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Thursday, 14 December 2017

Missed opportunity?

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The push towards establishing a covered bond market in the US has gathered pace. Despite the absence of covered bond legislation in the financial reform bills that came out of the House and the Senate this year, the securities have a lot of devotees in the US. Meanwhile, Yankee issuers have picked up the slack until domestic issuers get in gear. Timothy Sifert reports.

 The fate of covered bond market for domestic US issuers seems to be in the hands of politicians. All eyes have been on Capital Hill, as congressmen hammer out the final version of the much-anticipated (and much-critiqued) financial reform bill, which could hit the president’s desk in July.

A notable absence from either of the bill’s two current forms is any mention of covered bonds. For a package of legislation that purports to correct the mistakes that led to the credit crisis, the exclusion of covered bonds language is an unnecessary and costly oversight, said bankers and lawyers.

Without a covered bond law there is very little chance any US-based banks will issue the securities, even as Canadian and European issuers are finding the US investor base keen to diversify into these securities. That would be a shame: covered bonds are a safe way for banks to raise cheap capital using pools of mortgages as collateral. Indeed, European firms in particular have been enjoying the benefits for centuries.

Legal ease

Domestic banks are loath to issue covered bonds without a clear legislative framework in place. Investors don’t feel very comfortable either, amid concern about insolvencies at issuing banks. It is still unclear what would happen to the covered bonds if an issuer became insolvent and was seized by the FDIC.

A new law is necessary to put the major players in this nascent market at ease.

On March 18 2010 Republican Scott Garrett introduced a covered bond bill to address insolvency risks, among other things. It was the fourth incarnation of the bill he has introduced since the start of the credit crisis. By most accounts the United States Covered Bond Act of 2010 is exactly what is needed, a statutory framework that would get the domestic issuance underway.

Under the proposed legislation, the Secretary of Treasury would serve as the covered bond regulator. It would approve bond programmes and run an issuer registry. The legislation takes the concern for insolvent issuers head on, as well. If an issuer enters into bankruptcy or conservatorship the FDIC takes control for 15 days and has to meet all obligations with respect to the bonds. During that time it can seek out other private entities to assume the bonds and the covered pool. After that time, if no buyer is found, the regulator becomes the trustee of the covered pool estate. It would then make payments to investors and manage the pool as if it were the issuing bank. 

Investors should be able get on board with this comprehensible post-insolvency process, bankers said.

Many politicians have overlooked the legislation, lately, characterised by its omission from the financial reform bills. Bankers, lawyers and investors that have supported the legislation were sorely disappointed.

At present, the two bills must be reconciled before a uniform piece of legislation can be signed into law. Covered bond legislation could be added to the final bill during this process of reconciliation, which will take place late June.

“If the covered bonds language is included I’m optimistic that it would be one of the few aspects in the reform bill that does anything positive to promote the availability of credit to the markets,” said Congressman Garrett. “Most of the bill does just the opposite: it restricts businesses. The covered bonds language will be the silver lining.”

However, whether the legislation will find its way to the president’s desk is anyone’s guess, despite its support on Capital Hill and Wall Street. “The political smoke is really quite difficult to penetrate,” a banker said. “I think they are minded to do this. In what shape or form we don’t know. Everyone’s waiting for the politicians to get on with it.”

Before the recession was in full swing the US government was a staunch advocate of a covered bond market. At that time there had only been two domestic trades, from Washington Mutual and Bank of America. However, developing the market was seen as an important tonic to America’s mortgage woes – particularly in the residential housing market. By allowing mortgage-lending banks to issue bonds collateralised by a covered pool of mortgage assets, they hoped to lower the cost of mortgage financing.

The credit crisis destroyed hopes of a quick emergence of such a market. Investors weren’t interested in new securities, nor could issuers, stricken with their own liquidity issues, be bothered to tout them. The crisis even stymied the long-standing European covered bond market, which is only now in the middle of revival.

The US market looks ready for one, too.

“What has happened since [about 2007] was a bit of sea change. People have reassessed risks. We’ve started to present covered bonds as a rates product,” said Tim Skeet, head of covered bonds at Bank of America Merrill Lynch. “For the first time in a while investors are looking at the product afresh.”

Oh Canada

US issuers have been heartened by the success of Yankee banks so far. If nothing else, it proves that under the right conditions local investors are interested.

Bank of Montreal, for example, priced its first ever US dollar covered bond on June 2. Barclays Capital, BMO, HSBC and Morgan Stanley were joint books. The US$2bn offering of 2.85% five-year notes printed at pay to yield Treasuries plus 72.3bp or mid swaps plus 39bp. It was the tight end of guidance.

The Triple A deal is collateralised by a covered pool of Canadian Mortgage and Housing Corp mortgages.

It was the fourth covered bond to tap the US dollar market this year, all of them from foreign issuers. CIBC was first to market. It priced a US$2bn three-year offering in January, also backed by CMHC, Canada’s national housing agency. Following CIBC, Royal Bank of Canada and France’s CoFF priced deals in April.

“Domestically the market is still waiting for things to happen,” Skeet said. “The international market is where we got the ball rolling. The Canadians have done well. US investors are very comfortable with Canada.”

However, the success of Canadian deals doesn’t necessarily spell success from US counterparts. Canadian banks weathered the housing crisis much better than firms in the US or Europe. That has afforded Canada-domiciled credits, covered bonds issuers or not, notoriety with US investors.

Of the four deals that priced the one exception is, of course, France’s Compagnie de Financement Foncier. It priced a US$2bn 2.125% three-year deal on April 15 at plus 55.65bp. The issuer was France’s national mortgage bank, and the bonds were issued under legislation put in place in 1999. That it was a European deal – and therefore riskier – and the subject of recent legislation made it a better barometer for the US market’s potential.

CoFF finished wide of the Canadian deals, as expected. But investors were no less eager to get a piece of the credit.

“We have seen some US dollar covered bond issuance, and it is our expectation that there will be more. Hopefully the new transactions will be well received and lay the groundwork for future domestic issuance,” said Ben Colice, head of covered bond origination, Americas, at Barclays Capital.

Most potential market participants are like minded. They also realise that covered bonds would benefit the overall housing market. By allowing banks to use pools of mortgages that they keep on their balance sheet as collateral, it would increase safe mortgage lending.

“Covered bonds are not a 100% solution,” said Jerry Marlatt, an attorney at Morrison & Foerster in New York. “But they’re a financing apparatus that would benefit banks and the mortgage market. If you have them in place they would also take some of the pressure off Fannie and Freddie. It’s a win-win all around. So, why don’t you do it?”

Legislation aside, the fledgling covered bond market has several other challenges. There needs to be an infrastructure to ensure liquidity and investors need to be better educated about the security. In addition, there needs to be trading systems, indices as well as legal modifications for some investors to allow them to invest in covered bonds. It is not as simple as getting covered bond legislation in the financial reform law, bankers and lawyers point out.

On the other hand, having legislation is necessary. And if politicians ignore covered bonds while they’re working on reconciling the two bills this month, it stands less of a chance next time around.

“If it isn’t included in the financial reform it seems to me we’re starting all over again and with zero momentum,” Marlatt said.  

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