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Sovereign risk

29 October 2015
Richard Kemmish

If you accept my premise that covered bonds work consistently well in most jurisdictions (as evidenced by the comparable size of the rating uplift in each country) then the different behaviour of covered bond spreads in different jurisdictions should be largely be a function of the risk of contagion from a sovereign crisis to a failure of covered bonds.

It follows that if you want to reduce market fragmentation between covered bonds from different member states – which is Commission’s objective from the Covered Bond Consultation - the best way to do that is to immunise them from their sovereign risk. The problem is that there are many mechanisms that transfer sovereign risk to covered bond risk, each of which needs to be addressed.
The most obvious transmission mechanism is also the least real problem in practice. If a country goes into a severe economic downturn then the assets in the cover pool are likely to degenerate significantly.  But this just doesn’t happen in practice. The Greek and Irish mortgage markets went horribly wrong, they did not infect their respective cover pools. I speaking here about mortgage covered bonds, accepting that the same might not apply for public sector receivables.

Secondly, and relatedly, if a country goes into a downturn, so does the banking system. This was the main mechanism for most of the downgrades through the crisis. The bank resolution directive, the covered bond carve out, pan-European banking groups and the ever greater delinkage between covered bonds and unsecured bank ratings are all significant mitigants, but this contagion mechanism can never be totally ruled out.

The weaker the sovereign, the less likely they are to step in to support a failing issuer. How large a factor this is in investor spread demands is difficult to say but the probability of state support should become more standardised across Europe with a more rigorous approach to state aid rules and, again, the resolution directive.
The most nebulous contagion mechanism though is the probability that a government will effectively force a default – a risk captured in the rating agency sovereign ceiling risk. This does not happen when a municipality defaults in the US.

It could by direct action – the imposition of capital controls for example. Our friends who invest in Emerging Markets spend a lot of time on this one, is the bond goverened by domestic or English law? Where is the place of payment? Are there collective action clauses?

Or a default could be as a result of a country leaving the Euro. Again: what is the currency definition in the prospectus? How does the ISDA document currency redenomination? What about the underlying mortgage contracts.

This is an area that gets very little airtime in the debates in Brussels. Particularly relative to its importance. If some of the effort that was directed towards attempting to standardise valuation methodologies in Portugal and Holland were instead directed towards addressing this risk the impact on market fragmentation would be far greater. 

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