidation. Creditors of the aforementioned receivables (privileged creditors) are entitled to receive payments on a pari passu basis from the cover pool assets before all other creditors of the issuer or the intermediary loan debtor. Until all privileged creditors are fully paid, no other creditors may act against the cover pool assets.

This preferential status remains regardless of the insolvency of an intermediary loan debtor. The collateral pledged by the intermediary loan debtor included in the cover pool secures the issuer's obligations under the covered bonds, irrespective of the debtor's insolvency. These cover pool assets can be sold at the direction of the cover pool supervisor to fulfill the issuer's obligations under the covered bonds.

Under section 45 of the CBA, if an issuer or an intermediary loan debtor becomes bankrupt or insolvent, the bankruptcy administrator/liquidator, as applicable, may, with the consent of the cover pool supervisor, transfer cover pool assets to the bankruptcy estate or back to the issuer or the debtor only if the value of the cover pool assets considerably exceeds the minimum overcollateralization requirement. Additionally, it must be apparent that the collateral to be transferred is not necessary to fulfill the obligations under the covered bonds, derivative contracts, and bankruptcy liquidity loans (see below).

Therefore, in the insolvency of the issuer or an intermediary loan debtor, the cover pool assets are ringfenced and must be used to satisfy in priority the obligations due to privileged creditors. In an intermediary loan structure, we perform our analysis based on the underlying loans that are pledged as collateral for the covered bonds and form the cover pool.

Third-party execution risk.  As part of our asset isolation analysis, we evaluate the extent to which an issuer's third-party creditors might be able to enforce claims against the cover pool.

Third party creditors of the issuer or an intermediary loan debtor cannot challenge the priority status of the privileged creditors established in section 20 of the CBA. Under section 21 of the CBA, assets forming part of the cover pool may not be subject to a levy of execution or attachment. Furthermore, under section 21, collateral entered into the register for a covered bond in accordance with the CBA may not be recovered under the Act on Recovery of Assets to a Bankruptcy Estate (758/1991, as amended).

Additionally, the issuer or an intermediary loan debtor may not, without permission of the FIN-FSA, assign or pledge assets, which are included in the cover pool. Neither can a covered bond issuer assign nor pledge any intermediary loan without FIN-FSA permission.

Commingling risk.  This refers to the risk that cover pool collections fall into the bankrupt issuer's general estate and are either lost or frozen and therefore unavailable for payments to the covered bond program's priority creditors.

Under the CBA, before liquidation or bankruptcy proceedings against the issuer start, collections received from the cover pool assets are not separated from the issuer's other collections. Therefore, we believe commingling risk relating to cash flows pre-insolvency could arise. We analyze such risk on a transaction-specific basis, including the presence of any structural mitigants, for example dedicated cover pool accounts with appropriately rated banks according to our counterparty criteria (see "Counterparty Risk Framework: Methodology And Assumptions," published on March 8, 2019).

Following an issuer's or an intermediary loan debtor's liquidation or bankruptcy, under section 29 of the CBA, the funds accrued on the cover pool assets must be segregated from their other funds and entered into the register. Section 44 of the CBA additionally requires that after the commencement of liquidation or bankruptcy of an issuer, funds arising from the collateral, derivative contracts—or their collateral—and intermediary loans must be deposited in an account held with the Bank of Finland or a bank that does not belong to the same group or the same amalgamation of deposit banks as the issuer. The account receivable must be entered as collateral into the cover register, including the account bank name and number and the cover pool with which the account receivable is associated. Therefore, we understand that, under the CBA, collections from the cover pool assets are segregated from the collections of the issuer's other assets, following an issuer's liquidation or bankruptcy. We would typically not size commingling risk post insolvency.

Setoff risk.   This refers to the risk that borrowers are entitled to setoff amounts owed to them by the issuer (for example, from deposits that the borrowers may have with the issuer) against their repayment obligations under the loans that form part of the cover pool.

Under section 21 of the CBA, in the liquidation or bankruptcy of the issuer or an intermediary loan debtor, a creditor of the issuer or the intermediary loan debtor may not set off its claim against the cover pool assets, unless otherwise provided in the CBA. Under section 35 of the CBA, any right of recourse of an intermediary loan debtor due to the realization of the collateral assets provided by such debtor to the cover pool shall primarily be set off against the intermediary loan. Where the debtor has such a claim against the covered bond issuer exceeding the amount that can be set off against the intermediary loan, the claim shall not be payable before all covered bonds secured by the cover pool assets are fully repaid. In the bankruptcy or liquidation of the issuer, payments from an intermediary loan may only be used for fulfilling the obligations arising under the covered bonds.

Removal of assets from the cover pool without replacement if they cease to satisfy the eligibility criteria following an issuer's insolvency.   The CBA places no obligation on the cover pool supervisor to remove cover pool assets that fail to meet the eligibility criteria following an issuer's insolvency or bankruptcy.

2 – The risk of payment acceleration, payment moratorium, or forced restructuring of the covered bonds

Acceleration of payments.   Under the CBA, the issuer's bankruptcy or liquidation will not result in automatic acceleration of the covered bonds. Pursuant to section 39 of the CBA, in the event of bankruptcy of the issuer, a covered bond or a derivative contract shall not be deemed to have become due within the meaning of chapter 3, section 9 of the Bankruptcy Act (120/2004, as amended). Consequently, notwithstanding the issuer's liquidation and/or bankruptcy, a covered bond shall be paid until its maturity, in accordance with its terms and conditions from the cover pool assets before any other claims. The same applies to derivative transactions. We also understand that an intermediary loan debtor's insolvency would not affect the covered bond issuer's obligations. Therefore, a covered bond or a derivative contract will not fall due upon an intermediary loan debtor's insolvency.

Only in the instance where the total collateral amount requirements for the covered bonds cannot be fulfilled in the event of the issuer's or intermediary loan debtor's bankruptcy or liquidation, the bankruptcy administrator/liquidator must, upon the cover pool supervisor's request or approval, accelerate the covered bonds and related intermediary loans and sell the cover pool assets to pay privileged creditors. The essence of the cover pool supervisor's role, which also applies in this instance, is to protect the covered bondholders' interests.

Furthermore, under section 26 of the CBA, a derivative contract must contain a provision according to which it remains in force, notwithstanding an issuer's bankruptcy, liquidation, or resolution.

Moratorium and forced restructuring.  Covered bondholders enjoy preferential treatment as the CBA stipulates the separation of the cover pool assets from the issuer's general insolvency estate. Under the CBA, privileged creditors' payment from the cover pool is segregated from the general bankruptcy procedure and the repayment of associated bankruptcy debts under this procedure. Therefore, we understand that a moratorium, forced restructuring, or forced rescheduling of the issuer's payment obligations should not apply to covered bonds and should not affect the contractual payments of interest and principal to covered bondholders.

3 – Overcollateralization limits

The CBA sets out minimum overcollateralization and liquidity buffer requirements (2% of NPV or 5% of NPV if the requirements of article 129 (3)(a) subparagraph 3 of the CRR are not met; 180 days liquidity buffer; see table 1).

The CBA has no provision preventing issuers from voluntarily providing overcollateralization above the legal minimum. If an issuer enters into liquidation or bankruptcy, all cover pool assets entered into the register, including registered assets contributing to voluntary overcollateralization, are ringfenced. Accordingly, any claw-back of these cover pool assets is also excluded under sections 21 and 35.

4 – Treatment of hedging arrangements

Derivatives are cover pool eligible, provided they are used to hedge risks related to the cover pool register. Derivatives must be entered into the register. Derivative counterparties benefit from the same statutory priority right as covered bondholders.

Under section 26 of the CBA, derivative contracts shall, under their terms, remain in force, notwithstanding the issuer's bankruptcy, liquidation, or resolution. Moreover, under section 39 of the CBA, if the issuer becomes bankrupt, derivative contracts shall not be deemed to have become due within the meaning of chapter 3, section 9 of the Bankruptcy Act (120/2004, as amended).

5 – Access to funding after the issuer's insolvency

In our view, the Finnish covered bond law allows for the continued management of the cover pool until all privileged creditors are repaid.

Under sections 42 and 44 of the CBA, the cover pool supervisor is empowered to direct the bankruptcy administrator/liquidator to sell cover pool assets, enter into contractual arrangements to secure liquidity, or take out bankruptcy liquidity loans to ensure contractual payments to privileged creditors are honored.

Under section 44 of the CBA, bankruptcy liquidity loan providers have a right to receive payments from the cover pool assets after the privileged creditors have been fully paid.

Furthermore, under section 44 of the CBA, the supervisor can direct the bankruptcy administrator/liquidator to terminate or assign to a third-party a derivative contract if cover pool assets are sold or transferred. Likewise, the supervisor can demand the bankruptcy administrator/liquidator to enter into derivative contracts to hedge against risks related to the assets or the covered bonds.

Any of the above actions, when made on the bankruptcy administrator's/liquidator's initiative, is subject to the supervisor's consent, whose decisions must safeguard the covered bondholders' interests.

Section 32 of the CBA provides for the mitigation of short-term liquidity risk via a 12-month maturity extension if the covered bond terms contain such provision. Such extension is subject to FIN-FSA approval and certain conditions being met, including: (i) the issuer being unable to obtain long-term financing from ordinary sources, (ii) the issuer being unable to meet the liquidity requirement under the CBA upon payment of the covered bonds, and (iii) such extension not affecting the order of the maturity based on the original maturity dates of covered bonds secured by the same cover pool.

Related Criteria

• Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022