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Covered Bonds 2

Covered Bonds 2


Regulated covered bond programmes are used by banks and building societies to borrow money in wholesale markets. These programmes are “regulated” because they must comply with the FSA’s RCB Sourcebook.

When an issuer borrows in the RCB market the bond is the direct obligation of the issuer. However should the issuer default there is a pool of assets that guarantees repayment to the investor. These assets are ring fenced on the issuer’s balance sheet and normally comprise residential mortgages. For this reason the debt is considered less risky for investors, it often attracts a rating of AAA which also reduces the funding cost for borrowers.

This technique is not new. It has been used in Europe for many years with the German and Danish markets dating back over 200 years. The UK market started in 2003 with the US and Australia following in 2008 and 2010 respectively.

At the time of writing the UK market has 11 RCB issuers. Further information is available from the UK Regulated Covered Bond Council (RCBC) this is a trade organisation promoting the UK covered bond product.

Special Purpose Vehicle (SPV)

A SPV is used by the issuer to protect the investor. The bank or society that issues the RCB sets up a SPV which is normally an English Law Limited Liability Partnership (LLP). The members of the LLP are the issuer and designated parties who continue in the event that the issuer defaults.

When the RCB is issued the money raised is lent by the issuer by way of an intercompany loan to the LLP. The LLP then uses the funds to acquire the mortgage assets. At the same time a deed of charge and a guarantee in favour of the RCB is executed by the LLP.

If the issuer defaults the guarantee is triggered and repayment comes from the assets in the LLP. This can occur in one of two ways. Provided the asset pool continues to meet certain criteria in a coverage test then the LLP continues to meet the interest and principal payments as they are due. However if the LLP is in breach of the coverage test the security trustee can enforce the security and the bonds are redeemed. This means that the LLP assets must be sold or securitised in order to repay the RCB investors.

It is important to appreciate that the structure makes the LLP assets bankruptcy remote from the issuer so they can be used in event of issuer default to repay bond investors and not the issuer’s creditors.

RCB versus MBS

Mortgage backed securities (MBS) provide issuers with an alternative funding mechanism that also uses assets to secure funding. What is the difference?

With an MBS the assets are sold to a SPV and the SPV then issues notes or bonds to finance the purchase. These notes are not the direct risk of the originating bank. Investors are fully exposed to the credit risk of the assets that have been sold to the SPV. There is also a sequential pay structure. This means that junior note holders shoulder losses before mezzanine and senior tranches. This pecking order normally means that the senior tranche of a MBS is rated AAA.

It is therefore apparent that if the MBS issuer sells all the notes to third parties there is full risk transfer of what is contained in the SPV to those parties. In practice only partial transfer occurs because either issuers retain some notes because they are difficult to sell or there are regulations that insist the issuer has “skin in the game”. By way of contrast the RCB issuer cannot get risk transfer to the investor.

The attraction of RCBs

If MBS can achieve risk transfer why issue RCBs? The reason is mainly because of investor demand. In the aftermath of the 2008 crisis there was a flight to safety. Liquidity was at a premium and structured securities were mistrusted. In these conditions covered bonds to some extent retained liquidity and still offered a return over and above solid government bonds. Some of the investor confidence in RCBs is due to the fact that the product is regulated and there are rules that protect the investor. Issuers also need funding diversity and to the extent that MBS and covered bond investors are different this can be achieved.


Despite the attractions RCBs do have some drawbacks. First it has already been explained there is issuer retention of credit and market risk. Second you need a “reasonable” size in order to justify the cost of issuance. This rules out smaller firms. Third there are on-going management and maintenance requirements. They can be onerous. Fourth RCB mortgage pools are over-collateralised. In other words to borrow £500m you need £700m of assets. This is not efficient. Fifth there is the related matter of encumbrance.

Encumbrance is a sensitive subject. If a bank that has ring fenced assets defaults, those assets will go to pay off specific creditors rather than be generally available. Excessive encumbrance therefore increases the loss given default of unsecured creditors. This includes depositors. It also means that the deposit protection scheme (FSCS) may have to pay out more. For this reason regulators are looking to actively limit encumbrance. This limit is 8% of the balance sheet in Australia. Applying this in the UK would be difficult with some firms having much higher encumbrance ratios (20% plus). It is a moot point that in a rush to encourage firms to obtain longer dated funding the FSA has compromised itself by permitting encumbrance at levels that are too high. Furthermore senior debt holders of highly encumbered issuers must also ask themselves whether the return they require should be enhanced to compensate them for the possibility of a higher loss given default.


From 2008 the UK has had dedicated covered bond legislation. This requires all asset pools to be segregated by a SPV, only UK deposit takers with a UK Head Office can issue, the SPV must be UK domiciled and only eligible collateral can be used.

Before issuing a potential issuer must seek FSA approval. This involves returning the Application for the admission to the register of issuers and register of regulated covered bonds FSA RCB 2 Annex 1D.

This long and detailed application includes the need to keep the risk of default low. This is facilitated by regular stress testing by both the issuer, FSA and rating agencies of the asset pool. This in turn leads to an over-collateralisation requirement for the asset pool.

In 2011 there was a HM Treasury led review of the regime this included market consultation. Whilst no major deficiencies were encountered, changes will take place with effect from 1/1/13.

Legislative changes in 2013

These include, segregating asset types - there will now be an issuer option to designate a programme as being backed by a single asset type eg residential mortgages. Asset eligibility – securitisations are excluded emphasising the distinctions between RCB and structured finance.  Fixed minimum over-collateralisation (OC) – there will be an 8% minimum that must not be breached (this should have little effect because OC levels already exceed this floor). Asset pool monitor – the annual independent assessment of the pool will become a formal role. Investor reporting – there will be more and it and loan level data will now be provided.

There has also been discussion of permitting integrated models, this is where assets are retained on the issuer’s balance sheet and specific legislation ensures separation. This will not be enacted.

Reference has also been made to bail-in provisions whereby creditors automatically suffer haircuts should a bank default. The claims of covered bond holders would not be affected by such provisions. The impact assessment undertaken by the FSA suggests that these provisions will improve investor confidence and lower issuer borrowing costs by a sum 5bp per annum – an industry NPV benefit of £220m over 10 years (the central assumption).

Bonds Issued

RCBs can be issued with fixed or floating coupons. About half the covered bonds issued in the UK are GBP denominated and half EUR denominated. Maturities vary and are dependent on market conditions. Most issuance is shorter than 10 years but some bonds are in the 10-20 year range. The issuer’s all in cost amounts to the bond coupon (or swapped cost), plus any discount on issuance. For a three year issue fees can also add a further 7bp per annum. All bonds rank parri passu.

Investor reporting

This is mandatory. It is done monthly and tells the investor more about the risks they face. In 2013 in an effort to increase transparency the level of investor reporting will substantially increase and will include loan level data. Issuers should be prepared.

For investors one of the key parts of the report is the Asset Coverage Test (ACT). This tells investors whether the collateral in the pool is sufficient to meet the interest and principal repayments on the bonds. Whilst the exact nature of the calculation is complex a simple explanation follows.

The total security or pool value is multiplied by an asset percentage (this is less than 100%) this is a type of haircut. Any cash held is now added and some deductions are made for accrued interest and right of set off. The net figure is then compared with the value of the bonds issued. Provided the collateral value is in excess of the value of bonds issued the ACT test is passed. If the ACT test is failed the issuer must remedy the situation by topping up the collateral pool (technically the issuer has 3 months to do this). Failure to rectify amounts to an issuer defaulting and this in turn leads to the Bond Trustee servicing notice on the LLP.

The investor report also informs the investor about other aspects of the collateral and the structure of the programme. Information provided may include the counterparties (servicer, cash manager, swap providers and account bank), Ledgers, what is held in the bank accounts, portfolio details (number of mortgages, average balance, loan-to-value and seasoning), Arrears percentages, LTV percentages, Regional distribution, Repayment type, Mortgage size and Interest payment type.

To compare what different issuers provide investors refer to the publically available monthly investor reports – these are found on individual issuer’s websites or by way of an internet search.

The Asset Pool

Investors are concerned that the asset pool contains prime assets. Whilst this is difficult to define rules are in place to restrict what can be put in the pool. For example loans must be on residential property, the property must be in the UK, it must be freehold or leasehold, there must be prudent lending criteria, interest must be current and the loan must be to an individual. From an operational perspective additional classes of assets may be included. These substitution assets can be UK government debt and short term UK bank deposits. When individual assets fail to meet the criteria the issuer must remove them from the pool and replace them with assets that meet the restrictions. In this way the issuer rather than the investor retains the credit risk on the asset pool. Restrictions also apply on the percentages of substitution assets that may be held.

Ratings and Stress Testing

Stress testing is undertaken by the issuer, the FSA and rating agencies. It is used to determine whether the assets held in the pool are sufficient under adverse conditions to meet to meet the liabilities.

It has been explained that the asset percentage is used in the Asset Coverage Test. This percentage is derived from the stress testing process. The greater the stress and the weaker the collateral, the lower will be the asset percentage.

A lower asset percentage will dictate that the issuer must add more assets to the pool in order to ensure the ACT is continually passed. The stresses applied are unique to the pool. They consider the default history, a decline in house prices, delinquencies, prepayments and interest rates. Each one of these inputs is further subdivided. For example defaults are stressed and evaluated in accordance with factors that include affordability, LTVs, employment status, credit history and seasoning. In short the stress testing process is multifaceted and is developed to fit the portfolio under examination.

There are also additional tests that protect the investor. One is the interest rate shortfall test. This examines the interest income received by the LLP (mortgage interest can be fixed, SVR or base rate linked) and the interest payments (these are made under swap agreements that hedge the LLP against interest rate and currency risk). Failure to pass this test necessitates the issuer increasing the interest rates on the assets in the pool (by adjusting the SVR) or adding further assets to the pool.

Issuer Insolvency

If the issuer defaults the trustee takes over. The trustee appoints an administrator and the asset pool becomes a static pool (the issuer can’t add more assets because it is in default). Investors now rely on the pool for repayment.

The pool should be sufficient for this purpose. It has been subject to stress testing, an asset percentage, over collateralisation and the ACT test. At this stage an amortisation test is regularly undertaken. This test is like the asset coverage test. In addition an interest shortfall test is applied in order to ensure the cash flows going into the LLP are sufficient to meet those going out. If the LLP fails either the amortisation test or the interest shortfall test the trustee can accelerate the pool.

This means the pool is sold off or securitised with all covered bonds being repaid parri passu.

Some RCBs also have a structural feature whereby if the LLP has insufficient assets to pay the covered the bond is extended by a one year period. This is called a soft bullet and helps the issuer in the rating process (see below).


Moody’s, S&P and Fitch rate RCBs. The coveted AAA rating is desirable because it reduces the funding cost for issuers. Rating agencies evaluate the probability of timely interest and principal repayment.

In order to do this they look at the issuer and the asset pool. What is the risk that the issuer defaults? Is the asset pool sufficient? How will continuity between issuer and the pool be maintained?

The strength of the asset pool is evaluated by stress testing. By running stress tests rating agencies dictate (to the issuer) the amount of over-collateralisation (OC) that must apply in order to be consistent with achieving a rating of AAA (or AA). (This is communicated by way of the asset percentage).

This process is dynamic and means the asset percentage and OC may change as a result of the assets in the pool and also market conditions. Failure to maintain the appropriate OC level will lead to a downgrade of the RCB.

Continuity is also evaluated. In the event of the issuer defaulting there needs to be a smooth transition from the issuer to the pool meeting interest and principal payments on the bonds.

If default in the LLP triggered immediate repayment there could be timing problems. For this reason the one year extension (soft bullet) provides comfort that the transition will be smooth and the bonds can repay in an orderly fashion.

Fitch uses the issuer’s rating modified by a Discontinuity Factor (DF). The DF evaluates the pool, its segregation in bankruptcy, how the assets are managed, liquidity gaps and regulatory oversight.

Moody’s applies something called a Timely Payment Indicator. This reduces the probability that the RCB will be AAA if the issuer isn’t also AAA.


If the asset pool comprises mortgages then the LLP may receive fixed, SVR and base rate linked interest payments


The covered bond may be issued in GBP or EUR with fixed rate or Libor linked coupons. Therefore the LLP experiences mismatched interest on the assets and liabilities. These need to be hedged.

Hedging is achieved by way of interest rate swaps and currency swaps. Pool assets are swapped from fixed, SVR and Base rate to 3 month Libor. This is either a standard interest rate swap, basis swap or a blended swap. The LLP receives 3 month GBP Libor.

The bond issue is also swapped. Fixed or floating GBP or EUR is swapped to 3 month GBP Libor. The LLP pays 3 month GBP Libor.

From a net perspective the LLP is hedged.

Note that if the issuer defaults the covered bond may extend by one year. This option means the hedging swaps also require the option to extend (the LLP is long the option, the counterparty is short). This option has a value which is charged by the swap counterparties who adjust the swap rate accordingly.

Swap Credit Risk

Interest rate swaps and currency swaps incur mark-to-market movements. This leads to counterparty credit exposure. To reduce this risk, swap counterparties must have a minimum rating criteria. If the rating falls beneath this criteria assignment of the swap or collateral management will apply. Failure to stipulate this would potentially adversely affect the credit rating of the RCB should the swap counterparty be downgraded.

Pool Audit

The pool audit is a report to the Issuer, LLP and dealers. It is undertaken by an independent audit firm. Its function is to test the due diligence and record keeping behind the pool. Because the pool will have thousands of assets and it is not possible to look at each individual record a sample is taken. The sample must be of sufficient size in order to meet the criteria of a given confidence interval. The larger the sample, the greater the confidence that it is an accurate representation of what is in the pool.

In looking at whether the records are accurate the audit will examine the records surrounding the property address, postcode, loan to value ratio, valuation dates and amounts, who did the valuation, whether documents are properly signed, CCJ status, interest and repayment types, income multiples and arrears.

Errors require remedial action and poor record keeping would invite regulatory sanction. In 2013 the new regulations will make the pool audit subject to a greater level of confidence (99%). The auditor will also need to verify that the pool can meet the bond liabilities and that the pool is of sufficient quality to give investors confidence.

FSA Guidance

The FSA has issued guidance on RCBs. Finalised Guidance - Thematic feedback on the FSA’s reviews of the Regulated Covered Bond programme was issued in November 2011. This focused on governance and oversight. It asked how good was the second line of defence (risk management) and also emphasised the role of the compliance function.

The FSA expects firms to understand the RCB requirements, have formal terms of reference for committees, to instigate regular interaction, have accurate investor reporting, be aware of breaches, have adequate skills and defined escalation processes between the front office and senior management, to risk, compliance and audit.

The compliance department has been singled out as being important in so much that examples of good practice are provided. They include compliance being a voting member on covered bond committees, offering robust challenge and highlighting errors in investor reporting, reviewing the programme, reporting to senior committees, advising on regulatory changes and signing off on applications and material changes.

In December 2011 the FSA also issued Guidance consultation: Regulated Covered Bond Regulation.

This focused on three issues. 1. The quality and use of management information 2. Systems and controls including key man risk, operational processes and model validation 3. The senior manager signing the annual compliance must be aware of the risks, oversight, regulation, understand the ALM process, the market place and engage with compliance.

Because RCBs are central to wholesale funding strategies and market/investor confidence further prescriptive regulation will undoubtedly follow.

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