The idea that governments have to supervise covered bond markets is an old one. But it is increasingly apparent that there are different interpretations of what it actually means. These might start to become important.
There should be special public supervision to protect the interests of covered bond holders. That we know. We know it because it is not just one defining characteristic but a characteristic that was in the very first definition of covered bonds in any EU legislation. It is so old that it even predates the name ‘covered bond’ – which I believe dates from the mi-90s - to generically describe the national, and nationally named, markets.
Not only is it key to our early history, it is also used frequently as one of the more subtle but important characteristics defining our success. ‘Aren’t covered bonds just securitisations with recourse to the issuer?’ our securitising friends ask. No, because the special public supervision means that covered bonds have something else that securitisations don’t have. And something else that they can not fully replicate with rating agencies or auditors.
But some recent conversations about public supervision have made me realise that there is a diversity of opinion about what it actually means across Europe. That is fine within the context of current frameworks – as in so many other areas in covered bonds, a weakness in one area of a national legislation is compensated for by comparative strengths elsewhere. But if the market is to evolve, either in terms of other asset classes or the development of more standardised protection as implied by the draft covered bond directive, it might be useful to reflect on what special public supervision actually means.
First though, the differences. One regulator recently told me that their only obligation as supervisor was to ensure that the programmes that they supervise conform to the covered bond law. If the issuer does everything that they have to by law, then the actual credit quality of the bond is a matter for the market to decide. Supervisors are not rating agencies.
Others think differently, protecting the interests of covered bond holders goes above and beyond what is written in the law and also ensuring a minimum credit standard too. Arguably this role is second guessing the rating agencies. Those of a securitisation persuasion may well argue that this is not legitimate – if a bank wants to use poor quality assets and, for example, not include structural features that could be to their detriment, why shouldn’t they be allowed to? The market will charge them a premium for the extra risk but that might be a price worth paying for some issuers. Fair point. Plenty of securitisations are backed by non-performing loans, often these bonds come with juicy spreads for investors. The counter-argument is that the ‘minimum credit standard’ school of thought justifies the prudential treatment that covered bonds are granted for investors.
The EBA guidelines that form the basis of the directive provide plenty of indications of what should be done – but not to which of the two possible standards – complying with the law or ensuring a minimum credit. There is also a necessary ambiguity between what is in the law, what is in the supervisory processes and what is the role of the (usually) private sector ‘supervisor’ – the cover pool monitor. The ambiguity is necessary given the diversity of practice in Europe.
But if these divergent views are ok within the existing covered bond frameworks, why am I concerned? Two reasons, firstly we are exploring new forms of covered bonds which, contrary to a lot of opinions I have heard expressed are going to rely more heavily on supervision and less heavily on market discipline. Secondly, the more ridiculous house prices in Europe, the more likely a crash, the bigger the divergence between what is necessary to conform to the letter of the law and what is necessary to be creditworthy.
We might have to start questioning some very old precepts.