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Getting it wrong: great mistakes by covered bond structurers

27 November 2014
Richard Kemmish

The inability to learn from mistakes is, surprisingly, genetic. Scientists have isolated a particular defective gene which is strongly correlated with repeating mistakes in experiments. The fact that this gene is carried by 30% of the human population explains a lot about the modern world.

Whether the collective mind of the covered bond market contains this gene, I wouldn’t like to say. But in the interests of fighting it, here are some of the most common mistakes that I have seen by structurers:
1: Copying inappropriate parts of foreign legislation
Yes, pfandbrief legislation is magnificent. Yes, it is appropriate for the German mortgage market and banking system. No, it is not appropriate if your assets are floating rate or short duration. Or if they are denominated in a different currency from your target investors. And it is certainly not appropriate if you cannot demonstrate a supportive regulator who facilitates the transfer of mortgage pools from failing banks.
2: Not copying appropriate parts of foreign legislation
So your covered bonds aren’t going to qualify for preferential treatment under European law, so why conform to all of the bits of the European regulation that don’t seem to fit? Well, two reasons: firstly some of them are actually quite good – I’m thinking of the EBA best supervisory practices (not strictly a regulation, yet) and wondering why non-EU regulators haven’t started cutting and pasting yet.

Then there is that bright day in the future when the EU gets pragmatic about its shortage of appropriate securities and start mutual recognition of non-EU covered bond regimes. Sooner than you think.
3: Assuming its all about jumbos
Ignore what the investment bank tells you: most covered bonds are not jumbos, are not eligible for the league tables that investment banks fetishize over and are more appropriate for smaller funding needs. The jumbo was a great invention for the wholescale financing of German reunification, it does not suit all issuers.
4: Throwing money at IT
You think the lawyer’s bills are high? I’ve seen eight figure IT bills and two year delays on covered bond programmes thanks IT. Whatever the question the rating agency asks, there is usually a far more sensible alternative than the IT project. It can be via manual over-rides, it can be via a bit more over-collateralisation, it can be a bit of neat structuring.

Part of the problem is that too many front offices see covered bonds IT projects as a Trojan horse. Time to sneak in all of those system upgrades that we can’t get sign off for.

And, on a related topic...
5: Thinking it’s a securitisation
If you ever get a pitch book that tells you that rating agencies will demand every piece of information on every borrower in the pool, tell the investment banker to go back to the ABS team and send the covered bond structurer. I knew one bank who decided not to do covered bonds for precisely this reason.
6: Not thinking enough about the maturity structure
If it’s going to be a conditional pass through, you need to decide that now. It’s a non-trivial decision.

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