13 February 2008 In 2007, HM Treasury and the Financial Services Authority published a consultation paper inviting interested parties to comment on draft legislation introducing a statutory covered bond regime for the United Kingdom. A team of Cadwalader lawyers looked at the proposals principally from the perspective of using covered bonds as a means of financing commercial mortgage loans. Set out below are the specific comments which Cadwalader has submitted in the consultation process, which has now ended and which may result in a revised version of the legislation that is expected to be published shortly.

As a law firm recognised as a leading adviser on commercial loan origination and securitisation, our clients in this area (who primarily are European and US investment banks) have shown great interest in the proposals for the introduction of a covered bond law in the UK. We set out below the verbatim text of our submissions on some of the most important areas where additional clarity in the Regulations would be welcome:

Definition of “Eligible Property”

We think that it is intended that high quality CMBS and RMBS bonds can be “eligible property” for the purposes of the Regulations. However, we are not certain that the Regulations currently are sufficiently clear on this point.

The definition of “eligible property” in Regulation 2 refers to paragraph 68 of Annex VI of the Banking Consolidation Directive. Sub-paragraphs (d) and (e) of this refer to “..senior units issued by French Fonds Communs de Creances [“FCCs”] or by equivalent securitisation entities governed by the laws of a Member State...”. We find these words rather difficult to interpret.

First, under a recent change in French law FCCs are now allowed to issue debt as well as units bringing them in line with specialised securitisation vehicles in other jurisdictions such as Italian Law 130 vehicles. It is not clear to us that such debt interests qualify.

Second, as we are sure you are aware, many jurisdictions (such as the UK) do not have specific securitisation laws. In such jurisdictions, securitisation issuers are normal corporate entities formed under company law such as UK limited companies. Such entities do not appear to strictly fall within the above wording although it is difficult to see why they would not fall within the spirit of the provisions.

As such, we would suggest that it would be helpful if the Regulations could more specifically confirm that high quality (i.e. highly rated and low LTV) RMBS and CMBS assets from EEA (and the short list of other permitted jurisdictions) are “eligible property”.

Levels of Over Collateralisation

We note that the Regulations do not specify the levels of over collateralisation required for covered bond issues. We appreciate that it is likely to be beneficial to all involved in these transactions for the Authority to have a certain level of discretion in these matters to deal with the particular situations of certain issuers and their assets. However, the lack of guidance or parameters as to how overcollateralisation levels will be determined makes it difficult for our clients to ascertain the economic feasibility of arranging a UK covered bond transaction in comparison to other jurisdictions where specific levels of over collateralisation have been published by the legislature or regulators.

Furthermore, we think that a lack of transparency on this could lead to distortions in the market as regular issuers will acquire a knowledge of the requirements of the Authority that will not be available to new or less frequent issuers.

We think it would be very helpful if some greater level of specificity could be given on this in the Regulations. Perhaps maximum levels could be stated or a mechanism introduced for the Authority to publish its views as to specific kinds of transaction from time to time.

A/B Split

You may be aware that a techniques have been developed in the European commercial lending market in recent years allowing lenders to create high LTV loans and subsequently to split off (and sell to third party investors) subordinated interests in the loan leaving the original lender with a relatively low LTV loan which would be suitable for a highly rated securitisation. This technique is known as the “A/B split”, with the senior interest being referred to as the “A loan” and the subordinated interest as the “B loan”. Over the last three or four years, this technique has become very popular and has been used in relation to tens of billions of pounds worth of loans.

The subordination is typically effected by an English law governed intercreditor agreement between the A lender and the B lender and provides for full contractual subordination of the B loan following the occurrence of an event of default on the loan. English law contractual subordination is a well recognised legal device which has been approved by the courts in a series of cases.

We are not certain that the Regulations have contemplated such a technique. In particular, we are unclear that an originator which has created B loans in respect of its loan book will get credit for the subordination of the B loan in determining the LTV of a related A loan which it would like to put up as collateral for a covered bond.

By way of example, if a loan for £80 were secured on property worth £100, the LTV of the loan would be 80%. However, if the lender created a B loan for £20 from the whole loan and sold it to a third party on a subordinated basis, its remaining A loan should be treated as having a LTV of 60%. In other words, the A lender should be given credit for subordinating part of the loan.

It seems to us that credit for an A/B split should be given. All of the international rating agencies give full credit for such arrangements in AAA rated securitisations and we understand that the Irish regulators have indicated informally that they will give credit for the technique for the purposes of the Irish Asset Covered Bond Act and that the German regulators have been taking a similar approach in relation to Pfanbrief.

As such, we suggest that the Regulations should expressly state that the LTVs of commercial loans will exclude subordinated interests held outside the covered bond structure.

Use of Senior Units of Mortgage Loan Securitisations as Eligible Property

Our comment relates to Article 2(1)(a)(ii)(aa) of the Regulations which states that senior units issued by securitisation entities shall only be “eligible property” if “the residential real estate exposures or commercial real estate exposures secured were originated or acquired by the issuer or a connected person”. Article 2(1)(a)(ii)(aa) is a new addition to the draft Regulations and was not included in the previous draft of the Regulations included in the consultation paper issued by HM Treasury in July 2007.

The effect of Article 2(1)(a)(ii)(aa) is that senior units issued in a securitisation of mortgage loans effected by Bank A will only qualify as eligible property for regulated covered bonds issued by Bank B if such mortgage loans were held by Bank B or a connected person at some stage prior to being securitised by Bank A.

We do not see the rationale for the restriction in Article 2(1)(a)(ii)(aa) and, accordingly, it seems to us to be an unnecessary restriction on the use of senior units of mortgage loan securitisations as eligible property for regulated covered bonds. Article 2(1)(a)(ii)(aa) can also have arbitrary effects. We have seen the submissions made to HM Treasury in respect of the consultation paper by the Investment Management Association, by the City of London Law Society and, jointly, by the BBA, ICMA, the CML and LIBA, and none of those submissions suggested a restriction of the nature introduced by Article 2(1)(a)(ii)(aa).

Lack of Rationale

We have thought of some possible rationales for the restriction in Article 2(1)(a)(ii)(aa). However, as set out below, on consideration of each of them, we do not believe that any of these rationales apply:

  1. the credit quality of senior units of mortgage loan securitisations used as cover assets for regulated covered bonds where the issuer of the regulated covered bonds has originated or held the underlying mortgage loans on which such senior units are secured;
  2. the issuer of regulated covered bonds is in a better position to ensure the performance of senior units of mortgage loan securitisations where it is has originated or held the underlying mortgage loans; and
  3. the issuer of regulated covered bonds is in a better position to assess the performance of senior units of mortgage loan securitisations where it is has originated or held the underlying mortgage loans.

If, using the example above, senior units of securitisations of mortgage loans of Bank A are eligible property for regulated covered bonds issued by Bank A, why should the same senior units, if acquired by Bank B, not be eligible property for regulated covered bonds issued by Bank B? The credit quality of the senior units is the same in each case.

The nature of a securitisation is such that when Bank A securitises the mortgage loans on which the senior units are secured, Bank A will no longer own the mortgage loans and Bank A’s rights in relation to reacquiring or otherwise dealing with the securitised mortgage loans will be extremely limited in order to ensure that (i) the transfer of the mortgage loans to the securitisation SPV will survive any insolvency of Bank A and (ii) Bank A can recognise the sale of the mortgage loans for the accounting and regulatory purposes. In our view, Bank A does not have any better ability than Bank B to ensure the performance of the senior units of a mortgage loan securitisation merely because the mortgage loans securitised are originated by Bank A.

The level of information provided to investors in mortgage securitisations on the underlying mortgage loans is increasing (partly as a result of the disclosure requirements imposed on debt listed on a EEA-regulated market by the Prospectus Directive and the Market Abuse Directive). In any case, Bank B, if investing as a primary investor in a mortgage securitisation effected by Bank A, may always negotiate particular information rights in respect of the underlying mortgage loans. If the purpose of Article 2(1)(a)(ii)(aa) is to ensure that an institution uses senior units of mortgage loan securitisations of mortgage loans as cover assets for its covered bonds has sufficient information on the underlying mortgage loans of such mortgage loan securitisations then it would be better to state that as an information requirement rather than use the blunt instrument of Article 2(1)(a)(ii)(aa) to try to achieve it. In any case, the intention is that the credit quality of such senior units be assessed primarily from their rating, as already provided for under Article 2(1)(a)(ii)(bb) of the draft Regulations. In our view, where mortgage loans are securitised by Bank A, and in particular where the senior units of such securitisation are listed on an EEA-regulated market, Bank B has information to assess the credit quality of such senior units sufficient that it should be able to use such senior units as eligible property for regulated covered bonds issued by it.

Arbitrary Effects

In addition to lacking an apparent rationale, Article 2(1)(a)(ii)(aa) can have effects which seem to us to be arbitrary. As an example, if Bank A sells a book of mortgage loans to Bank B and Bank B subsequently securitises the mortgage loans, Bank A can use senior units issued in such securitisations to back covered bonds issued by Bank A (because the underlying mortgage loans were at one stage originated by Bank A) whereas Bank C, which has never had any connection with the underlying mortgage loans, cannot so use the senior units. As the securitisation of the mortgage loans may occur months or even years after the sale of the mortgage loans by Bank A and after Bank A has handed over all loan files and other documentation in respect of the mortgage loans, we think that it is impossible to justify placing Bank A in a different position from Bank C as regards the senior units being eligible property for regulated covered bonds.

It can be argued that there is less moral hazard in a bank including as cover assets for its regulated covered bonds assets senior units of mortgage loan securitisations of other banks, as the bank issuing the regulated covered bonds will have independently taken a view on the credit quality of such senior units and will have acquired them on an arm’s length basis. By contrast, where a bank includes as cover assets for its regulated covered bonds senior units backed by mortgage loans originated by that bank itself, the bank issuing the regulated covered bonds will not independently have taken a view on the credit quality of such senior units and may simply wish to use the regulated covered bond issuance as a means of raising funding on them. Please note that we are not suggesting that a bank should not be able to use senior units of its own securitisation to back its regulated covered bonds, but only that from the perspective of the regulated covered bonds this may be seen as “more risky” than where a bank uses senior units of other banks’ securitisations, thus further undermining the basis for the restriction in Article 2(1)(a)(ii)(aa).

Banking Consolidation Directive and other European Covered Bond Regimes

The regulated covered bond regimes of other European jurisdictions which allow senior units of mortgage loan securitisations to be included in cover pools do not contain provisions equivalent to Article 2(1)(a)(ii)(aa). For example, the Irish Asset Covered Securities Act 2001 (as amended by the Asset Covered Securities (Amendment) Act 2007) allows for the senior units of mortgage loan securitisation to be included in the cover pool for asset covered securities issued under the Act without any restriction equivalent to Article 2(1)(a)(ii)(aa).

Article 2(1)(a) of the draft Regulations already provides that eligible property for regulated covered bonds means eligible assets in paragraph 68 of Annex VI of the Banking Consolidation Directive. In the words of the consultation paper, “it is important to define ‘eligible property’ such that it captures high quality assets, but does not stifle the market by reducing flexibility both in the development of products and the assets an investor wants to see backing a bond”. As the list of eligible assets included in paragraph 68 of Annex VI of the Banking Consolidation Directive has already been drawn up with the purpose of providing, in words used in the consultation paper, the “guarantees and safeguards against bankruptcy which would enable covered bonds to be treated as equivalent to State bonds”, we do not think that how investors need to be further safeguarded by the restriction in Article 2(1)(a)(ii)(aa).

Our understanding is that it is not the intention of HM Treasury that the regulated covered bond regime in the U.K. should be more restrictive than those of other European jurisdictions unless the particular restriction in the U.K. regime has sufficient benefit in protecting investors and/or increasing confidence in U.K. regulated covered bonds. In our review, there are insufficient benefits flowing from Article 2(1)(a)(ii)(aa) to justify its application.