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Hard and soft LTVs

21 November 2014
Richard Kemmish

In covered bond land hard and soft typically refer to bullets in competing maturity structures. But the EBA also refer to hard and soft LTV limits. There is some confusion, but my (and I think the EBA’s definition) is that a hard LTV limit refers to the maximum LTV of a mortgage in the pool, whilst a soft LTV limit refers to the amount of LTV that can be used for over-collateralisation and other tests.

This is worth making explicit as in most cases they are either the same number or the hard limit is 100%.

Which of these two bonds would you prefer? One where mortgages of up to 100% are allowed but  only 70% of the value can be used towards the collateral target, or one where mortgages of up to 80% are allowed in the pool, but the entire amount can be used? Mortgages in the first bond are more likely to default, but because of the slice from 70% to 100% they will generate a lower loss given default. As long as you as a creditor do actually get the ‘top slice’, it isn’t clear which is the better.

When a rating agency looks at the first bond they of course give credit for the slice of the loan over and above the 70% when calculating both the default probability and the likely recovery. This is why, incidentally mortgage pools with ‘worse’ credit characteristics in the rating agency reports often don’t have higher over-collateralisation needs.
But if the rating agency does give credit for the top slice, the law invariably does not. That LTV limits exist at all is a statutory thing – the laws defined the limits long before rating agency models came into existence and you needed some proxy for credit quality.
The securitisation market – born after rating agency models started to become significant – have no comparable cut-off point.

Which approach – the rating agency or statutory – is the better guarantor of credit quality? Fortunately we have a vast body of evidence – the Asset Cover Test. One of the key parts of the asset cover test is that it takes the higher of two different ways to calculate the required collateral level. The first is essentially the statutory method – a hard cap on the LTV of mortgages. The second is essentially a rating agency driven one – the Asset Percentage multiplied by all of the mortgage, not just the statutory amount.

It is a great system, it guarantees both conformity with the EU definition (maximum 80% LTV) and with the need to keep the highest available ratings. But lawyers don’t exactly make this accessible. The fact that one term is called the Aggregate Adjusted Outstanding Principal Balance when the other is called the Aggregate Arrears Adjusted Outstanding Principal Balance doesn’t help the rest of us understand it.
It does answer my question though. In every asset cover test I’ve ever seen it is the ‘rating agency’ part of this equation (the Aggregate Arrears Adjusted Outstanding Principal Balance, if you prefer) that drives the credit enhancement.

Perhaps LTV limits are just a box-ticking exercise?

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