|Covered bonds gain interest after GSE takeover (October 2008)|
How this successful European tool can help U.S. rebound.
By Jerry Marlatt, a partner with Clifford Chance U.S. LLP. The author was involved in the first issuance of a covered bond in the United States.
In connection with the recent troubles surrounding Fannie Mae and Freddie Mac, there’s been a good deal of discussion about finding alternative forms of liquidity for the U.S. residential mortgage market. The U.S. Treasury has said it wants to shrink Fannie and Freddie by 10% annually beginning in 2010—from a high of $850 billion to a mere $250 billion. Naturally, the question on everyone’s mind right now is, “How do you replace more than a half a trillion dollars in funding?”
One idea that has a track record worth looking at is covered bonds, a financing vehicle Europe has used successfully and safely for a long time. U.S. Treasury Secretary Henry Paulson convened a meeting in Washington this June to ask what steps could be taken to stimulate the growth of a covered bond market. This was followed in July by issuance of the Treasury guide, “Best Practices for Residential Covered Bonds.”
Covered by the pool, not the bank
A covered bond is basically a corporate bond issued by a bank and secured by a dynamic pool of residential mortgage loans. Importantly, new mortgage loans are added to the pool every month as old loans pay down or default. Unlike the mortgage-backed bonds issued by savings and loans in the 1980s, a covered bond has its maturity date protected. In the event of the insolvency of the issuing bank, it is intended that the pool of collateral “covering” the bond will provide sufficient funds to continue to pay the outstanding bonds through their maturity date. The bonds are not accelerated and paid off upon the insolvency of the bank.
Covered bonds originated almost 250 years ago in Prussia as a means to finance rebuilding following a war. With the integration of the European financial markets in the 1990s and the introduction of the Euro, the market for covered bonds exploded. In Europe, there are no equivalents to Fannie Mae and Freddie Mac. Nor is there a Federal Home Loan Bank System. As a result, covered bonds developed as significant private-market means of financing residential mortgages. Today there is more than $3 trillion in covered bonds outstanding in the European market—equivalent to about 60% of the financing currently provided by Fannie and Freddie in the U.S.
Generally, European covered bonds are provided for in specific statutes that enable the pledged mortgage loans to be “ring-fenced.” In the event of the insolvency of the issuing bank, the cover pool is separated from the other assets of the failed bank and held for the benefit of the covered bond investors and used to pay the bonds.
Because covered bonds are issued by regulated entities and are also secured by high quality collateral, they are viewed as being in the same category as sovereign and agency bonds.
Two key differences here
Washington Mutual was the first U.S. financial institution to originate a covered bond when it issued four billion euros of covered bonds in September 2006 in Europe. This was followed shortly by a four billion euro offering by Bank of America in April 2007. Both banks issued subsequent series of covered bonds, including the issuance by Bank of America of a dollar-denominated series in the U.S.
There is no statute in the U.S. to enable the issuance of covered bonds, so U.S. banks utilize the techniques of securitization to issue what are referred to as “structured” covered bonds. The other significant difference in U.S. covered bonds is that upon the insolvency of an issuing bank, the collateral pool is monetized—either through a repudiation payment by the FDIC, or through a liquidation of the cover pool by the bond trustee. This has the effect of introducing market risk and reinvestment risk into U.S. covered bonds, as the proceeds need to be reinvested by the bond trustee until maturity.
The GSEs still dominate
While covered bonds have been highly successful in Europe and some are proposing covered bonds as a solution to a broken mortgage finance market in the U.S., there are many skeptics.
There are several factors that will influence the growth of covered bonds as a significant alternative means of finance for mortgage loans. When asked, a great many banks say they intend to finance their residential mortgage loans operations through Fannie Mae, Freddie Mac and the FHLB. That’s not surprising, really. Because of the implied (now explicit) government guarantee, no private financing source—including covered bonds—can finance loans as cheaply and efficiently as the GSEs. Certainly, a substantial reduction in the role of Fannie and Freddie would promote covered bond financing. As mentioned earlier, there are proposals to do that. However, this is a politically charged plan, the fulfillment of which will depend on the outcome of the Presidential election and the next Congress.
Three factors could promote change
There are several other factors that will also influence the reliance on covered bonds by U.S. banks. The first is the changing accounting environment.
Current proposals will make it more difficult for banks to obtain capital relief through the accounting sale treatment that has been available with residential mortgage securitization. In the future, these securitized mortgage loans are much more likely to remain on the bank’s balance sheet. That means one of the disadvantages of covered bonds—that the cover pool is retained on balance sheet—will be largely eliminated.
Bank capital rules are also changing. Under the proposed new rules that would implement the Basel II international capital standard, the capital to be held against residential mortgages would decrease from 100% of the standard capital charge to 50%. (See page 46.) This change will make it easier to retain mortgage loans on balance sheet, facilitating financing through covered bonds.
The regulatory environment is also likely to change in response to the perceived evils of the “originate-to-sell” banking model.
That model is viewed as lacking the necessary discipline in the underwriting process, resulting in the huge losses from subprime mortgage loans. It is proposed that banks should be required to retain some form of interest in the mortgage loans they sell to induce them to apply higher underwriting standards.
A substantial retained interest, however, is likely to make it more difficult to obtain accounting sale treatment even under the existing rules. Securitized mortgage loans would therefore remain on the balance sheet, subject to the bank’s capital requirements. Since cover pools for covered bonds have to be on the bank’s balance sheet, this change would eliminate a competitive disadvantage for covered bonds.
A conduit would help
The covered bond market in Europe is largely a jumbo market with typical issuances of one billion euros, providing a liquid secondary market for investors. Small to medium sized U.S. banks are unlikely to be able to issue in this size. But a pooling technique has been developed in Spain for the issuance of covered bonds by smaller banks through a conduit issuer. Some form of conduit issuer has been posited for the U.S.
Whether the conduit issuer in the U.S. would be a private bank or a government agency remains to be seen. Perhaps this could be a useful role for a restructured Fannie Mae or Freddie Mac.
Early resolution of the future role of Fannie and Freddie would certainly assist the development of a covered bond market in the U.S. Capital relief for U.S. banks investing in covered bonds would also help. Consider that European banks are only required to maintain half the capital against a AAA covered bond that they would be required to hold against an unsecured AAA bank obligation. It makes sense that a secured bank obligation should attract less capital.
More reaching yet would be statutory protection for the cover pool, similar to European legislation. If the cover pool could simply be set aside for payment of outstanding covered bonds, the market risk and reinvestment risk in current U.S. covered bonds would be eliminated. That would present a much simpler investment story, and the bonds would be less gimmicky. BJ
The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj1008/index.php?startid=12
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