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Does Libor matter for covered bonds?

28 November 2019

The demise of the Libor benchmarks has many implications and challenges, from IT systems to brand awareness, from legal questions to mathematical ones. The covered bond market so far has comparatively been in denial of the problem. Justifiably?

The Libor family of benchmark interest rates will (probably) be discontinued from the end of 2021. Covered bond market participants could be excused for thinking that, as a fixed rate market this is more or less irrelevant to covered bonds, so it is safe to ignore. Mainly this is true. But there are some minor changes needed and some debates that should be followed.

Not all covered bonds are fixed rate, according to the ECBC over €500bn carry variable coupons. But that big, scary number over-states the extent of the problem for two main reasons – most of the floating reference rates are EONIA – which will survive the benchmark cull – rather than the doomed Libor. And many floating rate bonds are created purely to be retained as repo collateral, so it will be very straightforward to make any necessary changes to the documentation. Only a very small number (albeit it an impossible to quantify number) of bonds actually reference Libor directly and are sold to third parties.

Not much to renegotiate then. But many floating rate covered bonds will have been swapped. And many of these swaps will benefit from hedge accounting. Will an amendment to a reference rate constitute a material change and trigger a loss of hedge accounting treatment? Probably not but we haven’t seen the rulings yet – the accounting standards people won’t rule until there is more certainty – and the potential implications for the loss of hedge accounting, particularly given how much rates have fallen since most bonds were issued (just look at cash prices), would be enormous.

So much for the liability swaps – the ones that give the cover pool the coupons on the bonds that they issue – but can the same be said about the pool swaps which translate the myriad different rates in any given pool of mortgages and convert them into, typically 3-month Libor?

Then there is the underlying pool – how many residential mortgages directly reference Libor interest rates? In Europe now many, particularly when compared with the US. But there will certainly be libor linked commercial mortgages and public sector loans in many pools. The effect on the covered bonds should be far less significant than the effect on the underlying assets themselves – which will be driving the re-benchmarking process – but it is something to be aware of. There will be litigation regarding Libor linked loans. Some of these loans will be in the pool. If the litigation becomes ‘class’ rather than isolated examples, this will start to materially change the composition of some cover pools.

Then there are the hidden Libors. A search of a randomly selected prospectus referred to Libor ninety eight times. Many of these referred to penalty interest rates and interest rates to apply in a case of a maturity extension under a soft bullet. The fact that this has never actually happened in the real world does not mean that it doesn’t need to be addressed, but does mean that it should be relatively uncontroversial to do so. And does mean that it has to be done, preferably at the next programme update.

A small number of libor references that I’ve found use the rate in connection with a present value discounting methodology. As I’ve discussed before, these methodologies are usually flawed anyway (unless the liability and assets have exactly matching durations), and it is a regulatory rather than a contractual matter to amend them. Does it have the potential to change reported levels of over-collateralisation? I simply don’t know.

Libor replacement is a far, far bigger problem in the, much more frequently floating rate, securitisation market. But as far as I can see industry is more on top if it there. Its also a bigger problem in the US mortgage market as far as the underlying assets are so frequently libor referencing. And we all know how litigatious American retail can be.

Do I think that the end of Libor will be a major problem for the covered bond market? No. Does that mean we can ignore the problem? Also, no.

By Richard Kemmish