Lettres de Gage are debt instruments issued by a covered bond bank that are secured with a cover pool. The particulars regarding Luxembourg covered bonds are in part explained below. For more information see www.cssf.lu.
The issuance of Lettres de Gage is regulated by articles 12-1 to 12-12 of the Financial Sector Act of 5 April 1993. These articles were introduced by the Act of 21 November 1997 for banks issuing covered bonds (Loi du 21 novembre 1997 relative aux banques d’emission de lettres de gage) and amended by the Act of 22 June 2000 (treatment of hedge instruments), the Act of 24 October 2008 (2 % overcollateralization; Lettres des Gage Mobilières), as well as 27 June 2013 (Lettres de Gage Mutuelles; Insolvency treatment of Cover Pools; Transparency requirements) an 22 June 2018 (new asset class Lettres de Gage énergie renouvelables, 180 day liquidity). The Lettres de Gage regulations are supplemented by the Commission de Surveillance du Secteur Financier (CSSF) in Circular 03/95, which defines minimum requirements for the issuance of Lettres de Gage and maintenance and control of the cover register and assets. The requirement of transparency for cover pool and valuation principles "renewable enery" are defined by CSSF (see Circular CSSF 18/706 „Transparency requirements based on Article 12-6 (2) of the Law of 22 June 2018“ and Circular CFFS 18/705 „General valuation principles, introduced by the Law of 22 June 2018, to be applied for the determination of the fair value of renewable energy assets that are eligible assets for the cover pool of covered bond banks“).
Lettres de Gage issuers (Banques d’emission de lettres de gage) have to be credit institutions with a specialized bank license, which implies a restricted range of activity. The bank’s principal areas of operation are limited to public sector financing, mortgage lending, granting of loans collateralized through tangible real estate rights or granting loans to credit institutions, which are members of a system of mutual guarantee or "durch dingliche Rechte oder dingliche Sicherheiten an beweglichen Vermögenswerten oder Grundstücken, die sich auf der Erzeugung erneuerbarer Energien dienende Werte beziehen, und durch Rechte auf Ersetzung in den maßgeblichen Projektverträgen besichert sind". The specialized bank license includes the privilege to issue covered bonds stipulated by the Luxemburg law – named Lettres de Gage (Art. 12-4, No. 3). The issuers may only engage in other banking resp. financial activities if these activities are accessory or auxiliary to their main business.
The issuer grant covered bond holders preferential access to certain assets pledged as collateral for the claims. Depending on their character these covered assets are being held in separate registers on the banks balance sheet. The register is divided in as much independent parts, as different categories of Lettres des Gage exists:
All obligations arising from Lettres de Gage are direct and unconditional obligations of the issuer, which have preferential rights before tax, employees etc. In the unlikely case of the issuer’s insolvency the law prescribes a certain procedure, which is dedicated to secure the preferential rights of all covered bond holders. Therefore all assets and derivatives registered in the cover pools are segregated by law from the general insolvency estate of the issuer. As a consequence outstanding Lettres de Gages and registered derivatives will not become due following the insolvency of the issuer but maintain their legal maturity. There is no direct legal link between a particular single asset in the cover pool and an outstanding Lettres de Gages. Interest and principal payments of outstanding Lettres de Gages of the same category (including registered derivatives) are jointly backed by all assets in the respective cover pool and rank pari passu to each other, irrespective of their issue date.
The cover register is managed by the issuer and consistently monitored by the special auditor (Réviseur d’entreprises agréé spécial). The special auditor is obliged to immediately inform the supervisory authority CSSF about any irregularities and to provide an annual report containing the activities and statements. As soon as registered, any asset or derivative product in the official cover register forms part of the cover pool. Without explicit written approval from the special auditor no asset or derivative instrument can be removed from the cover pool.
The cover pool underlies dynamical changes and is actively managed by the cover pool management team of the issuer in order to sustain its high quality. Measures involve the substitution or removal of deteriorating cover assets, whereby all transactions and changes are closely monitored by the special auditor.
Principally, there are five asset classes: public sector exposures, mortgage collateralized loans, loans collateralized through tangible real estate rights and loans to credit institutions, which are members of a system of mutual guarantee, loans financing renewable energy. For each asset category the Luxembourg Covered Bond Law shapes strict specifications. The eligibility criteria of public assets and renewable energy assets will be highlighted below.
Eligible cover pool assets for Lettres de Gages Publiques are determined in Art. 12-1 and 12-3 of the Financial Sector Act from 5 April 1993 as well as in the initially specified amendments and are defined as:
"Public authorities" within the meaning of Art. 12-3, No. (2c) refers to:
whereby the definition of "state" includes each state’s institutions or bodies, the central governments, the regional or local authorities, the other public authorities and the other public bodies or undertakings.
"Public undertakings" within the meaning of Art. 12-3, No. (2d) defines any undertakings or companies, over which the state or other regional or local authorities may directly or indirectly exercise a dominant influence by virtue of their ownership of it, their financial participation therein or the rules which govern it. A dominant influence on the part of the public authorities shall be presumed when these authorities, directly or indirectly in relation to an undertaking
In each of the aforementioned cover pools, the ordinary cover assets may be replaced of up to 20% of the nominal value of the covered bonds in circulation of the same category by substitute cover assets consisting of:
Amendment of “Lettres de Gage” law as of 22 June 2018 adopts the legal definition according to EU-Regulation 2009/28 Art. 2 (a) for “Renewable Energy” in local law.
Excerpt for the Luxembourg “Law of 5 April 1993 on the financial sector”, Art. 12-3, para. 3 f) ff:
Nominal and present value of cover assets (Art. 12-5, No. 5)
The nominal amount and the net present value of the cover assets of the relevant cover pool must at any time equal at least 102% of the nominal amount of the covered bonds of the same category in circulation.
Interest revenue of cover assets (Art. 12-5, No. 5)
The cover assets of the relevant cover pool must provide total interest revenue at least equal to the amount of interest of the covered bonds of the same category in circulation.
180 day liquidity (Art. 12-5, No. 5)
Availability of liquid assets at all times to cover the cumulative net outflows of the covered bond program over 180 days.
Inclusion of hedging derivatives (Art. 12-5, No. 5)
In order to ensure the full coverage of principal and interest for covered bonds in circulation, the issuer must take appropriate measures and can, in particular, use forward financial instruments (derivatives). Assets resulting from these measures must be enclosed in the relevant cover register as required by law. The sums payable according to these measures, after set-off if necessary, benefit from the same preferential right as the Lettres de Gage holders. (Art. 12-8)
Substitute cover asset limit (Art. 12-5, No.4)
In each of the cover pools, the ordinary cover assets may be replaced of up to 20% of the nominal value of the covered bonds of the same category in circulation by substitute cover assets.
Regulatory disclosure requirement (Art. -12.6, No. 2)
Issuers are required to publish certain information about the structure and quality of each cover pool and it’s outstanding Lettres de Gages on a regular basis, defined by CSSF.
Special auditor (Réviseur d’entreprises agréé special) (Art. 12-7)
The special auditor has to be different from the company auditor who audits its accounts and is appointed by the CSSF on proposal by the issuer. The special auditor continuously monitors the adherence to the aforementioned cover pool standards as well as signing and unsubscribing of assets. For the adherence of the legal requirements and for the documentation of with the Lettres de Gages evidenced bankruptcy privilege of the covered bond holder the special auditor has to sign every new issue additionally to the issuer.
Covered bond bank with limited business activity (Art. 12-9 to 12-10)
In case of a bankruptcy of a covered bond bank the assets and derivatives products registered in the cover pools are separated from the other assets and liabilities of the bank, whereby each category of cover pool forms a special estate (compartments patrimoniaux). The special estates will be run and managed as a covered bond bank with limited business activity by a qualified trustee, appointed by the responsible insolvency court. As the covered bond bank with limited business activity remains solvent and continues the covered bond business in respect to the outstanding Lettres de Gages, it is bound to the legal regulations and reporting requirements for covered bond banks and subject to banking supervision by CSSF. The management of the special estates by the trustee is furthermore carried out independently and solely in the interest of the covered bond holders. The trustee is empowered to issue new covered bonds for the account of the covered bond bank with limited business activity, dedicated to the relevant cover pool category, and to engage in open market operations carried out by the European Central Bank.
Deferral of payments of a special estate (Art. 12-11)
In case a special estate of a covered bond bank with limited business activity is in danger of insolvency or default, a deferral of payments can be adjudicated on request of the CSSF.
Closure and Liquidation of a special estate (Art. 12-12)
In case an adjudicated deferral of payments has not proven to be sufficient enough to archive the solvency of a special estate of a covered bond bank with limited business activity or its solvency is finally conceivable in danger, a closure and liquidation of the special estate can be adjudicated on request of the CSSF.