Credit induced hiatus

IFR Pfandbriefe Covered Bonds 2008
5 min read

The US covered bond market was shelved before it really got off the ground. Although policy officials and regulators have endorsed the product, investors' stamp of approval is still needed, as Andrew Stein reports.

While the broader financial system is headed for a makeover following the liquidity squeeze, the demise of certain products will inevitably give rise to others as participants seek more secure, efficient financing tools.

The nascent US covered bond market may be one of those beneficiaries in the wake of the credit debacle, as the asset class received the blessing of Treasury Secretary Henry Paulson this spring. "Covered bonds may address the current lack of liquidity in, and bring more competition to, mortgage securitisation. Rule-making, not legislation, is needed to facilitate the issuance of covered bonds," Paulson said in a statement.

The foundation for a US covered bond market is already in place as rule-making, rather than legislation, would spark more issuance of dollar denominated covered bonds, Paulson added. Those rules would likely emphasise the recovery process on a covered bond upon a bank issuer's insolvency. That vote of confidence was followed with the Federal Deposit Insurance Corporation providing some much needed clarification on how it regards the instruments.

The recovery issue and uncertainty about how the FDIC would treat the securities in the unlikely event of an issuer's failure were underlying themes in the deals that surfaced from Washington Mutual and Bank of America, the only two US banks to issue the securities to date.

One major concern with the FDIC is that under the Federal Deposit Insurance Act, the body could delay access to a collateral pool for up to three months in the event of a failure. Some issuers could get around that issue by providing additional liquidity or other hedges to mitigate that risk. However, those steps would increase the cost of issuing what is supposed to be a highly secure instrument. The FDIC also raised an insurance issue regarding whether an issuer's assessment rate should increase with a covered bond in its capital structure. An increased assessment could increase the cost of issuing the securities.

With the stipulation that covered bonds comprise no more than 4% of an issuing entity’s total liabilities, and no more than 10% of the collateral pool is made up of AAA mortgage-backed securities, the FDIC said in mid-April that an investor could have access to a collateral pool 10 days after a default.

The FDIC clarification, which was characterised as an interim final policy, was not necessarily groundbreaking, but it was one that was needed if a viable market is to take shape. Comments on the policy can be submitted to the FDIC until June 23, 2008.

"To revitalise the covered bond market in the US the consultation should be used for engagement with all stakeholders and especially investors. Their comments and interests should be reflected in the final provisions to provide investor security and to enhance investor confidence in US covered bonds," said Merrill Lynch's Sabine Winkler. "A lack of confidence makes it difficult for US banks to find their way back to the primary jumbo covered bond market. At the moment, the uncertainties facing the US product are reflected in higher spreads and spread volatility on the secondary market."

The acceptance of covered bonds on a policy and regulatory basis bodes well for potential issuers, but the recent turmoil in the credit market has emphasised that the true success of the market will depend on investors' acceptance of the product.

Potential investors previously expressed concern about the liquidity of the instruments, particularly from banks that may conduct self-led deals. Bank of America completed a self-led US$2bn offering of five-year covered bonds in June 2007 which rankled underwriters active in the European market but struck many domestic sources as the only way to go. Bringing in another firm would have been perhaps more controversial.

As the issuance in the US picked up speed in 2006 and 2007 from the likes of DEPFA, HBOS, BBVA, Nationwide Building Society and Northern Rock, there was also a question of whether investors would treat the instruments as a rates or credit product. After the government stepped in to essentially backstop Northern Rock, the elements of credit risk will surely be highlighted when that conversation resumes.

As those aforementioned deals sought US investors, several large institutional accounts had to seek permission to hold the securities. While that process more than doubled the US investor base on HBOS' US$3bn 10-year offering in February 2007 to 50 accounts, thoughts of going through that process are likely distant memories for the broader investor base amid the lack of issuance over the past year.