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About Covered Bonds
Background
Covered bonds are debt instruments secured by a cover pool of mortgage loans
(property as collateral) or public-sector debt to which investors have a
preferential claim in the event of default. While the nature of this
preferential claim, as well as other safety features (asset eligibility and
coverage, bankruptcy-remoteness and regulation) depends on the specific
framework under which a covered bond is issued, it is the safety aspect that is
common to all covered bonds.
Covered bonds are increasingly used in the marketplace as a funding instrument,
in addition to savings deposits, mortgage-backed-securities, etc. The issuance
of covered bonds enables credit institutions to obtain lower cost of funding in
order to grant mortgage loans for housing and non-residential property as well
as, in certain countries, to finance public debt. The portfolio investor has the
advantage of investing in safe bonds with a relatively high return. Thus,
covered bonds play an important role in the financial system.
The internationalisation of formerly domestic covered bond markets began 10
years ago with the introduction of a new benchmark product attracting
international institutional investors and providing the necessary market
liquidity.
As a consequence, many European countries have introduced new covered bond
legislation or have updated existing rules to be a part of this development and
to also respond to the considerable growth of mortgage lending activities in the
European Union. With a volume outstanding at the end of 2005 of 1.8 trillion EUR
from more than 20 countries, covered bonds play an important role in the
financial system and contribute not only to the efficient allocation of capital,
but also ultimately to economic growth.
Regulatory Framework of Covered Bonds
The special character of covered bonds has been enshrined in the 1988 Directive
on Undertakings for Collective Investments in Transferable Securities (UCITS).
Article 22(4) of this Directive defines the minimum requirements that provide
the basis for privileged treatment of covered bonds in different areas of
European financial market regulation. In brief, Article 22(4) requires:
(i) The covered bond issuer must be a credit institution.
(ii) Covered bond issuance has to be governed by a special legal framework.
(iii) Issuing institutions must be subject to special prudential public
supervision.
(iv) The set of eligible cover assets must be defined by law.
(v) The cover asset pool must provide sufficient collateral to cover
bondholder claims throughout the whole term of the covered bond.
(vi) Bondholders must have priority claim on the cover asset pool in case of
default of the issuer.
Covered Bonds that comply with those requirements are considered as particular
safe investments, which justify the easing of prudential investment limits.
Therefore, investment funds (UCITS) can invest up to 25% (instead of max. 5%) of
their assets in covered bonds of a single issuer that meet the criteria of
Article 22(4). Similar, the EU Directives on Life and Non-Life Insurance
(Directives 92/96/EEC and 92/49/EEC) allow insurance companies to invest up to
40% (instead of max. 5%) in UCITS compliant covered bonds of the same issuer. To
date, 17 EU member states have notified the EU commission on bonds and
authorised issuers fulfilling the criteria of Article 22(4) UCITS mentioned
above. The UK and The Netherlands, where covered bonds are issued on the basis
of contractual frameworks, have put forward the intention to examine the
possibilities for a legal covered bond framework, to make them compatible with
the UCITS directive. If all goes well, UK covered bond legislation can be
expected as early as 2007, with the Dutch probably following soon thereafter.
Another cornerstone of covered bond regulation at EU level will be the new
Capital Requirement Directive (CRD). The CRD is based on a proposal from the
Basel Committee on Banking Supervision to revise the supervisory regulations
governing the capital adequacy of internationally active banks. The new CRD
rules will apply to all credit institutions and investment service providers in
the EU.
The European Council formally adopted the CRD on 7 June 2006 and the Directive
has been published in the Official Journal (OJ) of the European Union on 30 June
2006 (L177) under reference Directive 2006/48/EC and 2006/49/EC.
According to the CRD, covered bonds benefit from privileged credit risk
weightings only if they fulfill the following requirements:
(i.) Compliance with the standards of Article 22(4) of Directive 85/611/EEC
(UCITS)
(ii.) The asset pools that back the covered bonds must be constituted only of
assets of specifically-defined types and credit quality . The comprehensive
list of classes of assets that are eligible as collateral for covered bonds
are:
- Exposures to public sector entities;
- Exposures to institutions;
- Mortgage loans (commercial & residential);
- Senior MBS issued by securitization entities;
- Loans secured by ships
(iii.) The issuers of covered bonds backed by mortgage loans must meet
certain minimum requirements regarding mortgage property valuation and
monitoring
In addition, the CRD includes a general exception whereby any covered bond
meeting the UCITS definition (but not asset eligibility criteria) to be issue
prior to December 2007 will benefit from the preferential treatment until
maturity.
ECBC Essential Features of Covered Bonds
For more information see the Essential Features of Covered Bonds and Explanatory Notes.
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