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New wine in old bottles

08 August 2017
Richard Kemmish

Just what will happen to old bonds under new covered bond laws? Grandfathering rules and dual programmes are two answers, but they could throw up more problems than they solve.

One thing is certain, the lawyers will be kept busy.

Every covered bond in Europe, possibly the world, is about to change as a result of the forthcoming  covered bond directive (yes, even Holland – the only country that meets all of the EBA’s best practice principles. The directive will go further than the current principles).

Before asking ‘how?’ it is worth asking ‘why?’ On the face of it there is nothing to stop newly produced bonds conforming to the new directive whilst existing bonds live out their sun-set years under generous, long-dated grandfathering rules.

Sadly, it isn’t that straightforward for many reasons.

Most obviously, not even the most generous grandfathering rules are likely to capture all bonds. There is at least one bond that I know that matures in 2055, and plenty that will be with us until the 2030s.

Secondly, it will involve having to run two programmes in parallel. That’s two sets of legal documents to be updated each year, two IT runs each month, two sets of pool reports, accounting system hand-offs, reports to regulators... All of which are a) hassle and b) expensive.

But even worse are the inter-creditor and regulatory implications of dual programmes. For example, am I allowed to show preference for one programme over another if I start to run out of eligible assets (particularly in a country where substitute assets are typically of lower credit quality than primary assets). Does a default on my grandfathered programme automatically trigger a default or acceleration event on my new one? (if it does, their credit ratings must be linked – no benefit from the new directive upgrades. If it doesn’t my new programme could be materially prejudiced in its residual claim against the issuer).

Things aren’t much better from an investor’s perspective. The old bonds will rapidly be worse than the new bonds. From the perspective of credit quality that’s kind of the point of the directive. But it also implies that investors will have to submit twice as many programmes to the annual credit review process, read twice as many rating agency reports...

But more significantly, the old bonds will rapidly become less liquid. Prudential treatment grandfathering under EU law is one thing, but will the ECB and other central banks (including an ex-EU Bank of England) continue to give the old bonds the same treatment in repo operations? They shouldn’t, it won’t be justified. If they don’t, the bond’s equal treatment under the liquidity coverage rules looks difficult to defend.

The regulators will need to ask whether they continue to regulate the old bonds under the old rules and the new under the new? And how to treat the two programmes in resolution – will it be possible for the two programmes to have different resolution paths?

Plenty of reasons why parallel old and new programmes are a temporary answer whilst we convert all of the existing bonds to the new law. Now that we’ve established the why? Time to struggle with the other question: how? Sadly, that will have to wait for my next post.

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