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Is there a case for action?

26 October 2015
Richard Kemmish

The European Commission open their covered bond consultation with the one fundamental topic: is anything wrong with the covered bond market?

Commission’s definition of ‘anything wrong’ seems to be based on whether the price divergence that we saw through the crisis was a function of ‘fragmentation’ in the market. You could argue that this is quite a narrow definition of something being wrong, but let us accept Commission’s definition of the question for now. 

The fact that covered bond spreads in Spain widened more than they did in Germany is not evidence of market failure, although this seems to be the default position of Commission. They argue that spreads can widen more or less because of either factors inherent to the structure of the covered bond market in each country (model, assets, supervisory practices) or external factors (the sovereign risk element and macro economic implications for cover pool assets). They then ask whether the internal factors were the cause of the spread widening, with the implication that if they are then there is a case for legislative action. That of course assumes that legislative action by Commission can address the perceived market imperfections, which I would argue is not the case.

But again, let them define the question. So did spreads widen differently in different countries because of flaws in national covered bond regimes or not? Regular readers will know my answer: no.

If you strip away market noise and look at the fundamental strengths of covered bond regimes then I think you will find that most covered bond regimes are remarkably similar. The best evidence for this is to look at the rating uplift that they provide relative to the unsecured rating of the issuer. It is remarkably similar in most jurisdictions (to do this you of course have to adjust for the AAA upper bound, because the covered bond can’t be rated any higher than that, you need to look at the potential rather than the actual uplift). 
Of course the rating agencies are no longer Pythia. But they have spent a lot of time looking at covered bond laws and have all come up with more or less the same opinion on this. That has to count for something.  

You can’t totally strip away market noise; spread widening did occur differentially by country. How can it be understood? I think in two ways.

The spread widening of covered bond indices was correlated with spread widening in the sovereign bond market, suggesting that country risk premia are important. There are many transmission mechanisms from sovereign to covered bond spread – another post to follow on that one.

Also, the spread widening was correlated to spread widening of senior unsecured bank debt. This is most obvious if you look at  the spread ratio of individual bonds (index comparison has too many other variables) as a spread over bunds, not swaps. Then the results are remarkably consistent: 40%.

Covered bond spreads reflecting their lower beta and county risk premia? Hardly evidence of market failure.

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