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Trigger’s broom

27 April 2016

In an episode of Only Fools and Horses Trigger, the road-sweeper, is honoured by the council for cost saving because he has only ever used one broom in his long career. On investigation Del discovers that it has had many new heads and many new shafts, but, as Trigger argues, ‘it’s still the same broom’.

The cover pool backing your covered bond is similar. If you have a particularly long dated bond – there are plenty of thirty year bonds outstanding and at least one, fifty year - it is perfectly possible that every single asset in the pool on the day the bond is issued will have matured and been replaced by the day it matures, ‘but it’s still the same cover pool’.

This seems very odd to people used to securitisations. Usually in securitisations the pool is fixed and amortises away over the life of the bond. The bond amortises in line with the pool and when both have melted away to nothing the process is repeated with a new pool of assets. The rare occasions when securitisations have allowed revolving pools are mainly very short dated and homogenous assets – such as credit card receivables – and then only with very strict asset eligibility criteria. Credit cards have the advantage that if you breach the criteria you stop the ability to buy new assets and the pool pays down incredibly quickly (largely within one month).
Without that sort of safeguard, our securitisation friends argue, surely you should have very strict criteria over the assets and automatic acceleration if the criteria are ever breached.

Perhaps securitisation market thinking underlies attempts, for example by the EBA and by local regulators, to impose stricter asset eligibility criteria? Your broom can have a new head but only if it is absolutely identical to the old one. Suggestions that the residential/commercial mortgage ratio should be fixed or that the geographical composition should be fixed (in multi-jurisdiction programmes) suggest that the securitisation market thinking is reaching into covered bond credit analysis.

But unfortunately that type of rule is more or less unenforceable. Covered bond pools – like Trigger’s broom – go on for ever. Assuming that the issuer wants to remain a covered bond issuer and that they don’t want to have to set up parallel programmes, the pool must be able to change as the issuer’s lending activity changes. Covered bond rules should not dictate the proportion of residential and commercial mortgages written, or whether more loans should be written in Sweden or Denmark.

The argument that the composition of the cover pool should be fixed belies its origins in the credit analysis of securitisations and ignores the fundamental difference in the products – risk transfer. Issuers are only incentivised to fund worse quality assets if some of their risk is being transferred to bond holders, which they are not.

Covered bonds are better compared to sovereigns or corporates than to securitisations – you don’t buy a broom with one head and one shaft, you buy Trigger’s broom, which goes on forever.

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