Roundup: S. Korea to introduce covered bonds for household debt restructuring
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E-mail Xinhua, October 18, 2012
South Korea's financial regulator said Thursday that it will introduce covered bonds soon in a bid to restructure household debts by promoting long-term, fixed-rate loans.
The Financial Services Commission (FSC) held a seminar in central Seoul to outline the Covered Bond Act that was scheduled to be submitted to the National Assembly in November.
According to the press release, covered bonds will be adopted as part of efforts to boost long-term fixed-rate mortgage loans by requiring the inclusion of such loans in cover pools.
The adoption was believed to offer stable dollar-funding sources for banks, and it was expected to foster the long-term bond market as the covered bonds tended to be issued with maturity of more than five years.
"Covered bond legislation will serve as a solution to household debt problems. It will become a useful source of foreign currency funding in times of market tension, and will be a catalyst for activating a long-term bond market," FSC Chairman Kim Seok-dong told reporters.
COVERED BOND
Covered bonds are debt securities issued by banks and secured by a pool of high-quality cover pool assets such as mortgage loans. Banks can cut funding costs by issuing the covered bonds as the bonds provide dual recourse, which is recourse to both the issuer and the cover pool, to investors.
That nature allowed higher credit ratings for the bonds than the issuers. "Due to the dual recourse nature of covered bonds, our rating on a covered bond is typically no lower than the relevant rating on the covered bond issuer," S&P said in a report.
The nature of the so-called bankruptcy remoteness protects investors from a credit event of issuer default. Cover pool assets stay on the issuer's balance sheet after the bond issuance, but the underlying assets are isolated from the insolvency of issuers. Bondholders are given priority claim over the cover pools upon issuer default.
GUIDELINES
The South Korean regulator published in June last year best- practice rule on covered bond issuance for banks jointly with the Financial Supervisory Service (FSS). A year later, the FSC formed a task force to help legislate the Covered Bond Act. The details on the draft bill were estimated to be released within this month.
The guidelines stipulated that eligible issuers should have a Bank for International Settlement (BIS) capital ratios of over 10 percent, and bond maturities should range from one to 30 years. Under the rule, eligible assets should consist of prime mortgage loans with loan-to-value (LTV) ratios below 70 percent and overdue less than 60 days as well mortgage-backed securities (MBS) that Korea Housing Finance Corp. (KHFC) issue.
Despite the guideline proposal, there remained a need to legislate a new law for covered bond issuance as the best-practice rule and the existing laws did not secure the covered bond's beneficial nature of bankruptcy remoteness and priority right over cover pool assets. "The guidelines were released, but demand for legislation has lasted due to the need for bankruptcy remoteness and priority claim over the assets," said Chung Sun-sup, a professor of law at Seoul National University.
Helped by the guidelines, Kookmin Bank, the country's No.1 lender, sold the five-year structured covered bonds worth 1 billion U.S. dollars in May 2009, yielding 7.25 percent, or 550 basis points (bps) above the similar-maturity U.S. Treasury notes. The yield was higher than 4.125 percent for the 5.5-year standard covered bonds issued in July 2010 by Korea Housing Finance Corp. ( KHFC) based on the KHFC Act.
ISSUER, ASSET ELIGIBILITY
South Korea's legislation for covered bond issuance was estimated to follow the rules of Europe rather than the proposed bill in the United States given the FSC's June 2011 guidelines.
Most European countries have been following the European legislation for collective investments that defines minimum standards for covered bonds. The rule defined the issuer as credit institutions such as banks and other lenders. The main cover pool assets were limited to mortgage loans, loans to municipal governments and ship loans.
In the United States, the range of eligible issuers and cover pools was widened to diverse financial institutions and asset classes. The U.S. Covered Bond Act proposed in November 2011 by Senator Kay Hagan defined eligible covered bond issuers as institutions originating loans, including banks and non-bank financial companies such as installment finance companies. Eligible assets were broadened to auto loans, leases and credit card receivables as well as prime mortgages.
ASSET LIABILITY MISMATCH
The FSC has been pushing for the covered bond legislation to promote long-term, fixed-rate mortgage loans, but it may risk causing risks of asset liability mismatch and interest rate mismatch. "In a typical covered bond program, the underlying assets are usually long-dated mortgage assets with maturities greater than 10 years, while the covered bonds tend to have short- to mid-term maturities averaging three to seven years," S&P said in a report.
Cover pool assets, mainly mortgage loans, with maturities longer than those of the covered bonds will inevitably bring about maturity mismatch. In the event of a issuer default, the covered bond would need to obtain external financing and liquidate assets to cover the disparity in maturities.
Meanwhile, the FSC planned to reduce floating rate loans, which account for around 95 percent of residential mortgage loans by banks. The regulator planned to lift the ratio of fixed-rate loans to 30 percent by 2016.
More fixed-rate loans may drive issuers to manage interest rate mismatch. Under the conditions that market interest rates are rising, fixed-rate assets with lower rates might have to support floating-rate liabilities with higher rates.
CROSS-BORDER ISSUANCE
Although the legislation is to be adopted, covered bonds were not expected to be issued actively in South Korea as banks already have highest credit ratings. "Even if the legal and regulatory framework for covered bonds is put in place, covered bond issuance is unlikely in Korea because most domestic banks have the highest domestic credit ratings," said Kim Pil-kyu, senior research fellow at Korea Capital Market Institute (KCMI).
Kim noted that local lenders had little incentive to use their assets as collateral to get higher credit ratings.
Cross-border issuance could be thinkable, but there seemed to remain little incentive for the overseas issuance by banks. Following the series of sovereign rating upgrades for the country, credit spreads for major banks reduced sharply, eating into cost saving incentives. Enditem
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