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The Covered Bond Blog: Discretion (continued)

15 May 2015
Richard Kemmish

In my last post I argued that the systemic support of the covered bond market is on an increasingly untenable ‘discretionary’ basis which is at odds with the Bank recovery and resolution directive.
The recent split of Kommunalkredit Austria makes a similar point about government’s ability to take actions which undermine assumptions about covered bond credit. It also makes a more general point about the basis of investor comfort, that it needs to move towards more contractual certainty.
The covered bond programme of Kommunalkredit was split into two parts – the Swiss Franc bits would go to ‘KA New’ – to be owned by a private equity consortium, whilst the euro bits go to ‘KA Finanz’ – ultimately owned by the Austrian tax payer. Although many covered bond issuers have been split in the past (usually in the event of a failure into a good bank and a bad bank), I know of no cases where the covered bond programme was split too, rather than go to one or the other legal entity.

Many investors have commented that they didn’t think that a split of a covered bond pool was even possible. Ignorance of the law is – famously – no excuse. But is the covered bond market really like that? Special public supervision to protect the interests of covered bond holders is a bedrock of our industry. It is one of the reasons that covered bonds have been so successful and well trusted by investors. If the large investors that have been quoted in the press didn’t think that a split was possible, what hope for the smaller investors?

Similarly, investors have always bought covered bonds on the understanding that, although they are dynamic pools and indeed programmes, voluntary commitments to ensure that they will remain high quality credits will always be met.

By and large they have been correct. The need to protect access to the covered bond market and the actions of supervisors charged with responsibility for investor protection has meant that programmes and pools have got better, not worse in a crisis.

This is challenged though when a cover pool can be transferred to an entity that has no real reason to maintain market access for the programme. JPMorgan took over the covered bond programme of Washington Mutual when it failed but had no further use for the programme as a funding tool and therefore no need to undertake any voluntary support – such as collateral over and above the contractual minimum. The notes were of course full recourse to JPMorgan, who were still well rated, so no-one really cared when the programme’s credit enhancement fell.

The two halves of the Kommunalkredit portfolio are going to very different entities. They will have very different views on how to manage their programmes going forward – a fact reflected in the differing spread moves on the announcement. And as Moody’s have pointed out there is nothing to stop either entity from cutting the current level of overcollateralization, which is not contractual but discretionary.

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