Conditional pass throughs: a modest proposal

16 May 2016

Conditional pass throughs – love them or hate them there is no escaping their increasing prevalence in new covered bond programmes. The more covered bonds are used in countries with lower credit ratings and without a tradition of mortgage portfolio sales, the more we are going to see of them. Poland enshrining the principle in its primary legislation is just the start.

Nobody knows what actually happens in the case of a full default of a covered bond issuer (differentiating that idea from an entry into resolution or a government sponsored restructuring, portfolio transfer or similar measure). So personally I don’t think that a properly structured conditional pass through is materially different from a programme that does not explicitly state what happens in that scenario.

I define ‘properly structured’ as: allowing no case where a bond that would otherwise have paid off on time, for par has a different pay down profile because of the existence of that conditional pass through language. There should be no hint of optionality in the structure. Take that as a given.

What of the ‘for par’ – part of that definition? Does a conditional pass through ever create a scenario whereby with the clause you get more money, later without it you get less, sooner? Yes, and that could be the basis of a legitimate investor complaint. On the other hand, if you care about an early, but loss realising exit in a distress scenario, you probably would have sold the bonds long before the repayment actually occurs.  

For me the most legitimate objection to the concept is that you get a better rating with lessover-collateralisation – you don’t need to hold collateral specifically for refinancing risk, but that collateral might be used to address credit risk.

The rating agencies are being consistent: they give a better rating with less over-collateralisation because they are rating a different event – no defaults under an extended schedule, rather than no defaults on a defined maturity date.
Here is a suggestion: why don’t the rating agencies tell us what the rating of a conditional pass through structure would have been if they were rating it to a ‘normal’ pay down schedule?

This could be in the form of: “programme X is rated AAA as is, but would be rated AA- if it had a hard bullet”, or “programme X would need n% more collateral to achieve the same rating if it wasn’t conditional pass through”. Issuer X could voluntarily add more collateral to equate the two ratings.

Alternatively the agencies could publish a generic piece – perhaps showing a fictitious issuer and how their models would measure both alternatives. Or they could just provide their model so that we could work it out ourselves.
This would allow sceptical investors to quantify their objection and I suspect that the actual numbers that would come out of this process would go a long way to addressing their concerns and allow them to buy in to the product. 

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