Coming to America
Issuing a record US$30bn in covered bonds, the US market became the talk of the covered bond town in 2010. But while Canadian and European banks continue to dominate issuance activity, the fate of covered bonds for US domestic issuers still hangs in the balance. Rachelle Horn reports.
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US banks are among the world’s largest users of capital market funding. But in the world of covered bonds they are minnows, accounting for less than 1% of a €2.4trn pie. To date, only two US lenders have offered covered bonds. Washington Mutual made its debut in 2006, and Bank of America followed shortly afterwards in 2007. A domestic asset class has since failed to gain traction because there is no legal framework in the US comparable to those found in Europe. The non-law based structure used by US banks previously is now less favoured by investors and subsequently more expensive for potential issuers.
Besides, originators had a number of relatively cheap alternative funding sources already available. However, since the last US covered bond was issued by Bank of America before the onset of the credit crisis, the securitisation market has been in a virtual state of paralysis. The ongoing bailout of Fannie Mae and Freddie Mac has left the US taxpayer with a US$150bn bill.
The future of Fannie Mae and Freddie Mac – a matter of great importance to investors, borrowers, US taxpayers and the housing market in general – has recently been the subject of much discussion. In February, the Treasury announced that the mortgage giants – known as government-sponsored enterprises, or GSEs – would be gradually wound down and replaced by private capital under three possible scenarios.
One of these proposals includes privatising the housing finance system, limiting government-guaranteed mortgages to the Federal Housing Administration and the other housing programmes targeted to creditworthy low-to-moderate-income borrowers.
The report also stated that the Treasury will also work with Congress to consider additional means of advance funding for mortgage credit, including the potential development of a covered bond market.
While any real reform will be years in the making, the rhetoric from the Obama administration was clear in its objectives: “The GSE model is dead,” an Obama administration official told reporters as the Treasury Department released the report.
Overtaken by events
Experts agree that the US market needs a statutory framework to develop a covered bond market. Previous regulatory efforts included the US Treasury’s best practices and the FDIC’s Financial Policy Statement on covered bonds. Both were devised in 2008 and, though well received, were soon overshadowed by wider capital market disruptions and went on to fail.
Hopes of a timely implementation of the US covered bond law were dealt a further blow in 2010 when US lawmakers excluded the covered bond legislation from the financial-regulatory reform bill. Advocates of the US covered bond legislation at the time were hopeful that a separate bill could be passed by the end of 2010, but this failed to materialise.
Despite the false starts, expectations are high that covered bond legislation will finally land on the US Present’s desk imminently. The initiative should derive some impetus from the fact that politicians on both sides of the aisle are striving to develop this asset class that so popular in Europe.
On March 8, US Congressman Scott Garrett and Congressman Carolyn Maloney introduced the covered bond act of 2011. This act was later approved by the House Capital Markets Subcommittee, but hurdles still need to be cleared as it makes its way through the Full Committee, the Full House and Senate.
Most notably, The FDIC has raised concerns that, in its current form, the legislation could put its bank deposit insurance fund at increased risk as investors of covered bonds would have priority in the event of a bank’s failure. During a hearing on the Garrett legislation on March 11, 2011, the FDIC stated that the bill fails to maintain the important balance between investor protection and government exposure.
At the mark-up, Democrat Maxine Waters suggested five amendments that address the FDIC’s concerns, including one to cap the amount of covered bonds one bank can issue and one that would limit the over-collateralisation. Waters withdrew these amendments after Garrett agreed to address these concerns before any full mark-up.
Amid a continuing decline in US agency paper issuance, sales of Yankee covered bonds reached an all-time high in 2010 at over US$30bn. Most market participants agree this could double in 2011. With five-year Canadian covered bonds offering roughly 25bp pick-up versus agency debt and European covered bonds offering somewhere in the region of 50bp, the potential appeal for the product is clear.
“There are significant gains to be had,” said Anne Daley, a managing director in Barclays Capital’s investment grade syndicate. “And with a declining volume of Triple A rated paper from the US agencies, it’s difficult to ignore covered bonds.”
Based on the success of Yankee covered bond issuance, many industry participants believe that the potential for covered bond issuance by domestic banks is significant.
“The problem, however, is that there has not been enough supply at this point to convince the market that this is a viable alternative,” said Daley. That it’s not for a lack of interest from buyers, he added. “The development of a US covered bond market will be very important in this respect.”
Gibson Smith, who is responsible for Janus Capital Management’s fixed-income strategy and oversees US$15.3bn in assets, has also thrown his weight behind the debt instruments. “I think they make a lot of sense,” Smith told Reuters in an interview. “Having collateral behind you is a good thing. We would be interested in buying them.”
If the US securitisation market does not revive its fortunes it could pave the way for covered bond issuance to grow, Smith added.
Taming the detractors
With the support that the first bill had garnered, significant industry support and the potential for adding a valuable tool for recovery, the stage is set for the emergence of a US covered bond market. “But while there is wide governmental and industry support for the act, there are still challenges and detractors,” warned Claire Mezzabotte, managing director at DBRS.
While four out of the five witnesses testifying before the Financial Services Committee in March came out in support of the act, one witness, Stephen Andrews, a community banker with the Bank of Alameda, dissented. He cited concerns that such a program would disadvantage smaller and community banks. With fewer banks competing, this would lead to higher costs of financing for borrowers, he argued.
Covered bond supporters have been quick to dismiss this argument as a misunderstanding of the product. Smaller European banks have used the product effectively in the past through multi-issuer covered bonds, they said.
Brad Brown, a managing director in Bank of America’s corporate treasury group – one of only two US banks to have an established covered bond programme – said that the firm supported the development of a covered bond market domestically.
“As a potential issuer, our view is that covered bonds provide an attractive private, stable and diversified funding source for issuers that promote transparency, underwriting discipline and quality liquidity to the credit markets,” he said.
However, a funding official at a competing US bank recently questioned the level of enthusiasm for covered bonds in the US, absent a law, with GSEs still such an important part of a US bank’s business. “This lack of support also translated to within our organisation,” he said. “Our view is that without an acceptable legislation in place, covered bonds, from a credit perspective, would be too expensive.”
While many market participants are interested in the possibility of a functioning covered bond market in the US, activity will likely be constrained since covered bonds remain on the banks’ balance sheet. FDIC currently limits covered bonds to 4% of a bank’s total liabilities.
With regard to timing, even without opposition, observers do not expect the legislation to be implemented in the intermediate term. Following the full mark-up, the next big step will be to see what Senator Charles Schumer produces in the Senate, where lobbying by the FDIC could continue to play out. Few expect any covered bond issuance to materialise before a law is in place. That will likely put issuance by US banks to next year, at least.