Mr Cooper Group Inc (COOP)

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Covered Bonds – Surviving issuer
defaults
Timothy Lopes | Senior Executive
Date – 19th June, 2020
VINOD KOTHARI CONSULTANTS PVT. LTD.
Kolkata
1006-1009 Krishna Building
224 AJC Bose Road
Kolkata – 700017
Phone: [phone]/ 3742 E: [e-mail]
Delhi
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New Delhi-110024 Phone: [phone] E: [e-mail]
Mumbai
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Mumbai – 400001
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Overview
Covered bonds are interesting securities that combine the features of securitisation with the traditional mode of financing through corporate bonds, leading to what can be called an “on- balance sheet securitisation”. Backed by a pool of mostly mortgage receivables, these bonds provide a dual recourse to both, the issuer and the underlying pool, in that order.
These bonds are designed to continue to pay investors as per the original terms until maturity even in cases of an issuer default.
A Moody’s report shows a list of 33 cases where covered bonds continued to survive even in case of issuer defaults.
In this write up the author attempts to go to the grass roots of as many cases of issuer defaults and establish the reason for cover bonds survival.

Table of Contents
Introduction........................................................................................................................................ 3 Default in case of covered bonds....................................................................................................... 3 Cases of issuer defaults ...................................................................................................................... 3
United States of America ................................................................................................................ 3 Austria ............................................................................................................................................. 4 Cyprus ............................................................................................................................................. 4 Portugal ........................................................................................................................................... 5 Italy.................................................................................................................................................. 5 Greece ............................................................................................................................................. 5 United Kingdom .............................................................................................................................. 6 Ireland ............................................................................................................................................. 6
Conclusion .......................................................................................................................................... 6
Covered Bonds – Surviving the inevitable
Key areas of discussion
1. Introduction to covered bonds
2. Cases of issuer defaults and its effect on covered bonds
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Introduction
A covered bond is a debt instrument that borrows from securitisation as well as the old age secured lending tradition. Covered bonds are entirely the obligation of the issuer, however, unlike in the case of traditional corporate bonds, they are backed also by the pool of assets usually consisting of residential mortgages or other debt.
Covered bonds have a dual recourse feature – the issuer, and the underlying pool, in that order. Covered bonds are generally issued by mortgage-lending banks in Europe. Therefore, a default of covered bonds may occur only the issuing banks face the risk of default. Even if that were to happen, the extent of over-collateralisation in the cover pool may be sufficient to hold the bondholders safe. The recourse that the bondholders have against the loan pool is further strengthened by inherent support in a mortgage loan in form of the LTV ratio.1
European banks have a high dependency on covered bond issuances. With a history of more than 250 years now, covered bonds would have withstood various calamities and disruptions, both economic and natural, over the years. Covered bonds have not seen defaults over all these years.
Default in case of covered bonds
As per a Moody’s report2, no covered bonds defaulted between 1997 and 2019, even though 33 covered bond issuers defaulted during this period. Covered bonds have performed steadily, both during and after the financial crisis.
This reflects the ability of covered bonds to withstand a crisis situation. Even if the issuer defaults and enters bankruptcy proceedings, servicing of covered bonds generally continues. Further, regulatory certainty in most countries provides relief to covered bond investors. In most European countries, covered bonds law specifies how they will be treated in case of a default.
Out of the 33 cases above, we have tried to analyse as many cases to try and establish the reason for covered bonds survival despite issuers defaulting on other debt obligations.
Cases of issuer defaults
United States of America
Washington Mutual Bank (WAMU) –
The case of Washington Mutual Bank (WAMU) is an interesting one. Back in 2006, WAMU became one of the first entities in recent history to issue covered bonds. Under the program, mortgages underwritten by WAMU were sold to the Washington Mutual Covered Bond Program, a statutory trust created to ring fence and separate the cover pool from the rest of Washington Mutual. The covered bonds were then issued to investors and secured with the mortgages3.
On September 25, 2008, the Federal Deposit Insurance Corporation was appointed the Receiver of Washington Mutual Bank owing to its deteriorating financial conditions caused by the global
1 Refer to Covered Bonds and the COVID disruption
2 See Rating transition rates for covered bond deals, 1997-2019: www.moody.com
3 See “Uncovering” The Cost Of Regulatory Uncertainty by Karan Bhanot and Carl Larsson
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financial crisis. Up until this point, there was regulatory uncertainty about the treatment of covered bonds in case of a failing bank.
Prior to 2008, the FDIC could undertake either of the three courses when appointed as a receiver of an insolvent bank with outstanding covered bonds –
(i) repudiate the secured bonds and pay principal and interest accrued up to the date of insolvency to the trust,
(ii) transfer the obligation on the secured bonds and the pool of mortgage loans to an assuming bank, or
(iii) permit the indenture trustee for the secured bonds to liquidate the pool of mortgage loans and pay the trust principal plus accrued interest up to the date of payment.4
There was no certainty as to which of the three courses the FDIC would pursue.
However, in April, 2008 the FDIC issued an interim policy statement on Covered Bonds, to mitigate uncertainty with respect to its treatment. The final policy statement was issued in August, 2008. The policy statement provided regulatory clarity by granting expedited access to covered bond collateral if the issuing institution fails and is placed into conservatorship or receivership and meets certain criteria.
The FDIC as receiver of WAMU, entered into a Purchase and Assumption Agreement dated September 25, 2008 with JPMorgan Chase Bank (Assuming Bank) and transferred substantially all WAMU's assets and liabilities to JPMorgan Chase. The Assuming Bank continued to service the covered bonds interest and principal payments till maturity of the covered bonds, which is ultimately how the covered bonds survived.
Austria
Hypo Alpe-Adria-Bank International AG (Heta) –
Austrian Financial Market Authority's (FMA) announced on 01st March 2015 initiation of resolution measures on Heta. The Financial Market Authority deferred the maturity and interest payment dates of most Heta debt instruments until 31 May 2016. Importantly HETA’s covered bonds were among certain others instruments explicitly exempted from this moratorium5.
Further, following a rejected offer to buyback securities at a discount, creditors were presented with the option to swap into a zero-coupon bond guaranteed by the Austrian government on a 1:1 ratio for Heta senior debt and on a 1:2 ratio for subordinate debt. Again, HETA’s covered bonds were not affected by the measures. In October 2016, 98.7% of HETA bondholders accepted the tender offer.
Cyprus
Bank of Cyprus -
The Bank of Cyprus had a major profit fall in 2012 due to increased provisions for impairment of loans (as a result of the continuing deteriorating economic conditions) as well as reduced operating income. Further, the Bank cancelled interest payments on its debt securities during 2012, in accordance with the terms of the issue (which allowed the bank sole discretion to cancel interest payments to meet capital adequacy requirements). Since the Groups capital adequacy ratios were negatively affected, it was placed under administration and underwent restructuring and
4 Refer to Co-published Covered bonds guide: US
5 Source: European Covered Bond Council (EBCB): Fact book 2019
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recapitalisation in March, 2013. Covered bonds were not part of the restructuring and recapitalisation plan.
In Cyprus, the Covered Bonds Law of 20106 governs the treatment of covered bonds in case of issuer defaults and specifies that in case where the issuing credit institution is subject to dissolution proceedings, a qualified person assumes the management of the cover assets in order to continue the servicing of the covered bonds. In such a case, if the claims arising from the covered bonds are not satisfied in full from the realisation proceeds of cover assets, the covered bond holders are, with respect to the unsatisfied part of their claims, unsecured creditors of the credit institution that is subject to dissolution proceedings.
Thus, in the case of Bank of Cyprus the servicing on covered bonds continued despite the bank being under administration.
Portugal
The case of Novo Banco -
As per the EBCB Fact book, 2019, in November 2015, the European Central Banks (ECB) stress test revealed additional capitals need at Novo Banco of at least EUR 1.4bn. A month later, the Bank of Portugal transferred five bonds of Novo Banco with a total volume of EUR 1.9bn back to Banco Espirito Santo (BES), which was setup as bad bank after the rescue of the troubled BES group. All five bonds were issued by BES before the banks rescue under Portuguese law.
After the transfer of the bonds to the bad bank, the cash price dropped from roughly 90% to below 20%. At the same time, the transfer significantly improved Novo Banco’s capital position.
The relevant point to be noted here is that covered bonds were exempted again.
Italy
Recapitalisation of four small banks -
Another notable reference can be made to the EBCB Fact Book, 2019, wherein in November 2015, the Bank of Italy rescued four smaller Italian banks (Banca delle Marche, Banca Popolare dell’Etruria, Cassa di Risparmio di Ferrara und Cassa di Risparmio di Chieti).
The largest domestic credit institutions UniCredit, Intesa Sanpaolo and UBI Banca as well as the Italian deposit guarantee fund were required by the supervisor to contribute about EUR 3.6bn. As part of the rescue process, the non-performing loans of the four troubled banks were transferred onto a bad bank, subordinated creditors were bailed in, while senior unsecured and covered bond creditors were spared.
This is another example where covered bonds (and senior unsecured) were exempted from a bail-in.
Greece
Alpha Bank AE –
In the year 2015 a bank holiday was announced on 28th June, 2015 which lasted until 19th July, 2015. Owing to several stress scenarios, the ‘Debt securities in issue and other borrowed funds’ underwent a distressed exchange. In the fourth quarter of 2015 the Bank proceeded to an exchange of senior,
6 Refer to:
https://www.centralbank.cy/images/media/pdf_el/UNOFFIC__TRANSL_OF_THE__LAW__KALYMMENA__AXIO GRAFA_EN.pdf
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subordinated and hybrid securities issued by Group companies, with non-transferable receipts issued by the Bank. The exchange offer aimed to cover the capital needs of the Bank. Senior securities with a nominal value of € 984.9 million as well as subordinated securities and hybrid securities with a total nominal value of € 100.9 million were included in the exchange offer. Under the terms of the offer the securities are exchanged for shares of a value equal to 100% of nominal amount for senior, 85% of nominal amount for subordinated and 50% of nominal amount for hybrid securities, including the accrued interest for each security and excluding the non-innovative hybrid title.
The above ‘Debt securities in issue and other borrowed funds’ does not include covered bonds. As at 31.12.2015, the balance of the covered bonds of the Bank amounted to €5 million. The value of mortgage loans provided as coverage for these bonds amounted to €18 million (which seems to be more than sufficient to have covered the payments in covered bonds.
United Kingdom
The Co-operative Bank plc –
Restructuring and recapitalisation of the Company took place in September, 2017 which resulted in the exchange of all Subordinated Notes held by Subordinated Noteholders for A shares in the Holding Company and the Mandatory Cancellation of the 2023 Notes held by Retail Noteholders in consideration of the payment by the Bank of the Retail Cash Consideration to Retail Noteholders.
Covered bonds remained unaffected in the above mentioned restructuring plan.
Ireland
Irish Bank Resolution Corporation (in Special Liquidation) -
The Irish Bank Resolution Corporation was placed under special liquidation in February, 2013, with the passing of the IBRC Act, 2013. As per the Act, all borrowers' loans were initially be managed by the special liquidators and all debts due to IBRC remained due and enforceable.
Portfolios of assets including the mortgage book of IBRC were to be identified by the special liquidators who would oversee an independent valuation and sales process of such assets to third party bidders. The proceeds of these sales will be used to repay creditors.
This continuation of loans being due to IBRC likely kept covered bonds afloat. Further, in case mortgages were sold to third parties, the proceeds would have been used to repay covered bond investors.
Conclusion
Looking into these cases, we see that covered bonds have an added protection as their treatment in case of crisis situations is predefined by legislation. These bonds are designed to withstand such situations given their dual recourse feature and hence prove to be an ideal solution in crisis events.
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Other relevant articles-
1. Covered bonds and the COVID disruption
2. Introduction to covered bonds
3. The Name is Bond. Covered Bond.
4. Securitisation and covered bonds for housing finance
5. Conditional Pass-Through Covered Bonds: A New Innovation
6. Some notable structured covered bonds globally
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