Overview of the Covered Bond Issuance Act
The Covered Bond Act entered into force on 1 July 2004. It enables Swedish banks and credit market companies (“Institutions”), which have been granted a specific licence by the Swedish Financial Supervisory Authority (Sw: Finansinspektionen) (the “Swedish FSA”), to issue full-recourse debt instruments secured by a pool of mortgage credits and/or public sector credits.
The Swedish FSA has issued regulations and recommendations under the authority conferred on it by the Covered Bond Issuance Act (Sw: Finansinspektionens föreskrifter och allmänna råd om säkerställda obligationer (FFFS 2013:1)) (the “SFSA Regulations”). Swedish covered bonds may take the form of bonds and other comparable debt instruments, such as commercial paper.
In the event of an Institution’s bankruptcy, holders of covered bonds (and certain eligible counterparties to derivative contracts entered into for the purpose of matching the financial terms of the assets in the Cover Pool with those of the covered bonds) benefit from a priority claim over the pool of assets (the “Cover Pool”). The Covered Bond Act also enables such holders (and derivative counterparties) to continue to receive timely payments also following the Institution’s bankruptcy, subject to certain conditions being met.
Administration of the Cover Pool in the case of bankruptcy
The administrator-in-bankruptcy has also got an express mandate, on behalf of the bankruptcy estate, to take out liquidity loans and enter into other agreements for the purpose of maintaining matching between the cover pool, covered bonds and derivative contracts. The administrator has an extensive mandate to enter into agreements, not only to achieve a liquidity balance but also to achieve a balance in respect of currencies, interest rates and interest periods. The administrator should only enter into agreements if, on the date of execution of the agreement, the agreement is deemed to favour bondholders and derivative counterparties and if the assets in the cover pool are deemed to fulfil the terms and conditions imposed in the Act. When the administrator enters into an agreement the contracting party receives a claim against the bankruptcy estate that ranks ahead of the secured creditors and creditors with rights of priority.
Information in respect of all covered bonds, assets in the Cover Pool and relevant derivative contracts must be entered into a special register (the “Register”), which is maintained by the Institution. The actual registration of the covered bonds and relevant derivative contracts in the Register is necessary to confer the priority claim over the Cover Pool. Conversely, only assets entered into the Register form part of the Cover Pool.
At all times the Register must show the nominal value of the covered bonds, the Cover Pool and the relevant derivative contracts. As a result, the Register requires regular updating, including without limitation due to changes in interest rates, interest periods, outstanding debt and the composition of the Cover Pool. The value of the underlying collateral securing mortgage credits in the Cover Pool must also be entered into the Register.
The Covered Bond Act does not prevent Institutions from supplementing and substituting assets in the Cover Pool.
The Cover Pool
The Cover Pool may consist of certain mortgage credits, public credits and supplemental assets.
Mortgage credits are defined as loans secured by
- mortgages over real property (Sw: fastigheter) intended for residential, agricultural, office or commercial purposes or site leasehold rights (Sw: tomträtter) intended for residential, office or commercial purposes,
- pledges over tenant-owner rights (Sw: bostadsrätter), or
- comparable security interests over equivalent assets situated in other countries within the European Economic Area.
Public credits are defined as certain loans to (or guaranteed by) inter alia the Kingdom of Sweden, Swedish municipalities and comparable public bodies, the European Communities, certain foreign states and central banks and certain foreign municipalities and comparable public bodies with powers of taxation.
Supplemental assets consist primarily of government bonds and cash, although the Swedish FSA may also authorise certain debt instruments issued by credit institutions and other bodies to be used as supplemental assets.
Loan-to-value ratios and other restrictions
For mortgage credits, there is a maximum loan amount which may be included in the Cover Pool, depending on the value of the underlying collateral:
- For residential collateral, a loan may be included in the Cover Pool only to the extent the loan amount does not exceed 75 per cent. of the market value of the collateral.
- For agricultural collateral, a loan may be included in the Cover Pool only to the extent the loan amount does not exceed 70 per cent. of the market value of the collateral.
- For office or commercial collateral, a loan may be included in the Cover Pool only to the extent the loan amount does not exceed 60 per cent. of the market value of the collateral.
The Covered Bond Act restricts the overall proportion of loans provided against security over real property (or site leasehold rights or tenant-owner rights) intended for office or commercial purposes to 10 per cent. of an Institution’s Cover Pool.
Furthermore, the proportion of supplemental assets may not exceed 20 per cent. of the Cover Pool, although the Swedish FSA has the authority to raise this limit to 30 per cent. for a limited period of time provided there is a particular reason for such increase.
Institutions are required to regularly monitor the market value of the mortgage assets that serve as collateral for loans included in the Cover Pool. If the market value of such a mortgage asset declines significantly (15 per cent. or more according to the preparatory works to the Covered Bond Issuance Act), then only such part of the loan that falls within the permitted loan-to-value ratio will be eligible for inclusion in the Cover Pool and will be subject to the priority right described below. However, a decline in the market value following an Institution’s bankruptcy would not result in a reduction of the assets to which holders of covered bonds (and relevant derivative counterparties) have a priority right, but may result in the Cover Pool ceasing to meet the matching requirements.
The Covered Bond Issuance Act prescribes that the value of the Cover Pool shall at all times, at least, be 102 percent of the aggregate value of claims that may be asserted against an Institution by reference to covered bonds. The calculation shall be made on the basis of current book values and shall take into account the effect of relevant derivative contracts.
Furthermore, an Institution must compose the Cover Pool in such a way as to ensure a sound balance between the covered bonds and the assets in the Cover Pool in terms of currency, interest rate and maturity profile. Such sound balance is deemed to exist when the present value of the Cover Pool at all times exceeds the present value of the liabilities relating to the covered bonds. The present value of derivative contracts shall be taken into account for the purposes of such calculation. The calculations of present value shall withstand certain stress tests (changes in interest rates and/or currency exchange rates).
The payment flows relating to the assets in the Cover Pool, derivative contracts and covered bonds shall be such that an Institution is at all times able to perform its payment obligations towards holders of covered bonds and relevant derivative counterparties.
Non-performing assets in the Cover Pool which are more than 60 days overdue must be disregarded for the purposes of the matching tests.
Supervision by the Swedish FSA and the independent inspector
The Swedish FSA monitors that an Institution complies with the Covered Bond Act and other provisions of the legislative and regulatory framework which regulates the business of the Institution. In addition, the Swedish FSA appoints an independent inspector (Sw: oberoende granskare) for each Institution that issues covered bonds.
The independent inspector is responsible for monitoring the Register to assess whether or not it is being maintained correctly and in compliance with the Covered Bond Issuance Act and the SFSA Regulations. In particular, the independent inspector shall verify that
- covered bonds and relevant derivative contracts are registered in the Register,
- only loans and supplemental assets that satisfy the eligibility criteria are included in the Cover Pool and registered in the Register,
- the valuations of the underlying collateral for loans in the Cover Pool are in accordance with the Covered Bond Issuance Act and the SFSA Regulations,
- mortgage loans the underlying collateral of which has decreased significantly in value are, for the purpose of the matching requirements, deducted from the Cover Pool to the extent necessary to comply with the relevant loan-to-value ratio and
- the matching requirements are complied with.
The independent inspector is entitled to request information from the Institution, conduct site visits and is required to report regularly and at least once a year to the Swedish FSA. The Covered Bond Issuance Act does not provide for any change to the independent inspector’s remit upon the bankruptcy of an Institution.
Benefit of a priority right over the Cover Pool
Pursuant to the Covered Bond Issuance Act and the Swedish Preferential Rights of Creditors Act (Sw: förmånsrättslagen (1970: 979)), holders of covered bonds benefit from a priority claim over the Cover Pool should the Institution be declared bankrupt (Sw: försatt i konkurs). The same priority is awarded to the Institution’s eligible counterparties to derivative contracts entered into for the purpose of matching the financial terms of the assets in the Cover Pool with those of the covered bonds. Such derivative counterparties and the holders of covered bonds rank pari passu with joint seniority in relation to the Cover Pool.
By virtue of the aforementioned priority, holders of covered bonds and relevant derivative counterparties rank ahead of unsecured creditors and all other creditors of the Institution in respect of assets in the Cover Pool (except the administrator-in-bankruptcy as regards fees for his administration of assets in the Cover Pool and costs for such administration). The priority claim also covers cash received by an Institution and deriving from the Cover Pool or relevant derivative contracts, provided that certain administrative procedures have been complied with.
Administration of The Cover Pool in the event of bankruptcy
Should an Institution be declared bankrupt, at least one administrator-in-bankruptcy would be appointed by the bankruptcy court and one administrator-in-bankruptcy would be appointed by the Swedish FSA. The administrators-in-bankruptcy would take over the administration of the bankruptcy estate, including the Cover Pool.
Provided that (and as long as) the Cover Pool meets the requirements of the Covered Bond Act (including the matching requirements), the assets in the Cover Pool, the covered bonds and any relevant derivative contracts that have been entered into the Register are required to be maintained as a unit and kept segregated from other assets and liabilities of the bankruptcy estate of the Institution. The administrators-in-bankruptcy are then required to procure the continued timely service of payments due under the covered bonds and any relevant derivative contracts. Consequently, the bankruptcy would not as such result in early repayment or suspension of payments to holders of covered bonds or to counterparties to derivative contracts, so long as the Cover Pool continues to meet the requirements of the Covered Bond Act.
If, however, the Cover Pool ceases to meet the requirements of the Covered Bond Act, and the deviations are not just temporary and minor, the Cover Pool may no longer be maintained as a unit and the continuous payment under the terms and conditions of the covered bonds and derivative contracts will cease. The holders of covered bonds and counterparties to derivative contracts would in such case instead benefit from a priority claim over the proceeds of a sale of the assets in the Cover Pool in accordance with general bankruptcy rules. This could result in the holders of covered bonds receiving payment according to a schedule that is different from that contemplated by the terms and conditions of the covered bonds (with accelerations as well as delays) or that the holders of covered bonds are not paid in full. However, the holders of covered bonds and derivative counterparties would retain the benefit of the right of priority to the assets comprised in the Cover Pool. Any residual claims of the holders of covered bonds and derivative counterparties remain valid claims against the Institution, but will rank pari passu with other unsecured and unsubordinated claims.
See draft proposal in the following section.
The Covered Bonds Issuance Act
Regulations and General Guidelines Governing Covered Bonds
The Riksbank accepts covered bonds on condition that they meet the Riksbank's normal requirements for approved collateral:
- The securities are listed
- The issue or issuer has an external credit rating of at least A-/A3
- The outstanding volume is at least SEK 100 million (or equivalent)
- The securities are issued in SEK, DKK, EUR, GBP, JPY, NOK or USD
- There is an arrangement under which the Riksbank will be provided with collateral (such an arrangement exists, for example, if the securities are issued in Euroclear Sweden or in Euroclear Bank).
Covered bonds belong to liquidity class 2 when calculating the haircut (between 1 and 7.5 percentage points depending on maturity), given that the Riksbank has access to daily prices. Otherwise they belong to liquidity class 4 (between 4 and 24 percentage points depending on maturity).
Unlike the situation for other securities, the Riksbank accepts covered bonds issued by the counterparty or by companies with close links to the counterparty. In such cases, however, there is an extra haircut of between 1 and 10 percentage points depending on maturity. This exception to the rule to not accept securities issued by the counterparty or companies with close links to the counterparty applies only to covered bonds under Swedish law (Säkerställda obligationer).
For covered bonds governed by other legislation the ban also applies to securities issued by banks or foreign credit institutions domiciled in the same country as the counterparty. If the issuer is not domiciled in the same country as the counterparty, the collateral value (the market value minus the haircut) for each individual issuer or group of closely-linked issuers may not amount to more than 25 per cent of the collateral value of all the collateral the counterparty provides to the Riksbank.