As 2008 wore on and banks found it increasingly difficult and costly to fund themselves, covered bonds were touted by industry professionals and politicians alike as the panacea for the liquidity drought. But they have also proved susceptible to the illiquidity that has ravaged financial markets, especially in the second half of the year.
Despite the global aversion to bank and mortgage-related risk, issuance of jumbo covered bonds has dipped in Europe this year: at the time of writing, the primary market has not seen a jumbo covered bond in more than two months.
This has been exacerbated by the emergence of government-guaranteed bank debt. Faced with this competition, covered bonds now face a crisis of identity. The industry has to face this new competition head on: why would an investor put money in covered bonds at their current levels when they can buy government-guaranteed paper? Equally, why would an issuer give up valuable collateral when it can take advantage of a government guarantee?
Investors might, of course, judge that sovereigns have overstretched themselves with the numerous guarantees they have made. This is of particular concern in countries where the size of the finance industry is big relative to their GDP. Ireland, Iceland and perhaps even Switzerland fit into this category.
Another reason is that such guarantees have a cost, even if it is not immediately obvious. In the first instance that will be passed on to the providers of the collateral. But ultimately it will be passed on to the consumers.
This begs the question: should covered bonds – the traditional super-safe investment – require the added cost of a government guarantee overlay?
Among the market participants assembled by IFR to discuss industry issues, it seems there is still confidence in the collateral pools of most covered bonds – despite the battering that real estate has taken this year. The real doubts, justified or not, are over the health of the financial institutions issuing the securities. Perhaps when confidence returns in the strength of the institutions, some semblance of normality can return to the covered bond market.
A covered bond has never defaulted, but even that has not been enough to protect demand in the face of investor panic. Their jitters have ensured that cash is in fashion. What demand there is for covered bonds has become increasingly concentrated at the short end – particularly as this is where government guarantees can be found.
The market has been left to consider to what extent things will ever return to normal – defined as pre-credit crunch conditions. The guarantees will not be around forever, yet there is a feeling that, with respect to liquidity at least, pre-crisis levels will not return.
There is equal uncertainty around price. The covered bond industry has faced a series of repricings, with even Germany and France in on the act, following the near collapse of HRE and Dexia.