Covered Bond Guide 2013 6 November 2013

EuroPEan CrEd iT rEsEarCh i novEMbEr 2013

Covered bond Guide

n With a total outstanding volume in excess of 2.8trn euro equivalent globally, coveredbonds are one of the largest asset classes. The remarkable stability with which coveredbonds have proven themselves in the global financial crisis and the broad basedregulatory acknowledgment of covered bonds has boosted investor demand on a globalscale. Within this publication we look at the growing complexity of regulatory treatmentof covered bonds, defining features of covered bonds as well as the latest developmentsin rating methodologies. The comparison of covered bond frameworks focusses on the key markets that provide covered bond issuance in benchmark format.

Heiko [email protected]+44 20 7595 8569

www.GlobalMarkets.bnpparibas.com Please refer to important information found at the end of the report

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EUROPE

AmsterdamHerengracht 595Amsterdam 1017 CE, NetherlandsTelephone: +31 20 550 1212

Athens94 Vassilissis Sofias Avenue & Kerasountos1Athens 11528, GreeceTelephone: +30 210 74 68 000

BrusselsMontagne du Parc 31000 Brussels, BelgiumTelephone: +32 2 565 11 11

BudapestRoosevelt ter 7-8H-1051, Budapest, HungaryTelephone: +36 1 374 63 00

Dublin5 Georges Dock IFSCDublin 1, IrelandTelephone: +353 1 612 5000

FrankfurtEuropa, Allee 12Frankfurt, GermanyTelephone: +49 69 71930

Geneva2 Place de Hollande1211 Geneva 11, SwitzerlandTelephone: +41 22 787 7111

London10 Harewood AvenueLondon NW1 6AA, United KingdomTelephone: +44 20 7595 2000

LuganoRiva A, Caccia 1ALugano 6907, SwitzerlandTelephone: +41 58 212 4111

Luxembourg10A Boulevard RoyalLuxembourg L-2093Telephone: +352 46 47 1

New YorkThe Equitable Building, 787 Seventh AvenueNew York, NY 10019, USATelephone: +1 212 841 2000

San FranciscoOne Front Street, 23rd FloorSan Francisco, CA 94111, USATelephone: +1 415 772 1300

So PauloAv. Pres. Juscelino Kubitschek, 510, 12 andarSo Paulo 04543-906, BrazilTelephone: +55 11 3841 3100

ASIA-PACIFIC

Bangkok29th Floor, Abdulrahim Place990 Rama IV Road, BangrakBangkok 10500, ThailandTelephone: +66 2 636 1900

Beijing2001 China World Tower1 Jianguomenwai AvenueBeijing 100004, Peoples Republic of ChinaTelephone: +8610 6535 0888

Ho Chi Minh CitySaigon Tower, 29 Le Duan, Suite 504, Dist. 1Ho Chi Minh City, VietnamTelephone: +848 823 1265

Hong Kong63/F Two International Finance Centre8 Finance Street, Hong KongTelephone: +852 2909 8888

JakartaMenara BCA, 35th Floor, Grand IndonesiaJl. MH. Thamrin No. 1, Jakarta 10310IndonesiaTelephone: +62 21 2358 6262

Kuala Lumpur348 Jalan Tun RazakVista Tower, Level 48A, The Intermark50400 Kuala LumpurMalaysiaTelephone: +603 2179 8383

MadridCalle Serrano 735a Planta, Madrid 28006, SpainTelephone: +34 91 388 8300

MilanPiazza San Fedele 2Milan 20121, ItalyTelephone: +39 02 72471

Moscow1-2 Bolshoy, Gnezdnikovsky, Pereoulok125009 Moscow, RussiaTelephone: +7 095 785 6000

Paris3 rue dAntinParis 75002, FranceTelephone: +33 1 42 98 12 34

Sofia2 Tzar Osvoboditel BlvdSofia 1000, BulgariaTelephone: +359 2 9218 640

WarsawPl. Pilsudskiego 1Warsaw 00-078, PolandTelephone: +48 22 697 2300

ZurichSelnaustrasse 16Zurich 8022, SwitzerlandTelephone: +41 58 212 6111

AMERICAS

Buenos AiresBouchard 547, 26th FloorBuenos Aires C1106ABG, ArgentinaTelephone: +54 11 4875 4300

Chicago155N. Wacker Drive, Suite 4450Chicago, IL 60606, USATelephone: +1 312 977 2200

Montreal1981 McGill College Avenue, MontrealQuebec H3A 2W8, CanadaTelephone: +1 514 285 6100

Mumbai8th Floor, BNP Paribas House1 North Avenue, Maker MaxityBandra - Kurla ComplexBandra (East) Mumbai 400 051, IndiaTelephone: +91 22 3370 4000

Manila30th Floor Philamlife Tower8767 Paseo de Roxas AveMakati City, Metro Manila, Philippines 1226Telephone: +632 814 8700

Seoul23rd & 24th Floor, Taepyeongno Building310 Taepyeongno 2-ga, Jung-gu, Seoul 100-767, KoreaTelephone: +82 2 317 1700

Shanghai25F Shanghai World, Finance Centre100 Century Avenue, Shanghai 200120Peoples Republic of ChinaTelephone: +86 21 2896 2888

Singapore10 Collyer Quay, #31-00 Ocean Financial CentreSingapore 049315Telephone: +65 6210 1288

Sydney60 Castlereagh StreetSydney, NSW 2000, AustraliaTelephone: +61 2 9216 8633

Taipei72F, Taipei 101, No.7 Xin Yi Road Sec.5Taipei 110, TaiwanTelephone: +886 2 8758 3101

TokyoGranTokyo North Tower, 1-9-1 MarunouchiChiyoda-ku, Tokyo 100-6740, JapanTelephone: +81 3 6377 2000

MIDDLE EAST & ASIA

ManamaBahrain Financial HarbourFinancial Center - West TowerPO Box 5253, Manama, Bahrain Telephone: +973 1786 6666

2 European Covered Bond Research

Contents Covered Bonds in high demand 3

Australian Covered Bonds 21

Austrian Fundierte Anleihen 24

Austrian Pfandbriefe 27

Belgian Covered Bonds

Canadian Covered Bonds

29

32

Cypriot Covered bonds 35

Danish Covered Bonds 38

Dutch Covered Bonds 41

Finnish Covered Bonds 44

French Obligations Foncires 46

French Obligations de Financement de lHabitat 50

Caisse de Refinancement de lHabitat 54

German Pfandbriefe 56

Greek Covered Bonds 61

Hungarian Covered Bonds 63

Irish Asset Covered Securities 65

Italian Covered Bonds 68

Korean Covered Bonds 71

Luxembourgian Lettres de Gage 73

New Zealand Covered Bonds 75

Norwegian Covered Bonds 77

Portuguese Covered Bonds 80

Spanish Cdulas 83

Swedish Skerstllda Obligationer 86

Swiss Covered bonds 89

UK Covered Bonds 91

US Covered Bonds 94

Appendix - Glossary 97


Covered bonds in high demand Covered bonds have been the asset class of remarkable stability during the global financial crisis. Rating and spread volatility of covered bonds have been significantly below the levels seen in comparable unsecured bank bonds and government bonds. On the issuer side, covered bonds have provided access to funding, be it through market directed or retained issuance, even at times of greater overall market volatility. The relative strength of covered bonds and the long track record of the asset class can be seen as the main reasons behind the preferential regulatory treatment that covered bonds enjoy in a number of areas. Such treatment ranges from lower haircuts for covered bonds as repo collateral with central banks, reduced risk weightings, lower capital charges for insurance companies under Solvency 2 to eligibility of covered bonds as liquid assets for the planned Liquidity Coverage Requirement (LCR).

Benchmark covered bond issuance denominated in euro

020406080

100120140160180200

2010 2011 2012 30-Sep-13

OthersAustraliaAustriaFinlandSwedenNetherlandsNorwayItalyUKSpainGermanyFrance

EUR bn

Source BNP Paribas The preferential treatment of covered bonds has noticeably increased demand from investors. The fact that Basel 3 will make covered bonds LCR eligible also outside the EU has already led to increased investor interest on a more global scale. This development should also help to expand benchmark issuance in currencies other than euro.

The increased demand for covered bonds has hit the market at a time when issuance volumes are significantly below levels seen in 2011 and before. Reduced issuance activity in a world where more banks than ever before have covered bond programmes sounds somewhat counter intuitive. However, with most banks having lower funding requirements due to ongoing deleveraging and stagnating mortgage markets in several countries it is understandable that covered bond issuance is below record volumes of previous years. Another factor that has reduced issuance volumes is the increased reliance of banks on central bank funding. The two LTROs of the ECB and the Funding for Lending Programme of the Bank of England are the most prominent examples. Offering cheap central bank funding has caused a larger number of banks to channel the already reducing funding volumes away from the covered bond market. It is important to recognise that both factors are of a temporary nature. A stronger reliance on market


based funding and a recovery of local mortgage markets could result in a resurgence of covered bond issuance volumes. Until then, the imbalance between supply and demand is likely to continue which should be supportive for relatively tight spread levels within the covered bond market.

Use of covered bonds as collateral within the ECB Eurosystem

0

100

200

300

400

500

2004 2005 2006 2007 2008 2009 2010 2011 2012 Q2 2013

EUR bn

Source ECB Despite the greater importance of secured funding and a very protracted recovery of the securitisation sector, product innovation within the covered bond market has remained relatively limited in recent years. The use of alternative asset classes (i.e. other than public sector debt or mortgage loans) as collateral for covered bonds has only occurred sporadically since the outbreak of the global financial crisis. One of the most recent examples has been the issuance of a covered bond secured by loans to small and medium sized enterprises (SME loans) by Commerzbank in Germany. At the time of writing there had been no follow-up issuance from the same or other issuers despite the positive market resonance of the inaugural bond. The pace of future product innovation in the covered bond market will, in our view, depend mainly on increasing funding needs, the availability of funding alternatives (i.e. central bank funding or securitisation) as well as risk appetite from investors. Given that preferential regulatory treatment of covered bonds will likely remain an important driver of covered bond demand, reliance on non-legislative or structured covered bonds for alternative collateral usage may impact the competitiveness of covered bonds over securitisation. Broadening asset definitions within the covered bond frameworks may lead to a better regulatory treatment of covered bonds with alternative collateral but ultimately bears the risk of a dilution of the covered bond product.

The covered bond concept The expansion of the covered bond sector also means that heterogeneity within the sector potentially increases as covered bond frameworks or programmes are tailored to meet the requirements set by the local market or issuers. Nevertheless, the defining core features of a covered bond have not changed:

Preferential claim of the covered bondholder on a segregated pool of assets. In the event of the issuers bankruptcy, the assets in the cover pool are used exclusively to satisfy the claims of covered


bondholders. Other creditors typically have no access to these assets until all covered bondholders have been fully repaid.

Full recourse against a bank, acting as an issuer or asset originator. Covered bonds are senior obligations of the issuer/originator. In a pre-bankruptcy scenario, interest and capital on the outstanding covered bonds are paid through the overall cash flow of the issuer and are not limited to the cash flows arising from the cover pool. In the event of an issuers bankruptcy, claims from covered bondholders which cannot be satisfied from the cover pool rank pari passu with unsecured creditors of the issuer.

Dynamic nature of the cover pool. Maturing or defaulting assets within the cover pool are replaced by the issuer to ensure that there is always sufficient cover for the outstanding covered bonds. In many frameworks, the composition and value of the cover pool is observed by an independent cover pool monitor, which usually reports to the banking supervisory authority. In the case of structured covered bonds, the monitoring of the cover pool is mainly conducted by the rating agencies. Auditing firms usually run annual checks on the validity of the asset cover test calculations.

Non-acceleration in the event of the issuers/originators bankruptcy. In the event of the issuers bankruptcy, cash flows arising from the segregated pool of assets will be used to make interest and capital payments on the outstanding covered bonds as originally scheduled. Even though this sounds relatively straightforward it can lead to a number of questions about management of the segregated pool, as well as mismatches between cover assets and covered bonds in terms of interest rates, currencies and maturities. These problems are addressed mainly in the post-bankruptcy procedures and the asset/liability matching requirements contained in the covered bond framework. Increasing penalisation of asset liability mismatches through rating agencies have recently led to the issuance of covered bonds where the payment structure of the covered bonds can turn from a bullet repayment into a pass through under certain conditions in a post-bankruptcy environment. As a result, issuers can achieve a higher rating uplift for their covered bonds over their unsecured rating.

The way in which these core features are implemented differs significantly between frameworks, with the segregation of cover assets being the main point of differentiation. Currently, one can identify four main systems of asset segregation in the covered bond universe, namely:

On-balance sheet register The classic form of asset segregation relies on the earmarking of cover assets through a special cover register. Respective bankruptcy or covered bond legislation provides a preferential claim of the covered bondholders on the registered cover assets in the event of the issuers bankruptcy. The register is usually kept by an independent monitor which ensures that only eligible assets are entered and that there is always enough collateral to secure the outstanding covered bonds. The cover assets remain on the balance sheet of the issuer/originator and are only segregated in the event of the issuers bankruptcy. Covered bondholders have full recourse against the issuer/originator. A typical example for this type of asset segregation would be the German Pfandbrief.


Bankruptcy remote subsidiary This method is based on the segregation of assets outside the originators balance sheet. In this case the cover assets are transferred to a bankruptcy remote subsidiary which uses these assets as collateral for the covered bonds. It is important to note that the subsidiary cannot be affected by the bankruptcy of the parent company. On the other hand, covered bondholders only have access to the assets held by the subsidiary and no further direct recourse against the parent company. Typically, all of the assets held by the subsidiary are collateral assets. A typical example for this type of asset segregation would be French Obligations Foncires.

Assignment to a guaranteeing vehicle This segregation method uses a transfer of cover assets to an SPV or trust based on an equitable or silent assignment. Instead of issuing a covered bond itself, the SPV or trust will issue a guarantee for a senior unsecured bond from the originating bank. The equitable or silent assignment means that the transfer of assets to the SPV or trust is only completed upon certain trigger events such as the issuers default. From that moment on, the SPV or trust will take over payment of interest and capital to the covered bondholders. The bondholders have full recourse against the issuer/originator based on the senior bond and additional recourse against the SPV or trust based on the guarantee. A typical example for this type of asset segregation would be UK Covered Bonds or Canadian Covered Bonds.

Using secured loans or secured bonds as collateral Within this method, the actual collateral (e.g. mortgage loans) stays with the originating bank and is used as collateral for a loan that is extended from, or a bond that is sold to, a separate entity. This entity can be a Special Purpose Vehicle (SPV) or a specialised banking subsidiary. The SPV or subsidiary then issues a covered bond that matches the terms of the secured loan or bond (i.e. same amount, coupon and payment dates). Each covered bond is thus secured by one or several secured bonds or loans with identical terms. However, all secured loans or bonds are collateralised by the same pool of assets which is held by the originating bank. While the covered bond issuer is merely passing on cash flows to the covered bondholders, asset substitution is conducted at the level of the originator, which has to ensure that the secured bonds/loans are sufficiently collateralised. As the secured bonds/loans are full recourse obligations of the originator, this recourse is passed on to the covered bondholders through the covered bond issuer. A typical example for this type of asset segregation would be French Obligations de Financement de lHabitat or US Covered Bonds.

In some cases, the above-mentioned segregation methods can be combined. This is usually the case where a special bank principle requires the establishment of an issuing subsidiary, which in turn needs to segregate assets within its balance sheet via a cover register. The segregation within the issuing subsidiary becomes necessary if the subsidiary also holds other types of assets which are funded via senior unsecured debt. A typical example for this type of asset segregation would be Irish Asset Covered Securities.


Although the asset segregation is such a vital part of the covered bond concept, it tells little about the quality of the covered bond. Composition of the cover pool, matching requirements, supervision, post-bankruptcy procedures and, to a varying extent, the creditworthiness of the issuer are important factors for the quality of a covered bond. However, the asset segregation largely impacts the dynamics of a covered bond, and thus influences the effectiveness of the other security features.

Rating Divergence of ratings within the covered bond sector has continued to increase during 2012 and, year to date in 2013. The ongoing pressure on sovereign and senior bank ratings has been the main driver of this development. The scale of the rating migration can be illustrated with the following example given by Moodys. In Q1 2011 over 70% of covered bonds rated Aa3 or higher by Moodys in countries with a sovereign rating of A1 and below were rated. In Q4 2012 no covered bonds in countries with a sovereign rating of A1 or below were rated Aa3 or above. The downward trend of ratings was also observable at S&P and Fitch as well as within rating brackets other than the single-A bracket. While a larger number of covered bonds have moved from the AAA rating bracket to the single-A and double-A rating bracket, there has also been a small but increasing number of covered bonds with sub-Investment Grade ratings.

When sovereign and bank ratings are under pressure, the rating uplift on covered bonds of an issuers unsecured rating often decreases, this was a key driver of the rating volatility seen during the crisis. When focussing purely on credit risk, the decline in rating difference between covered bonds and senior unsecured debt of the issuer in times of stress is somewhat counter intuitive. One would expect that the asset quality within the cover pool would deteriorate at a slower rate than outside of the cover pool, especially considering that the issuer would have to substitute assets in the cover pool that no longer meet the eligibility criteria. This should lead to a scenario where the rating gap between covered bonds and unsecured debt would actually increase rather than decrease. The reason why we have seen the opposite development is linked to the fact that liquidity risk and counterparty risk have gained significant weight in the rating process during the crisis. The fact that covered bonds typically have a mismatch of cash flows between cover assets and outstanding liabilities means potential liquidation of cover assets in a post-bankruptcy scenario can lead to cash flow shortfalls depending on achievable prices. Thus, the need to sell assets in order to repay maturing covered bonds in a post-bankruptcy scenario exposes covered bondholders to market risk. The deteriorating credit worthiness of a sovereign and its banking sector can cause the rating agencies to change their assumptions about how difficult it may be to liquidate cover assets and thus impact the rating uplift granted to covered bonds above the issuers unsecured rating. In addition, the lowering of rating ceilings for covered bonds (or structured finance products in general) in connection with declining sovereign ratings can also reduce the rating uplift provided for covered bonds.


Relevance of covered bond ratings remains high Despite the call from regulators and politicians to curb the power of the rating agencies, the relevance of ratings and their ability to impact the market abides. Minimum rating requirements contained in the investment criteria of certain institutional investors may be one of the reasons for the strong rating impact. However, we regard the linking of regulatory treatment to certain rating levels as the significant driver behind the strong impact of rating levels. Preferential risk weighting, eligibility for Liquidity Coverage Ratio (LCR) and eligibility for liquidity operations with central banks are the most important examples where regulatory treatment is linked to a certain minimum rating. Losing such preferential treatment due to a rating downgrade can lead to selling pressure and increased spread volatility. While this development is not desirable, it is likely that future regulation will also rely on minimum ratings as one of the criteria that need to be met for preferential treatment.

Average euro benchmark covered bond swap spreads (2018-2021)

0

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400

500

600

Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13

GermanyFranceSpainItalyNordic Region

bp

Source BNP Paribas S&P Since 2010, S&Ps rating methodology for covered bonds links the covered bond rating to the creditworthiness of the issuer. Previously, the agency had employed a delinked approach for most covered bond products. Linking the covered bond rating to the rating of the issuer is based on the assumption that payments on covered bonds may be affected by the failure of the issuing bank. One key element of linking the covered bond rating to the issuer rating is determining asset-liability mismatch (ALMM) between the covered bonds and the cover pool.

Before the ALMM risk is determined S&P looks at legal, regulatory and administrative risks to ascertain how likely a default for the issuer will impact its covered bonds. The aim is to determine if the covered bonds can be rated higher than the issuer and to what extent additional structural mitigants might be necessary to get to a better rating.

The analysis of cover pool specific factors include credit quality check of the cover assets and a cash flow analysis that looks at ALMM risk.


Asset-liability mismatch: S&P classifies ALMM risk in three categories: low, moderate or high. The classification is based on the magnitude of the ALMM risk (considering cash flow mismatches but also potential credit risk) and the timing of the mismatch. Mismatches occurring later have a less severe impact than mismatches that occur earlier.

Programme categorisation: S&P will segment the covered bond programme country by country, based on the external funding options available to the programme as well as the track record and systemic importance of the covered bond product in the its country. S&P uses three categories (see table below); the higher the category, the higher the potential rating uplift.

Based on the ALMM risk and the programme categorisation, S&P determines the maximum achievable rating uplift of the covered bonds from the issuers unsecured rating. Following that, S&P calculates the amount of credit enhancement necessary to achieve the maximum possible uplift.

Maximum achievable rating uplift (notches) Programme Category

ALMM risk 1 2 3

Zero Unrestricted Low 7 6 5 Moderate 6 5 4 High 5 4 3

Source S&P At the final stage, S&P determines whether other external factors such as counterparty risk or country risk can limit the level of achievable ratings for covered bonds. Depending on the counterparty criteria, S&P may link the rating of the covered bonds to the rating of one or more counterparties (typically derivative counterparties or bank account providers). One way to avoid such a linking, which could result in a lower covered bond rating, would be the use of appropriate counterparty replacement clauses within the programme that act upon the breach of certain rating triggers.

Country risk can limit the achievable covered bond rating either through the jurisdiction of the issuer or the assets in the pool (or both). Specifically, for public sector covered bonds, S&P limits the achievable covered bond rating to one notch above the rating of the country under which jurisdiction a substantial part of the cover assets fall. In October 2013, S&P launched a request for comment on a planned amendment of its structured finance rating methodology. The proposed changes could cap the rating level that mortgage covered bonds can achieve to two to four notches above the sovereign rating, depending on the level of asset liability mismatch. If implemented as proposed, the amendment would mainly affect covered bonds of higher rated issuers in peripheral countries such as Italy and Spain where covered bonds are currently rated up to six notches above the sovereign rating.


Moodys Moodys employs a two-step approach when rating covered bonds. In the first step Moodys applies its expected loss method. The second step consists of applying a cap to the rating that resulted from the first step on the basis of Moodys Timeliness of Payment Indicator (TPI) framework.

Moodys expected loss model looks at the credit strength of the issuer prior to the issuers default and the value of the cover pool following the issuers default. The value of the cover pool is determined through three main categories: credit quality of the pool, refinancing of the pool and interest rate and currency mismatches. The credit quality of the pool determines the amount of loss due to credit deterioration after an issuer default. It can also have an impact on refinancing risk as Moodys assumes that lower quality or non-standard assets may be more difficult to liquidate. Moodys measures the credit quality of the pool though the Collateral Score. Refinancing risk looks at cash flow mismatches between the cover pool and the outstanding covered bonds. Moodys applies haircuts to the collateral value to reflect market risk which can reduce the price achievable in an asset sale. Finally, Moodys incorporates interest rate and currency risk by running stressed scenarios.

The Timely Payment Indicator (TPI) measures the likelihood of timely covered bond payments after the default of the issuer. The TPI limits the maximum number of notches between the covered bond rating and the rating of the issuer. The TPI has six categories ranging from very improbable to very high. The higher the TPI, the higher the delinkage between the sponsor bank and the covered bond ratings. In order to determine the TPI Moodys looks at the relevant jurisdiction (including the level of potential systemic support) as well as programme specific features (such as maturity extensions or reserve funds). For each covered bond programme, an individual TPI is published. The TPI in connection with the issuers unsecured rating can be used to determine how much (if at all) a downgrade of the issuer would affect the covered bond rating. However, there has been incidents where Moodys has lowered the TPI in the case of significant downgrades of the sovereign rating, which led to stronger downgrades of the covered bonds in that country than otherwise expected.

In September 2013, Moodys published a request for comment (RFC) on a planned change of its rating methodology for covered bonds. The main reason for the RFC is the expected explicit exemption of covered bonds from a bail-in as stipulated in the latest proposal of the EU Bail-In Directive. In order to reflect the support that covered bonds may receive in a bail-in through the burden-sharing of unsecured creditors as well as the increased probability that the issuer will end up in an orderly wind down rather than bankruptcy, Moodys proposes an alternative anchor point for the issuers covered bond rating. This alternative anchor point is the adjusted Baseline Credit Assessment (BCA), which reflects the banks standalone financial strength relative to other banks including potential parental support. Based on the availability of bail-inable debt, Moodys intends to add up to two notches to the adjusted BCA in order to determine the anchor point for the covered bonds. Since Moodys acknowledges that some banks may still benefit from public sector support, the senior unsecured ratings (which incorporates public sector support) will still be used as an alternative rating


anchor for covered bonds in such cases. The agency expects that the majority of European covered bonds which are not yet Aaa rated or capped by a sovereign ceiling could be upgraded by a notch or two as a result of the proposed changes.

Fitch In its rating methodology Fitch generally links the covered bond rating to the Issuer Default Rating (IDR) of the issuing bank. The rating agency mainly addresses probability of default but also gives some rating uplift on a recovery basis. The risk that the default of the issuer will cause a default of the covered bonds is evaluated in Fitchs Discontinuity Caps (D-Caps). D-Caps determine the maximum rating notch uplift for the covered bonds from the IDR. Fitch has eight different D-Caps categories which correspond with the number of achievable notches of rating uplift for the covered bonds. The D-Caps rank from zero (full discontinuity) to eight (minimal discontinuity). The D-Caps are driven by five risk components: asset segregation, liquidity gap and systemic risk, systemic alternative management, cover pool specific alternative management and privileged derivatives.

The first step is for Fitch to determine the maximum achievable covered bond rating on a probability of default basis which corresponds with a certain level of overcollateralisation using its D-Caps categorisation. The second step comprises the stress testing of the overcollateral using certain assumptions in a wind down scenario of the issuer. The stresses include, among other factors, credit losses, cost for bridging maturity gaps, adverse interest rate and currency scenarios as well as expenses for cover pool managers. In the final step, Fitch determines the level of expected recovery from the cover pool and applies a notching to the rating level, which has been determined by the covered bond probability of default. Depending on the outcome of the stressed recovery assessment, Fitch can provide a further uplift of up to two or three notches.

In addition to the above mentioned parameters, the sovereign rating of the jurisdiction of the issuer or a substantial part of the cover pool can limit the maximum achievable rating. It is also worth noting that Fitch gives less credit to overcollateralisation where the programme is dormant or in wind down, which could lead to rating pressure in cases where an issuer receives support and subsequently is put into wind down.

Regulatory treatment of covered bonds Due to their relatively high safeguards and stability covered bonds offer compared to other categories of bank debt, they are enjoying preferential regulatory treatment in a number of cases. Within the EU, preferential treatment of covered bonds has been known since the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive which granted higher investment limits for certain institutional investors and laid the foundation for lower risk weighting of covered bonds. More recent regulation such as Basel III has broadened the recognition of covered bonds beyond the borders of the EU area by granting them eligibility for the upcoming Liquidity Coverage Requirement (LCR). This in turn has given demand for covered bonds from investors located outside Europe a significant push. As the regulatory environment is still very much in flux and the implementation of new regulation may lead to further changes in some cases, it is difficult to


predict which covered bonds exactly will be affected and what market impact it will bring. It is clear though that regulatory treatment has become a significantly bigger driver of market dynamics for covered bonds, which also bears the risk that future changes to the regulatory environment may lead to more significant price movements. In this chapter we are looking at the current status of main regulation which grants preferential treatment to covered bonds.

Risk weighting Covered bonds are bank obligations and thus have the same risk weighting as senior bank debt unless there is a preferential regulatory treatment in place. Within the EU this preferential treatment is granted to covered bonds based on the European Capital Requirements Directive (CRD) of 2006. This regulation is being replaced by the CRD4 Package which will be applicable from 2014 onwards.

The CRD4 Package, which consists of the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD) continues to refer to the UCITS directive in order to define covered bonds. Article 52 (4) of the UCITS directive requires that:

Issuer is an EU credit institution; Bonds are issued on the basis of a legal provision to protect

bondholders; Special supervision by public authorities; Sums deriving from the issuance must be invested according to the law

in assets which cover the claims of the bondholders; Bondholders have a preferential claim on assets if the issuer fails; The member states must notify the EU Commission. In addition to the referral to Article 52(4) of the UCITS directive, the CRD4 Package (Specifically Article 129 of the CRR) holds another set of requirements which focus predominantly on the quality of the cover assets. Article 129 of the CRR contains the following collateral criteria:

Exposures to or guaranteed by central governments, EU central banks, public sector entities, regional governments or local authorities in the EU;

Exposures to or guaranteed by Non-EU public sector entities if they qualify for the credit quality assessment step 1 (minimum rating of AA-). Non-EU public sector entities that qualify for the credit quality assessment step 2 (rated between A+ and A-) are limited to 20% of the nominal amount of outstanding covered bonds;

Exposures to credit institutions that qualify for the credit quality assessment step 1 (minimum rating of AA-) if the total exposure to these types of institutions does not exceed 15% of the nominal amount of outstanding covered bonds. Exposures to credit institutions within the EU with a maturity not exceeding 100 days shall not be comprised by the AA- minimum rating requirement. Supervisory authorities, after the consultation with the EBA, may allow the inclusion of exposures to credit institutions rated at least A- of up to 10% of the amount of outstanding covered bonds if it helps to avoid concentration risk which would occur by limiting exposure to AA- rated institutions;


Residential mortgage loans with a maximum LTV of 80%; French home loans with a maximum LTV of 80% and with a loan-to-

income ratio of not more than 33% at the time of granting. The protection provider of the home loans must have a minimum rating of A-;

Commercial mortgage loans with a maximum LTV of 60%. Commercial mortgage loans with a maximum LTV of 70% are permitted if the covered bonds provide for a minimum over-collateralisation of 10%;

RMBS which are secured by at least 90% with mortgages with a maximum LTV of 80%, as long as the share of these RMBS does not exceed 10% of the outstanding covered bonds and the RMBS tranches are rated Aa3/AA- or higher;

CMBS which are secured by at least 90%, with mortgages with a maximum LTV of 60%, as long as the share of these CMBS does not exceed 10% of the outstanding covered bonds and the CMBS tranches are rated Aa3/AA- or higher;

Ship mortgage loans with an LTV of up to 60%. The CRD4 Package also sets a certain minimum disclosure standard for covered bonds to receive preferential treatment. On a semi-annual basis information must be available on:

The value of the cover pool and outstanding covered bonds; The geographical distribution and type of cover assets, loan size,

interest rate and currency risk; The maturity structure of cover assets and covered bonds; and The percentage of loans more than ninety days past their due date. Credit institutions investing in covered bonds have to demonstrate to the regulators that they receive the above listed information as part of their due diligence in order to benefit from the preferential risk weighting.

Until the end of 2017, the share of RMBS and CMBS is not limited if the underlying residential or commercial mortgage loans were originated by a member of the same consolidated group of which the issuer is also a member. Before the end of 2016 this regulation will be reviewed and potentially amended. Covered bonds meeting the above listed requirements qualify for preferential treatment when determining the risk weighting under the Standardised Approach as well as the Internal Ratings Based Approach.

Standardised Approach: With the implementation of the CRD4 Package the risk weighting of the covered bonds is no longer linked to the rating of the issuer (or the country the issuer is located in) but to the rating of the covered bond itself. Only in cases where there is no covered bond rating, the risk weighting still depends on the rating of the issuing entity.

Risk weighting of covered bonds under the Standardised Approach Covered Bond Rating

AAA to AA-

A+ to A- BBB+ to BBB-

BB+ to BB-

B+ to B- CCC+ or lower

Risk weighting 10% 20% 20% 50% 50% 100%

Source - European Commission, BNP Paribas


Internal Ratings Based Approach (IRB): Within the IRB, the risk weighting is based on the following parameters: Probability of Default (PD), Loss Given Default (LGD), Maturity of the bond and Exposure at default. The Foundation IRB allows the bank that holds the covered bond to assess PD itself, provided that it will not reach a value of less than 0.03%. LGD and maturity are set by the regulator. With the amendment of CRD in June 2010, an LGD level of 11.25% was introduced for all covered bonds. Previously covered bonds could only reach a LGD level of 11.25% in special circumstances, while the general LGD level for covered bonds was set at 12.5%. The maturity is set at 2.5 years for all covered bonds. Under the Advanced IRB, both PD and LGD have to be estimated by the credit institution. The maturity can be set within a range of one to five years. The use of the IRB will, in most cases, result in risk weightings for covered bonds which are below 10%, as long as the issuer is rated single-A or better. For covered bonds of issuers, which are rated in the BBB area, the risk weighting will be higher than 10%.

Covered bonds issued before 31 December 2007 which meet the requirements of article 52(4) UCITS but not the CRD4 requirements, still benefit from preferential treatment until their maturity.

Liquidity Coverage Requirement According to Basel regulation and its EU equivalent CRD4 banks will be required to hold a stock of high quality liquid assets to cover the total assumed volume of net cash outflows over a 30 day period in a stressed scenario. The assets must be unencumbered, i.e. cannot be used as collateral for other transactions (including repo transactions with central banks). Under Basel rules, high quality liquid assets are split into Level 1 Assets and Level 2 Assets. Level 2 Assets are split again into Level 2A and Level 2B Assets. At least 60% of the total stock of liquid assets must be comprised of Level 1 assets.

The following assets are considered Level 1 Assets:

Cash. Central bank reserves. Marketable securities issued or guaranteed by: sovereigns, central

banks, non-central government public sector entities, the BIS, the IMF, the European Commission or multilateral development banks. The aforementioned securities need to be 0% risk weighted, traded in large, deep and active repo or cash markets characterised by low levels of concentration. The securities must have a proven track record as a reliable source of liquidity in the markets even during stressed market conditions. The securities must not be an obligation of a financial institution or any of its affiliated entities.

The following assets are considered Level 2A Assets:

Marketable securities issued or guaranteed by: sovereigns, central banks, non-central government public sector entities or multilateral development banks. The aforementioned assets need to be 20% risk weighted, traded in large, deep and active repo or cash markets characterised by a low level of concentration. The securities need to have a proven track record as a reliable source of liquidity in the markets


even during stressed market conditions (the Basel paper names a maximum decline of price, or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10% as a measure for this). The securities must not be an obligation of a financial institution or any of its affiliated entities.

Covered bonds and corporate bonds if they are rated at least AA-; such bonds need to have the same track record in trading and liquidity as the other marketable securities in the Level 2 bucket.

Senior bank debt is not eligible. All Level 2A Assets are subject to a 15% haircut. Level 2B Assets can comprise RMBS (25% haircut), corporate debt securities rated between A+ and BBB- (50% haircut) or common equity shares (50% haircut). Level 2B Assets must not account for more than 15% of the total stock of liquid assets. Level 2A and 2B Assets together must not account for more than 40% of the liquid buffer.

The CRD4 Package which implements the Basel regulation on an EU level defines covered bonds that are eligible for the LCR as those which meet the requirements of article 52(4) of the UCITS directive. Instead of Level 1 Assets and Level 2 Assets, the CRD4 Package refers to assets of extremely high liquidity and credit quality and assets of high liquidity and credit quality. Covered bonds could be considered as assets of extremely high liquidity and credit quality under certain circumstances, which would mean that no 40% limit and a lower or no haircut or would be applied. However, it will be up to the EBA to advise the European Commission on which liquidity category covered bonds will fall into and under which conditions. The EBA will also determine haircuts of the different asset groups, taking the haircuts set by the Basel group as a minimum. The EBA will base its assessment, to a large extent, on quantitative factors such as trade volume, maximum bid/ask spread and other metrics of price transparency and volatility. In a public hearing in October 2013, the EBA presented very preliminary results of its assessment in which covered bonds ranked at the same level as government bonds. While this does not guarantee that covered bonds will be considered assets of extremely high liquidity and credit quality in the final report, it increases the chances for a favourable treatment of the asset class. The final EBA report is due by 31 December 2013.

Implementation of the LCR requirement will happen gradually starting from the beginning of 2015 with 60% of the requirement with full implementation at the beginning of 2018.

Bail-in Covered bonds enjoy preferential treatment under the proposed Bail-In Directive of June 2012. The proposed directive aims at providing the necessary tools to resolve a failing financial institution in an orderly manner while minimising the burden-sharing on taxpayers. One key tool is Bail-In, which means the authoritys ability to write down and convert into equity claims of shareholders and debtors.


The proposed Bail-In Directive explicitly exempts secured liabilities, including covered bonds, from bail-in. In cases where the collateral does not fully cover the secured liabilities, burden sharing can be applied to the uncovered part of the secured liabilities. The proposed directive does not specify how it should be determined whether there are sufficient cover assets for the outstanding covered bonds. Unless nominal values are used to make such an assessment at the time of bail-in, the decision whether or not covered bondholders may be affected by the bail-in could depend on the valuation of the cover pool. According to the proposal, EU countries have the option to exempt UCITS compliant covered bonds from bail-in completely, i.e. also in the case of the collateral being insufficient to secure all covered bonds. The proposed directive stipulates the application of the bail-in tool effective from January 2018.

Solvency II Solvency II aims to provide a regulatory framework for insurance companies that provides capital requirements and risk management standards. One key element of Solvency II focuses on market risk associated with the assets held by insurance companies and the capital necessary to cover such risk. Covered bonds that comply with article 52(4) of the UCITS directive are eligible for preferential treatment under Solvency II. The most important preferential treatment is the reduced capital charge for spread risk which applies to covered bonds rated at least AA-. Covered bonds rated below AA- are treated like senior unsecured exposure. According to the current proposal the difference in spread risk capital charge for covered bonds compared to unsecured exposure ranges from 0.2 percentage points for bonds with one year duration (both for AAA and AA rated covered bonds) to 1.1 percentage points for bonds with 10 year duration (1.4 percentage points for AA rated covered bonds). Implementation of Solvency II is not expected before 2016.

Covered bonds within the ECB collateral framework Covered bonds receive a preferential treatment over unsecured bank bonds and ABS within the collateral framework of the ECB. The preferential treatment of covered bonds results in the assignment to a lower haircut category. The collateral framework has five haircut categories. Government bonds and central bank debt falls within Category I. Jumbo covered bonds, together with local and regional government debt as well as agency and supranational debt fall in Category II. Category III contains traditional covered bonds (i.e., non Jumbo format), structured covered bonds Spanish multi-Cdulas, as well as corporate bonds. Unsecured bank debt falls in Category IV, while ABS falls in Category V.


ECB haircuts by liquidity category and residual maturity

Residual maturity (years)

Fixed coupon

zero coupon

Fixed coupon

zero coupon

Fixed coupon

zero coupon

Fixed coupon

zero coupon

0-1 0.5 0.5 1.0 1.0 1.0 1.0 6.5 6.51-3 1.0 2.0 1.5 2.5 2.0 3.0 8.5 9.03-5 1.5 2.5 2.5 3.5 3.0 4.5 11.0 11.55-7 2.0 3.0 3.5 4.5 4.5 6.0 12.5 13.5

7-10 3.0 4.0 4.5 6.5 6.0 8.0 14.0 15.5>10 5.0 7.0 8.0 10.5 9.0 13.0 17.0 22.5

Residual maturity (years)

Fixed coupon

zero coupon

Fixed coupon

zero coupon

Fixed coupon

zero coupon

Fixed coupon

zero coupon

0-1 6.0 6.0 7.0 7.0 8.0 8.0 13.0 13.01-3 7.0 8.0 10.0 14.5 15.0 16.5 24.5 26.53-5 9.0 10.0 15.5 20.5 22.5 25.0 32.5 36.55-7 10.0 11.5 16.0 22.0 26.0 30.0 36.0 40.0

7-10 11.5 13.0 18.5 27.5 27.0 32.5 37.0 42.5>10 13.0 16.0 22.5 33.0 27.5 35.0 37.5 44.0

22.0

Category V

Category I Category II Category III Category IV Category V

10.0

Category IV

Credit quality Step 3

(BBB+ to BBB)

Credit quality Steps 1 and 2 (AAA to A-)

Category I Category II Category III

Source ECB, BNP Paribas

The ECB applies an additional valuation haircut to ABS, covered bonds and unsecured bank bonds if no market price can be obtained and the Eurosystem has to define a theoretical price. In July 2013, the ECB announced the introduction of an additional markdown for retained covered bonds, i.e. covered bonds that are used by the issuer as collateral for repo transactions instead of being sold to investors. The ECB will introduce a valuation markdown of 8% for retained covered bonds rated A- or better and 12% for retained covered bonds rated between BBB- and BBB+.

The ECB currently accepts covered bonds from issuers located in EEA countries or non-EEA G10 countries. The bonds can be denominated in EUR, USD, GBP or JPY. Meeting the requirements of Article 52(4) of the UCITS directive is not a requirement as the ECB currently also accepts covered bonds that are not issued under a specific legal framework or where the issuer is located outside of the EU. Since March 2013, covered bonds that contain external, non-intra group MBS as well as public sector ABS (external and internal) are no longer accepted in the Eurosystem as covered bonds. Bonds that were already on the list of eligible assets in March 2013 will benefit from a grandfathering period until 28 November 2014.

Benchmark covered bonds In 1995 the first covered bond in Jumbo format was issued out of Germany. The Jumbo segment was created to enable German Pfandbrief issuers to broaden their investor base domestically and internationally by increasing the liquidity and standardisation of the market sector. Issuers from other European countries followed soon after, making the Jumbo format the standard for benchmark issuance in Europe. Choosing a minimum issuance size and providing standardised market-making through at least three underwriting banks were the key features of this benchmark standard. Underwriting banks agreed to quote two-way prices with a fixed bid-offer spread for a ticket size of at least 15mn. The actual bid-offer spread depended on the remaining maturity of the Jumbo covered bond and ranged from 5 to 25 cents. With the outbreak of the global financial crisis, the


standard market-making was severely disrupted as liquidity in most market sectors dropped. Subsequently, secondary market liquidity improved again; however, market-making in Jumbo covered bonds remains differentiated with bid offer spreads being wider and tradable sizes being smaller for covered bonds of lower rated issuers or within non-core markets.

Large scale deleveraging of banks, reduced demand for mortgage lending in a number of countries and increasing use of central bank liquidity have reduced issuance volumes of covered bonds in general and average issuance sizes in particular. As of September 2013, the share of new benchmark covered bonds issued with a size of 500mn has increased to 45% from 14% in 2011. Market acceptance of smaller sized benchmark bonds was also supported by Index providers such as Markit lowering the minimum issue size for covered bonds to be included in the iBoxx EUR indices to 500mn at the beginning of 2012.

Share of new Jumbo issuance by size (excl. increases)

0%

20%

40%

60%

80%

100%

2011 Jan-Sep 2013

1bn and larger

500mn

Source BNP Paribas

Another factor that has supported the increasing use of smaller sized benchmark transactions is the stronger focus of rating agencies on liquidity and refinancing risk. When rating agencies changed assumptions about achievable prices when selling cover assets to repay maturing covered bonds in a post-bankruptcy scenario, maturity mismatches between cover assets and covered bonds led to higher over-collateralisation requirements for issuers of covered bonds. One way to reduce such mismatches and lower over-collateralisation requirements is to spread liabilities of covered bonds more evenly across the curve with smaller sized bonds.


Average issue size of Jumbo covered bonds (excl. increases)

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2009 2010 2011 2012 Sep-13

EUR bn

Source BNP Paribas The US dollar market In just under four years, the USD covered bond market has grown to an outstanding volume of more than $120bn. A key driver of this development has been covered bond issuance from Canadian banks especially within the years 2010 to 2012. Other important contributors to the market sector have been banks from Australia and Northern Europe. While it is not surprising to see mainly issuers from outside the euro area at the forefront of USD covered bond issuance, there has also been issuance from French, German and Dutch banks in the dollar market.

Breakdown of USD covered bond issuance in 2013 by country

05

101520253035404550

2010 2011 2012 30-Sep-13

South KoreaGermanyNetherlandsUKSwitzerlandSwedenFranceNorwayAustraliaCanada

USD bn

Source BNP Paribas As the chart above shows, issuance volumes in USD until the end of September 2013 have been significantly below the levels seen in 2012. The main reason for the reduced supply is the introduction of a legislative covered bond framework in Canada, which no longer allows Canadian banks to use CMHC insured mortgages as collateral for covered bonds.

Apart from changing regulation in Canada, a tightening EURUSD cross currency basis is affecting issuance volumes in the USD covered bond market. While a tighter basis primarily affects supply from issuers based in the euro area as USD denominated funding becomes less attractive, we have also seen that Canadian issuers have recently returned to the euro market as the tighter basis leads to funding advantages.


We expect the dollar covered bond market to grow further albeit at a potentially reduced pace in the near term. At the same time, we expect the market to become more diversified as the dominance of Canadian issuance seen in 2010, 2011 and 2012 begins to wane. One driver of greater diversification could come from new covered bond jurisdictions emerging from areas such as the Asian Pacific region, which may issue predominantly in USD due to investor preference within the region.

The GBP market Significant benchmark issuance denominated in GBP started in 2011 with a strong focus on longer dated maturities. Demand from UK based insurance companies which were aiming to increase their covered bond exposure mainly in anticipation of Solvency II regulation (see above) was filled predominantly by UK based issuers. Supply from UK banks stopped relatively abruptly when the Funding For Lending programme was announced by the Bank of England. More recent issuance of shorter dated GBP denominated covered bonds was mainly driven by Australian, German and French banks.

Despite the disruptions that were caused in the secondary market by the financial crisis, the benchmark sector continues to be an important part of the covered bond market. The importance of the benchmark sector has actually increased since it became clear that covered bonds will be eligible for the LCR. It is likely that regulatory treatment of covered bonds will remain a key driver of developing benchmark issuance in currencies other than euro.

The Covered Bond Label In January 2013, the European Covered Bond Council (ECBC) created the Covered Bond Label. The Covered Bond Label is an initiative to increase transparency within the market and to outline core standards that apply to covered bonds that are certified through the label. The standards that define covered bonds under the label are set out in the Covered Bond Label Convention. These standards include, among other things, certain asset types that can be used as collateral, the existence of a dedicated legislative framework, a dynamic cover pool with ongoing asset substitution and a dual claim of bondholders. In addition the Covered Bond Label provides a template for the regular publication of cover pool data through the issuers that have their covered bonds certified through the label. Further information on the label as well as links to the cover pool data of participating issuers can be found at www.coveredbondlabel.com.


Australian Covered Bonds Legal basis Australian Covered Bonds can be issued on the basis of the Banking Amendment (Covered Bonds) Bill 2011 which was passed into law on 17 October 2011. The law is complemented by regulations and guidelines from the Australian Prudential Regulation Authority (APRA) which were issued as Prudential Standard APS 121.

The issuers Any deposit taking institution in Australia (ADI), which includes banks, credit unions and building societies, is allowed to issue covered bonds. The legal framework requires that the cover assets are owned by a Special Purpose Vehicle (SPV), i.e. an entity that is different from the issuer. The law does not specify the legal form of the SPV, which means that it could be a company or a trust. The SPV holds the cover assets for the benefit of the covered bondholders. The covered bonds represent a dual claim: a senior unsecured claim against the issuing ADI and a secured claim against the SPV, in case the issuer cannot fulfil its payment obligations towards the covered bondholders.

The law also allows for the issuance of grouped or aggregated covered bonds. For this purpose, a number of ADIs establish an aggregating entity which buys covered bonds from those ADIs and uses them as security for a bond issue. This means that an ADI is not liable in the case that the collateral provided by another ADI of the grouped issue underperforms. This method is not dissimilar from that used by Spanish multi-issuer Cdulas, where a number of different covered bonds are pooled together in one large issue.

Cover assets Australian Covered Bonds can be secured by the following assets:

Call deposits held with an ADI and convertible into cash within 2 business days;

Bank accepted bill or certificate of deposit that: 1. Matures within 100 days;

2. Is eligible for repurchase transactions with the Reserve Bank; and

3. Was not issued by the ADI that issued the covered bonds.

A bond, note, debenture or other instrument issued or guaranteed by Australia, or a State or Territory within Australia;

Loans secured by a mortgage, charge or other security interest over residential property in Australia;

Loans secured by a mortgage, charge or other security interest over commercial property in Australia;

Derivatives used for hedging purposes.


Claims from mortgage insurance policies and other compensation claims relating to a cover asset, can also be included in the cover pool. Bank accepted bills and certificate of deposits must not account for more than 15% of the value of the outstanding covered bonds. The law does not contain a provision regarding the use of separate pools for different cover asset classes, i.e. different asset types could be mixed within one pool.

Loan to value limits (LTV limits) for residential and commercial mortgage loans are set at 80% and 60%, respectively. This means that loans only count as collateral for up to 80% or 60% of the value of the property. Outstanding amounts of other loans ranking prior or equal to the loan included in the cover pool, are taken into consideration when calculating the LTV limit.

Each cover pool must have a cover pool monitor. The monitor must be independent from the issuing ADI. Its main tasks are to keep a register of the cover assets, assess compliance of the pools with the asset eligibility criteria and the 3% over-collateralisation requirement, as well as produce cover pool reports. On request, the cover pool monitor also provides cover pool reports to the APRA.

Matching requirements The law requires a minimum over-collateralisation of 3% on a nominal basis. An ADI must not issue covered bonds if the combined value of assets in the cover pools of that ADI would exceed 8% of the value of the ADIs assets in Australia. The issuance cap can be changed by the APRA at any time by way of regulation and is intended to limit structural subordination of unsecured creditors of the ADI. Other matching requirements referring to interest rate or currency mismatch are not contained in the law.

Post-bankruptcy procedures In the event of a failing ADI that has issued covered bonds, the external administrator has no power over the assets held by the SPV. Cash flows deriving from the pool of cover assets will be used to make payments to covered bondholders. Covered Bonds do not automatically accelerate in the case of the issuers insolvency. The documentation of individual covered bond programmes contains asset cover tests and amortisation tests as well as trigger events that outline various steps and procedures before and after an issuers insolvency.

Risk weighting Australian covered bonds do not meet the requirements of Article 52(4) of the UCITS directive, and therefore do not qualify for preferential treatment under CRD.

Market development The first Australian covered bond was issued in November 2011 denominated in USD. Since then five Australian banks have issued covered bonds in various currencies including EUR, AUD and GBP. All issuers have so far only used Australian residential mortgage loans as collateral for their covered bonds.


Australian Covered Bonds Rating Overview Issuer Australian Covered Bonds Unsecured Debt

S&P Moodys Fitch S&P Moodys Fitch ANZ n.a. Aaa AAA AA- Aa2 AA-

CBAAU n.a. Aaa AAA AA- Aa2 AA-

NAB n.a. Aaa AAA AA- Aaa2 AA-

SUNAU n.a. Aaa AAA A+ A1 A+

WSTP n.a. Aaa AAA AA- Aaa2 AA-

Source - S&P, Moodys, Fitch

Jumbo Australian CB Gross Issuance Jumbo Australian CB Maturity Profile (Sep 13)

02468

1012141618

2011 2012 Sep-13

US$ bmk

bmkbn

0

2

4

6

8

2015 2016 2017 2018 2019 2020 2022 2025

US$

bn

Source - BNP Paribas Source BNP Paribas


Austrian Fundierte Anleihen Legal basis The law regarding the issuance of Austrian Fundierte Anleihen (FA) dates back to 1905. It was last amended in June 2005, mainly adding more detailed post-bankruptcy procedures. As a result, payments made under FA no longer accelerate in the event of the issuers bankruptcy. However, issuers can specify in their articles of association that the FA will be pre-paid at their net present value (NPV) upon bankruptcy of the issuer.

The issuers Any Austrian bank which has been granted a special license can issue FA. There is no special bank principle. FA represents full recourse against the issuing bank and a preferential claim on the cover pool in the event of the issuers bankruptcy.

Cover assets Austrian FA may be covered by mortgages and public sector debt. In addition, Pfandbriefe and other FA may be used as collateral. So far, only FA secured by public sector collateral have been issued. Loans and bonds which are issued or guaranteed by public sector entities in the EU, the EEA and Switzerland are eligible as collateral. Substitute collateral is limited to a maximum of 15%, and can consist of cash or deposits with central banks and other approved credit institutions. The cover assets have to be entered into a special register known as the cover register. An independent cover monitor has to approve any asset that is entered into or taken out of the cover register. Derivatives used for hedging purposes can also be entered into the cover register. In this case, claims of derivative counterparts rank pari passu with those of covered bondholders.

Matching requirements The cover assets must at all times cover at least the repayments and interest payments of the outstanding FA. In addition, potential administration costs occurring in the event of the issuers bankruptcy must also be covered. Issuers may commit themselves to provide cover for the FA on an NPV basis including 2% over-collateralisation. This commitment has to be included in the issuers articles of association. BAWAG and KA have both committed themselves to NPV coverage including a 2% over-collateralisation.

Post-bankruptcy procedures In the event of the issuers bankruptcy, the cover pools and pertaining covered bonds are split from the issuers balance sheet and run on their own. A special administrator will be appointed by the bankruptcy court in order to manage the segregated pools. The administrators task is to satisfy the claims of covered bondholders using payments coming from the cover pool by selling assets or by engaging in bridge financing. If possible, the administrator will transfer the cover pool and the covered bonds to another sound bank. Alternatively, the covered bonds accelerate and will be repaid at their net present value if this has been specified in the articles of association of the issuer. Both issuers of FA have included in their articles of association the possibility of acceleration and repayment at net present value in the event of the issuers bankruptcy.


Risk weighting Austrian FA meet the requirements of Article 52(4) of the UCITS directive as well as the CRD requirements, and qualify for preferential treatment under CRD as long as other covered bonds are not used as collateral.

Market development There are currently four issuers that have FA in benchmark format outstanding. BAWAG P.S.K. Bank fr Arbeit und Wirtschaft und sterreichische Postsparkasse Aktiengesellschaft (BAWAG), Kommunalkredit Austria (KA), Raiffeisenlandesbank Niederoesterreich-Wien (RFLBNI) and Raiffeisen-Landesbank Steiermark AG (RFLBST). We expect issuance activity in this market sector to remain stable going forward. There are plans to combine the existing covered bond products in Austria (i.e. Fundierte Anleihen and Pfandbriefe) into one single product governed by a single covered bond law.

Fundierte Anleihen Rating Overview Issuer Public Sector Fundierte Anleihen Mortgage Fundierte Anleihen Unsecured Debt

S&P Moodys Fitch S&P Moodys Fitch S&P Moodys Fitch BAWAG n.a. Aa1 n.a. n.a. Aa2 n.a. n.a. Baa3 n.a. KA n.a. Aa2 n.a. n.a. n.a. n.a. n.a. Baa3 A RFLBNI n.a. n.a. n.a. n.a. Aaa n.a. n.a. A2 n.a. RFLBST n.a. Aaa n.a. n.a. Aaa n.a. n.a. A2 n.a. Source S&P, Moodys, Fitch


Total Outstanding Jumbo FA Outstanding Jumbo FA By Issuer (Sep 13)

0123456789

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sep-13

bn

0

1

2

3

4

BAWAG KA RFLBNI RFLBST

bn

Source BNP Paribas Source BNP Paribas

Jumbo FA Gross Issuance Jumbo FA Maturity Profile (Sep 13)

0.0

0.5

1.0

1.5

2.0

2.5

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sep-13

bn

0

1

2

2014 2015 2016 2018 2019 2020 2022 2028

bn



Austrian Pfandbriefe Legal basis Austrian Pfandbriefe are issued either in accordance with the Austrian Pfandbrief Law from 1927 or Austrian Mortgage Banking Act from 1899. The legal framework applicable depends on the legal structure of the issuer (see below). Both legal frameworks were last amended in 2005.

The issuers Pfandbriefe can either be issued by public sector banks, in accordance with the Pfandbrief Law, or by specialised mortgage banks in accordance with the Mortgage Banking Act. While the Mortgage Banking Act stipulates a special banking provision, the two existing banks (Erste Group Bank (ERSTBK) and Unicredit Bank Austria (BACA)) using this framework are exempt from this regulation for historic reasons. Any new issuer that wants to use the Mortgage Banking Act, would have to adhere to the special bank principle.

Cover assets Austrian Pfandbriefe may be covered by mortgages or public sector debt. Both types of collateral have to be kept in separate pools. Commercial and residential mortgage loans only count as collateral up to a LTV level of 60%. Geographically, lending is limited to Austria, other EEA states as well as Switzerland. Mortgage loans to countries where the preferential treatment of claims of Pfandbrief holders is not comparable to that in Austria, must not exceed 10% of the volume of domestic mortgage loans. For public sector collateral the same geographical restrictions apply. In addition, eligible public sector debt must not have a risk weighting of more than 20%. Substitute collateral is limited to a maximum of 15%, and can consist of cash or deposits with central banks and other approved credit institutions. Derivatives used for hedging purposes can also be entered into the cover register. In this case, claims of derivative counterparts rank pari passu with those of covered bondholders. An independent cover pool monitor is appointed by the Austrian Ministry of Finance. The monitor has to ensure that the cover required for the Pfandbriefe is available at all times.

Matching requirements The cover assets must at all times cover at least the repayments and interest payments of the outstanding Pfandbriefe. In addition, there is a legal minimum over-collateralisation of 2%. Issuers may commit themselves to provide cover for the Pfandbriefe on an NPV basis. This commitment has to be included in the issuers articles of association.

Post-bankruptcy procedures In the event of the issuers bankruptcy, the cover pools and pertaining covered bonds are split from the issuers balance sheet and run on their own. A special administrator will be appointed by the bankruptcy court in order to manage the segregated pools. The administrators task is to satisfy the claims of covered bondholders using payments coming from the cover pool by selling assets or by engaging in bridge financing. If possible, the administrator will transfer the cover pool and the covered bonds to another sound bank.


Risk weighting Austrian Pfandbriefe meet the requirements of Article 52(4) of the UCITS directive as well as the CRD requirements and qualify for a preferential treatment under CRD.

Market development Since 2010 the number of benchmark issuing institutions has remained stable. BACA and ERSTBK have issued Mortgage Pfandbriefe as well as Public Sector Pfandbriefe, while HYPO NOE Gruppe Bank AG (HYNOE) has issued exclusively Public Sector Pfandbriefe. There are plans to combine the existing covered bond products in Austria (i.e. Fundierte Anleihen and Pfandbriefe) into one single product governed by a single covered bond law.

Austrian Pfandbriefe Rating Overview Issuer Public Sector Pfandbriefe Mortgage Pfandbriefe Unsecured Debt

S&P Moodys Fitch S&P Moodys Fitch S&P Moodys Fitch BACA n.a. Aaa n.a. n.a. n.a. n.a. A- A3 A ERSTBK n.a. Aaa n.a. n.a. Aaa n.a. A A3 A HYNOE n.a. Aaa n.a. n.a. n.a. n.a. n.a. A n.a. Source S&P, Moodys, Fitch

Total Outstanding Jumbo Pfandbriefe Outstanding Jumbo Pfand. By Issuer (Sep 13)

0

2

4

6

8

10

12

2009 2010 2011 2012 Sep-13

Public Pfand.

Mortgage Pfand.

bn

0

1

2

3

4

5

BACA ERSTBK NDOLB

Public Pfand.

Mortgage Pfand.

bn


Jumbo Pfandbrief Gross Issuance Jumbo Pfandbrief Maturity Profile (Sep 13)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2009 2010 2011 2012 Sep-13

Public Pfand.

Mortgage Pfand.bn

0

1

2

2014 2015 2016 2018 2019 2021 2022

Public Pfand.

Mortgage Pfand.

bn



Belgian Covered Bonds Legal basis Belgian covered bonds can be issued on the basis of the Covered Bond Act of 3 August 2012. The law is complemented by two Royal Decrees which were issued in October 2012. Furthermore, the National Bank of Belgium has issued regulations regarding the application of the covered bond framework.

The issuers Any Belgian bank is able to issue covered bonds, provided that it has received the necessary authorisation from the National Bank of Belgium. This means that there is no special banking principle in the Belgian covered bond framework and that covered bonds can be issued directly from the originating banks balance sheet. The covered bonds will be full recourse obligations of the issuing bank, providing a preferential claim for the bondholders against a pool of segregated assets in the case of the banks insolvency.

Cover assets Belgian covered bonds can be secured by the following assets:

Residential mortgage loans where the underlying property is located within the European Economic Area (EEA);

Commercial mortgage loans where the underlying property is located within the EEA;

Public Sector Debt from issuers within the OECD area; MBS/ABS tranches, where at least 90% of the underlying assets

consist of assets that meet the eligibility criteria for one of the three asset classes mentioned above and where such assets have been originated by an entity which is part of the same group as the covered bond issuer.

At least 85% of the outstanding covered bonds have to be secured exclusively either by residential mortgage loans, commercial mortgage loans or public sector debt (or by MBS/ABS with respective underlying assets). Up to 15% of the outstanding covered bonds can be secured by deposits with credit institutions or other eligible assets. Consequently, it is not possible to have a cover pool that contains 50% commercial and 50% residential mortgage loans. A residential mortgage pool could, however, contain up to 15% of commercial mortgage loans. Derivatives used for hedging purposes can be included in the cover pool as well.

Residential mortgage loans count as collateral up to a maximum of 80% of the value of the underlying property, while the limit is 60% for commercial mortgage loans. Residential mortgage loans, where the mortgage is supplemented by a mortgage mandate, can be used as collateral as well. If the value of the mortgage mandate exceeds 40% of the loan amount, only a part of the loan can be taken into consideration when applying the 80% LTV cut off to calculate the eligible amount.


A mortgage mandate gives the bank the right to register a mortgage at any time in the future. In Belgium, mortgage mandates are used to reduce registration costs in mortgage lending by registering only a part of the loan amount as a mortgage, while the remainder is covered by the mortgage mandate. If the mortgage loan is repaid without the bank seeing any need to register for the full amount, the borrower has saved part of the registration costs.

Cover assets which are in arrears for more than 30 days only count for 50% of their original value. Defaulted cover assets do not count as collateral.

Matching requirements The legal minimum over-collateralisation amounts to 5% calculated on a nominal basis. The framework also provides for an issuance limit, which requires banks to obtain special authorisation from the National Bank of Belgium if any new covered bond issuance would result in the cover pool exceeding 8% of the issuers total assets.

Belgian covered bond issuers have to provide a liquidity buffer within the cover pool that is sufficient to cover payment obligations arising from the covered bonds within a period of six months. Issuers are also allowed to use third party liquidity lines to provide the liquidity buffer.

Issuers have to ensure that potential interest rate and currency risks between the cover pool and covered bonds are adequately managed. A specific controller monitors compliance with the collateralisation requirements and reports regularly to the National Bank of Belgium.

Post-bankruptcy procedures Cover assets are earmarked as collateral by entry into a special cover register. In the case of the issuers insolvency, the assets contained in the register will not become part of the insolvent estate, but are used to satisfy the claims of covered bondholders. A special portfolio manager is appointed for the segregated assets. The covered bonds do not automatically accelerate in the case of the issuers insolvency.

Risk weighting Belgian covered bonds fulfil the requirements of Article 52(4) of the UCITS directive. Depending on the composition of the cover pool, they can also meet the CRD requirements and qualify for a preferential risk weighting within the EU.

Market development The first Belgian covered bond was issued in November 2012 by Belfius Bank (CCBGBB). KBC followed shortly thereafter with its own covered bond issue. Both issuers have so far only used Belgian residential mortgage loans (partially secured by mortgage mandates). At the date of writing no other Belgian issuer has joined the market. We expect both issuers to continue to build a curve in euros, while the number of issuers is unlikely to grow in the near term.


Belgian Covered Bonds Rating Overview Issuer Belgian Covered Bonds Unsecured Debt

S&P Moodys Fitch S&P Moodys Fitch CCBGBB AAA n.a. AAA A- Baa1 A-

KBC n.a. Aaa AAA A- A3 A-

Source - S&P, Moodys, Fitch

Outstanding Belg. bmk. CB by issuer (Sep 13) Belgian benchmark CB Maturity Profile (Sep 13)

0

1

2

3

4

CCBGBB KBC

bn

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2016 2017 2020 2023

bn



Canadian Covered Bonds Legal basis In mid-2012, the Canadian government introduced the long awaited covered bond legislation through the amendment of the National Housing Act (NHA). Previously, Canadian banks had issued covered bonds without a specific legal framework, i.e. based on contractual agreements. The new legislative framework, which is complemented by the Canadian Registered Covered Bond Programs Guide (the Guide), allows Canadian banks to issue registered covered bonds. With the introduction of the legislative framework, Canadian banks are no longer allowed to issue non-registered (i.e. structured) covered bonds.

The issuers The overall issuance structure for Canadian covered bonds remained largely unaffected by the introduction of a legislative framework. The covered bonds are issued by the originating bank. The bonds are full recourse obligations of the bank and, in addition, benefit from the covered bond guarantee issued by a vehicle (the Covered Bond Guarantor) which acquires the cover assets from the originating bank. The purchase of the assets is funded by a loan from the bank to the vehicle. This loan is split in two tranches, i.e. the guarantee loan and the demand loan. The guarantee loan represents the amount needed to fund the collateral necessary to pass the asset cover test, which includes any over-collateral provided through this test. The demand loan is equal to the amount of any voluntary over-collateral that may be contained in the pool and which is not necessary to pass the asset cover test. The originating bank can request repayment of the demand loan at any time and thus reduce voluntary over-collateral that is not needed to pass the monthly asset cover test.

Federally regulated financial institutions as well as cooperative credit societies in Canada can register their covered bond programmes with the Canada Mortgage and Housing Corporation (CMHC). CMHC is sponsored by the Canadian Government and has full recourse to government funds. It is rated AAA by S&P, Moodys and Fitch. CMHC has been given responsibility to administer the legal framework for Canadian registered covered bonds. It has supervisory powers that include suspension of registered issuers in case of non-compliance of an issuer with the legal framework. In June 2007, the Office of the Superintendent of Financial Institutions (OSFI) set a limit to the issuance of Canadian Covered Bonds. The outstanding covered bonds must not exceed 4% of the issuers total assets. Registered covered bonds are subject to the same 4% issuance limit as previously issued non-registered covered bonds

Cover assets The cover assets for registered covered bonds consist of first lien Canadian residential mortgage loans with an initial LTV ratio of not more than 80%. Insured mortgage loans do not qualify as collateral for registered covered bonds. This means that covered bonds that have been issued before the implementation of the legal framework and that are secured by insured mortgage loans cannot be registered with the CMHC. Instead, issuers have to establish new programmes that meet the requirements of the legislative framework.


The cover pool is dynamic and subject to a monthly Asset Coverage Test (ACT). Within the ACT, mortgage loans are only taken into account up to a maximum LTV ratio of 80%. From July 2014 onwards, indexation of underlying house prices is mandatory at least on a quarterly basis. The ACT has to contain a minimum and a maximum asset percentage, resulting in maximum and minimum over-collateralisation. The legal framework does not quantify the levels of maximum and minimum over-collateralisation.

Substitution assets can consist of securities issued by the Government of Canada, repos of Government of Canada securities having terms acceptable to CMHC and sums derived from Government of Canada securities or repos of Government of Canada securities. The volume of substitution assets must not account for more than 10% of the cover pool.

Matching requirements In order to mitigate interest rate and currency exchange rate risk, the Covered Bond Guarantor is required to enter into hedge transactions. Instead of entering into hedge contracts at the time of inclusion of the cover assets, the Covered Bond Guarantor may use Contingent Covered Bond Collateral Hedges to mitigate risks stemming from mismatches between outstanding covered bonds and the cover assets. These contingent hedges do not become effective until the rating of the contingent hedge counterparty falls below a predetermined level or an issuer event of default occurs. The covered bond guarantor is required to perform valuation calculations on a monthly basis. The aim of such calculations is to determine the net present value differences between outstanding covered bonds and the cover assets.

Most Canadian programmes allow for the issuance of covered bonds either with a hard bullet maturity (in conjunction with a pre-maturity test) or with a soft bullet maturity. For covered bonds issued under programmes with both repayment types, the respective transaction documents need to be checked to identify whether its a hard or soft bullet repayment.

Post-bankruptcy procedures Following an issuer event of default, the assignment of mortgage loans to the Covered Bond Guarantor is completed and the Covered Bond Guarantor will take over payments of capital and interest to the covered bondholders. Substitution of assets would stop and the cover pool would become static. Cash flows arising from the pool would be passed on to the covered bondholders as originally scheduled, as long as the pool is solvent. The Guide sets a number of minimum events of defaults for the issuer or the guarantor that registered covered bond programmes must contain. These events include the impending or actual insolvency of the issuer, failure to pay principal, interest or any other amount under the covered bonds when due, failure to comply with the remedial action contemplated by a ratings trigger and failure to meet an Amortisation Test (AT) by the guarantor. Registered covered bond programmes may contain additional events of defaults.

Solvency of the pool is determined by a monthly AT, which replaces the ACT after the issuer event of default. In principle, the AT is a simplified ACT. If the AT is breached, the assets held by the Covered Bond Guarantor will be liquidated and the covered bonds accelerated. The purpose of the AT is to


limit subordination of holders of covered bonds maturing at a later date. Covered bondholders continue to have a claim against the issuer, which ranks pari passu with other unsecured creditors.

Risk weighting Registered Canadian covered bonds do not meet the requirements of Article 52(4) of the UCITS directive, and therefore do not qualify for preferential treatment under CRD.

Market development The implementation of a legislative framework for the issuance of Canadian covered bonds has been a significant event for the Canadian covered bond market. The fact that insured mortgage loans are no longer eligible as collateral for new covered bond issuance has caused a drop in issuance activity in the Canadian market. As more Canadian banks establish new registered covered bond programmes, issuance levels are likely to increase again. It remains to be seen, however, if Canadian banks will have similar funding needs for uninsured mortgages as they had for insured mortgages. The fact that there will be a noticeable increase in maturing Canadian covered bonds in the coming years will not necessarily lead to increased covered bond issuance since the insured collateral of the maturing bonds cannot be used again for new registered bonds. At the time of writing, four Canadian banks (CIBC, RY, BNS and NACN) had their covered bond programmes officially registered with the CMHC.

Canadian Covered Bonds Rating Overview Issuer Canadian Covered Bonds Unsecured Debt

S&P Moodys Fitch S&P Moodys Fitch BMO AAA Aaa AAA A+ Aa3 AA-

BNS* n.a. Aaa AAA A+ Aa2 AA-

CCDJ n.a. Aaa AAA A+ Aa2 AA-

CM* n.a. Aaa AAA A+ Aa3 AA-

NACN* n.a. Aaa AAA A Aa3 A+

RY* AAA Aaa AAA AA- Aa3 AA

TD n.a. Aaa n.a. AA- Aa1 AA-

Source - S&P, Moodys, Fitch *) registered programme

Outstanding Benchmark Canadian CB Outstanding Canadian benchmark CB (Sep 13)

05

1015202530354045

2007 2008 2009 2010 2011 2012 Se

Documents

Covered Bond Guide 2013 6 November 2013