Changes to Turkey’s covered bond legislation are supportive of the credit ratings on these instruments, according to Moody’s Investors Service.

Last week, the Turkish Capital Market Board released a definitive communiqué that unifies and improves two existing pieces of legislation governing mortgages and other assets backing covered bonds. The legislation will enable issuers to better match cover pool assets with covered bond liabilities, reduce market risk and mitigate operational risks in case of issuer insolvency, according to Moody’s.

 At the same time, the legislation will limit the issuance of covered bonds, which ensured that issuers have sufficient eligible assets to replenish their cover pools.

Importantly, the legislation allows banks to use derivatives as part of the cover pool, making it easier for banks to issue foreign-currency covered bonds and lessen risk for covered bondholders. Previously, only mortgage covered bonds could have derivatives in the cover pool, and there was a limit of 15% of the cover pool’s net present value.

The legislation also calls for new stress tests aimed at protecting cover pool value against sharp fluctuations in currency-exchange and interest rates. The interest rate tests involve shifting the interest rate by 300 basis points for Turkish Lira-denominated cash flows and 150 basis points for foreign-currency denominated cash flows. The currency stress test involves upward and downward shifts of the exchange rate by 30%.

“Although the tests have benefits, they do not sufficiently protect against potentially higher discount rates in the case of an asset fire sale where interest rates can widen by more than 300 basis points following an issuer default in an illiquid secondary loan market such as Turkey,” Moody’s stated in the report. “This is especially the case for mortgage loans with much higher durations than loans to small and midsize enterprises.”

If a covered bond issuer breaches a stress test, the cover pool monitor will freeze collections from the cover assets in a separate account for the repayment of the covered bonds, thereby providing protection from continuous deterioration of the cover pool. If the issuer does not fulfill its payment obligations, the cover pool monitor will ensure that the underlying cover pool borrowers redirect their payments to a separate account to avoid a comingling of cover asset cash flows with the issuer’s other assets in an insolvency.

The legislation also limits issuance to 10% of the issuer’s total assets, and 5x the issuer’s equity for specialized mortgage lenders. This allows for the replenishment of the cover pool and protects unsecured creditors’ interests. The limits can be doubled for issuers rated ‘A’ or higher.

“By having more eligible assets, issuers can more easily replace assets that become ineligible,” the report stated. “If an issuer becomes insolvent, unsecured creditors would have recourse to a greater portion of the issuer’s assets that otherwise would be encumbered to covered bondholders.”

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