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What is the point of over-collateralisation?

22 October 2017

Before we discuss the appropriate level of over-collateralisation, we need to talk about whether we need it at all.

I had the pleasure of chairing a discussion on the harmonisation of over-collateralisation levels at the Euromoney Covered Bond Forum last month. I went into it expecting to have a debate about whether there should be a standard minimum level and if so how to calculate it. Perhaps I was a bit naïve. Before we decide things like how much we need, we should try to reach a consensus on why we need it.

The opinion of an inhabitant of the credit market, or the naïve viewpoint as you prefer, is that over-collateralisation exists to address possible credit losses on the underlying assets.

The contrary, frequently heard argument is that if you use a sufficiently conservative loan-to-value ratio, valuation methodology, an obligation to top-up defaulting assets and a bit of excess spread on the underlying assets, there will never be a credit loss, therefore no need for over-collateralisation. A friend in the securitisation market told me that this argument justifies his belief that the covered bond market is totally insane and should be closed down tomorrow. I suspect that based on empirical evidence he may be wrong.
If over-collateralisation isn’t for credit risk it might be for refinancing risk. But again, if assets and liabilities are sufficiently matched, either through internal matching augmented with liquidity buffers or through a conditional pass-through (or similar) structure, then nothing is needed for this either.

Cover pool transfer
The most radical viewpoint expressed was that over-collateralisation primarily exists to allow a cover pool to be transferred to a back-up servicer. This is obviously an onerous exercise – very expensive in the case of large, granular pool of residential mortgages, less so in the case of a lumpy pool of public sector loans or ships.

Arguably, though, the cost of such a transfer is more likely to be mainly a fixed amount – the costs of transfer are mainly systems, personnel and legal costs that differ little if you are transferring 100 or 100,000 mortgages. Bear in mind here that the on-going servicing costs should be covered not by this reserve but by on-going spread on the mortgages. Certainly in a couple of jurisdictions the cost of transfer of accounts must be held in a reserve account as a cash lump sum, not a function of the size of the mortgages.
Also, for a very large issuer the reality is that it is probably impossible to transfer all of those assets to a new servicer. Some form of compromise must be reached in insolvency to allow part of the existing servicer to continue to operate. This was true for Northern Rock (for example), it is far more likely to be true for the next failure given the workings of the Bank Recovery and Resolution Directive.
Why have a rule about ‘over-collateralisation’ may seem like an academic discussion – we all have it, so obviously need it – but the differences of opinion in the roundtable underline the real problem – trying to agree on how much it should be.

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