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Pass throughs and new jurisdictions

17 June 2016
Richard Kemmish

The Polish law is the first to hard-code the concept of the conditional pass through into legislation – so far it has always been introduced as a contractual feature. I can see the appeal of doing this, and some drawbacks. Whether it becomes the norm in new jurisdictions is very difficult to tell.

Let us start with the most obvious appeal. Conditional pass throughs are not easy to document, there are a lot of subtle differences between existing contractual programmes, all for legitimate reasons, but not necessarily conducive to analysis by hard pressed investors. There are many benefits to a standardised approach, nothing does that as well as defining conditional pass throughs and their terms and conditions in the law itself.

The flipside of standardisation is inflexibility. It is possible to conceive of cases where the Polish law will extend bonds that would not otherwise have been extended. This is particularly the case in a country where the mortgages are 100% variable rate (as is the case in Poland), as conditional pass through structures are more useful, the higher the asset side duration.

Certainty of treatment is a good feature of the approach, the implied inflexibility less so.

Less obviously, enshrining the concept in the law is a sign of its regulatory approval. In the current environment regulatory approval for a product is increasingly important in our ever more ‘discretion reliant’ culture.
And why wouldn’t Polish regulators approve of a conditional pass through mechanism? I’ve written before about how, from the perspective of systemic stability, conditional pass throughs have significant advantages. In a nutshell, they require less over-collateralisation and they preclude the possibility of a fire sale of assets. How much more significant are these two advantages in a new jurisdiction coming to the covered bond market with reticence about the asset encumbrance that covered bonds produce and with no tradition of selling or securitising mortgage portfolios (to meet bullet bond maturities)?

The issuer’s interest is aligned with that of the regulator on the ‘less over-collateralisation point’. But from their perspective there is also the higher rating uplift that pass throughs can achieve, again more significant in newer (invariably lower rated) countries.

There are though a couple of negatives to highlight. It is more difficult to swap such structures and it may require a higher yield premium.

The swap problem is obvious enough. Covered bond swaps are different, even with a pari passu treatment with bond holders enshrined in the law, their special features make them a more difficult sell in credit committee. Swapping bonds that have longer legal final maturities and potentially unknown pay down profiles is that much more difficult. What is worse, in new covered bond jurisdictions – frequently without developed local currency covered bond investors - FX swaps are more important than anywhere else.

Then there is still some investor reticence about the product (see my earlier post on the topic).

Overall, pros and cons of hard coding this sort of feature into the law. More debate needed please.

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