Covered Bond Over-collaterisation

When is over-collateralisation used?

• Making up for potential losses on mortgages in the pool
• Address refinancing gaps – if the issuer isn’t around to refinance the bonds at their maturity, over-collateralisation can be used to help refinance the bonds when they fall due
• Payment disruptions – for example, if a borrower falls ill, their mortgage payments may slow for a while

What is the general OC requirement?

EU Covered Bond Directive – recently passed into law states there is a minimum level of over-collateralisation that the covered bond issuer must maintain at all times. In most countries this is 5%, but there are plenty of exceptions to that rule with over-collateralisation by law ranging from 2-25%.

The Directive only requires that the nominal value of assets is at least the nominal value of liabilities.

Are covered bonds from some countries safer than others?

This is more complex because:

• Some countries require less over-collateralisation than others because they have other forms of credit protection embedded elsewhere in the law. I.e. LTV
• There are different ways to measures the value of mortgages and of covered bonds
• Almost no covered bond issuer in the real-world issues bonds with only the legal minimum over-collateralisation

How do we calculate over-collateralisation?

Two methods:

1. Take the notional value of all the bonds and compare it to the notional of all the assets in the pool
2. Take the present value of all the cashflows on the bonds and all of the cashflows on the underlying assets discounted to today’s value

What other forms of over-collateralisation are there?

• Banking supervisors are being allowed to set over-collateralisation on a case-by-case basis as the legal minimum is inadequate
• Another source of additional investor protection is provided on a voluntary basis (a little more than a promise to maintain enough collateral)
• Asset cover test – it holds that an issuer must provide the greater of the over-collateralisation that is required by law and the over-collateralisation that is needed to maintain the highest rating then achievable by the programme