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Reasons to be fearful (2)

20 October 2014
Richard Kemmish

As promised, I want to come back to the threat posed to covered bonds by changes in the government’s attitude towards them.

Covered bond investors in all nine of the issuers who failed during the crisis benefitted from government intervention to some extent. The whole point of banking union, in particular the single resolution mechanism, is to prevent this having to happen again. Whereas covered bonds are exempt from bail-in, bail-in is not the be all and end all of Banking Union. There are other resolution mechanisms that could create risks.

For example, assets in cover pools and covered bond liabilities might move to a new entity, either an existing solvent bank or a ‘new bank’. This doesn’t need the resolution directive in order to happen. The covered bonds and cover pool of Washington Mutual were transferred to JPMorgan. On one level, great, JP Morgan is a highly rated bank. On another level they had no obligation, moral or economic to maintain the cover pool in the way that a repeat issuer would, hence the decline in the ratings towards those of JPM on an unsecured basis.

Something similar has just happened in Portugal with the transfer of the relevant bits of Banco Espirito Santo to a Novo Bank (ten out of ten for being investor friendly, zero out of ten for coming up with an original name). A less investor friendly regulator – for example one in a jurisdiction strong enough to survive a bank failure – might not be as incentivised as the Portuguese to do this transfer in a friendly way.

There is also the possibility in the resolution directive that the bank will be wound up. Then we have the great test case – can servicing be transferred to a third party? Relevant but off topic here. More importantly, there is the possibility that unsecured creditors of the bank may challenge the transfer of excess collateral to the covered bond. For me this is one of the risks of a statutory minimum level of over-collateralisation. If the law says you need X% and you actually transfer Y% then surely the difference between X and Y should be clawed back in insolvency? Is contract or statute law stronger in this case? Do changing attitudes in society towards banks and the rule of law create new risks? What if the creditors are mainly foreigners and the failure is part of a sovereign default?  Argentina doesn’t have covered bonds, but it is interesting to speculate on how they would have performed in the current legal stand-off in the US. 

The other, broader change in government behaviour and nothing to do with the resolution directive, is a growing tendency to loosen personal bankruptcy law in response to the credit downturn. The debtor friendly nature of US bankruptcy law must have been a significant contributor to the sub-prime crisis and it feels like that’s the way it is going in many countries in Europe. Understandable from a compassionate standpoint, problematic for an investor.

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