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What is normal anyway?

11 January 2016
Richard Kemmish

The European Union consultation on covered bonds which closed recently, argued that the spread widening seen in national covered bond markets was abnormal. Nothing too controversial there. But more than one person that I spoke to about the consultation argued that what happened to covered bond spreads before and after the crisis wasn’t normal either. The latter isn’t very controversial either – the market is clearly distorted by the ECB’s actions. But before the crisis?

At the risk of sounding old (perish the thought!), those of us who formed our definition of normal before the crisis are increasingly being outnumbered in the industry. It was one of those - for want of a better word - youngsters who put it to me that the spread behaviour on the charts from before 2007 made no sense whatsoever, even without the benefit of hindsight. 

The spread differentials that we saw then, lets say 10 basis points, were barely adequate compensation for technical factors in the market – like the rapid expansion of the cedulas market without an associated ‘natural’ buyer base. Which suggests that we were in total denial of the concept of credit, either sovereign credit – the Spanish housing market is riskier than the German – or covered bond credit, the possibility that a covered bond of a failing bank might not actually work. The market for unsecured bank credit, or bank capital, might have under-priced the possibility of bank failure but it at least took into account the idea that one bank might be more likely to fail than another.  

We can use the Naples defence – it isn’t wrong if everyone is doing it – and point to other rates markets such as that for government bonds where prices were also underpinned by the flawed assumption of infallibility. Or we could argue that we were right all along – no covered bond failed so hindsight is actually on our side: there shouldn’t have been a credit element in the price. Neither argument is particularly convincing.

Perhaps this is academic. We can not tardis ourselves back to 2006 and reprice all of the bonds. But we can ask ourselves what the appropriate price for credit risk should be today. A price that takes into account what has changed in the interim: far lower probabilities of government support, better covered bond structures, new risks in mortgage assets and a very different model of banking.

My friend’s argument though was this: that those people who have interpreted the central question of the consultation paper as ‘how do we get back to the pre-crisis pricing levels?’ are fundamentally flawed. We didn’t price risks right then any more than we did in the height of the crisis. The credit risks may have changed but they have not gone away. Any attempt to hold up the pre-crisis spread environment as an ideal to be aspired to and to recreate a market with no price differential for bonds with different risk characteristics is doomed to failure.

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