Back on track?
After a hiatus during the credit crash, the momentum towards creating a covered bond market in the US has picked up again. Potential issuers, investors and dealers are discussing the future of the asset class, but several questions, related to structure, liquidity and default, still remain. Timothy Sifert reports.
Before the global economic crisis hit its peak, the Treasury and the FDIC were advocating a vibrant US covered bond market. At that time there had only been two deals, but expanding the market was seen as an important fillip to the US residential housing market. By allowing mortgage-lending banks to issue bonds collateralised by a covered pool of mortgage assets – a structure similar to RMBS – they hoped to lower the cost of mortgage financing.
The plan was overtaken by economic events and the idea of fostering a relatively untested asset class became untenable, at least temporarily. Even the market for covered bonds in Europe, a natural benchmark for its development in the US, lost steam. The US market couldn’t grow in that environment.
The return of more stable liquidity levels, and the boom in the bond market, has encouraged potential covered bond issuers, investors and dealers to consider the securities again. Several hurdles remain, but there is a new confidence that the market will take shape soon.
"Globally there is a lot of excellent momentum on covered bonds," said Ben Colice, head of covered bond origination, Americas, at Barclays Capital in New York. "For some time, banks were focused on staying solvent and remaining in existence. Now they're starting to shift their focus to longer-term funding, which has led them to re-examine covered bonds."
A lot of groundwork was done in preparation for growth. Last July the FDIC approved a final policy statement, providing bondholders fast access to collateral if the FDIC declined to step in to meet the liabilities of an issuing bank in the event of a collapse. The US bond industry never tested the new guidance. Also in July, the US Treasury published best practices for residential covered bonds, while the Securities Industry and Financial Markets Association created the US Covered Bonds Traders Committee.
In December, SIFMA and the American Securitization Forum created the US Covered Bonds Council to help the development of market policies and practices to foster public confidence in the securities and lobby policymaking bodies.
But some fundamental questions remain before issuers, dealers and investors chart a clearer course for the market. Investors require more transparency on how the FDIC, whose mandate is to support depositors, will respond in a failed bank scenario than was provided last July. It set a precedent in September when Washington Mutual collapsed, and the FDIC said that JP Morgan had acquired “the assets and most of the liabilities, including covered bonds and other secured debt, of Washington Mutual Bank from the FDIC as receiver for Washington Mutual Bank". Some investors believe WaMu’s situation was a relative anomaly and call for more clarity. It’s unclear whether US legislation would follow the lead of Europe.
Some investors have further concerns about relative value. Because issuance has been sparse, they do not know how to value covered bonds. Investors have dual recourse: to the issuer and the pool over covered assets. (RMBS differ in that investors have recourse only to specific assets.) There is some confusion regarding how to value that compared to risk from a bank’s senior credit, as well as other securities in the wider market.
In January the FDIC recently made a further mention of its strategy to develop covered bonds, in what was one of the last utterances to be made on the subject. Buried in a press release about support for Bank of America as it acquired Merrill Lynch was a comment that it was considering extending the very successful Temporary Liquidity Guarantee Program from three to up to 10 years. It said it would only do this “where debt is supported by collateral and the issuance supports new consumer lending.”
It was later understood that this structure was specifically being considered to pave the way for a covered bond market, which would support consumer lending. However, the originally constructed TLGP was such a success that banks are no longer relying on it for finance, so the transition from TLGP to covered bonds never materialised.
There is still work to be done. "While there are certainly issues that must be resolved before this can becomes a sustainable market in the US, the potential funding source is highly attractive to banks," said Colice.