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Audit trail

26 February 2016
Richard Kemmish

As briefly mentioned in an earlier comment, the ECB has suggested that covered bonds should disclose changes to a cover pool, specifically “a history of additions, removals and substitutions of assets in the cover pool”. They haven’t exactly gone out of their way to draw attention to this suggestion – it doesn’t even get an entire sentence to itself on page 34 of a response to the European Commission that very few people will actually read.

But it is an excellent idea and one that deserves a lot more discussion.

Most of the time this will not reveal anything even vaguely interesting – mortgages frequently change, they repay, default or change in some minor way that makes them ineligible for the cover pool. As such they regularly need to be replaced by a more or less identical asset.  As long as a prime residential mortgage with a 60% LTV is replaced by another prime residential mortgage with a 60% LTV, the report is fairly uninteresting.

But, the cases where the changes aren’t like-for-like are the interesting ones and - unless you make a habit of comparing cover pool reports to previous editions – are easily missed. There are two cases where I think this can happen: asset quality deterioration and changes to the business model.
Asset quality deterioration is obvious enough as a risk. But it doesn’t actually happen in practice as there is no incentive for an issuer to put worse assets in a covered bond pool, they only have to replace them when they go wrong. Dynamic securitisation pools in contrast have to put in place very strict asset quality safeguards.

Changes to the business model though are a more significant risk that needs either mitigation or at least highlighting for bondholders.

The EBA proposed that fundamental changes to cover pools should be limited. If a bond starts out as mainly residential mortgages in Germany, it should continue to be mainly residential mortgages in Germany, not commercial mortgages in Belgium.  That is admittedly an extreme case. But if cover pool data – such as LTV profiles or geographic distributions - actually matter to investors, then presumably changes to these smaller details too could potentially be as significant as the Germany/Belgium or residential/commercial breakdown of the cover pool.
Covered bond issuers are dynamic businesses, so are their cover pools. Whereas switching from a German residential to a Belgian commercial lender is beyond what would be considered reasonable by an average investor, switching the risk profile or geographic focus of the asset pool within a country should be something which we can accommodate and which it would not be commercially reasonable to prohibit.

If rules don’t work – and in cases like this they clearly either wouldn’t or would at such a loss of flexibility to make an issuer have second thoughts about their covered bond programme – then disclosure is the next best thing. A cumulative report on changes to a cover pool, properly designed, can give an excellent early warning of this type of change.

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