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Dictating the cover pool

16 October 2014
Richard Kemmish

The EBA’s attempt to limit the change allowed in cover pools from their starting composition has an obvious motive; scepticism about the credit worthiness of commercial mortgages. The fact that they lovingly detail all of the jurisdictions which limit commercial mortgage exposure in pools gives away their real view. There are of course no jurisdictions that limit the percentage of residential mortgages in the pool. 

Never mind that those jurisdictions with commercial mortgage caps are those jurisdictions with few if any commercial mortgages in cover pools anyway. This is not because of the caps. The causation works the other way, you put a cap (or outright ban) on commercial mortgages because you want to make it totally clear to investors that this is a residential mortgage dominated market. Underlying that statement is the same core belief that the EBA has, or for that matter that the securitisation market has, residential mortgages are safer.
In the opposite corner, commercial mortgages in cover pools in practice come almost exclusively from a jurisdiction where they are not limited, where the regulator has the opposite viewpoint.

All other things being equal the first group is probably correct. Residential mortgages are invariably safer than commercial ones. But all other things aren’t equal, is a commercial mortgage in a safe country safer than a residential mortgage in a less safe country?

Then there is the terminology. We refer to commercial or residential mortgages as if every mortgage in the world is either one or the other. But many mortgages are both. Whether you call it multi-family or buy to let, it amounts to the same thing, someone lives there, but the owner owns it for commercial reasons. It’s a grey area that exhibits credit characteristics of both sectors.  Each country draws the line between the two sectors in a different way.

Then there are the owner occupied commercial properties. If the dentist takes out a personal mortgage to buy her clinic that has a very similar credit profile to the mortgage on the house that she buys to go home to each evening. When the two are combined (she lives in the flat above the clinic) the dividing line is even more obfuscated.

The more you think about the EBA’s intention the more practical difficulties occur. As covered bonds are invariably issued off programmes which usually have multiple bonds outstanding the prohibition on changing the asset mix for the life of any bond is effectively a prohibition on ever changing the business model – unless the issuer sets up a parallel covered bond programme, which in turn generates vast practical problems.

Recognising that cover pools (and for that matter issuer business models) are dynamic and that historically the covered bond market has not differentiated significantly between the asset classes in price terms, is it really up to the EBA to set limits? If you allow that commercial mortgages are an eligible asset class for covered bonds, surely it is wrong to set a limit that implies they are second class assets?

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