Covered bonds are a type of banking senior debt securities — already regulated in most European Union (EU) countries — whose key feature is that they are guaranteed not only by the general assets of the issuing bank but also by a segregated cover pool of high credit quality assets (typically claims arising from mortgage loans and claims due or guaranteed by public administrations).
Thanks to this double guarantee, if the issuing bank fails to meet its payment obligations under the covered bonds (including as a result of bankruptcy proceedings or a moratorium on payments), the relevant holders of the covered bonds can continue to be paid through the proceeds of the cover pool without interruption or acceleration of the covered bonds (i.e. on the same terms as provided by the covered bonds’ terms and conditions).
This key feature makes covered bonds generally a highly rated, low risk investment whereby investors are willing to receive lower spreads compared to those paid under ordinary bank debt securities.
The legislative process of the Italian covered bonds law has taken a long time. Nevertheless, the wait has certainly been well-rewarded as the preliminary technical analysis of this law has been very positive.
One of the major strengths of this legislation will undoubtedly be the cover pool guarantee typical of covered bonds which will be created through the segregation techniques provided for by Law 130/99 (the Italian securitisation law) — a legal regime already well-known in the structured finance market. This should speed up and facilitate the understanding of the new law by rating agencies and investors. The primary covered bonds legislation comprises two new articles that have been added to the text of Law 130/99. The cover pool guarantee will be created through the following legal structure which is very similar to the one already used in
- an Italian special purpose vehicle (SPV) will use the proceeds of a subordinated loan granted by a bank to purchase the cover pool from the bank issuing the covered bonds (or another bank). The cover pool will comprise claims arising from mortgage loans, loans to or guaranteed by public entities and/or asset backed notes collateralised by the above mentioned types of claims.
- subject to compliance with certain simple perfection formalities (i.e. without need for the sale being notified to or accepted by each assigned debtor), (i) the sale of the covered pool will become enforceable against third parties, including the assigned debtors; (ii) the security interests relating to the assigned assets will be transferred to the SPV without additional charge or formality; and (iii) the cover pool will be segregated in favour of the holders of the covered bonds and the other transaction creditors, pursuant to Law 130/99.
- the SPV will then issue a first demand guarantee in favour of the holders of the covered bonds and would meet any demands thereunder by using funds derived from the segregated cover pool.
This new legislation has benefitted from the practice and experience of the well-tested Italian securitisation market. In fact, the provisions of Law 130/99 relating to segregation have been reproduced in the covered bond law with certain substantial improvements which should render the structure of the cash-flows, bank accounts and contractual security packages of covered bond issuances far simpler compared to Italian securitisation transactions.
Compared with the vast majority of the analogous European regimes, the Italian covered bonds law has a much shorter and simpler structure. The Italian law is limited to establishing the key elements of covered bond transactions and to specifying the fundamental principles for investor protection. This structure should guarantee maximum flexibility and ensure the possibility of tailoring contractual structural solutions to provide the greatest efficiency for each individual transaction.
One of these fundamental principles for investor protection is to ensure the regularity and continuity of cover pool management and the payment of the covered bonds in the event of default, bankruptcy or moratorium on payments of the issuing bank. In such cases, the Italian law expressly provides that the SPV will continue to pay the covered bonds according to the original terms of the relevant terms and conditions, using the cover pool cash-flows. Furthermore, should the issuing bank be subject to a bankruptcy proceeding, in order to allow the holders of the covered bonds to be paid out of the issuing bank’s general assets, the law provides that the SPV will exercise exclusively — under the supervision of the Bank of Italy — the rights of the holders of the covered bonds against the insolvent bank.
The law specifically takes into account the risk of maturity mismatch between the amortisation profile of the cover pool and the covered bonds. To this end, banks must ensure at all times that: (i) the net current value of the assets comprised in the cover pool must be at least equal to the net current value of the covered bonds; and (ii) the interest and other proceeds generated by the segregated assets must be sufficient to cover the interest and costs owed by the issuing bank on the covered bonds. This undertaking must be complied with by the banks through periodical checks and by means of asset and liability management techniques and verification and supervision by an auditing company acting as an asset monitor. Nevertheless, this is undoubtedly a particularly delicate aspect of covered bond issuances owing to the fact that generally mortgage and public debt pools have uneven maturity profiles while most covered bonds have bullet maturity profiles. Moreover, upon insolvency of the issuing bank, the latter will no longer be able to comply with its legal undertakings for handling maturity mismatches, as described above.
Accordingly, in line with market practice, under the Italian covered bonds transactions the risk of maturity mismatch will need to be addressed through specific contractual arrangements complying with the criteria of the rating agencies. In addition to hedging agreements which are expressly referred to in the law, these arrangements will likely include, if necessary: (i) access to liquidity facilities; (ii) increase in the level of contractual overcollateralisation and/or (iii) specific provisions of the terms and conditions of the covered bonds such as extendable maturity or caps on the value of bonds maturing during a predetermined period.
Contrary to many other EU jurisdictions, the Italian law does not provide any minimum level for overcollateralisation (i.e. the value of the cover pool exceeding that of the covered bonds). However, certain provisions are set out to allow the possibility to agree overcollateralisation contractually.
Finally, the law sets out some provisions aimed at protecting ordinary bank creditors (other than the holders of the covered bonds) and, in particular, bank depositors. First of all, the covered bond market will be accessible only to asset-rich banks that have a minimum consolidated regulatory capital of Ä500m (£336m) and a minimum consolidated-level solvency ratio of 9%. According to the Bank of Italy, based on the asset levels as at the end of 2006, 30 Italian banking groups satisfied the asset levels. Moreover, the law also sets out limits on the assets which can be transferred to the SPV for banks with an aggregate asset ratio under 11% and a tier one ratio under 7% (up to 25% for banks with an aggregate asset ratio of 9%-10% and a tier one ratio greater than 6% and up to 60% for banks with an aggregate asset ratio of 10%-11% and a tier one ratio greater than 6.5%).
Given the above requirements and limits, it is likely that some of the Italian covered bonds transactions will be structured to allow the involvement of pools of banks so as to grant smaller banks/banking groups access to the market.
According to estimates by the Italian Banking Association, the potential Italian covered bond market could be worth around Ä200bn (£134bn).