Federico García Lorca

Covered bonds, in most of the European jurisdictions, are issued by the financial institutions that is subject to certain regulations and supervision. However, the structure of CBs varies across these jurisdictions. The issuer of CBs in some countries, like Denmark, Germany and Latvia, must have licence from the competent authorities to issue CBs. CB issuers in other countries, like Italy and Spain, are not required to get licence from the authorities. However, they can only issue CBs if they show compliance with the requirements laid out in the relevant legal framework of the country. Banks in some jurisdictions are also required to provide an ex-ante notification to the authorities about their CB programme (EBA, 2013).

The regulatory authorities provide guidelines to the CB issuers about the eligibility of the assets those can be collateralised against the CB issuance. An important criterion used to evaluate the eligibility of the assets, apart from the eligibility with respect to the asset class, is LTV ratio.26 The loans placed in cover pool are required to meet certain threshold of LTV in all jurisdictions. The requirement varies across countries, but in most of the cases LTV should not exceed 80% limit.27 These eligible assets are placed in a cover pool and ring-fenced on the issuer’s balance sheet. The assets in the cover pool are segregated by the law from the insolvency estate of the issuer, providing a status of bankruptcy remoteness to the cover pool. Hence, these assets cannot be used for any other purpose until CBs issued against them are retired. There are two legal structures followed for the issuance of CBs i.e. Special Law Based Structure and General Law Based Structure.

Special Law Based Structure

Most of the CBs issued in various countries of Europe are subject to a defined set of regulations. These regulations are specifically devised for regulating the CB issuance. The CBs issued in compliance with these regulations benefit from a preferential treatment with respect to risk weightings.28 CBs issued under this structure are called Legislative Covered Bonds (LCBs).

26LTV is used to assess the risk associated with the mortgage lending. This ratio shows that how much loans has been issued against the value of the mortgage. The higher LTV ratio shows a higher risk. Consequently, if the loan with high LTV is issued by the bank it may cost higher to a borrower because of higher risk associated with it. A loan with high LTV may become ineligible as a collateral for CB.

27Some countries have more strict limits. For instance, the LTV threshold in Germany is 60%. See Table 3.2 for the details of LTV in different jurisdictions.

Apart from the local legislations, LCBs are subject to compliance with Undertakings for Collective Investment in Transferable Securities (UCITS) and Capital Requirement Directive (CRD). These legislations provide bankruptcy protection to investors. By virtue of these regulations, investors enjoy the strength of underlying assets at first place and not the strength of the issuer. Most of the legislations supervising LCBs require the issuer to maintain a dynamic cover pool and provide a dual recourse to investors.

Many countries, like Germany, require the issuers to have a licence before issuing CBs. It is expected that the LCB issuance is not an erratic or opportunistic, but it is a regular activity of the FI. The regulators also provide guidelines about the eligibility of the assets backing the LCB issuance. The assets other than eligible ones cannot be used for LCB issuance. For instance, German Pfandbriefe can only be issued against mortgage loans, public loans, ship loans and aircraft loans. Commercial and consumer loans cannot be used in the issuance of Pfandbriefe. The assets backing the Pfandbriefe are recorded in the cover register and these registered assets cannot be included in bankruptcy estate of the issuer if such proceedings are started. The holders of LCBs can only participate in the insolvency to the extent their claims remain unsatisfied by the assets recorded in the cover register. Usually, if bankruptcy proceedings are opened against an LCB issuer, the court appoints two administrators of the cover assets. These administrators either continue to service the assets or dispose them off at once and make payments to the LCB holders.

General Law Based Structure

Some countries follow a general law based structure for the issuance of CBs. These CBs are not subject to any special law but they are issued under contractual arrangements. The laws governing the issues of these bonds are based on general laws or contract laws. These CBs are called Structured Covered Bonds (SCBs). SCBs are more flexible as compared to LCBs. The eligibility criteria for the assets backing these bonds is not very rigid and issuers may decide to place the asset according to their requirements. The main purpose of issuing SCBs is to get an uplift in the rating of these bonds, as these bonds can get a better rating than their issuers.

SCBs follow a structure that is similar to ABS. The assets used as collateral for SCBs are not held by the issuers but are sold to an SPE. However, unlike securitisation, bonds backing these assets are not issued by the SPE but are issued by the originator. Therefore, these bonds are the direct obligation of the issuing institution. The SPE in this transaction plays the role of a guarantor. The proceeds generated from the SCB issuance are lent to the SPE that is used

by it to purchase the assets from the originator. Hence, SPE becomes the legal owner of these assets. A guarantee is issued by the SPE to investors about making the payment if the issuer SCBs faces a bankruptcy. This is an irrevocable guarantee that is secured by the cover pool. The originator makes the payment of principal and interest to investors. The loan to SPE and assets purchased by it are squared-off when bonds are repaid by the originator.

Though SCBs are not subject to a special law enacted for CBs but a monitor is assigned to ensure that a level of credit enhancement is well-maintained till the maturity of the issued SCBs. The guarantee issued by the SPE to investors is enforced if bankruptcy proceedings are opened against the issuer. The assets backing the bonds are passed on to an administrator. The claims of the bondholders are settled from the sale of the assets held in cover pool. If these assets are not sufficient to meet the claim of bondholders, they will have a recourse to the issuer along with its other creditors.