Covered Bonds to Be Spared in EU Bail-In Rule, Lawmaker Says

European Union plans to impose losses on creditors of failing banks will spare covered bonds and other secured debt, said Gunnar Hoekmark, the lawmaker leading work on the measures in the European Parliament.

“Secured liabilities such as covered bonds shall not be subject to bail-in,” Hoekmark said in an e-mail, referring to the process of writing down lenders’ creditors.

Spanish newspaper Expansion reported today that the EU may consider forcing losses on covered bond investors in future bank rescues as part of legislation to lift the burden from taxpayers. EU nations have injected 1.7 trillion euros ($2.2 trillion) into their banking systems since the 2008 collapse of Lehman Brothers Holdings Inc., according to European Commission data.

Under proposals from Michel Barnier, the EU’s financial services chief, regulators would have the power to impose losses on a crisis-hit lender’s unsecured bondholders, or convert that debt to equity, once the bank’s capital has been wiped out. While the writedown plans excluded debt “backed by assets or collateral,” an issue has arisen because of the possibility that declines in the value of the collateral might make a cover pool too small to fully back the bonds.

Weak Bank

Covered bonds are backed by high-quality collateral such as residential mortgages, as well as by the credit of the issuing bank, and have never defaulted since they were created in the 18th century. Rules governing the terms and structure of the securities differ depending on the jurisdiction.

“To believe that every covered bond is equal has already been seen to be an error,” said Jozef Prokes, a London-based fund manager at BlackRock Inc., which oversees $3.79 trillion as the world’s largest money manager. “If you buy a covered bond from a weak bank and it goes under, then it’s absolutely fair that any uncovered part is on a level with senior unsecured bonds.”

Still, national supervisors would force an issuer to correct matters if a cover pool was inadequate for any reason, making it hard to see how that situation could arise, Prokes said.

“It’s vital to have clear rules that respect the secured nature of the product,” Prokes said. “Our view is that the bail-in regulation should uphold preferential treatment for covered bonds.” For bail-in “how you carry it out is the key issue,” he said.

Investment Boost

The commission said last month that it is weighing the need for “greater harmonization” of rules for covered bonds as part of broader bid to boost investment in the bloc’s businesses.

Covered bonds “have proved relatively resilient during the crisis,” the commission said. “However, markets are fragmented along national lines.”

The law must give “high legal certainty,” Hoekmark said. “This means secured liabilities shall be secured and insured depositors shall be protected.”

“Legal clarity is crucial in order to make the bail-in tool applicable in crisis situations,” he said.

The EU faces a self-imposed June deadline to adopt legislation for handling bank failures, which requires approval from the parliament and national governments before it can take effect.