U.S. Legislation - Concerns
Concerns about covered bonds
Best assets are taken away. Sometimes regulators are heard to complain that banks will use their best assets for covered bonds thus leaving the regulator, in the case of a failure of the issuing bank, with lower quality assets to meet the claims of depositors. There are several responses to this concern. First, there is a certain level of risk in financing long term assets like mortgage loans with short term deposits and therefore some benefit to financing mortgage loans with longer term liabilities. Second, the same complaint could be made, but never seems to be, about securitization - the bank will securitize its best assets and leave the regulator with lower quality assets. Third, the complaint says something about the regulatory environment that lets a bank originate lower quality assets. Mortgage loans cannot be the only quality assets a bank can orginate. And fourth, the complaint probably reflects a concer more with the size of the covered bond program relative to the bank's mortgage portfolio and therefore may be addressed with limits on issuance appropriate for the balance of different business lines of the bank.
Refinance risk. Sometimes a concern is heard that covered bonds expose a bank to refinance risk when the covered bonds mature. Unlike a securitization, a bank continues to own the mortgage loans that are part of the cover pool. Thus when a series of covered bonds mature, the bank needs to find a new source of financing to pay off the maturing bonds and provide continued financing for the mortgage loan assets it holds. Most often this will be a new series of covered bonds, but there are also many other sources of funds available to a bank. This risk is reduced if covered bond maturities more closely match the maturities of the mortgage loans. But this ignores the fact that the bank is continuously originating new mortgage loans and the mortgage portfolio is not in run-off mode. The answer to the concern really is that banks are always faced with refinance risk as funding matures - this is not unique to covered bonds. If a bank is unable to securitize it will face similar problems as loans pooled for a securitization are usually financed temporarily by short term warehouse lines of credit that require loans to be withdrawn after a period of time. Similar risks arise whether a banks finances with deposits or term funding of any nature. If deposits are withdrawn or funding is not renewed, there will be a need for emergency funding typically provided through central banks.
Continued origination required. By design, covered bonds are not pass-through securities. As assets amortize or mature, funds received are used to purchase more loans to maintain the required asset covereage ratio of the cover pool. This requires the continued origination of new mortgage loans. Thus there is risk that if the bank is unable to originate mortgage loans in sufficient volume the cover pool may breach the asset coverage test, resulting in an event of default for the covered bonds. This is a risk that does not exist with securitization, but only exists with on-balance sheet funding. The concern is addressed in part with a limit on the portion of the mortgage loan portfolio that can be used for covered bonds. But the larger concern is that if a bank is unable to originate new assets, it will need to begin shrinking its liabilities. After all, assets and liabilities need to match (accounting for equity of course). An over reliance on long term funding increases a bank's exposure to this risk, so it is properly addressed through managing the balance of funding maturities.
Encumbrance. The concern about encumbrance of assets is addressed elsewhere. It is basically the same concern listed above regarding the best assets being unavailable to the regulator in the event of the failure of the bank.
Covered bonds do not provide capital relief. True. The mortgage loans will continue to be carried on the balance sheet of the bank since they are owned by the guarantor, which is a subsidiary of the bank and consolidated on the bank's balance sheet. But few options exist for obtaining capital relief short of the outright sale of the mortgage loans. With the changing regulatory and accounting requirements, it is increasingly difficult for a bank to obtain capital relief through securitization, particularly when investors look for the securitizer to have a real continued interest in the performance of the assets. This requires a bank to keep a significant retained interest in the mortgage loans, complicating achieving capital relief. Funding mortgage loans through deposits or senior debt will not provide capital relief either. If there is a desire for capital relief, there will be a tendency to keep the best assets and sell or securitize the riskier assets as that probably will achieve the most capital relief. In that sense it is likely that the best assets will be used for covered bonds as some regulators complain.