More countries get in on the action

It has been an interesting year for covered bonds. While few asset classes outside commodities have flourished in the current market conditions, covered bonds on aggregate have enjoyed relatively good performance. This has ranged from being among the least bad performers in the credit universe in some of the newer covered bonds markets – such as Spain and the UK – to delivering very good returns in absolute terms in some of the more established markets – like Germany and France. This has attracted considerable new attention to the sector from players on both sides of the net: issuers with no history in covered bonds have been bringing deals to market, with a number of inaugural issues – often from new markets like Italy – coming in 2008. Meanwhile, investors have been turning their attention in increasing numbers to an asset class that promises to outperform in difficult times. There has been much debate as to where these investors are coming from – or, more accurately, whether the rise of covered bonds will be offset elsewhere as investors turn their backs on other asset classes. RMBS is one of the most obvious comparisons to make. Many people argue RMBS has been discredited, and that the asset class is set for terminal decline, in which case an argument can be made that covered bonds make a natural replacement. This is, however, an oversimplification. As our article comparing covered bonds with structured products (page 20) outlines, the similarities between the two products do not extend much further than the mortgages underlying them. There are, in fact, significant differences between them and their risk profiles, a product of their structures (covered bonds tend to be structured as bullets while RMBS transactions amortise) and the recourse to the issuer provided by covered bonds. This accounts for the differences in the types of investor the different markets have traditionally attracted – and are likely to continue to attract. Yet undeniably covered bonds have looked increasingly attractive relative to a number of other sectors and it is obvious that the product's success as an asset class has, to some extent, been at the expense of a number of other credit products. It has not been all plain sailing. The industry faces a range of challenges, particularly pertaining to the wide disparity between markets – not only between those that already exist, but, even more challengingly, between those just emerging now or planning to emerge in the foreseeable future. Many of these differences are based in cultural and legislative traditions and will be difficult to change, while others may be ironed out to create something a little more standardised from the patchwork quilt of markets which acts as a barrier to entry for some investors. The other headline-grabbing challenge for covered bonds has been market making, which broke down as market volatility increased. The system is yet to be adequately fixed, although much attention has been given to this problem by regulators, investment banks and trading technology providers. Considering these obstacles, the big question is whether covered bonds can live up to their hype.

The European Covered Bond Council (ECBC) was formed by the European Mortgage Federation (EMF) in November 2004. It has over 90 members from 16 different European countries, covering many different market segments. The group claims to represent around 85% of all covered bond issuers.According to the ECBC, the onset of the credit crunch has exacerbated a number of fault lines that had started to appear in the patchwork of the international covered bond industry.As the problems tightened their drip on the global economy, the ECBC’s response was to form the 8-to-8 Issuers and Market-Makers Committee, bringing together the eight biggest issuers from the eight largest covered bond issuing countries, with the eight investment banks comprising the industry’s market-making community.The committee is illustrative of the modus operandi of the ECBC, which has set itself up as a forum for the different players in the industry to discuss various issues. Besides the 8-8 Committee, since inception the ECBC has created six working group committees which represent the main challenges and issues it has identified as issues the collective covered bond industry needs to address: EU Legislation, lobbying the European Commission, Council and Parliament; Technical Issues, looking at things such as the use of derivatives in the covered pool; Statistics and Data, responsible for publishing market data on the industry; Covered Bond Fact Book, responsible for communicating developments in the industry; Rating Agency Approaches, which monitors the treatment of the industry by the rating agencies; and Market Related Issues, assessing problems like those around market making – the committee that has seen the most publicity since the credit crunch took hold.The most pressing single issue facing the industry – one that is touched upon by several of the committees – is the need to repair the secondary market, principally by restoring confidence through the creation of a stable market-making practice, to support transparency and liquidity and support the primary market, according to Luca Bertalot, head of the ECBC.Another issue at the heart of the ECBC’s work and running through that of all its component committees is the lack of standardisation, let alone harmonisation, in the various national covered bond industries constituting the global market. “Covered bonds are a very European product, and there is a long tradition in the different countries – such as Pfandbrief in Germany, Realkreditobligationer in Denmark, Cédulas Hipotecarias in Spain and Obligations Foncières in France,” said Bertalot.This has led to differences that predate the more recent efforts of European financial integration, for example in the legal framework underpinning the mortgage market, which in some countries is based on common law, and in others in court legislation. Such differences will only grow more pronounced as the covered bond industry gains traction in more countries.Monitoring the developments of the covered bond industry in countries where it has not existed traditionally is a key function of the ECBC. Japan and the US are embryonic covered bond markets that look set to grow considerably over the coming years. But there is also activity in other markets from Mexico to Azerbaijan.In order to maximise harmony in an industry already suffering its share of discord, the ECBC cannot simply observe and document the progress in different countries; it has been working together with US institutions like Washington Mutual and Bank of America to help them develop something compatible with what already exists in Europe.Notwithstanding the problems the ECBC has wrestled with, covered bonds have fared reasonably well, compared to many other asset classes, said Bertalot. The case can be made that the credit crunch has strengthened the position of the industry, relative to other markets like securitisation. The covered bond industry is in a position to fill at least part of the vacuum left

Global financial problems have ensured issuers have reined in their impulses to deliver increasingly innovative covered bonds in recent months. There is a prevailing mood of conservatism in the market. The credit crunch has frightened investors, driving them to become more risk averse and encouraging them to invest exclusively in securities they understand.That investor sentiment must be seen in light of many experiencing what they had not previously envisaged, even as a worst case scenario: the collapse in value of Triple A structured credit investments and the sudden disappearance of liquidity in the structured markets.Covered bonds are a relatively simple product – especially when compared to the structured credit instruments fashionable just a year ago – and that has drawn new investors to the sector."Although the covered bond market has not entirely escaped the problems affecting the credit markets over the past year, investors are aware of their flawless payment record since they were first introduced in 1769," said Ted Lord, head of covered bonds at Barclays Capital. It is certainly true to say that the covered bond market was affected by the credit crunch. The market effectively shut down for two months in February and March, when issuance dropped to virtually nothing, and year-to-date issuance is now approximately 30% down on last year as a result. But in April, issuance picked right back up again, with as many issues as in the preceding two months combined, and that improvement of market conditions has continued through May.The market is providing a particularly welcome alternative to issuers looking at different means of securing their funding, with some other markets closed and others ailing. Investors have been showing more interest in covered bonds – especially at the short end of the curve – as a period of underperformance relative to sovereigns has seen an increasing relative value trade between the two.Some investors have been selling their sovereign exposure to lock in the appreciation they have already seen in the expectation of enjoying a pickup of up to 40bps on covered bonds with maturities this side of 2012. For longer dated bonds, the pickup falls off rapidly.Certainly spreads have widened out dramatically over the last year. “Each new issue cycle is coming with slightly wider spreads,” said Heiko Langer, senior covered bond analyst at BNP Paribas in London. In the second half of May, Deutsche Postbank became another bank to price its covered bond weaker than expected, after guidance for the seven-year jumbo mortgage Pfandbriefe was set at mid-swaps plus 8bp area, with a coupon of 4.5%.“The pricing isn’t ideal but at least the market is open,” said Karen Naylor, managing director in the structured finance ratings group at S&P in London.Spreads being as wide as they currently are – at least partly a result of problems in the secondary market – is doing no harm to the appeal of covered bonds with new investors. Middle Eastern investors have joined the ranks of those showing some interest in recently launched products. Central banks have in increasing numbers added covered bonds to their benchmark indexes, said Lord. "The range of weighting can be anywhere from 10% to 26%, depending on the central bank investor, and this is a good sign for the asset class going forward."The increasing expense in spread terms of issuance is no longer deterring new issuers from coming to market with inaugural deals, of which there have been a good number already in 2008. For example Banco Santander Totta, Portugal’s fourth-largest banking group, launched its inaugural €1bn three-year covered bond issue in mid May. The deal, which was led by BNP Paribas, Morgan Stanley, Santander and UniCredit, was rated Triple A at an indicated spread guidance of 40bp–42bp over mid-swaps, before being heard half sold within an hour.Also in May, Bankinter's inaugural May 2010 Cedulas Hipotecarias was priced at mid-swaps plus 52bp by Barclays

Pfanbrief issuance in the first five months of 2008 totalled €19bn, versus €18.6bn for the same period in 2007. First quarter volumes of all covered bonds may have fallen 41% compared to 2007 levels, but stable issuance in April and May have put the market on a much more healthier path than three months ago, said Ted Packmohr, Dresdner Kleinwort’s head of covered bond research. “Before April the primary market was stop and start, now after stabilising somewhat, demand has been picking up as more investors are prepared to buy at current spreads,” he said.A re-pricing of the market in mid-April saw public sector (Öffentliche) and mortgage (Hypotheken) Pfandbrief spreads widen out up to 5bp by the end of May. In addition, a growing number of primary market transactions are being priced at significant premiums over outstanding bonds. On average Pfandbrief new issue premiums have widened to 5bp over mid-swaps, from about 3bp-4bp during the second half of 2007, and compared to 10bp for other covered bond markets, states one head of covered bond strategy. “Issuers accept they have to pay a significant premium to get deals done,” said Frank Will, senior strategist for frequent borrowers at Royal Bank of Scotland. Issuance has focussed on shorter-dated tenors with 60% of this year’s volumes in two- to three-year maturities, 29% between four and five years and only 11% at longer maturities. “Investor demand for shorter maturities is driven by yield, as they are able to get the same or better yield for a two-year maturity than a three-year or longer tenor,” added Will. Though the weighted average duration for jumbo covered bonds issued in 2008 has fallen to four years from 7.5 in 2007 and 8.2 in 2006, longer maturities were beginning to appear by May, said Franz Rudolf, head of financials credit research, UniCredit Markets and Investment Banking. Dexia Kommunalbank and Eurohypo launched 10-year jumbo Pfandbriefe, while Deutsche Postbank issued a seven-year transaction. “Eurohypo and Dexia Kommunalbank showed that there is still demand at the longer-end of the curve for Pfandbrief issuers,” said Will. “These transactions illustrate a return of the investor base for longer-dated paper which prompts more borrowers to look at other maturity segments,” added DK’s Packmohr. Two five-year deals particularly represent the impact that collateral can have on spread levels even within the German Pfandbrief market: Dexia’s public sector Pfandbrief priced at 9bp over mid-swaps and Eurohypo’s mortgage Pfandbrief priced at 13bp over. The Pfandbrief market has remained relatively stable compared to many peer covered bond markets due to a very supportive and loyal domestic investor base, which is hungry for paper: between 30% and 50% of new issues (not just Pfandbrief bonds) are being allocated to German portfolios.The supply demand imbalance caused by a shrinking Pfandbrief market is resulting in ever more pronounced spread levels between public sector and mortgage bonds. A 1bp differential in the middle of 2007 had widened to 5bp by May, and this gap could widen even further. March figures from the Bundesbank show public sector issuance fell by 17.4% in that time. One German bank strategist predicted volumes will continue to fall as many banks have seen their public sector business decrease over 2007. The mortgage Pfandbrief market has been shrinking by 10% year-on-year, though growth levels in the last year have remained flat. “We are going to see more supply of mortgage Pfandbrief, which have become a more attractive instrument in the past twelve months,” said the strategist. “A lot more borrowers are focussing their origination business towards assets that are eligible for Pfandbrief cover or enhancing existing loan documentation.” A number of debut borrowers have tapped the jumbo market, including Deustche Postbank, which launched its inaugural €1.5 billion five-year jumbo mortgage Pfandbrief in January and HSH Nordbank that issued the first ever

The implementation of a law to govern UK covered bonds can only be a good thing for the market. Investors have been battered by worries regarding a range of financial instruments, most of which are less transparent and more complex than covered bonds. This law provides them with some level of comfort in a stressed environment. For issuers, it offers another fundraising tool and, possibly, a wider investor base. Specifically, the new law brings UK covered bonds in line with the directive for the undertakings for collective investments in transferable securities (UCITS). It allows UCITS funds to buy more covered bonds from the UK, with an investment limit for regulated covered bonds set at 25%, compared to just 5% before. For insurers, the limit goes up to 40% – also from 5% previously. The risk weighting associated with UCITS-compliant covered bonds has been reduced to 10% from 20%.Bankers are optimistic the favourable conditions brought by the new legislation could inspire issuers and investors to come to market. Since the credit crisis blew up, investors have tended to see UK deals in the same light as Spanish and Portuguese ones. Spain’s Banco Sabadell reopened the local market by selling €1.5bn (US$2.4bn) worth of covered bonds in early May, even pricing within initial guidance at 53bp over mid-swaps. Since then, several other Spanish deals had also sold. Given the positive reception recent Spanish deals have been met with, bankers said the UK could see an offering of its own soon. Some have suggested the UK market could absorb a £2bn (US$3.9bn) jumbo.“Investors of the recent Spanish deals are the same ones who would have bought covered bonds before the crisis, which is incredibly encouraging,” said Mauricio Noe, head of covered bonds at ABN AMRO. “It shows that investors’ love affair with covered bonds hasn’t diminished. The spreads they are demanding are a fair bit wider but the fact is that the investor base remains solvent and still likes the product.”The fact that UK issuers are not rushing to the market could also indicate that worries about mortgage banks’ liquidity are unfounded. Bradford & Bingley, which already has a covered bond programme, has said it still has £2bn of undrawn secured facility, and is in no hurry to tap the market in current conditions. Its head of funding and capital markets, Mark Winter, added that while the legislation was positive, it made little difference to Bradford & Bingley for now.“Covered bonds under the new legislation may be seen as a safer buy by some investors because the bonds are underpinned by legislation but I’m not sure it’s going to have a significant impact for us because of our diversified investor base,” said Winter. “It may add a few accounts but I don’t think that is going to be material.”The fact that the UK housing and mortgage markets are facing their worst period in years is certainly not helping issuers. The value of houses fell again in May, and the mortgage market has also contracted as buyers stayed away. “The general concern which affects issuers such as those in the UK continues to be uncertainty over macro-level mortgage risk, not the (covered bond) programmes themselves,” said Rob Robinson of the covered bond syndicate at Merrill Lynch and former chairman of the UK covered bond standing group committee.Participants said regulators want to be able to react to the market in a dynamic way. As such, the legislation does not lay out a specific framework for issuers – as is the case in the German Pfandbrief market – but rather relies on a principles-based approach which allows regulators to assess cases on an individual basis. For example, it does not specify a minimum over-collateralisation limit. “The FSA is actually expecting to be able to address what is required on a case-by-case basis,” said Angela Clist, a partner at Allen and Overy who was involved in the drafting of the legislation. “It enables the FSA and issuers to work at the level that is relevant to t

For Caisse de Refinancement de l’Habitat (CRH) president director general Henry Raymond, the principal success of the €2.5bn (US$3.9bn) dual tranche covered bond transaction, launched in February, was in bringing many international accounts onto CRH’s books. Although CRH is the largest mortgage loan covered bond issuer in France, Raymond said the institution was not well-known enough to international investors, as CRH had not developed a marketing strategy until late 2006. CRH bonds provide safe haven assets for investors in the face of uncertain markets, Raymond stressed, because the institution is governed by a specific legal framework in France. The government established CRH in 1985 as an institution through which mortgage banks can raise funds. Legislation governs its operations and dictates the kinds of mortgages available as collateral to CRH, ensuring borrowings are backed by high-quality loans. CRH requires an over-collateralisation of 25%, backed by first-rank mortgage loans of not longer than 25 years, each not exceeding €1m. These stringent requirements allowed CRH to pull off its first-ever dual tranche offering in February despite issuing in a climate of extreme investor cautiousness.“For the market, it was a good deal,” said Raymond. “Notwithstanding the pricing and spreads in the market, it was important for the market to have in their assets sound, very liquid and straightforward bonds. Our bonds provide that.”In the February transaction, 80% of the €1.5bn three-year covered bonds were placed outside of France and 55% of the €1bn 10-year bonds were sold to overseas investors. The need for CRH to expand and diversify its investor base intensified in recent years as its funding programme grew rapidly, more then doubling in 2006 to €7.2bn from just €3bn the year before, and rising in 2007 to €8.3bn. This forced CRH to rethink its strategy and to wade into the international market for support.CRH took the decision to deviate from its typical strategy of issuing small taps to fund through benchmark transactions with a full market-making commitment. The February transaction was CRH’s third such benchmark deal, following a €2.5bn offering in September 2007, and another €1.25bn in January this year, which revived the French market for covered bond issuers. Raymond said CRH intends to continue issuing jumbos as long as the market has the appetite for them. He was unable to give an estimate for its funding needs this year as it depends on demand from banks, but suggested it could be bigger than last year’s.“We’re not sure how much we will borrow, maybe €8bn, maybe €10bn,” Raymond said. “It depends on market demand. If it’s possible for us to issue benchmarks, it would be more straightforward and clearer for investors. But if it’s not possible, we will go on issuing by tap.”Given that investors are currently reluctant to buy anything with a long tenor, CRH’s ability to place all of its 10-year bonds in February was a massive achievement. It can be partly explained by the fact CRH bonds have sufficient liquidity for investors to easily sell out of their accounts if required. Orders for the 10-year just exceeded €1bn, while those for the three-year surpassed the €1.8bn mark. According to Raymond, the turnover for CRH bonds – rated Aaa by Moody’s and AAA by Fitch – was almost six times its debt in 2007. Despite the growing number of covered bond issuers in France, Raymond is sanguine about the future. The declining level of deposits in France since the credit crunch has increased the funding requirements of French institutions, while the regulators – and French banks themselves – see the merit of diversifying funding sources. There is plenty of room for CRH alongside a growing number of new issuers, he said.Its covered bonds have also been given a fillip by their reclassification in the iBoxx annual review. "As CRH had a somewhat different status in the market than other French legal framework based covered bond, the inclus

According to Juan Pablo Soriano, managing director at Moody’s Investors Service in Madrid, 2008 issuance volumes of cedulas will decrease by about 30%. In addition to the general malaise that dogs mortgage assets globally, the Spanish banking system has had to contend with a more pronounced weakening of the real estate market than initially anticipated, he explained. The real estate boom of the past years, driven by a high demand for residential property against the background of a vibrant economy, had fueled the boom in the cedulas market on both the investor and issuer side. Now things have slowed down significantly. In addition to dealing with a challenging funding market, Spanish banks are faced with highly indebted domestic households, threatening a rapid increase of problem loans that will quickly feed into the cedulas market.The ratio of non-performing loans on Spanish bank balance sheets has risen significantly, agreed Florian Hillenbrand, vice president of covered bonds at Unicredit in Munich. Further loan losses on mortgages would in turn negatively impact the Cedulas market and exacerbate an already dicey situation, particularly if there is a crisis in the Spanish construction sector which would result in massive unemployment. Looking ahead, some of the smaller, weaker issuers could find themselves faced with the choice of going under or merging with a stronger entity.“It’s always easy to talk about the bad aspects, so it’s important to take a look at the mitigating factors,” said Hillenbrand. The greatest of these is the strength of Spanish banks. Banco Santander Central Hispano, the second largest issuer of Cedulas with €26bn outstanding, has seen spreads on its issues widening by 30 bps to 35 bps, he said. “If this had happened anywhere else, you’d have seen the bank go belly-up, but not in Spain.” Spanish banks have been business-savvy enough to develop strong and diversified balance sheets, able to offset the potential downturn of a mortgage loan crisis. “They do not have a great deal of subprime exposure, and they are probably the most highly efficient and profitable banks on the planet, with 10 years of solid performance behind them,” Hillenbrand said.Spanish banks enjoy recurring and stable earning streams and boast very strong efficiency indicators. Despite having the highest branch coverage per capita in Western Europe, they show sizeable capital gains and significant counter cyclical provisions to absorb potential impairment losses, added Soriano.Currently, the volume of subprime mortgages granted by Spanish institutions is close to 30% of overall loan volume, said Sergio Nasarre-Aznar, associate professor of civil law at Spain’s University Rovira I Virgili. The volume of credits in arrears is only slightly above 1.2% – far below both the 15% registered during Spain’s last real estate crisis in the early 1990s and the 5% current figure for the US market.However, the bigger challenge for the covered bond market in Spain is the regulatory and legal framework in which it operates. While Spanish authorities have made changes to bring the legislation governing Cedulas and other covered bonds more in line with Eurozone requirements (even as recently as this month, there have been some changes to the law), there needs to be further reform of mortgage securities to give them more transparency, strength and an optimal situation in an insolvency crisis.“The security of Spanish cedulas is really unknown and dark, while their behaviour in case of insolvency is far from being optimal in relation to other legislations – like the German one,” Nasarre-Aznar said. In the Spanish legal framework, the creditor privilege of Cedulas holders extends to the entire mortgage lending portfolio, meaning there is a huge over collateralisation, while the banks’ depositors enjoy less protection in case of bankruptcy. The recent legal changes enacted in Spain, which go towards easing the withholding tax on Cedulas, could help the Cedul

Covered bond and RMBS both reference the same underlying mortgage assets. Yet with the former, investors have recourse to the underlying assets and the issuing bank. Investors in RMBS only have recourse to the assets.While covered bonds are usually structured in fixed rate bullet format and are generally held on balance sheet, RMBS carry a floating rating, amortise as the mortgage assets pay down and are held by an SPV. Moreover, while covered bond spreads are usually quoted against mid swaps, RMBS are quoted against the three month Libor or Euribor.While the additional protection offered by covered bonds means they should trade somewhat tighter than RMBS, it is debatable whether the spreads seen earlier this year were really justified.In a report written in mid February, JPMorgan ABS research recommended clients switch out of Spanish five-year covered bonds, at the time typically yielding 20bp over mid swaps, and into five year RMBS, typically yielding 150bp – or possibly as much as plus 260bp, had the trade been executed in early April. JPM noted that given the significant differential, investors could also buy senior protection on the underlying names, "and still make the trade materially carry positive."Buy buying RMBS and CDS protection on the issuing bank, investors would typically more closely match the lower risk of covered bonds (see accompanying graph for spread history). That trade would have worked well had it been possible to execute, but with liquidity in the secondary cedulas market almost as bad as it had been in the RMBS market, putting on such a trade may have been a challenge for bank dealers. It would, however, have been more executable for real money clients.More recently, spreads have widened in the cedulas market, with two year primary issuance recently seen in the plus 50bp to 60bp range. Thus, adjusting for the curve, finding a bid for five year cedulas, would by mid May arguably be closer to plus 70bp or more, based on where the primary clears.Another more recent report produced by ABN AMRO in early March also compared covered bonds with RMBS. Head of covered bond and ABS research, Christoph Anhamm, said spreads for Spanish RMBS and Cedulas discount a much higher probability of default than had been observable just two month's previously. "The conditions that could lead to a default of Triple-A tranches or Cédulas are substantially worse than everything seen in the Spanish market so far," Anhamm said.For an 80% LTV RMBS, defaults would need to rise to 12.5%, a stress that would require a 42% fall in house prices before for Spanish Triple A RMBS with credit enhancement of 6% get hit. For 95% LTV deals that have 13% credit enhancement, 22.5% of borrowers would need to default and house prices would need to fall by 60%. Given the massive 150% overcollateralisation featured in Cedulas, default rates would need to rise to 50% and house prices fall by 73% before investors of the Triple A debt got hit.Though all scenarios are highly improbable, the latter affecting Cedulas is the most negligible. But the risks for RMBS are marginally higher. In conclusion, Anhamm said that for 80% LTV deals, investors could lose an incremental 6%, whereas Cedulas investors would get all their money back.Notwithstanding these highly unlikely events, the spread pick up currently offered for Spanish RMBS against Spanish Cedulas is still likely to prove alluring to those investors capable of arbitraging the two markets.That universe may be growing but it is likely to remain very small in absolute terms. One of the main reasons for issuing banks to tap both the covered bond and RMBS market is that they target different investors. Were the securities’ buyers the same there would be no justification for issuing in both sectors.In any case, with prime Spanish RMBS typically trading in the plus 150bp to 170bp range, there is still very good upside potential, irrespective of whether this is hedged against covered bonds or not.But one

Following a meeting held in mid-May a number of market participants put forward proposals to offer a screen-based trading platform for covered bonds. "Many traders say that the old market making obligations can no longer be supported in current market conditions and that it will be to everyone's advantage to improve market transparency," said Richard Kemmish, chairman of the market related issues working group at the ECBC, which arranged the meeting. "However others say that the old rules have served the market well and can continue with only minor modifications."As a result BGC Partners, Bloomberg, EuroMTS, Eurex, ICAP and TradeWeb have presented their proposals, some of which embrace electronic price quotation based on requesting prices from competing trading firms – or a system of auto-executable prices. There remains, however, the caveat as expressed by Ralf Grossmann, head of covered bond origination at SG CIB: "It is difficult for any system to be completely infallible, especially considering the gyrations of the market seen since last summer, and in that respect flexibility will be required of whatever platform(s) it is decided to adopt as part of the medium term objective of the ECBC group."This development is the latest attempt to find a sustainable solution to the breakdown in secondary market liquidity following the advent of the credit crunch last summer, accompanied by heightened volatility in the world's stock markets. The resultant change in the credit perception of the world's major banks created major dislocations in the Libor curve, the prime reference point used in the pricing and trading of covered bonds. The ensuing pace of the changing Libor valuations proved too much for banks participating on MTS, the dominant inter-dealer market making system, resulting in the abandonment of electronic trading. Despite efforts by MTS to restore liquidity in the following months, the unwillingness of the banks to take on additional risk through dealing with their competitors has remained central to the ongoing debate over how to restore liquidity in the covered bond market.Prior to the events of last summer the prices of covered bonds, as well as those of many European agency issuers, were provided by banks who displayed live tradeable prices over the MTS electronic platform to each other. Against a background of relatively stable swap spreads, both these markets were widely regarded as quasi-rate products, with small price fluctuations largely determined by supply and demand. Pricing new issues was, therefore, relatively straight forward for frequent issuers, with good investor demand requiring only small concessions to their secondary trading levels. The interest rate swap market, through the Libor curve, provided the main reference point for comparing issues, although cash Bunds (or in some cases OATs) were often used in conjunction with futures contracts to hedge bond positions.When volatility increased it became imperative to be hedged against something mirroring the underlying exposure. As intraday volatility became extreme, the electronic transmission of prices became a liability for the banks involved, as suitable hedges couldn't be set before the underlying market moved. "In addition to this the widening of bid/offer spreads in the government and swaps markets made the trading of covered bonds more problematic. This reached a point where it became cheaper to sell new positions than to hedge them, and the effect of relatively small tickets was to create large spread movements as the position changed hands," added Kemmish. It didn't take long before the whole system ground to a halt and even when the markets started to behave more rationally, the reduction in risk appetite continued to act as a disincentive for banks to trade with each other.The restoration of liquidity and investor confidence in covered bonds as a rates product necessitated stable and visible secondary markets and the ability to transact in good

Mortgage funding has been an especially topical subject since the onset of the global credit crisis. Global credit woes rocked both the RBMS and the covered bond markets. Yet the Swiss Pfandbrief sector has continued to hold its position as one of the most important bonds in the Swiss domestic market. One distinguishing feature of the Swiss framework, established by the Pfandbriefgesetz (Pfandbrief law) of 1930, is the existence of only two domestic institutions entitled to issue Pfandbriefe: Pfandbriefzentrale der Schweizerischen Kantonalbanken (PfZ) and Pfandbriefbank Schweizerischer Hypothekarinstitute (Pfandbriefbank). PfZ acts as the issuing vehicle for the Cantonal banks, while Pfandbriefbank looks after the remaining banking institutions. Both bodies pool the refinancing needs of their respective member banks by granting secured loans to their member banks, refinancing them via covered bonds – or Pfandbriefe – with the same maturity. The two are of a roughly comparable size: as of March 2007, the Pfandbriefzentrale had issued Pfandbrief worth around SFr23.8bn, compared to Pfandbriefbank’s SFr22.5bn.Both issuers are supervised by the Swiss Federal Banking Commission and are rated Aaa by Moody's. Loans to members are on a fully matched basis, with issuance in Swiss francs only. The LTV on Swiss mortgages eligible for inclusion in asset pools is limited to two-thirds, and the two issuers' bonds trade roughly in line with each other. The Swiss system benefits from good transparency; details of the mortgages are readily available to the lending vehicles. In early 2007 global credit markets were benefiting from a positive spread environment and both PFZ and Pfandbriefbank were accessing funding at record tight levels. Pfandbriefbank funded a 12-year tenor at mid-swaps minus 15bp in February last year. By the end of April 2008 it priced a bond in 10-years at 11bp through. Clearly Swiss covered bonds have not been immune to the credit troubles but compared to other European markets – pricing at double digits through Libor is a distant dream for German Pfandbrief borrowers – their spreads have experienced a mere correction. The relative illiquidity of the Swiss franc bond market generally ensures its secondary bonds trade incredibly tight, and this has also helped Switzerland's Pfandbrief spreads. More importantly, the two Pfandbrief issuers benefit from a very strong domestic bid. Matthias Signorell, director of the Credit Suisse DCM team in Switzerland, said a reduction in the Swiss government bond supply over recent years has been vital in accentuating demand. Since 2005 there has been a sharp fall in government confederation and Cantonal issuance, both benefiting from the proceeds of gold sales, leaving the Swiss franc market decidedly short domestic bonds. Spreads have subsequently moved in line with this supply and demand imbalance, leaving covered bonds as the best alternative, thanks to their relative liquidity, large size and Aaa ratings.In some European jurisdictions, like Spain, pooled covered bonds are often seen as poorer quality than their single-name counterparts. In Switzerland, however, the duopoly is generally deemed very efficient. Over 200 member institutions have access to advantageous-cost funding and even global heavy-weight banks like Credit Suisse and UBS have the incentive to refinance mortgages through the Pfandbriefbank. UBS recently priced a SFr300m April 2012 bond at 110bp over mid-swaps.Thomas Jordan, member of the governing board of the Swiss National Bank, is an unsurprising advocate of the product; he recently said he believed the weaknesses of mortgage bonds, revealed by the financial market crisis, do not apply to Swiss mortgage bonds. "Consequently, it should definitely have the potential to play an even greater role in maturity-matched refinancing of mortgages in Switzerland in the future," he said. "In addition, banks can improve their liquidity by holding portfolios of Swiss mortgage bonds

The slow emergence of the Italian covered bonds industry can be at least partly explained by negative developments in the broader covered bond market, where spread volatility had hampered issuance volumes across most jurisdictions. Even so, arguably even more significant has been what one market professional described as the “sluggish response by Italian banks to get their act together”. Yet after a number of false starts a handful of potential issuers seem finally almost ready to take the plunge. Intesa Sanpaolo was initially expected to be first out of the blocks through Banca IMI and HSBC. The issuer’s initial covered bonds will be collateralised using public-sector assets, although the bank also plans to structure a covered bond programme on residential mortgages this year. Banca Popolare di Milano (BPM) has also revealed its intention of issuing in the asset class off its €5bn covered bond programme through UBS and HSBC, and is now tipped as favourite to be the first to surface, along with UBI Banca. Banca Carige, which has appointed Natixis and UBS to structure a €5bn covered bond programme secured by residential mortgages, expected to be finalised in September with a deal to follow thereafter. Other banks bandied around as potential candidates to issue covered bonds include UniCredit and Monte dei Paschi. Along with Greece (see boxed item), Italy is one of the last remaining large Eurozone countries to establish a covered bond market, and, as such, its arrival in the covered bond world has been eagerly awaited. Covered bond participants hope that the introduction of a fully-fledged covered bond market in Italy will encourage greater participation from the Italian investor base into the covered bond product, whose interest in the asset class has already seen healthy increases in recent years.One common topic of deliberation is where OBGs should price in relation to other already established European covered bond markets. The Italian framework was built to resemble the UK mechanism but was originally based on statutory law. To achieve this it devised a system where an operating entity assigns collateral to a special purpose company which, in turn, guarantees an issue of the operating entity. However, Mauricio Noe, managing director and head of covered bonds at ABN/RBS, said “the quality of the law is no longer as relevant in determining value, as spreads seem to be driven by perception and less rational factors. Ireland is a good example of this despite very solid [covered bond] legislation, while Spanish Cedulas have also found the going tough this year as Spain’s cooling housing market has seen selective investors demand higher yields.” He identified Portuguese Obrigacoes Hipotecarias as probably the most useful covered bond pricing benchmark, but believes the Italian senior unsecured and RMBS markets are more relevant to assess relative value in the current environment. Andrew Porter, head of covered bonds at HSBC, agreed. “Italian banks have held up well against their European peers, having escaped the worst of the fallout from the market turmoil as the Italian private sector is perceived as being less leveraged than many other jurisdictions,” he said. Italian banks still trade wide at senior level versus many other European jurisdictions. Intesa Sanpaolo, rated Aa2/AA-/AA-, paid Euribor plus 85bp to secure funding in three-year fixed, and the issue had compressed to plus 61bp bid as of May 19 – about 15bp over comparable French paper from BNP Paribas and Credit Agricole. Intesa Sanpaolo compares more favourably with outstanding Spanish bank paper, where Santander’s 5.125% April 2011 (Aa1/AA) was around the swaps plus 65bp area, having priced the same week as Credit Agricole at plus 90bp. Other covered bond issuers that have tapped three-year senior fixed include DnB Nor (Aa1/A+) that priced at swaps plus 80bp and was around the plus 60bp area on May 19, broadly in line with Intesa. Meanwhile, Triple A five-year I

While the Italian covered market has been conspicuous by its absence, it is likely to establish itself some time before its Greek neighbour – the only other “large” Eurozone jurisdiction that is still to get of the ground. Greece released its primary legislation for covered bonds towards the end of last summer. While already approved by Parliament and containing many necessary facets that indicate a solid legislative framework, many details are still fairly general and will be left to secondary legislation which will then have to be signed off by the Bank of Greece.“In our view, this way was chosen intentionally in order to leave sufficient room for secondary legislation and detailed regulations following a consultation period for Greek banks,” said UniCredit in a release. “We welcome the implementation of a trustee, the stipulation of overcollateralisation, the implementation of a register, and the preferential claim on cover assets. The very broad definition of eligible assets, however, needs some more clarification in order to draw a comparison with other frameworks.” It is therefore a little premature to forecast when the first Greek covered bond will grace the market. One originator pointed out that this is probably still quite some way down the line as many potential Greek covered bond issuer’s systems still need some work, the legal process has taken longer than anticipated and most importantly, banks that could potentially issue covered bonds are sufficiently liquid. So far the National Bank of Greece and Piraeus Bank Group have voiced plans to issue covered bonds in the future.