Italian banks may soon be able to issue covered bonds. A new
initiative could provide the necessary amendments to existing
legislation to facilitate the development of a market that
would allow banks to finance themselves on better terms.
If the proposed new legislation is passed, Italy will follow
at least 12 other countries in Europe that have adopted new
legislation or adapted existing legislation, including Germany
where covered bonds (Pfandbriefe) were first issued at
the end of the 18th century. Some countries, such as France,
Ireland, Sweden and Luxembourg, have recently opted to pass
specific enabling legislation. In contrast, in the UK the first
issue of covered bonds, which took place in 2003, made use of
existing legislation and combined securitization techniques
with corporate guarantees to create a covered bond and no
specific legislative changes were necessary.
Using securitization techniques, banks can transfer
performing and non-performing receivables to an
off-balance-sheet special purpose vehicle and thus remove these
assets from their balance sheets and benefit from regulatory
capital relief. Under a covered bonds structure, on the other
hand, the assets used to secure the repayment of bonds must be
performing and will usually remain on the bank's balance sheet
(or at least on its consolidated balance sheet).
The market for the securitization of receivables in Europe
has seen tremendous growth since the 1980s but it is likely
that, partly as a result of the modifications that will come
into force with IAS 39 and Basel II, the market for covered
bonds will also expand throughout Europe.
In fact, if the new provisions introduced by Basel II reduce
the risk weighting requirements for residential mortgages from
the current 50% to perhaps 35% or even 20%, banks will have
less of an incentive to remove performing mortgages to improve
capital adequacy ratios.
Also, the introduction of IAS 39 will make it more
complicated (and therefore more expensive) to obtain genuine
off-balance-sheet treatment. Banks may well prefer to explore
the covered bond route rather than the securitization route,
especially if they think they are likely to get better
pricing.
For investors, the risk weighting of covered bonds is often
lower than for bonds issued under a mortgage securitization
because, under the covered bond structure, the investor will
have the benefit not just of the security over the mortgage
portfolio but also the benefit of a bank covenant and/or
guarantee which, although unsecured, entitles the investor to a
claim against one or more companies in the originator's
group.
As a result, both originators and investors have an interest
in developing the covered bond market, and Italian banks are
convinced that now is the time to introduce Italian legislation
to permit the issue of covered bonds.
Moreover, banks operating in the European market will need
to be able to compete on a level playing field and they will
want to benefit from financing techniques that are available in
other countries.
First attempt at an Italian law for covered
bonds
In the second half of last year, the Association of Italian
Banks (ABI) and the Bank of Italy put together the outline of a
bill that essentially would have permitted Italian banks to
issue asset-backed bonds provided that the assets involved fell
within one of the following categories:
- medium- and long-term loans, secured by mortgages on real
property in member states of the EU;
- receivables owed by member states of the EU or regional
public bodies or receivables guaranteed by such public
bodies; or
- asset-backed securities, provided that the relevant
assets fall within categories 1 or 2 and those securities are
not subordinated to any other securities issued as part of
the same transaction.
Features of the proposed legislation included the
following:
- the bonds to be issued could not exceed 80% of the value
of the assets securing the bonds;
- details of the bonds issued and the assets securing them
would need to be entered on a register and, from the date of
registration, the security would be enforceable against third
parties, with the holders of the bonds having priority over
other creditors in respect of the assets;
- if the originator becomes insolvent, the bank insolvency
commissioners would have the power to continue servicing the
assets and the bonds or to transfer that function to another
bank authorized by the Bank of Italy; and
- the periods during which the security could be overturned
and the assets clawed back by a liquidator under relevant
insolvency legislation would be reduced from two years
(transactions at an undervalue) and one year (preference) to
six months and three months respectively (as under Law 130/99
- the Italian securitization law).
For various reasons, the original proposals did not provide
Italian banks with the flexibility they needed to implement a
covered bond structure. In particular one of the concerns was
that, because it would have involved the originator itself
giving security over its assets, it would not have been
available to banks with existing negative pledges because
creating the security for such bonds would have caused a
breach.
The Ministry of Economics and Finance
initiative
The initiative to develop the covered bonds legislation has
now been taken on by the Ministry of Economics and Finance (the
MEF), which, it seems, intends to amend the existing Law 130/99
rather than create entirely new legislation.
It is good news that the MEF is aiming to tackle this issue
by amending existing legislation. Professionals operating in
the structured finance market know and understand the existing
legislation and adapting that legislation should reduce the
time and cost involved in understanding the changes. It would
also appear to signify that the Italian government intends to
adopt an approach of fixing only the main points in primary
legislation and leaving the task of identifying and modifying
other technical aspects and consequential changes to secondary
legislation (such as decrees by the MEF and orders of the Bank
of Italy).
It is understood that the MEF proposes to introduce new
articles in Law 130/99 that will permit the incorporation of a
vehicle company of the type contemplated by the current Article
3 (a Law 130 company). Unlike the current Law 130 company,
which has to acquire assets and fund itself by an issue of
notes, the new Law 130 company would be permitted to acquire
the assets and give a guarantee for an issue of notes by the
originating bank secured on the assets.
In effect it would permit a bank to issue bonds pursuant to
Article 12 of Legislative Decree 385/1993 (the Consolidated
Banking Act or CBA) and use the proceeds of the issue to
advance a subordinated loan to a Law 130 company, which would
then use that loan to acquire from the same bank the assets to
secure the covered bonds. That loan would be subordinated to
repayment of all amounts due under the bonds.
The benefit of adapting Law 130/99
By adapting Law 130/99, the covered bond structure would
benefit from the following provisions:
- the assets transferred to the Law 130 company would be
segregated assets for the purposes of Law 130/99 and
therefore available only to satisfy the claims of the
bondholders (paragraph 2 of Article 3);
- a legal transfer could be effected by publication of a
notice of transfer in the Official Gazette and that transfer
would be enforceable against debtors and third parties
(paragraphs 1 and 2 of Article 4);
- payments made by debtors to the Law 130 company would not
be subject to clawback (paragraph 3 of Article 4); and
- the transfer of the assets and the clause in the loan
agreement between the issuing bank and the Law 130 company
that concerns subordination should both benefit from the
reduction of the periods for potential clawback action from
two years and one year to six and three months respectively
(paragraph 4 of Article 4).
Furthermore, there is no reason why a Law 130 company cannot
be a subsidiary of the originating bank and therefore a covered
bond structure would enable the originating bank to keep the
assets on its consolidated balance sheet (and protect its
stated market share).
One point that may need to be addressed is that, under
paragraph 3 of Article 3 of Law 130/99, a Law 130 company can
be incorporated in various forms including in the form of an
SpA (a joint-stock company) or an Srl (a limited liability
company). Article 2343 bis of the Italian Civil Code (in
relation to an SpA) and Article 2465 (in relation to an Srl)
provide that, where a company is proposing to acquire
receivables from a shareholder in the two years after its
incorporation for a price equal to or greater than 10% of its
corporate capital, the selling shareholder must produce a
formal report prepared by an independent expert (chosen by the
court in the case of an SpA company). That report must contain
a valuation of the assets to be sold and a confirmation that
the value of the assets to be sold is not less than the price
to be paid by the purchaser. If one is looking at doing an
on-balance-sheet transaction involving a subsidiary of the
originator, the need to produce this formal report will add to
the cost involved and may affect timing. It will also overlap
much of the work being done by the originator and its arranger
with the rating agencies. It may be sensible to try to ensure
that the proposed amendments provide for an express exemption
from the need to produce such a report in these
circumstances.
The eligibility criteria
It is likely that the MEF will want to introduce certain
eligibility criteria to limit the availability of the covered
bond structure. No details of any proposed limitations are yet
available but possible candidates include:
- Type of assets: As in a number of other countries, it
will probably be provided that the receivables to be
transferred can only be mortgages over real property,
receivables owed by member states of the EU or regional
public bodies or receivables guaranteed by such bodies and
bonds deriving from securitization transactions of the type
above, provided that they are not subordinated to other
securities issued as part of the same transaction. The list
would be broadly the same list contemplated by the outline
bill referred to above.
- Loan-to-value ratios (LTVs): Some countries have included
limitations that mean that transactions can only benefit from
the covered bond legislation if the LTVs for the loans to be
included do not exceed specified levels. For example, Germany
imposes limits of 60% for both residential and commercial
property (while some other countries set the figure
higher).
- Minimum over-collateralization: Germany has introduced a
minimum over-collateralization requirement. It will be
interesting to see if other countries follow suit.
Servicing and the insolvency of the
originator
It is assumed that the requirements of paragraph 6 of
article 2 of Law 130/99 would apply to the new Law 130 company
so that the function of servicing the assets would have to be
performed by a bank or financial intermediary entered on the
register maintained by the Bank of Italy pursuant to article
107 of the CBA, but appropriate changes would need to be made
to Law 130/99 to achieve this. In fact, as with existing
securitizations, it will usually be the originating bank that
continues to perform this function, so the registration
requirement should not add any additional burden because the
originating bank should already have its registration.
The insolvency of the originator would not automatically
result in an insolvency of the Law 130 company and, ideally, if
ever there were a default, the separation of the issuing and
asset owning functions would mean that the underlying mortgage
portfolio could be allowed to run its natural course and pay
out the bondholders on a scheduled (that is, not accelerated)
basis. Clearly, if the originating bank becomes insolvent, it
would be necessary to turn to a back-up servicer, who would
continue to manage the portfolio of receivables. That back-up
servicer would itself also need to be registered with the Bank
of Italy but there should be plenty of available candidates. It
is possible, however, that the Italian government would want to
reserve the right for the regulator to choose or at least to
approve the appointment of the back-up servicer (as happens in
Luxembourg).
The separation of the issuing and asset owning functions
also has the advantage that an insolvency of the issuing bank
would not necessarily cause any derivatives contracts entered
into by the Law 130 company to protect itself against exchange
rate risk and interest rate risk to be terminated early which
would, of course, potentially crystallize an unanticipated
additional liability to pay any close out or termination
sums.
Benefits arising from the Ucits
Directive
If the proposed changes are adopted in Italy, covered bonds
issued by Italian banks (as with those issued in France, Spain,
Ireland, Germany and other jurisdictions) should fall under the
category of securities identified in Article 22(4) of the
Undertakings for Collective Investment in Transferable
Securities (Ucits) Directive (85/611/EC), that is, bonds that
satisfy the following criteria:
- the bonds must be issued by a credit institution
registered in the EU;
- the credit institution must be subject by law to special
public supervision requirements designed to protect
bondholders;
- sums from the issue of those bonds must be invested
directly or indirectly in assets so that, for the whole
maturity period, the bonds are fully covered by the
assets;
- if the issuing bank defaults, the proceeds of the assets
must be applied in priority towards payment of principal and
accrued interest on the bonds.
If they do fall within that criteria, covered bonds issued
by Italian banks should qualify as low risk investments and,
under regulatory capital requirements, enjoy a risk weighting
of 10% rather than the 20% risk weighting that applies to
unsecured bonds issued by European banks. As a result, they are
likely to be much more attractive to investors.
Growth
The flexibility introduced by Law 130/99 has meant that in
recent years Italy has been one of the most active
securitization markets for originating banks. If the MEF is
able to obtain parliament approval of the amendments to Law
130/99 before, or immediately after, the summer break, the
general expectation is that the market for covered bonds issued
by Italian banks could develop quickly.