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Why direct issuance?

07 February 2019
Richard Kemmish

As I’m asked about the optimal choice of covered bond model quite frequently, I thought I’d share a few thoughts, for the second instalment: the direct issuance model.


Let me get one thing off my chest straightaway: I don’t really approve of the second of the covered bond models being called ‘on balance sheet’. That’s a phrase that causes a lot of confusion as a balance sheet is an accounting term and the accounting of the ‘SPV’ model and of the direct issuance model are basically the same. 

Now that I’ve got that straight, the direct issuance model is the leading model in terms of bonds outstanding, but comes second to the ‘SPV’ model in terms of jurisdictions that have chosen it and has certainly been falling behind recently. Why?

Whilst its an intuitively straightforward model – I’ll issue a bond and if I don’t repay it you can have these assets – it is surprisingly difficult to get right. Changes to bank regulation and to public policy make it more important than ever that you do. The countries that have made it work – Germany being the most obvious example – have done so because they have spent a lot of time perfecting the legal technology and are continually reappraising the model in the light of, for example, the resolution directive.

The main difficult bits are segregating a bunch of assets without transferring them to someone else and entering into contracts with yourself. Taking those in turn:

If a bank fails you need a totally bullet proof mechanism to maintain your control over the assets. Just as parental controls on internet browsers are locked in a constant battle with the technological prowess of frustrated teenagers, so your covered bond law must be tested against the finest lawyers unsecured creditors can buy. As the resolution board is discovering in the case of Banco Popular, that is one tough opponent. 

If the covered bond law does best those lawyers, it might then have to take on the even more fearsome consumer rights lobby. Pacta sunt servanda or populist politician? How about when it’s the local savings bank that has gone bust? And the bail in debt has all been sold to depositors…sorry, retail investors.

Then there is the little detail of entering into a contract with yourself – a necessary feature of any direct issuance structure that wants to, for example, include a swap of the assets against the bond coupons – one leg of the swap needs to be in the cover pool, one outside, even though they have the same legal identity. New year’s resolutions are effectively contracts with yourself and about as effective (since you ask, 13 hours. Pub lunch on new year’s day? What was I thinking?).

Which is not to say that the structure doesn’t work or can’t be made to work with diligent legal drafting. It just more difficult to get it right and I’m not convinced that every jurisdiction is necessarily up to the task.

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