While the Basel Committee may be done with its guidelines, industry players continue to sort out the potential effects of the new rules. One recurring theme is the increased use of covered bonds, as RMBS risk weighting may become less favorable.

Standard & Poor's last week published an update on the expanding European covered bond universe. "There have been so many changes that we thought it would be a good opportunity to start consolidating our ratings approach for the different markets," said one analyst. "Everybody has seen the advances made in the U.K. market and an increasing number of countries are looking to implement this instrument on a regular basis."

The better defined Basel II may negatively impact RMBS with more conservative risk weightings, prompting an ever increasing number of bank issuers to start looking at the covered bond alternative to securitization holdings.

"The new Basel accord will likely have a negative impact on future RMBS supply, and some bank issuers have already indicated that they will replace some part of RMBS with covered bonds," reported analysts at JPMorgan Securities.

As the market grows more covered bond-conscious, analysts said there has been a non-deliberate convergence of legislation across the board. Starting with the German law, as the expansion occurs new entrants build on past legislation and improve opportunities for issuance and investors. According to S&P, structural enhancements are used to exceed minimum regulatory requirements and improve the credit quality of the covered bonds. The emphasis is to attain the highest credit rating in spite of the counterparty credit rating of the issuing bank.

"The French law looked at what Germany was doing, and one question that came up was the treatment of swaps; some later legislation introduced better definition on how risks would be hedged," said one source. "This convergence through hopscotch means that, little-by-little, the markets are moving toward a common standard."

Although it's unlikely to replace RMBS issuance, banks are beginning to better understand how the two instruments can work together. This has been demonstrated by some of the major U.K. mortgage lenders that have established new covered bond programs this year alongside their established RMBS master trusts.

U.K. issuers have already sold 12.25 billion in the covered bond market with an estimated potential to grow to 200 billion, according to data released by Barclays Capital at the 2004 Pfandbrief investor conference in New York last month.

Among other market participants, Barclays estimated that Ireland has issued 18 billion with the potential to grow volumes to 50 billion. Luxembourg has issued 14 billion; Germany, over 510 billion; Austria, 3 billion; France, 47.45 billion; and Spain, 78 billion. Barclays estimates that, once the country begins its highly anticipated issuance program, Italy has the potential to offer 200 billion in product. Sweden, which is expected in the market at the end of this year or the beginning of 2005, has the potential to grow to 50 billion, and Norway has the potential to issue over 6 billion.

While the more punitive RMBS weightings entice new issuers, the European Union is hammering out its own directive favoring Pfandbriefe-like programs. According to Commerzbank, under the new EU directive, which basically translates the terms set out by the Basel committee, covered bonds will be

assigned 10% risk weightings when investors adopt the revised standardized ratings approach. Unsecured bank bonds hold a 20% risk weighting. It is unclear what type of risk weighting the EU plans to apply for investors using the internal ratings based approach (IRB).

Under the foundation IRB approach, the risk weighting is calculated on the probability of default (PD) and the loss given default (LGD) of an issuer. While a current Pfandbrief investor calculates the probability of default and the loss given default at a standardized 12.5%, under the advanced IRB approach, investors have to determine both the PD and the LGD themselves, which requires extensive issuer information to conduct correct assessments. This could lead to difficulties when determining internal ratings for covered bonds, explained analysts.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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