Italy has completed the first phase of introducing its new structured covered bond legislation, making way for the large issuance most industry players are expecting from the sector. In general, most European countries are making strides to accommodate the potential for structured covered bonds - heralded as the next big thing in Europe.
"In Italy we updated the existing securitization law (Legge 130/1999) to enable structures that are similar to what we have seen in the U.K.," explained Michele Cueno, an analyst at the Fitch Ratings Milan-based office. "To put it simple, the covered bond is directly issued by a bank and guaranteed by the collateral that the bank itself segregates' by selling it to an SPV governed by existing securitization law. You can appreciate how this is quite similar to the way covered bonds are set up in the U.K., with the difference that the structural framework here is set up by law."
Italy had previously moved ahead with an ad-hoc law that allowed 70% state-owned Cassa dei Depositi e Prestiti (see ASR 12/13/04) to segregate public sector loans within its balance sheet and to issue covered bonds against them - a legal framework that was tailored to the issuer. Fabrizio Dotti, a financial markets lawyer at Simmons & Simmons, said in December that Italy was likely to find better success under an amended securitization law that would allow a guaranty to be issued by the SPV set up to ring fence the selected mortgage assets, rather than seek a full-blown, specific legislation for covered bonds.
The Italian Ministry of Treasury and Finance is targeting the completion of secondary legislation (without which covered bond issues can't take place) by the end of the summer, although some market players think that it's more likely to be finalized by 4Q05, with the first issue coming to market sometime in the first half of 2006. "We can reasonably expect that the secondary legislation will take the best from the covered bond existing legislation throughout Europe," said Cueno. "We see a good potential for the development of covered bonds in Italy; the first issuers are likely to be the largest rated banks that have the resources to go through the pioneering phase' of the market and can leverage on larger and more diversified portfolios." Italy has, in the past, been estimated to have a 200 billion ($250 billion) in potential covered bond assets.
While Italy is itching to uncover its covered bonds potential, it doesn't mean banks are looking to let securitization structures fall by the wayside - these banks are also looking at the regulatory capital relief associated with covered bonds. For the largest banks, there will be a trade-off between covered bonds and ABS as similarly done in the U.K.
There are two key dynamics to the covered bonds versus RMBS scenario - the cost of funding and risk transfer. Covered bonds have a 20% risk weight versus 50/100% for RMBS currently. However, Basel II will change this to 10% versus 20% Standardized Approach, 2% to 7% risk weight dependant on maturity versus 7% (RMBS) for IRB qualifying banks, explained Chris Greener, an analyst on the Royal Bank of Scotland securitization research team. "This may reduce RMBS spreads to equivalent covered bond levels (essentially the levels we were at 2 months ago) and is one argument for recent spread compression on triple-A notes," he said. "Banks are also likely to pursue RMBS where their mortgage book is insufficient to run a covered bond program, or where concerns over future origination exists."
In the U.K., four of the major mortgage lending institutions have issued a covered bonds program. The latest of these comes from Abbey National plc. Abbey's initial offering consists of 2 billion ($2.5 billion) of covered bonds issued via Abbey National Treasury Services, backed fully by Abbey National. But the group has registered a 12 billion program, although sources at the bank said there is no time frame as to when Abbey intends to issue the additional notes. "What's most appealing to originators is the diversification this product offers and the duration is much longer than our securitization program," said one source at Abbey.
Northern Rock, HBOS and Bradford & Bingley have already sold covered bonds in the U.K., but the potential for further issuance was somewhat muted by talk of FSA-imposed limitations on how much these institutions would be allowed to issue. The FSA last year issued a letter to the Council of Mortgage Lenders and the British Bankers Association stating that issuers should be limited to issuing bonds to around 4% of their total assets. The largest lenders would not be able to fulfill all of their potential under these proposed limitations, but industry sources are hopeful the FSA will revisit the topic again. FSA is currently reviewing guidelines for U.K. covered bonds.
"The U.K. FSA has restricted the amount of covered bonds that may be issued by a bank due to concerns of risk concentration," said Greener. "Banks may be more comfortable offsetting risk via RMBS than just raising funds using covered bonds. Likely influenced by price, Northern Rock issued a synthetic securitization of the mortgage pool backing the covered bond to remove the risk from its books."
Other legislative musings...
The second draft of the European Capital Directive, where covered bonds are to be specifically addressed, is expected be finalized soon. Europe will get a standard approach as to what is considered a covered bond (because at the moment the types of assets covered under these bonds vary from country to country). "The directive provides a more detailed definition of covered bonds and of the type of eligible assets that may be included in the cover pools, which is likely to set the standard for the covered bond concept," said Raimon Royo, director of European Covered Bonds at Fitch.
It's been busy on the legislative front. While Italy has formally announced its legislative changes, there is market talk that Belgium will follow and is actively working to set up legislation that governs structured covered bond issuance. Austria is also tweaking its existing frameworks - which individually legislate private mortgage banks and public sector banks - to make these instruments more insolvency remote.
There have been minor developments in Sweden, where a new law came into effect in July 2004, and extended regulation was passed in October 2004, said Royo. In the Netherlands, potential issuers are looking to access the market, via a U.K. point of view. Norway's law regarding covered bonds takes effect in January 2004, but detailed legislation still in a draft stage and the expected summer introduction of its new law looks likely to be put on hold, said Royo. In Ireland, some minor changes to the Securitization Act are underway. In Portugal, a draft law has been circulating, which was expected to come into effect sometime this year. It would permit universal banks to issue directly from their balance sheet or through a specialist mortgage subsidiary. But at the moment, the country has put everything on hold, said Royo. In Eastern Europe, issuance potential is considerably smaller but countries are still pursuing the option of setting up legislation to issue covered bonds. Royo said that Latvia was currently trying to modify its laws.
Germany is also making strides to better incorporate a changing regulatory environment that will see all of its Landesbanks lose their state supported triple-A ratings this year. The amended legislation allows all German banks to issue Pfandbriefe, provided they obtain a license from the Federal Financial Supervisory Authority (BaFin). The new legislation introduces greater disclosure requirements and reliance on support will diminish (Landesbanks issues have relied primarily on their underlying state guarantees) and the deals will be rated solely based on their intrinsic features. It's a big change - this single act will encompass all German covered bonds and will allow every institution, as long as they obtain the required licensing, the right to issue.
"The major driver to look at new legislation in countries where no regulations exist is that covered bonds are quite easy - very plain and simple," said Claudia Vortmueller, an analyst on the covered bonds research team at Commerzbank. "It uses the same assets an institution would use in a securitization but it's cheaper and quicker to set up and you get better funding. And these countries can either look to add new legislation for covered bonds or go the U.K. route."
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