Should Singapore investors love the proposed covered bond rules?

Quality maintenance, check; Legal protection, not covered.

The Monetary Authority of Singapore published a consultation paper on covered bond issuance by banks incorporated in Singapore early this March. According to Moody’s, the proposed rules would provide protection to investors in the areas of quality covered assets, as well as through specifying minimum overcollateralization levels and a requirement for ongoing monitoring of risk.

But they do not cover areas such as legal protection of cover pool segregation, and do not provide enough detail on operations and servicing. These areas would have to rely on the protection of the existing legal framework, and the incorporation of contractual arrangements into covered bond programs.

Covered bonds are new to Singapore and no programs have been issued as of today. The consultation periods ends on 10 April.

Quality assets will support cover pools
According to the proposals, covered assets only include residential mortgage loans and derivatives held for the purpose of hedging risks arising from covered bond issuance. These restrictions would be credit positive as residential mortgage loans have proven to be the best performing assets on bank balance sheets.

Covered bonds investors would stand to benefit from improved cover pool value. For mortgage loans with loan-to-value ratios (LTV) above 80%, their contributions – for the purposes of calculating the value of cover pools – would be limited to 80% of the property value.

The cover pool value would improve because the liquidation proceeds of a mortgage loan with LTV above 80% (say 90% LTV) would be allocated to the covered pool as if it were an “80%” LTV loan, instead of a 90% LTV loan. This approach would be analogous to an overcollateralization.

Minimum overcollateralization provides additional protection
Minimum 3% overcollateralization of the face value of total covered bonds – another one of the proposed rules –would be credit positive to the investors as it would provide additional protection. If a covered bond program fails to meet this criteria, the issuer might have to reduce its face value, transfer additional assets, and/or replace assets in the cover pool over time in order to meet above-minimum overcollateralization requirements.

Ongoing management and monitoring of cover pool would maintain bond quality
Another credit positive feature is the requirement on the issuer to put in place adequate risk management processes and internal controls to manage the risks arising from a covered bond issuance. These steps would include appropriate governance arrangements and the iimplementation of regular stress tests on the associated risks. Covered bond programs would naturally benefit from such strengthened risks management awareness and process.

Appointment of qualified external third-party transaction parties would improve monitoring of assets
The appointment of a cover pool monitor would provide an additional layer of checks and balances, mitigating operational and fraud risks, as well as offering additional protection to investors.

The cover pool monitor, an external third-party qualified to be an auditor under the Company Act, would bring professional checking and surveillance of covered bond programs. The cover pool monitor would submit annual verifications and reports to the regulator on the accuracy of
registrations of cover pool assets, bank compliance with the proposed rules, and the adequacy of a bank’s risk management process and internal controls. Such verification would provide early detection of fault and fraud.

Segregation of cover pool would still rely on existing legal regime
Unless the proposed rules are enacted as law, the separation of the cover pool from the bankruptcy estate of the defaulted issuer would still rely on the current legal regime. The processes, procedures, and formats under which a bank segregates the cover pool would have to comply with all existing legal and regulatory requirements.

Compliance with the proposed rules would not automatically ensure that the covered pool would be separated from the bankruptcy estate of the banks. If the issuing bank was in bankruptcy, other creditors could still challenge the validity of the segregation.

Although the proposed rules have defined covered bonds as bonds, notes or other debentures that have dual recourse from 1) the issuing bank and 2) the cover pool, they would have no binding power over the courts unless they are enacted as law.

Operational and servicing aspects would have to be considered in greater detail
Details of the operational and servicing aspects have not been laid out in the proposed rules which would provide instead a high level of guidance. As a result, addressing these issues would require additional clarification or contractual agreements among transaction parties. Some of these steps would be:

1. The inclusion of cash to form part of a cover pool, for example, cash collections from mortgage loans and cash deposits to be made by the banks upon the breach of certain triggers

2. The need for coverage tests, such as adjustments for deteriorated assets1 in the cover pool, and the matching of present value2 in coverage test calculations

3. In the areas of the administration and servicing of the transactions, there is a need for clarification on the format of investor reports to improve market transparency and details of the servicing procedures to avoid disruptions to servicing.