While traditional (statutory) Pfandbriefe still dominate the Swiss covered bond market, the avenue of structured (contractual) covered bonds has recently been explored when first UBS (in 2009) and then Credit Suisse (in 2010) established their respective covered bond programs and presents an alternative for Swiss mortgage lenders seeking for flexibility and an improved access to international institutional investors. This article describes the key features of Swiss structured covered bonds.

By Dieter Grünblatt / Stefan Kramer / Benedikt Maurenbrecher (Reference: CapLaw-2012-50)

1) Introduction

According to the European Covered Bond Council’s definition, covered bonds are secured debt instruments which satisfy the following criteria: (i) The issuer or the guarantor of the debt instrument is a prudentially regulated credit institute (i.e., a bank); (ii) the debt instruments are secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default; and (iii) the bank has a continuing obligation to provide a sufficient amount of assets to the cover pool in order to be able to satisfy the claims of the covered bond investors, and compliance with such obligation is subject to supervision by a public authority or independent third party.

In Switzerland, there are two different legal concepts which correspond to this definition.

On the one hand, in 1931, the Swiss legislator created the Swiss Pfandbrief system by enacting the Mortgage Bond Act (MBA), complemented by a respective ordinance (Mortgage Bond Ordinance, or MBO). The MBA provides for explicit regulations regarding all key elements of the Pfandbrief system, such as the institutions authorised to issue instruments under the MBA, the structure and valuation of the cover pool, and certain insolvency-related issues.

On the other hand, the concept of freedom of contract allows an issuer to structure a covered bond program based on contractual agreements with investors and other persons or institutions to be involved in the transactions. Instruments issued under such contractual agreements qualify as structured covered bonds. The avenue of structured covered bonds has only recently been explored in Switzerland, when first UBS (in 2009) and then Credit Suisse (in 2010) established their respective covered bond programs.

Today, Pfandbriefe still dominate the Swiss (covered) bond market with an aggregate size of CHF 63,7 billion or 24,5% (end of 2011) of the nominal amount outstanding of all listed domestic bonds. The issuing volume for Swiss Pfandbriefe is somewhat restricted, however, since the capital adequacy provisions in the MBA provide that, in addition to the maintenance of the cover pool, Swiss Pfandbriefe must be underpinned by equity of PBB and PBZ in excess of 2% of their respective total Pfandbrief issuance volume. Nevertheless, Pfandbriefe are the second-largest and second-most liquid segment of the Swiss franc bond market after Swiss government bonds (Eidgenossen). Structured covered bonds are catching up quickly in light of the Swiss big banks having more than CHF 13 billion outstanding at the end of 2011, mainly in the form of jumbo issuances into the European market.

2) Swiss Structured Covered Bonds

a) Key Elements
Due to the aforementioned limitations applicable to the Swiss Pfandbrief market, and in response to the tightening of the market for liquidity during the financial crisis, the two Swiss big banks developed structured covered bond programs which fall outside the scope of the MBA. The contractual structure of these programs allowed UBS and Credit Suisse to include a number of structuring features which aim to improve investor protection and enabled the covered bonds to be allocated an AAA/Aaa rating.

Under Swiss covered bond issuance programs, covered bonds are issued into the international market by the UK or other non-Swiss branch of a Swiss bank as issuer. Initially, issuances were predominantly made in reliance on Regulation S under the US Securities Act of 1933 into the European market. More recently, both issuers followed up with 144A offerings into the United States.

There are a number of key elements of this structure:

1. The Swiss bank, acting through a non-Swiss branch, issues covered bonds as direct, unconditional and unsubordinated obligations of the issuer.
2. The obligations of the issuer under the covered bonds benefit from a guarantee issued by a subsidiary of the issuer under a so-called guarantee mandate agreement in favour of the holders of covered bonds, represented by the bond trustee.
3. Under the guarantee mandate agreement, all liabilities, costs and expenses incurred by the guarantor under or in connection with the guarantee will have to be reimbursed (or pre-funded accordingly), by the issuer.
4. As security for the relevant reimbursement and pre-funding claims of the guarantor, the Swiss bank transfers a pool of mortgage loans, together with the related mortgage security, to the guarantor.

Accordingly, if the issuer defaulted under the covered bonds and the guarantee was to be drawn, the guarantor could claim for coverage by the issuer under the guarantee mandate agreement. Failure by issuer to pre-fund the payments lowered under the guarantee would allow the guarantor to enforce in the cover pool (as further described below) and to use the proceeds to satisfy its payment obligations under the guarantee.

To a considerable extent, Swiss structured covered bonds build on features developed in the context of English structured covered bonds. But the resulting structure is unique, driven by Swiss legal, regulatory, tax and insolvency law considerations. Furthermore, combining the requirements of issuing into the international market with the particularities of a cover pool consisting of Swiss mortgage assets has led to a bifurcation of the governing law:

Certain agreements essential for the functioning of the covered bond program, such as the intercreditor deed governing the priority of payments in relation to the proceeds of the cover pool and the guarantee deed pursuant to which the guarantor guarantees the payment of principal and interest under the covered bonds, are governed by English law. English law also applies to the swap agreements needed for purposes of mitigating the interest rate risk and the currency risk and certain other documents (cash management agreement, trust deed, agency agreement, and so on).

Conversely, the agreements governing the establishment of the cover pool and the relationship between the issuer and the guarantor are governed by Swiss law. Relevant agreements include the agreement under which the mortgage loans and the related mortgage certificates are transferred to the guarantor and into the cover pool. The same applies for the guarantee mandate agreement pursuant to which the issuer instructs the guarantor to issue a guarantee for the payment obligations of the issuer under the covered bonds.

b) Role of Issuer

Following the issuance, the main duty of the issuer in relation to the covered bonds is to always maintain an appropriate level of eligible mortgage assets or substitute assets in the cover pool. The cover pool assets are legally owned and held by the guarantor rather than by the issuer. The mortgages are, however, only transferred to the guarantor for security purposes and therefore remain on the issuer’s balance sheet (as further explained below).

c) Guarantor and Guarantee

The guarantor is a Swiss corporation, which is majority-owned by the relevant issuer with two independent board members which are also minority shareholders. Under the constitutional document of the guarantor, the two independent board members/shareholders are granted a veto right in respect of all relevant decisions on the shareholders and the board level. This corporate governance setup is designed to enhance the protection of the interests of the covered bond investors and the stability of the guarantor in case of an insolvency of the issuer.

The guarantor is structured as a bankruptcy remote special purpose vehicle with a limited corporate purpose. In essence, this purpose consists in holding and, if necessary, enforcing the assets in the cover pool. Therefore, the guarantor may only enter into such agreements and transactions as are necessary to effectively perform its function under the covered bond program. Moreover, it benefits from non-petition and limited recourse provisions, to which substantially all parties to the transactions have acceded with view to reinforce the bankruptcy remoteness of the guarantor.

While an issuer event of default accelerates the payment obligations of the issuer, it will not change the payment schedule under the guarantee. Accordingly, amounts of principal and interest will be payable by the guarantor as originally stipulated in the terms of the bonds as long as no guarantor event of default occurs. Such event would occur if a guarantor failed to make any payments when originally due, an amortisation test failed or if the guarantor itself became insolvent.

As indicated, the guarantee is issued pursuant to a Swiss law guarantee mandate agreement entered into between the issuer and the guarantor. Under this agreement, the issuer instructs the guarantor to issue a guarantee for the benefit of the holders of covered bonds, on the account and risk of the issuer. As consideration for the issuance of the guarantee by the guarantor, the issuer pays to the guarantor an annual guarantee fee. As mentioned earlier, the issuer also undertakes to indemnify and pre-fund the guarantor for any outstanding and future amounts payable by the guarantor under or in connection with the guarantee and to reimburse any such payments made by the guarantor which have not been pre-funded.

For Swiss regulatory and tax reasons, the mortgage claims in the cover pool only secure the indemnification and pre-funding obligations of the issuer towards the guarantor under the guarantee mandate agreement, but not the claims of the holders of covered bonds under the guarantee. Technically speaking, the obligations of the issuer under the covered bonds are, therefore, (aside from the guarantee) unsecured obligations of the issuer. Moreover, as opposed to English covered bonds, the issuer does not sell the mortgages in the cover pool. Rather, for Swiss insolvency law and other reasons they are only transferred to the guarantor for security purposes.

d) The Cover Pool

The cover pool consists of residential mortgage loans which are transferred for a security purpose to the guarantor together with the related mortgage certificates. Accordingly, the guarantor will acquire legal title in the mortgage certificates, which represent the lien on the residential real estate encumbered. In addition, certain substitutes such as cash or governed bonds may form part of the cover pool.

Each mortgage certificate transferred will continue to secure only the related mortgage loan(s) and can not be enforced unless a relevant mortgage loan is in default. Together with a number of other precautions, this helps to ensure that the interests of the mortgage debtors are not unfairly prejudiced by virtue of the transaction. 

The mortgage loans in the cover pool have to meet certain eligibility criteria including a certain maximum loan-to-value ratio (LTV). Moreover, the composition of the cover pool has to meet certain additional criteria, including a minimum amount of over-collateralisation acceptable to the rating agencies from time to time. Accordingly, the mortgages in the cover pool are subject to regular replenishment and substitution in order to ensure ongoing compliance with the relevant tests and eligibility criteria.

In case of insolvency of the issuer, the bondholders benefit, in addition to their direct recourse to the issuer, from the guarantee issued by the guarantor, which is backed by the assets in the cover pool. While mortgages in the cover pool have been transferred to the guarantor for security purposes only and, therefore, have remained on the balance sheet of the issuer, in an insolvency of the issuer, the assets in the cover pool would be segregated from the estate of the issuer. Accordingly, as the guarantor is the title owner of the cover pool assets it may, subject to any avoidance action, manage and enforce such assets independently from any insolvency procedure concerning the issuer. Upon the occurrence of an enforcement event, the guarantor is entitled to liquidate a sufficient part of the cover pool assets to by collecting the mortgage claims (if and when they fall due) or, subject to certain restrictions, by way of a private sale of mortgage assets to an eligible investor.

3) Conclusion

Recent developments have not only highlighted the importance and versatility of the Swiss Pfandbrief, but have also increased the options available to Swiss mortgage institutions. The development of a transaction structure compatible with the Swiss legal environment, the prevailing practice in the Swiss mortgage business and the requirements of issuances into international markets offers Swiss mortgage lenders flexibility and an improved access to international institutional investors.