New rules for Italian covered bonds – worth the wait?

Italy has finally reached regulation on covered bonds. Covered bonds pay a vital role in Europe’s capital markets. But the new simpler Italian rules aim to encourage the growth of the Italian covered bond market as well as in other parts of Europe

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The new covered bonds regulation provides for an exceptionally safe regime according to procedures set out in articles 69-70 of Royal Decree 2440 of November 18 1923. These ensure they effectively grant a transfer against the assigned debtor/public entity. This is done through:

1) Notification to the assigned debtor/public entity of the transfer agreement through a Court Bailiff

2) Acceptance by the assigned debtor/public entity of such transfer agreement) that would not be applied unless the agreement from which the receivables originate expressly sets out that, notwithstanding the new legislation, the procedure of Royal Decree 2440 still needs to be complied with to consider any assignment valid

Assets purchased by the SPV represent a segregated portfolio, which may be used by the originating bank as a guarantee for the originating bank’s issued bonds, or in connection with their funding when the SPV is remote from an insolvency.

The guarantee from the SPV must be irrevocable, payable on first demand, unconditional and independent from the obligations of the bank issuing the covered bonds. It will be also enforceable on the issuing bank’s failure to pay or on insolvency, within the limits of the assigned assets, on the basis of the bankruptcy remoteness of the SPV.

Receivables fall into several categories, such as:

Residential mortgage loans provided that the ratio of the value of the mortgages issued by the originating bank and any other mortgage on the same property to the value of the property (LTV) is less than 80 percent of the value of the property, if the assets are in the EU or Switzerland and the terms of any applicable claw-back periods have expired in the relevant jurisdiction.

Commercial mortgage loans provided that the LTV is less than 60 percent (if the assets are in the EU or Switzerland and the terms of any applicable claw-back periods have expired in the relevant jurisdiction).

Loans to all public administrations including ministries, public territorial entities and any other public entity or body – both national and local – of any member state of the EU or Switzerland, provided the risk weighting of exposures to that entity under the standardised approach credit risk capital requirements under Basel II is no higher than 20 percent.

Loans to public administrations of any non-member State provided that they must have a zero risk weighting in the case of central governments or 20 percent risk weighting in the case of public territorial entities and other non-economic public entities, both national and local.

Asset backed securities that represent no less than 95 percent of the value of the segregated portfolio and have risk weightings no higher than 20 percent, whose repayment is not subordinated to the issue of other assets in the same transaction.

New changes, new limits
Under the original 2006 provisions, in order to issue covered bonds the originator/issuer needed consolidated regulatory capital (CRC) of € 500 m, a CRC ratio of at least 10 percent and a consolidated Tier 1 capital ratio of at least 6 percent. These parameters were much criticized by the Italian Banking community as being too restrictive. But the final version of the Bank of Italy Regulation of May 2007 imposes a lower minimum CRC Ratio of 9 percent and accordingly it opens the market to the most significant national players.

These limits are defined as:

Banks with a CRC Ratio of at least 11 percent and the Tier 1 Ratio of at least seven percent face no limits to the amount of assets that can be transferred to the SPV

Those with CRC Ratio between 10 percent and 11 percent and a Tier 1 Ratio of at least 6.5 percent can transfer 60 percent of their assets to the SPV

Banks with a CRC Ratio between nine percent and 10 percent and a Tier 1 Ratio of at least six percent can transfer only 25 percent of assets to the SPV. The thresholds of capital position (CRC Ratio and Tier 1 Ratio) for each range must be met together. In case only one of the two ratios above is met, the lower range must be applied

Rating agency criteria risk
Most importantly, the new Italian legislation appears to be in line with the criteria envisaged by rating agencies. Fitch has identified four key areas that need to be considered (and the relative weights to be given to each) when measuring the risk that payments owed to investors might be interrupted in the event of an insolvency of the issuer. They are as follows:

1) Segregation of cover assets backing the issues of covered bonds from the bankruptcy estate of the issuing financial institution (50 percent weight) – under the new Italian legislation, asset segregation is achieved by the transfer of the assets to a bankruptcy remote special purpose vehicle acting as a guarantor of the issued covered bonds

2) Alternative management of the cover assets and the covered bonds (15 percent weight) – the legislation provides that in the event of the issuer’s mandatory winding up (liquidazione coatta amministrativa) the SPV shall represent bondholders vis-à-vis the issuer

3) Liquidity gaps between the respective amortisation profiles of the cover pool and the covered bonds (30 percent weight) – the Bank of Italy’s prescriptions provide that the net value of the segregated assets must be at least equal to the net value of the covered bonds and that interests and other revenues generated by the cover pool must match all the costs due on the covered bonds; also, the supervisory legislation introduces specific strategies of asset and liability management for banks to follow in order to bridge potential maturity mismatches

4) Dedicated covered bonds oversight (5 percent weight) – the Bank of Italy imposes specific transaction guidelines and will supervise banks implementation as part of its overall mission to safeguard the stability of the domestic banking environment.

Strict asset segregation satisifies Fitch
Fitch expressed a favorable evaluation on the Italian covered bond regulation in its last research report, published at the end of last January 2008. In particular, Fitch expressed satisfaction for the assets segregation mechanism provided by Italian regulation. Given such strict asset segregation mechanism, Fitch states, “a high degree of credit is given to the ‘true sale’ transfer of the assets to the SPV. In fact, in the case of issuer insolvency, this segregation mechanism will allow,” continues Fitch, “to grant the repayment of the covered bonds holders through the covering assets and the cash flows deriving from them.”

A favorable opinion is expressed also with reference to the supervision role assumed by the Bank of Italy (BoI) in respect of the covered bond issuance. On this point however, Fitch points out that while BoI is the first regulation authority on covered bonds which imposed specific insolvency limits for prospective originators, the Italian framework is less detailed and prescriptive than in some other European jurisdictions, in particular with respect to the ongoing surveillance of asset and liability management. In fact, although there is a generic requirement that issuers have to report to BoI on the proposed management of maturity mismatches and on the system in place to control specific risks, there is no specific provision for a regular audit by BoI to take place, nor is any reference made to stress testing under different scenarios.
Positive feedback sets the tone

The general evaluation made by rating agencies on the Italian covered bond regulations certainly seems positive. The new regime appears to be characterized by a high level of innovation, both legally and commercially. It has introduced liquidity safeguards and robust strategies of asset and liability management designed to maintain a balance between protecting the interests of creditors and the creation of a potentially large covered bond market.

So, when can we expect to see the first Italian covered bond issuance? Due to the recent news in the financial markets – Banca OPI has officially announced its plans to launch a public sector backed deal while UBI Bank recently communicated to have mandated Barclays Capital to arrange its program – maybe by the end of 2008. Meanwhile the foundations for growth have been laid and the future of the Italian covered bond market seems much brighter.

For further information:
Tel: +39 06 362 271
Email: mbaldissoni@tonucci.it
Website: www.tonucci.it