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In Praise of Sara

27 March 2017
Richard Kemmish

I do like Sara. Clever, subtle and useful, Sara lets covered bond structurers do all sorts of good things. As I’m sure you know – I hope you know – Sara is the Selected Assets Required Amount test, frequently included in conditional pass through programmes. I hope you weren’t thinking anything else.

She is also a bit complicated. When the issuer of a conditional pass through programme has defaulted there are many possible scenarios. Bonds might pay down at their scheduled maturity, they may fail to and therefore enter pass-through or they may – in some programmes only – enter pass through before their scheduled maturity – because either, other bonds have defaulted and there is a cross-acceleration clause between tranches, or, because the cover pool is worth less than the bonds (aka an amortisation test failure).
In some of those scenarios Sara comes into her own. When the trustee is trying to pay down any given series of bonds they have the option to sell mortgages to a third party if, and only if, the mortgages can be sold for enough to redeem the bonds and the mortgages in question are no more than that series of bond’s fair share of the total cover pool. If you take too many, or too good, mortgages from the cover pool you are effectively putting yourself senior to the bonds that haven’t entered pass through yet.

So far, so good.

But there are two problems with Sara.

Firstly, not all conditional pass through structures are created equal. The principle of a fair share of assets in the cover pool might work differently for example, when you have some bonds in pass through and some still expecting to meet their scheduled maturity date. Some conditional pass through programmes have cross acceleration clauses (one enters pass through, they all enter pass through), some do not, making it difficult for Sara to be consistent between programmes. To make it even more difficult for her, not all covered bond programmes necessarily extend all bonds in the event of a breach of the amortisation test (that is, no more over collateralisation).

Secondly, perhaps less obviously, Sara might contradict statutory provisions within covered bond frameworks. Well-meaning covered bond law writers frequently include clauses that require the proceeds of asset sales post-insolvency to be shared pari passu between all tranches of bonds. This makes perfect sense of course, unless a more equitable and practical contractual arrangement for the sharing of proceeds– such as Sara – is in place to address the same concern. If it is, this statutory clause will probably contradict Sara and quite possibly make it impossible to include her in the bond documentation. This is almost certainly a bad thing.
By the way, when I say frequently I have to admit that I haven’t exactly undertaken a comprehensive survey of covered bond laws yet. What I really mean is, I’ve seen the mistake twice now, if you happen to be drafting a covered bond law today, please don’t repeat it.

Sara is great, let her work properly.

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