The Monetary Authority of Singapore introduced rules last year to allow covered bonds to be issued in Singapore. This has the potential to result in between S$25 billion to S$30 billion worth of initial issuances. However, we are yet to see the first issues in Singapore under these new rules. This briefing provides an analysis of the underlying nature and structure of covered bond transactions, together with an overview of the Singapore covered bond rules and the potential issues that issuers and arrangers might face in the Singapore covered bond market. We also suggest some solutions to those issues.
What are “Covered Bonds”?
Covered bonds are debt securities generally issued by banks and other regulated financial institutions and backed by a pool of assets (referred to as a “Cover Pool”), which typically comprises residential or commercial mortgage loans originated and managed (i.e. sold, replaced or substituted) by the issuer of the covered bonds or originator (an affiliate company of the issuer).
Payments of interest on the covered bonds and the repayment of principal are guaranteed, or “covered”, by ring-fencing the assets (the “Cover Assets”) in the Cover Pool from the other assets of the bank or financial institution. This ensures that the assets in the Cover Pool are (1) available to all covered bondholders on a priority basis; and (2) Insulated from the insolvency of the issuer.
How do Covered Bonds differ from other asset-backed bonds?
The two key defining features of covered bonds, as a form of secured, low-risk investment, are also the main distinction from other forms of asset-backed securities (for example, issues under a securitisation):
On-Balance Sheet Funding
Unlike securitisation structures, the underlying credit risk of the assets supporting the covered bonds is not transferred off the originator’s balance sheet. In addition, the Cover Assets may be transferred from an originator to an affiliate company (which acts as a covered bond guarantor or issuer), but there is no sale of assets to a third party “orphan” SPV (which results in off-balance sheet accounting treatment as is the case for typical securitisations).
No Prepayment Risk
Covered bonds are typically structured on a strict bullet repayment basis (similar to most corporate bond issues). As such, if covered bond assets prepay, the Cover Pool must be replenished to ensure that the maturity profile of the Cover Assets in the Cover Pool matches the maturity profile of the covered bonds. This differs from the “pass-through” risks inherent in a securitisation of an underlying portfolio of mortgage receivables.
Dual-Recourse Feature – an essential characteristic of covered bonds
Covered bondholders have full priority recourse to both the Cover Assets in the Cover Pool and the issuer (compared to a securitisation, where bondholders only have recourse to the assets backing the bonds).
This provides a double-layer of protection, and it is important to ensure that, whatever structure is adopted, this dual-recourse feature is retained.
Types of Covered Bond Structures: Integrated and Segregated
Covered bond structures are either “integrated” or “segregated”.
Integrated structures are those where legislation automatically allows the Cover Pool assets to remain on the issuer’s or originator’s balance sheet, encumbered only for the benefit of the covered bondholders and kept isolated by operation of law from the issuer’s / originator’s remaining assets (i.e. beyond reach of creditors on insolvency). A prime example of an integrated covered bond structure is the US$500,000,000 3.50% covered bonds issued by Korea Housing Finance Corporation in 2011, pursuant to the statutory security structured created by the Korea Housing Finance Corporation Act No. 7030. This is the only “true” covered bond issue by an Asian financial institution, and is similar to the integrated covered bond structures in Europe.
Segregated structures necessitate the transfer of the Cover Assets to a separate legal entity, or “SPV”, in order to insulate them from the issuer’s / originator’s insolvent estate. Requirements are met by applying the contractual techniques employed by securitisation structures. This is the most prevalent form of covered bond structure in Australia (under the Australian Banking Amendment (Covered Bonds) Act 2011) and the United Kingdom (under the Regulated Covered Bonds (Amendment) Regulations 2012).
As outlined below, rules relating to Singapore covered bonds contemplate the use of a segregated covered bond structure.
The diagram below sets out a simplified depiction of a segregated covered bond structure, where the originator also issues the senior secured bonds:
Please click on the view original link to view the diagram.
Regulatory Overview of Singapore Covered Bonds
On 31 December 2013, the Monetary Authority of Singapore (“MAS”) issued MAS Notice 648 Issuance of Covered Bonds by Banks Incorporated in Singapore (the “Singapore Covered Bond Rules”), pursuant to section 55 of the Banking Act (Cap. 19).
The Singapore Covered Bond Rules permit all banks incorporated in Singapore and licensed to conduct banking business by the MAS to issue covered bonds, subject to the conditions set out in the Singapore Covered Bond Rules.
In addition, the MAS published responses to feedback on a consultation paper in respect of the draft-version of the Singapore Covered Bond Rules (“MAS Feedback Responses”), and in respect of the proposed rules for the issuance of covered bonds by banks incorporated in Singapore.
Key Features of the Conditions Imposed by the Singapore Covered Bond Rules
The Singapore Covered Bond Rules impose three key conditions on a Singapore-incorporated and licensed bank that wishes to issue a covered bond:
(1) Cover Assets and Encumbrance Limitations
A number of conditions are imposed on the kinds of Cover Assets allowed to form part of the Cover Pool, and risk exposure limitations are also prescribed. From a structuring perspective, the key features of these conditions and limitations are as follows:
- Limitations on the kinds of Cover Assets that a Cover Pool can comprise: these include mortgage loans secured by residential property (whether in Singapore or elsewhere); other loans secured by the same residential property; assets forming part of all security provided for residential mortgage loans (including guarantees and indemnities); derivatives held for the purpose of hedging risks from the issuance of covered bonds; cash; Singapore Government Securities; and MAS Bills.
- Limitations on the aggregate value of Cover Assets: Principally, the aggregate value of the Cover Assets included in the Cover Pool for all covered bonds issued by the bank and the SPV on behalf of the bank, as the case may be, shall not exceed 4% of the value of the total assets of the bank (including assets of branches but not assets of the subsidiaries of the bank) at all times. Cash (including foreign currency), Singapore Government Securities and MAS Bills are permitted as Cover Assets, but the value of these Cover Assets shall not exceed 15% of the aggregate value of assets included in the Cover Pool.
- Capital Adequacy Requirements: The bank shall continue to hold capital against its exposures in respect of the Cover Assets in accordance with MAS Notice 637 on Risk Based Capital Adequacy Requirements for Banks Incorporated in Singapore. A “look through” approach is adopted, meaning that the bank and the SPV shall be treated as a single entity for the purposes of MAS Notice 637.
- Minimum Loan-to-Value Ratio: An 80 per cent. loan-to-value limit (as determined by the current market valuation of residential property used to secure the residential mortgage loans referred to above) shall be applicable to residential mortgage loans.
(2) Risk Management Requirements
Banks are required to comply with certain conditions aimed at managing the risks arising from the issuance of covered bonds. These include:
- Appropriate Governance Arrangements: Banks are required to perform regular asset coverage tests to ensure collateral quality and the proper level of over-collateralisation, and conducting stress-tests on risks arising from issuing covered bonds, such as default, prepayment, currency, interest rate, counterparty and liquidity risks.
- Appointment of a Cover Pool Monitor: An external third party qualified to be an auditor under the Companies Act (Cap 50) is to be appointed as the Cover Pool monitor in order to, among other things, submit an annual certified report to the MAS on the monitoring, verification and assessment tasks set out in MAS Notice 648, and report to the MAS immediately if it becomes aware of any breaches by the bank of the conditions imposed by the Singapore Covered Bank Rules.
(3) Notification Requirements
Banks are required to submit information on their covered bonds to the MAS at least one month in advance of the issuance of covered bonds. In addition, banks have to notify the MAS in writing at least three business days prior to the issuance of any covered bonds, provided that the bank has already submitted information to notify the MAS on its covered bond programme a month in advance.
Structural and Execution Issues for Singapore Covered Bonds
A Singapore covered bond offering would raise interrelated structural, commercial and legal issues that are unique in the context created by the Singapore Covered Bond Rules and Singapore’s associated banking legislation. These issues, which are outlined below, would need to be carefully considered in the structuring phase and execution process of a transaction.
The role of the Central Provident Fund (“CPF”)
The CPF is a compulsory savings system that keeps funds in trust to benefit and provide old-age savings for Singapore citizens and permanent residents. As part of the CPF scheme, members can use their funds for investment purposes, including for the repayment of mortgage loans. This creates a difficulty for proposed covered bond structures in Singapore in that the CPF, as a key player in the Singapore mortgage market, has a priority claim on homes financed with CPF funds, which complicates issues of security where the Cover Pool includes Cover Assets which are mortgages funded by the CPF.
We understand that legislation is imminent which will clarify the order of priority of the CPF and mortgage lenders to allow an orderly ranking of claims on the insolvency of mortgage originators, in the meantime however, potential approaches to overcome this problem may include the following:
- Requesting the CPF to subordinate its claim over the Cover Assets. We understand that the CPF has given banks first priority over the proceeds from the sale of a property following foreclosure, despite the CPF having a first charge over the underlying mortgage loan.
- Coupled with subordinating the CPF’s claim as referred to above, obtain the CPF’s explicit approval for transferring the underlying mortgages into the Cover Pool.
- Restricting the Cover Assets to only mortgages that are not CPF funded (if practicably feasible).
Singapore banking law issues
Any covered bond in Singapore would need to be carefully structured bearing in mind the Singapore Covered Bond Rules, the MAS Feedback Responses and the Banking Act. Set out below is a brief summary of the issues which would need to be taken into account.
- A segregated SPV structure and enhanced structural flexibility
As discussed above, the Singapore Covered Bond Rules do not provide for the statutory ring-fencing of the Cover Assets in the way that European covered bond legislation does. The Singapore Rules are in this respect closer to the UK and Australian covered bond regimes. The MAS has confirmed that banks “will be allowed the flexibility to adopt the structure in which they have assessed to best suit their needs”.1
This will, in our view, provide Singapore financial institutions with greater flexibility than would be the case under an integrated regime (such as Korea), but care will need to be taken to ensure that the contractual mechanics of the structure achieve appropriate segregation in an insolvency scenario. In particular, adequate provision will need to be made in the documentation for the appointment of an administrator to enforce investors’ rights to the collateral in the event of the issuer’s / originator’s insolvency.2
- Choice of Cover Assets
The Singapore Covered Bond Rules provide for great flexibility in the range of structures that an originator / issuer can adopt, but place stringent limits on the types of assets that can form part of the Cover Pool. See “The Regulation of Covered Bonds in Singapore – Key Features of the Conditions Imposed by the Singapore Covered Bond Rules”, above. As such, great care will need to be exercised, and detailed diligence conducted, to ensure that the Cover Pool is not only adequately contractually ring-fenced from an originator’s other assets on insolvency, but that it complies with the limits, requirements and conditions stipulated under the Singapore Covered Bond Rules. Issues relating to the CPF’s priority claim over mortgage security will also need to be addressed.
- Equitable Assignment and Set-Off Risks
Singapore banking law3 allows a liquidator of a bank to first set-off a depositor’s liabilities to the bank against any deposit of the depositor placed with the bank. Accordingly, it is vital in the establishment of the covered bond structure to ensure that the equitable assignment of the Cover Assets to the SPV is perfected prior to issuance of the covered bonds (and therefore before the risk of insolvency arises). This would include the need to highlight the risk of statutory set-off to investors, and make disclosure in the notice of assignment to the underlying borrowers of the Cover Assets.
In summary, the Singapore Covered Bond Rules and Singapore’s contract and insolvency laws provide for both a sophisticated and accessible legal framework through which its financial institutions can look to access a cheap and secure source of funding in an internationally under-supplied covered bond market. Once absolute certainty is achieved on the manner in which CPF contributions will be treated in a covered bond structure, we are likely to see a strong degree of activity by issuers in this market.