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Answering the cynics

14 October 2014
Richard Kemmish

As you may have heard before, no covered bond has ever failed. Well done everyone. It’s a tennent of faith in the industry that this is because the idea and structure of covered bonds is completely brilliant and we are all so good at our jobs.

The cynic responds that since the crisis, nine major covered bond issuers have required bail-in or some other form of government intervention. If it hadn’t been for this intervention we wouldn’t be able to brag so much.

How can we answer the cynic? Three points.

Firstly, they probably didn’t need to be bailed in. We don’t know for sure whether the transfer of servicing of half a million residential mortgages can really be transferred to a third party – payment disruption is always a risk, although I suspect a remote one - but we do know that the credit quality of the cover pool can survive the stresses that bought down the issuer. As far as I can discover, in all nine cases the rating uplift for the covered bonds was still at or near as high as it could be just before the government intervention.  That can only be because the cover pool was still sufficient to service the bonds.

Secondly, they were bailed in.  The cynic says that they were bailed in because they were major covered bond issuers and that governments felt that they had to keep the covered bond market intact. This might be true, but did they also need to protect the senior unsecured bond holders, as they did in 8 of the 9 cases?

We are now (effectively) in the era of a single resolution directive. Tax payers aren’t supposed to come to the rescue of failing banks and I suspect that they will impose losses on senior debt holders. But as covered bonds become more systemically important, and as the wording of the resolution directive gives the regulators greater latitude to protect secured bond holders, I can’t see that regulators are any less likely to protect covered bond holders in future.

Polyanna, in the eponymous novel was delighted to get a gift of a pair of crutches because it reminded her that she didn’t need them. Which leads to my third point, covered bond structures evolve and are less likely to be in need of bail-in in future. It seems to me that one of the guiding principles of the EBA’s recent recommendations is to think the unthinkable, to ensure that a covered bond really could survive a bank failure without government support.

In summary, covered bonds work, are getting better and will continue to be supported anyway.

Am I really such an optimist? No. Are there new challenges to the 240 year track record? Yes. But let’s leave that for a future comment.

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