Economic burdens will also affect cover pools going forward
The COVID19 pandemic, and the direct and indirect economic and legal consequences resulting from the steps taken to curb the spread, must be assessed in terms of their short-term as well as their medium to long-term significance for covered bonds as well. In addition to the credit quality of the issuer, the question of the impact on the cover pools intended to secure the claims of covered bond investors, if necessary, plays a key role. It comes as no surprise that the current developments represent a potential burden both for the credit quality of the issuer as well as the valuation of the cover pool. The influences here are complex and can be closely interlinked and their impact is not always clear. In this article, we look at the options that have been created, in some cases by law, for deferring interest and principal payments under loan agreements in response to the COVID19 crisis and examine several different approaches. We believe this is necessary, not least because the impact of these measures on the credit quality of covered bonds is unclear. For instance, the direct loss of cash flows from interest and principal payments from the loans concerned would jeopardise the cash-flow from ongoing operations and limit the payment flows of the cover pool. However, in an ideal scenario, this would be offset by the temporary limitation of the potential risk of default if the loan continued unchanged.
Payment moratoriums do not follow a one-size-fits-all approach
Unsurprisingly, the approaches and models for payment deferrals announced to date follow the same idea but vary significantly in terms of implementation and agreement level. This is true both with regard to the length of the moratoriums as well as to the group of borrowers eligible. Issues such as the regulatory treatment of deferred loans or the requirements for applying for a moratorium do not follow a one-size-fits-all approach either. In a review that is by no means exhaustive, we look at the approaches adopted by Germany, Spain, Italy, the UK, Belgium, Canada and Ireland. These countries have been chosen to highlight how these moratoriums can be based both on legal amendments as well as on contractual agreements. Moreover, some countries, such as France, have not yet announced any detailed approaches.
Germany: Bundestag passes the COVID19 Act (term can be extended by a maximum of 12 months)
On 25 March 2020, the German Bundestag passed the COVID19-Act and published it in the Bundesgesetzblatt (Federal Law Gazette) on 27 March 2020. The Act includes special provisions relating to insolvency, corporate, criminal and civil law. In addition to restricting the termination of leases and rental agreements for privately and commercially used rental property (see Article 5, para. 2), with regard to loan moratoriums, the Act refers to possible deferrals of consumer loans, which also include private property finance. Commercial loans, on the other hand, are excluded from the loan moratoriums. Under the Act, for consumer loans which were concluded before 15 March 2020, the claims of the lender for repayment, principal and interest payments due between 1 April and 30 June 2020 can be deferred for a period of three months from the due date (see Article 5, para. 3(1)). This is contingent on the consumer having lost income as a result of the exceptional circumstances caused by the spread of the COVID19 pandemic, which make it unreasonable to expect the borrower to fulfil the service. In accordance with the authorisation to adopt regulations (see Article 5, para. 4(3)), the German government can extend the regulation beyond 30 June 2020 to 30 September 2020 without the consent of the Bundesrat (Federal Council). In formal terms, the deferral is an extension of the loan agreement by the term of the moratorium, whereby Article 5, para 3(5) stipulates that the contracting parties can reach a mutually agreed solution and that if this is not the case, an extension of the loan term of three months (or an extension of 12 months to be stipulated by the German government on the basis of the authorisation to adopt regulations (see Article 5, para. 4(3)) applies. Extending the term of the loan agreement is aimed in particular at saving the borrower from a dual burden as of the end of the moratorium.
Spain: Real Decreto-Ley 8/2020 (no term cited)
The emergency measures agreed by the legislators in Spain in the wake of the COVID-19 pandemic are enshrined in the Real Decreto-Ley 8/2020 dated 17 March 2020 and include payment moratoriums for mortgage loans, whereby the “economic vulnerability” of the borrower is defined as a prerequisite for the corresponding deferral. This can be due to unemployment on the part of the borrower, or in the case of commercial clients, substantial losses or the collapse of sales figures (decline of at least 40%). The law also stipulates as additional requirement criteria that the households or family units concerned must fall below specified salary thresholds, extraordinarily high burdens (loan agreements plus basic supplies ≥35% of the net income of all members of a family unit) as well as the provision that the family unit has suffered a considerable change in their economic circumstances as a result of a health emergency. No interest or principal payments will be made for the, as yet unspecified, duration of the moratorium, and the loan may not be called in or default interest applied. Borrowers who meet the conditions for the moratorium can submit the corresponding application to the bank that provided the loan. After granting the moratorium, the credit institutions must notify Banco de España so that, among other reasons, these moratoriums are not taken into account in a regulatory risk assessment.
Italy: Decreto Cura Italia (18 months maximum suspension of loan payments)
As a country that was hit early and particularly hard, Italy has created new legal framework conditions for dealing with the challenges of COVID19 in the form of the Decreto Cura Italia (published in Italy’s Law Gazette on 17 March 2020), which applies nationwide. Some of these framework conditions are based on previous legal acts in the context of the coronavirus crisis as well as on existing operations by Italian banks on a regional basis. The Decreto Cura Italia enables eligible mortgage debtors to defer principal and interest payments on the loan which was taken on for the purposes of acquiring their “first home” a maximum of two times during the term of the loan (maximum deferral 18 months and consequently extension of the term of the loan by a maximum of 18 months). The criteria for a corresponding moratorium as well as for dependent employees (layoff from work or reduction in working hours for a minimum period of 30 days) as well as for the self-employed and entrepreneurs (decline in sales during a quarter following 21 February 2020 or within a shorter period between the date of the application and 21 February 2020). The borrower must themselves confirm that this decline is greater than 33% of income in the last quarter of 2019 and results from the closure or restriction of business activity due to the coronavirus crisis. In the context of the Italian government, we believe it should also be noted that, where applicable, banks are to be reimbursed 50% of the interest accrued during the moratorium via the Fondo di Solidarietà (solidarity fund). When examining the impact of the change in the law on covered bonds, it should also be taken into account that the Italian legal framework has provided for the possibility of deferrals since 2008.
United Kingdom: government announces payment holidays (3 months)
In the United Kingdom, both the government and the Financial Conduct Authority (FCA) have been tackling the issue of payment holidays. As the coronavirus crisis intensified, the British government announced measures on tenant and landlord protection as well as for home owners with mortgages and talked of an agreement reached with mortgage lenders. The FCA also presented guidelines for the use of payment holidays for customers of mortgage lenders (Information for Customers) as well as for companies (Guidance for Firms). To sum up, the moratoriums are to be granted to those customers “with payment difficulties as a result of circumstances relating to the coronavirus” and requesting a payment deferral. The FCA referred to a deferral period of three months.
Belgium: government, central bank and financial sector reach agreement (6-month moratorium)
In order to manage the extraordinary challenges, the Belgian government, the National Bank of Belgium (NBB) and representatives of the country’s financial sector have agreed a two-pillar package of measures (see also Press release from NBB). As part of this package, the financial sector has agreed to grant a payment deferral free of charge until 30 September 2020 to viable non-financial companies and the self-employed as well as mortgage borrowers with payment difficulties as a result of the corona crisis. To this end, the government is establishing a guarantee system for all new loans and credit lines with a maximum term of 12 months, which the banks will make available to viable non-financial companies and the self-employed.
Canada: cooperations with the financial sector (payment deferral of 1 to 6 months)
According to official information, the Canadian Finance Minister is in regular dialogue with major banks in the country and discussing the role the banking sector is playing in the current crisis. Canada’s COVID-19 Economic Response Plan states that banks are required to find flexible solutions for customers on a case-by-case basis to overcome hardships (e.g. wage cuts, interruption to childcare or illness) caused by the crisis. Canada’s major banks are said to have confirmed that this support comprises a payment deferral of one to six months for mortgage loans and the possibility of relief on other loan products. The Canadian government also provided information on the options and framework conditions relating to payment deferrals via the state-owned Canada Housing and Mortgage Federation (CMHC), which is also a higher level authority for Canadian covered bond issuers.
Ireland: agreement in financial sector (up to 3 months payment holiday)
On 18 March, the CEOs of five commercial banks in Ireland (AIB, Bank of Ireland, KBC, Permanent tsb and Ulster Bank), together with the Banking & Payments Federation Ireland (BPFI) with the participation of the country’s Finance Minister agreed a joint approach to supporting companies and households affected by the pandemic (see also Press release from BPFI). The agreement includes a payment deferral of up to three months (Payment Break) for companies and private customers. With regard to the regulatory treatment of loans in arrears, the banks see the need for further talks with the Central Bank of Ireland. According to the BPFI press release, there have also been initial talks with credit-servicing companies and non-bank lenders. Even though there is a further need for clarification in this context from the Central Bank of Ireland, these institutions are also said to have undertaken to work with the government and commercial banks.
The payment moratoriums agreed or enshrined in law to date in the wake of the coronavirus crisis vary to a significant degree even just in the jurisdictions examined here. This is true both with regard to the duration of the payment deferral as well as in terms of borrower eligibility. The legal criteria governing this latter point appear particularly restrictive in Spain and Italy. The UK approach already indicates an almost cooperative approach, as is the case in Belgium in particular, as well as in Ireland and Canada. In terms of assessing the implications for the cover pools concerned, these will initially depend on the extent to which the measures are utilised and the scale of the resulting effect on the cash flow side. However, the advantages that the payment moratoriums, which are flanked by additional regulatory easing, can have from an issuer perspective should also be taken into account. In particular, assuming the burdens in the wake of the COVID19 pandemic are temporary in nature, in the medium-to-long-term we would also see advantages from the moratoriums outlined above as they imply lower loss ratios. This in turn would speak for better credit quality on the part of the issuers in the medium-to-long-term, which would render any necessary recourse to the cover pool correspondingly less likely.