JCB scope extended to non-statutory OC needs

Danish covered bond legislation has been amended to allow for a broader use of so-called Junior Covered Bonds (JCBs), making them the first financial instrument explicitly designed to satisfy non-statutory OC requirements that essentially stem from rating agency considerations.

Until December JCBs were governed by Section 33e of Denmark’s covered bond legislation, with some mortgage banks preferring to refer to the bonds as Section 33e senior secured issuance rather than Junior Covered Bonds.

However, on 19 December the Danish parliament repealed Section 33e and replaced it with a new Section 15, which allows Junior Covered Bonds to be issued to create and/or increase overcollateralisation (OC) for purposes other than statutory compliance.

Previously, Junior Covered Bonds could only be issued for the purposes of generating collateral so that SDOs (særligt dækkede obligationer) would satisfy continuous current LTV requirements stemming from the Capital Requirements Directive (CRD) while safeguarding the balance principle that is at the heart of the Danish mortgage system. This is the principle that originated mortgages must be funded or refinanced via covered bonds that match the coupon structure and maturity of the asset.

Karina Chen, Nykredit Markets

The scope for issuing JCBs has been expanded in two ways, according to Karina Chen, senior analyst at Nykredit Markets.

“Before the legal change Junior Covered Bonds could be issued to fund supplementary collateral needed when property prices are falling and LTVs are under pressure,” she said, “but now mortgage banks can issue Junior Covered Bonds for other purposes, too, for example just to create or increase OC, mostly due to rating agency requirements.

“The other difference is that junior covered bonds can be issued out of RO capital centres, which was not the case before.”

Realkreditobligationer (ROs) are mortgage bonds issued under pre-CRD Danish legislation, and therefore do not have to satisfy continuous LTV requirements, meaning that collateral does not have to be topped up if house prices fall, as is the case with SDOs.

The December legislative change is the result of an initiative by Denmark’s mortgage banks, according to Morten Bækmand, head of investor relations at Nykredit Realkredit.

“The old legislation was written so that Junior Covered Bonds could only be issued for regulatory OC compliance,” he said, “but the reality was that rating agencies were giving credit for that, too, so we thought it would make sense to acknowledge that rating agency and regulatory OC requirements are really addressing the same risk.”

To the extent that house prices are falling mortgage banks have in the past been able to “kill two birds with one stone” via Junior Covered Bond issuance, added Bækmand, with JCBs satisfying regulatory and any rating agency OC requirements.

However, it was considered important that mortgage banks have at their disposal a tool to be able to deal with the “awkward” situation where there is no regulatory LTV-linked OC shortfall but still rating agency OC requirements to be met, he said.

“To align these interests it was proposed to the government to allow issuance of Junior Covered Bonds to fund additional collateral for rating agency purposes, too.”

Although the December legislative change is very technical and has at its origins a specificity of the Danish mortgage market it could resonate more widely. Indeed, the instrument is said to have attracted interest in some other European covered bond issuing jurisdictions given a backdrop of downward rating pressure and associated increases in rating agency OC requirements, paralleled by concerns about asset encumbrance and the future of senior unsecured funding in light of regulatory bail-in plans.

“The interesting concept here is that this is the first time in Europe that an instrument has explicitly been designed to create or increase OC,” said Nykredit’s Bækmand, “without creating a group of deeply subordinated creditors.”

JCB holders have a secondary claim on any cover pool assets left over after the claims of holders of an issuer’s mainstream covered bonds have been satisfied in the event of an issuer default, and then rank pari passu with senior unsecured creditors in terms of claims on the mortgage bank itself.

While they have welcomed the legislative change, Danish mortgage banks do not appear in a rush to take advantage of the new JCB issuance possibilities.

Klaus Kristiansen, RD

In Realkredit Danmark’s case this is mainly because the mortgage bank does not issue ROs, according to Klaus Kristiansen, executive vice president at Realkredit Danmark.

And while the ability to issue JCBs to top up collateral in SDO capital centres for non-statutory OC purposes is positive, he added, in practice this expansion of their use will not make much of a difference.

“It adds a bit more flexibility, but only in specific scenarios that maybe are not so likely, like where there would not be requirements for supplementary collateral but rating agency OC requirements remain high,” said Kristiansen.

“It’s positive from a contingency planning point of view to have access to this instrument that is now becoming a market standard in all scenarios,” he added.

The amendment does not change DLR Kredit’s plans, said Pernille Lohman, investor relations manager at the issuer. It has an RO capital centre, but this is closed, and although it is considering issuing JCBs before the end of the first half of the year this is to refinance, in full or in part, maturing state guaranteed senior debt, she said.

“We don’t actually have a need for additional security,” she added, “but it is more of a buffer consideration for our SDOs.”

Nykredit has yet to make a strategic decision on whether it will take advantage of the new possibilities to issue JCBs, said Bækmand, which could, for example, involve switching issuance to a different capital centre, including an RO capital centre.

The issuer expects the total outstanding amount of its JCBs to decline, according to Bækmand, based on expectations that house prices will be flat or slightly increase in 2013 and implementation of two tier mortgage lending.

“That will curb our need for junior covered bonds, all else being equal,” said Bækmand. “We have more than Dkr6bn of Junior Covered Bonds coming up for refinancing in 2013 but we expect to refinance less than that.”