Biggest Covered-Bond Issuers Prepare to Fight SME Inclusion

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Europe’s biggest mortgage-backed covered bond market is preparing to fight any plans to use small-business loans as collateral.

The European Commission may signal as early as this month whether securities backed by pools of small-business loans can carry the sought-after covered-bond designation. Issuers in Denmark’s $450 billion mortgage-backed covered-bond market say doing so would devalue a label they argue should be reserved for securities backed by a higher grade of collateral.

“It’s very important not to water down the collateral in covered bonds,” Peter Jayaswal, deputy director at the Association for Danish Mortgage Banks, said in an interview. “That would jeopardize one of the best funding tools that we have.”

But Europe is looking for ways to support small and mid-sized businesses -- the region’s biggest employers -- and giving them better access to funding markets is one way to do that. Covered bonds are cheaper to issue because investors know they can make claims against both the issuer and the collateral in the event of a default.

“It is obviously a very successful technique where it works,” Jonathan Faull, the European Commission’s director general for financial services, said at a June 3 briefing in Copenhagen.

Banks holding covered bonds enjoy lower capital requirements, and more of the securities can be used to fill liquidity buffers than other assets issued by private entities.

Not Standardized

“We hear a lot that SME lending is important for growth and the economy, but you have to draw the line somewhere,” said Bernd Volk, head of European covered-bond research at Deutsche Bank AG. “Everyone talks about SME loans as if they were a standardized product, but they’re not standardized.”

The European Union wants to expand covered bond use to give banks more access to cheap funding, according to a February paper by the commission.

“There is uncertainty about what is covered by the notion of covered bond from one place to another,” Faull said. Use of SME loans as collateral is “not necessarily” appropriate, he said. “We don’t want to create more confusion and we’d like to have the clearest possible definition, and that’s what we’ll try to do.”

Hit Hard

Bricks and mortar provide the backing for almost 80 percent of European covered bonds, which fund about 20 percent of home loans, according to the European Covered Bond Council.

Businesses that own property tapped Denmark’s mortgage market when the financial crisis froze bank credit, Sidsel Dyrholm Holst, head of SMEs for the Confederation of Danish Industry, said. But that “was only possible for companies that had real estate that they could use as collateral.”

“It has still been a challenge for companies that can’t do that,” Holst said. “They have been hit hard.”

There’s already a shift toward broadening eligible collateral to include SME loans. Securities on the market include bonds issued by Germany’s Commerzbank AG. Turkey allows it, as will Italy after a second implementing decree from the Ministry of Finance, the ECBC said.

To stop the trend, the Brussels-based industry group, whose members include JPMorgan Chase & Co. and Deutsche Bank, last month proposed the creation of a similar security with a different name -- European secured notes -- for SME loans.

Regulatory Edge

If an issuer defaults, investors would have recourse to both the collateral and the issuer, as with covered bonds. But the product wouldn’t be termed a covered bond, said Luca Bertalot, ECBC’s secretary general.

“The covered bond is a success story and, unfortunately, covered bond is not name-protected,” Bertalot said.

Covered bonds’ better regulatory treatment needs to be addressed if other funding options are to succeed, according to the International Monetary Fund.

The IMF urged Europe in a January discussion paper to reconsider regulations that put securitized products at a disadvantage, including higher capital charges.

Whatever the label, Fitch Ratings says a security backed by a cover pool of business loans probably wouldn’t be as highly rated as covered mortgage bonds. SME loans are less liquid and information on them sketchier, according to Cosme de Montpellier, Fitch’s senior director for covered bonds.

The bond “would have a limited uplift above the issuer’s rating,” de Montpellier said. If an issuer defaults, “SME loans would be more difficult to sell than residential mortgages since their credit quality is lower and less stable.”

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