US woes reveal where covered bonds are most vulnerable
“We consider everything in the European Covered Bond Directive as positive, but the area of maturity mismatches is not so well covered,” said Karlo Fuchs, Scope’s head of covered bonds. “With the covered bond market moving to a soft-bullet format, the requirement to maintain decent liquidity protection has become a ‘shark with no teeth’ since legislation allows extended maturities to be used to calculate of the 180-day liquidity buffer.”
Fuchs adds that this makes this well thought through condition redundant as it shifts risk into the future and it leaves European covered bond programmes with one flank open. “Investors are fine for now and are happy to leave liquidity management in the hands of issuers. The question is: should they be?” he said.
Meanwhile, the uncertain economic environment has continued to push European house prices lower. Spoiled by years of growth, the party is over for homeowners, borrowers and lenders alike. Challenges are also crystallising in net residential mortgage lending, which nosedived to almost zero in the half year to February 2023, only slowly reverting in March.
“We do not see a swift recovery in the European housing market for most countries because affordability remains under pressure from rising interest rates, high inflation and general economic uncertainties. These factors are making house purchases unattainable,” said Mathias Pleissner, deputy head of covered bonds.
The situation exposes mortgage covered bonds to several risks: weakening credit quality resulting from higher defaults and decreasing property values as well as lower recoveries and by definition higher expected loss. Lower property values can also affect the over-collateralisation of covered bond programmes. Further OC constraints may be driven by lagging supply of eligible mortgages. After nine years of increasing mortgage stocks, declining new business is reducing the stock covered bond managers can dispose of.
Italy made the CBD transposition cut last July but missing secondary legislation meant Italian covered bond issuers missed out on record covered bond issuance. “Italy’s full transposition in March has paved the way for Italian issuers to return to the covered bond market. This will ease their path to redeeming their EUR 320bn of maturing TLTRO funding and will once again give Italian covered bond issuers access to more predictable and less volatile funding,” said Reber Acar, associate director. “We expect Portuguese legislators to introduce secondary legislation in the coming weeks.”
In the primary market, well over EUR 100bn of covered bond issuance year-to-date confirms that weaning banks off the ECB’s purchase programmes has not led to too many problems. Positive interest rates have lured back long sidelined investors who have been ample substitutes.