An emerging asset class

It has been a long, cold winter in the financial markets. The land of the covered bond has been as bleak as anywhere, with issuance in 2008 and early 2009 reducing to the merest of trickles. In 2008 there were questions about whether the covered bond market could ever regain its relevance after the emergence of the government guaranteed market robbed it of its natural investor base. But now some are latching on to evidence that spring might at last be here – at least in this corner of the financial markets. May saw a rebound in the fortunes of covered bonds: more was raised via the instrument in one month than in rest of the year combined. But is this evidence of a changing of the seasons, or merely a winter heat-wave? If there is a single phenomenon shining light and warmth on the industry and causing unseasonal exuberance among European issuers it is the actions of the European Central Bank. In its May policy meeting it announced that from July it will make purchases of European covered bonds of up to €60bn. This ray of sunshine provided a much-needed boost to both issuers and investors, even though many questions remain regarding the details of the initiative – not least the price the ECB is willing to pay for its investments. Other central banks have indicated their support for covered bonds, for example, via the Special Liquidity Scheme in the UK and the Financial Assets Liquidation Fund in Spain. The ECB extended the maturity on its repo transactions to 12 months, meaning covered bonds could be used as collateral and banks could borrow for longer, freeing them from the need to constantly roll over their positions. In an environment where complexity is spurned and simplicity is king, many believe covered bonds will remain a currency of choice for central banks. The crisis has transformed the industry in terms of its relationship with investors. Banks have become the most important investors in covered bonds, attracted by the low risk weighting and the recourse to the underlying assets, not to mention their utility as a currency in dealing with the ECB. Fund managers have gravitated to the shorter dated issues, while institutional investors have taken the longer dated bonds – to a much larger extent than was seen before the crisis took hold. An interesting paradox in all this has been the disconnect between the timing of the ECB announcement and the simultaneous glut of issuance with the broader performance of the asset class. Rating agencies are reviewing their rating methodologies and are hawkishly watching the bonds they rate: a wave of downgrades is on the cards. Yet the overall picture remains relatively positive. A market that is still almost exclusively European looks set to extend its borders: the first deal has been completed in Asia and the US, which has seen false starts in this market before, is again looking at how it can establish a market as a way of reducing the cost of mortgage financing. It looks like covered bonds are back. But whether these green shoots of recovery can blossom into something more substantial remains to be seen.

The financial crisis that began in the summer of 2007 did not prevent the Triple A bond market from functioning, though it did transform its terms of reference. The covered bond market, on the other hand, suffered more dramatic consequences, seeing supply reduced to a trickle for most of this year. The intervention by the ECB, with its announcement of up to €60bn of covered bond purchases in the 12 month period starting in July this year at its May policy meeting, provided new support for the market. At a stroke, the supply tap was turned back on. Although shrouded by a lack of clarity over details, the news led to a significant spread tightening, resulting in €16.25bn of jumbo deals being priced during May. After including taps, this "means that the average weekly issuance volume had risen from about €500m in the first 17 weeks of the year to almost €5bn in the four weeks after the ECB announcement," said Frank Will, strategist at RBS. If nothing else, investors at least had a better idea of where fair value lay in the market. The initial ECB statement made no reference to the price at which it intends to buy assets, nor a required minimum rating, making the full impact on spreads difficult to assess. Even after the first stage of clarification a month later, which specified "the covered bonds had to be eligible for use as collateral in the ECB's credit operations", there remained unanswered questions. On the morning of the May announcement, covered bond traders had reported that buying in the sector was at the busiest level they had seen in months – particularly in core covered bond markets of France, Germany and Scandinavia. In the aftermath of the announcement some covered bonds, such as the Spanish multi-cedulas, were quoted around 50bp tighter. Traders in general said they had marked their books about 20bp tighter. But with very few prices and fewer covered bonds available to trade following a prolonged dearth of issuance, bid/offer spreads initially widened significantly, ahead of the June ECB meeting at which further details were announced. In June the ECB said its "direct" purchases would be made from both the primary and secondary markets. It would target three to 10-year issues that met certain credit rating and size criteria (minimum AA and €500m). Although there remained a lack of clarity over how the purchase operations would be conducted, it transpired that the assets to be acquired were those covered bonds currently eligible to be posted as ECB collateral. Prior to the clarification, Deutsche Bank had already said that "some Germany Pfandbriefe had traded extremely tight again [following the original ECB announcement], with short dated issues at around mid-swaps plus 20 bp. On the other hand, some UK covered bonds were still bid at around swaps plus 350 bp …confirming that European covered bonds are very heterogeneous and some sectors lack secondary market liquidity." The notion of covered bond purchases had been mooted for some months by the shadow ECB and, no doubt, the ECB itself, as a means of boosting the Eurozone economy. Jean-Claude Trichet, the ECB president, denied that the decision in principle to purchase covered bonds issued in the euro area amounted to quantitative easing. Instead, he stressed the idea was to revive a market that had been hit very hard by the financial crisis. "Covered bonds were considered by the governing council as one of the segments of securities . . . that have been particularly affected in terms of impact of the financial turbulence," said Trichet. It was only a matter of days before the dearth of supply was addressed, as covered bond issuers lined up to ride the new wave of post-ECB optimism. Immediate response The creation of a valuation floor stabilised (and reversed) the slide in covered bond spreads which had seen German-based issues widen by 92bp year- on-year, according to Unicredit, and by 126bp over the same period for French issuers. "The widening tendencies that n

At €16.5bn, May's covered bond issuance already surpassed the total amount of jumbo's issued during the first four months of the year. One could be forgiven for thinking covered bonds have turned a corner in this financial crisis. Last year was the most challenging year for the covered bond market since its inception in 1995. Secondary liquidity and new jumbo issuance ground to virtual standstill on several occasions. But the remarkable comeback of the primary market since May tells its own story: required new issue premiums are no longer increasing with every deal, which is an encouraging sign of recovery; but a look at the placement statistics of recent new issues highlights how much ground has been lost in terms of investor penetration.Sprechen Sie Deutsch? There have typically been five core investor groups making up this product: banks, central banks, funds, pension funds and insurance companies. Given its origins, it is of little surprise that Geographically, Germans have always represented the largest investor group, followed by Scandinavians, French, Spanish, Irish and UK investors. The latter three had increased significantly in the years preceding the crisis, but now the balance has shifted again. Besides Germany, the issuers’ home market is still the main sales channel, said Ted Packmohr, head of covered bond research at Dresdner Kleinwort. “On average, 75% of recent weeks’ new issues were sold in the domestic market or German speaking region,” he said. “While Spanish banks also managed to sell a relatively large portion of their Cedulas in the UK, the range of countries featuring in the placement remains fairly concentrated overall.” Despite the market’s apparent recovery and an ECB induced revival (see next two stories), international interest and trust in this market has not yet returned to pre-crisis levels. For example, Dexia Kommunalbank's €1bn 3.5% June 2014 public-sector Pfandbrief placed 72% with German and Austrian accounts, while WL Bank, a rare issuer in the jumbo market, issued a €1.25bn 3.75% November 2014 public sector Pfandbrief at a spread of 48bp over mid-swaps. A massive 90% of the deal placed with domestic accounts (see graph). In new issuance from the French region, Dexia MA's €1.5bn 4.875% 12-year Obligation Fonciere placed 70% with France and 22% with Germany. But not all jurisdictions have the luxury of a robust domestic investor base. The Nordic region, considered part of the “core” covered bond market, has been conspicuous by its absence of late, despite benefiting from a relatively stable housing market. Swedbank's €1bn 4.125% five-year Swedish covered bond priced in late may at a spread of 130bp to mid-swaps, with only 10% placed domestically. The fact that the Benelux region and Scandinavia play only a minor role in the recent placement statistics illustrates the regional concentration of buying orders, said Packmohr. While both regions once had a clear double-digit percentage share of the books, their current order book share is typically no more than a lower single-digit figure. This is perhaps partly because Norges Bank, once a powerful force in this market, no longer plays such a prominent role. In terms of investor type, banks dominated as investors of covered bonds in 2008, according to Bernd Volk, a covered bond strategist at Deutsche Bank. They hold a significant amount of covered bonds as collateral for their liquidity transactions with the ECB. Deutsche Bank estimates that approximately 40% of banks placed with banks in 2008, while fund managers made up approximately 27% of demand, central banks 11%, insurance 10% and pension funds 6%. “The combination of a low risk weighting, high security and ECB eligibility generates significant buying interest from the banks,” said Volk. For short to medium term bonds, banks have again proved the most important buyer group. Fund managers have become the second pillar of investors, buying 30% to 50% of non German covered bonds said Packmohr.

In May, in an unprecedented move to help bolster lending markets, the European Central Bank announced it would buy €60bn worth of covered bonds. In late May the ECB was yet to release details of how exactly it would undertake its purchases, but the announcement itself immediately boosted confidence in the covered bond market, being quickly followed by a number of large issues of new instruments (for more on the ECB see previous story). “The announcement by the ECB gives a strong perception that this is a safe product,” said Bernd Volk, Frankfurt-based head of European covered bonds research at Deutsche Bank. As well as agreeing to directly buy covered bonds, the ECB also announced it had extended the maturity on its repo transactions. “Repos are usually only short-dated, three months or so transactions, which meant banks had to roll their positions, but the ECB has extended this to 12 months,” said Volk. This enabled banks to post covered bonds as collateral and borrow for longer, locking in the current historically low rates. Jean-Claude Trichet, president of the ECB, said the steps, along with a 25 basis point fall in its benchmark interest rate to 1%, should encourage banks to maintain and expand lending and improve market liquidity. Central banks have long accepted covered bonds as collateral when lending to banks via repos. The ECB’s buying programme, however, took it from a position of tacit support to explicit endorsement. “The ECB sees this as a critical market that needs to be repaired in order to get lending and economic growth going again,” said Ted Lord, head of European covered bonds at Barclays Capital in London. That may not be the end of the story. The ECB and other central banks have other reasons to want the covered bond market to recover. The originate-and-distribute banking model, which constantly expanded banks balance sheets by originating business and then, supposedly, moving it off balance sheet via securitisation vehicles, led to massive systemic risks. Covered bonds, unlike securitisation structures such as collateralised debt obligations, retain the risk of the underlying pool of assets within the bank raising funds. As banks are directly exposed to the default risk of the pool, they have an incentive to properly manage that risk, eliminating the moral hazard problem. Covered bonds are heavily regulated. If an underlying entity in the collateral pool defaults, for example, the issuing institution has to replace it with a credit-worthy alternative. Some argue covered bonds offer the benefits of securitisation – allowing banks to turn illiquid assets such as mortgages into a source of funding – but without the negatives associated with structured credit. Jeremy Jennings-Mares, a partner and structured credit expert at law firm Morrison & Foerster in London, believes the ECB and other central banks will view covered bonds favourably as a form of financing in the post credit crunch world. More complex forms of securitisation, he predicted, will be frowned upon. Supporting the expansion of the covered bond market, therefore, could also be seen as one move in a longer term strategy to shift the balance in capital markets more in favour of an originate-and-retain model. “There is no tranching with covered bonds, and so no complicated subordination issues,” said Jennings-Mares. “The covered bond remains on the balance sheet, so the rating depends heavily on the general credit worthiness of the bank, backed up by the quality of the portfolio.” Financing of the future Covered bonds look set to be a politically correct, as well as relatively cost effective, form of raising financing for the foreseeable future. The ECB was not the only central bank acting in their best interests: the emergence of the UK’s Special Liquidity Scheme and Spain’s Financial Assets Acquisition Fund, both of which accept covered bonds as collateral in return for funding, is also shaking things up. Peter Green, another London-based partn

Standard & Poor's new methodology proposal for covered bonds will have issuers everywhere on red alert. If implemented, they could see the credit ratings of more than half of Europe's covered bonds come under pressure. The news is obviously negative for the product, but the changes will essentially link the rating of the issuer with the covered bonds themselves. This will bring S&P’s methodology into alignment with those of Moody's and Fitch. S&P estimates that approximately 60% of the programmes by number would not meet the proposed minimum rating guidelines for covered bond issuers. A large number of the bonds would also have to increase their over-collateralisation to maintain current ratings. The proposals would put more emphasis on the ability of covered bonds to access liquidity to repay investors in the event of an issuer default. While S&P has not downgraded any covered bonds so far, such actions would become more frequent as the ratings of issuers came under pressure, said Karen Naylor, head of European covered bond ratings at S&P. "In proposing a new methodology for rating covered bonds, S&P finally says goodbye to the ‘de-linked’ rating approach," said Heiko Langer, a covered bond strategist at BNP Paribas. "De-linking the covered bond rating from the issuer rating has been a key point of differentiation of S&P's methodology from that of Moody’s and Fitch." When S&P initially made the announcement earlier this year, the agency requested market feedback on the proposal during a period that was extended until March 27. The agency was still digesting what it described as an extensive and detailed response from the market when this report was filed, much of which was quite critical of the proposals according to market sources. There was no official date earmarked for further announcements as the report went to press. Regarding liquidity risk Fitch Ratings has also been reviewing its procedures, particularly with regard to how it evaluates the sticky subject of liquidity risk within covered bond programmes. Overall, the proposed amendments would lead to a tighter relationship between the issuer default rating of a financial institution and its covered bond rating. The level of over-collateralisation between the cover assets and covered bonds in line with a given rating scenario is expected to increase. Other aspects of the Fitch covered bonds rating methodology remain unchanged. Notably, covered bond ratings will continue to reflect the probability of default of the instrument, as well as stressed recoveries from the cover pool in the event of a default. "Since the onset of the global financial crisis, banks' funding sources have dwindled dramatically. This lower certainty attributed to asset liquidation in a given timeframe will be reflected in changes to Fitch's Discontinuity-Factor scoring," said Helene Heberlein, head of covered bonds at Fitch. The agency finished its six-week consultation period on April 30 and is expected to publish revised criteria that will take into account new liquidity assumptions later this month. That could result in the downgrade up to 5% of public sector and 10% of mortgage covered bonds. Meanwhile, the prospect of lower ratings could take the gloss off the recent announcement from the ECB, which stated it would provide unprecedented support for covered bonds in the form of a €60bn buy-back. Issuance in the jumbo sector has soared since the announcement, and at €16.25bn as the report went to press, fresh supply in May comfortably surpassed the total volume of benchmarks priced during the first four months of the year combined. At best the continuing moves by the leading agencies to tighten criteria could mean that obtaining the top rating may become more expensive for issuers as more over-collateralisation is required. At worst the covered bond market's status as a Triple A arena could be eradicated. Not to be outdone and with scythe in hand, Moody's also warned recently that a mass cull o

For now, there is a happy co-existence of the old and the new. The ECB’s announcement in May that it would purchase up to €60bn of covered bonds sent the moribund market into a catch-up frenzy. The primary market consequently witnessed the busiest session for new jumbo supply since May 2008. Banks made a beeline to welcome the return of this important funding tool and promptly placed €6.5bn through five new benchmark bonds by the end of the week beginning May 11. It was an impressive revival, given that the first four months of this year only brought seven new benchmarks. "It goes without saying that a powerful player like the ECB committing to absorb a significant amount of a certain market defines a hard valuation backstop," said Florian Hillenbrand, a covered bond strategist at UniCredit. "The fear of many investors, that every point of time for an investment was second-best because spreads widened with every new issue, is practically off the agenda." Since mid-May, as supply in the covered bonds market has picked up, primary market activity in the government-guaranteed senior bonds space has cooled off. An increase in investor risk appetite has to some extent made market access possible across the credit and capital spectrum. "The use of covered bonds as collateral for repo business with central banks has become more popular and economical, stimulating a major increase in the number of financial institutions issuing covered bonds," said Holger Horn, senior director in Fitch Ratings' covered bond team. The €500m two-year priced by A2/BBB+/A- rated Alpha Bank on May 28th in the senior, unsecured, unguaranteed market, and the re-opening of the Lower Tier 2 bullet format (10-year trades from Rabobank and Credit Agricole) and callable structures (by insurers RSA and Prudential) and even the Tier 1 (courtesy of Rabobank, again) all demonstrate that the conducive market backdrop has been put to good use by financial borrowers. There are significant fees associated with government-guaranteed bonds that do not generally apply to covered bonds, except in a few jurisdictions where the guarantees covered them. In the UK, for instance, bonds issued under the HM Treasury's Credit Guarantee Scheme attract a fee of 100% of the institution's median five-year CDS spread in the 12 month period to July 2008 plus 50bp per annum. Such fees have made covered bonds an attractive, long-term and cheaper source of funding. "There is an overall allocation limit on the Credit Guarantee Scheme (£250bn), and the [UK] government does expect issuers to utilise other available sources of liquidity as well,” said Angela Clist, partner, international capital markets group at Allen & Overy. “Uptake under the proposed ECB scheme will be dependent on the applicable eligibility criteria." Despite the gap between the cost of guaranteed and non-guaranteed issuance, in general, being about 100bp, banks have succeeded in issuing larger amounts with longer maturities without guarantee. This is an encouraging trend. Not a one-trick pony The glut of issuance in the two-and-three-year maturity space in the government-guaranteed senior funding market has convinced some market participants there could be pent up investor demand for five-year tenor or longer duration in the covered bond market. Investors have recently shown a preference for relatively short-term risk of up to five years, which is maximum duration for the government-guaranteed market. But covered bonds have the advantage of the flexibility to extend out to longer maturities, which has some appeal to the real money investor base and to those investors looking to add some exposure to mortgage-market related credit risk. However, the relatively low levels of public issuance of covered bonds makes it difficult to generalise. "The jumbo covered bond market has always been a five-year plus market, so no great change here," said Nick Morgan, managing director, head of financial institutions Europe & Middle East, R

The delay in introducing covered bonds to Asia has been blamed on the lack of a legal framework and regulations backing covered bond issuance in the region. But that theory has to a certain extent been undermined by Kookmin Bank’s ability to bring its deal, despite a lack of a covered bond law in South Korea, by utilising its ABS legislation. Given the success of Kookmin’s deal and the obvious attractiveness of the asset class, it seems likely that covered bond issuance in Asia will take off. European investors have long extolled the virtues of the covered bond, citing the instrument’s high credit quality (issuance generally comes with a higher credit rating than the sovereign rating of the issuer’s domicile country), standardised format and large issue sizes. All this contributes to strong liquidity. Regulators are also keen on the instrument because there has never been a covered bond default, while any problems can usually be detected early in the asset pool. Given Asia’s vast infrastructure needs over the next decade, and its desire to develop residential property ownership, the instrument could prove invaluable. It can also reduce the financing burden at the sovereign level. Cheaper and longer Kookmin’s deal came via Citigroup and HSBC. “By issuing a covered bond were able to retain our independence rather than relying on the government guarantee,” said Kookmin Bank CEO Kang Chung-won – a guarantee that would have cost 70bp for offshore issuance. “We could price at a longer tenor than the three years imposed by the use of the government guarantee.” The deal came with a five-year tranche supplementing the three-year. The senior paper, issued by KB Covered Bond First Securitization, is guaranteed by KB Covered Bond First International. The SPV is incorporated in Ireland and is secured by a pool of residential mortgage loans and credit card receivables that will always exceed the bond’s value. As with all covered bonds, investors have recourse to the bank's balance sheet. But there is a further enhancement: a requirement that Kookmin top up non-performing loans in the pool with performing ones. “The bonds are supported by a relatively typical asset-backed securitisation structure. This asset-backed structure seeks to match the cash inflow from the asset side with the cash outflow needed on the liability side,” wrote S&P analyst Frank Lu in a ratings note ahead of issuance. “The structure does not rely on the market value and the refinancing capability of the trust assets.” Kookmin has a US$1.5bn-equivalent mortgage portfolio, more than sufficient to support the deal’s 75% subordination requirement. Demand and the ultimate deal size will determine the exact balance between mortgage and credit card receivables. S&P rated the paper AA, compared to the issuer’s A rating from S&P (or A+ by Fitch) and the sovereign’s A2 rating, clearly demonstrating the covered bond’s superior ratings dynamic. While the risk on the securities remains with Kookmin, the deal comes with an ultra-conservative LTV of 48%, and includes hedging of won exposure via a currency swap. Well received The US$1bn five-year deal was indicated in Asia hours at mid-swaps plus 525bp but bankers involved signalled this guidance would be tightened as New York came in. It opened at 515bp/510bp and by 9am had tightened to 495bp/492bp. By 10am it was in at 494bp/492bp and by the late afternoon settled at 475bp/472bp, for a quick 2.5 points gain for investors, or a handy US$125,000 on a US$5m ticket. South Korean insurers and pension funds, unable to subscribe to the deal in the primary, were jumping at the chance to book Double A assets, since there are no assets available of this credit quality in Korea. But this sharp tightening prompted rival bankers to proclaim the deal had been offered too generously. The leads cited the need to leave sufficient yield on the table, given the fact this was the product’s Asia debut. The deal amassed a staggering US$6bn book, a testame

With a total outstanding volume of some €800bn – roughly one fifth of the entire German bond market – the importance of Pfandbriefe, Germany’s highly prized covered bond market, must not be underestimated. But few asset classes have come out unscathed from the crisis, and despite being widely regarded as the strongest of all covered bonds, Pfandbriefe have been no exception. In the first quarter of this year, only €3.25bn of jumbo Pfandbriefe (excluding taps) were publicly issued in the market – a staggering 62% less than the same period of 2008. Post-Lehman brothers risk aversion to most bank related debt, and the dramatic rescue of Hypo Real Estate - Germany's second largest issuer of Pfandbriefe - accounts for some of this decline. But it was the newly created government guaranteed bank bonds that stuck the final nail in the coffin. While jumbo Pfandbrief volumes have been on the decline, issuance of government guaranteed bank debt has soared. During the first three months of 2009, such issuance amounted to €21bn in Germany, providing stiff competition for investors' attention. Of the three jumbo German covered bonds that were placed in Q1 this year; all were in a five-year maturity. Demand prior to this had been concentrated in the short-end of the Pfandbrief curve. Since the onset of the GGB market, this part of the curve has suffered an erosion of demand. Despite the impact on the Pfandbrief asset class, in mid-February Germany's federal cabinet agreed on a new local law that would extend the Financial Market Stabilisation Act. As part of the move it granted an extension of the maximum maturity for government guaranteed bank bonds to up to five years, putting further pressure on jumbo Pfandbriefe. The Government’s motives are as clear as they are credible: to align the framework conditions in Germany with those in effect across Europe and prevent distortions of competition. The draft law extends the maximum guarantee term from the current 36 months to 60 months, thus following the EU commission's policy regarding state aid, which permits a term of between three and five years for one third of guarantees. Yet the move flies in the face of a very clear warning from the Association of German Pfandbriefbanks (vdp) that it will further increase competition. "The issuers accept the inevitable distortions that government-guaranteed unsecured bank bonds create in the capital market," said Henning Rasche, vdp president. "But a widening of the scope of such guarantees would result in an unfair disadvantage for Pfandbrief sales." Covered bond analysts at BayernLB have supported this argument. Under the new provision, "not only ailing banks but also ‘healthy banks’, for whom Pfandbriefe are actually an important funding tool, would shift over to the new asset class," they said. On the other hand, Pfandbriefe could benefit from higher returns compared to state-guaranteed bonds, and a steep yield curve will encourage investors to move out of safe havens and into more risky investments like spread products. "We can also expect to see a shift to medium and longer maturities in the medium term," the analysts said. Banks cannot survive forever on short dated funding and Pfandbriefe may well provide the opportunity for banks to lengthen their duration. A recent steeping of the curve, but more importantly the back-stop provided by the ECB in its announcement that it plans to purchase up to €60bn of covered bonds, has encouraged a revival of public jumbo issuance. This has been particularly evident in the Pfandbrief market. Since the announcement from the ECB in early May, five jumbo Pfandbrief deals have been launched to a total value of €6bn. That represents more than the total jumbo issuance of the entire first quarter. Private placements prevail The German Pfandbrief banks have four Pfandbrief types at their disposal: mortgage Pfandbrief, used for the funding of property loans and secured by real estate; public Pfandbriefe, covered by le

German investors are traditionally the biggest buyers of covered bonds in across Europe. They, like most others, had taken a huge step back from the asset class during the financial crisis. But their interest in a €1bn, five-year transaction, issued by Swedish bank SEB in late March, has opened the door again for Nordic covered bond issuers. “Germans took around 70% of the SEB issue,” said Monika Rast, head of origination/international financial institutions at UniCredit Group in Munich. “They make up a large part of the original buyer base for covered bonds in general, so if they are showing interest again, this is one of the signs that the covered bond market is back on track.” Issuers have been broadening their investor bases and lengthen their debt maturity profiles by pricing transactions in the euro-denominated covered bond market, and those in the Nordic region are likely to be no exception. Eurobond issuance possibilities could increase further still if the European Central Bank includes Nordic covered bonds in its plans for asset purchases, a decision that is yet to be made. Whichever way that decision goes, the Nordic domestic covered bond markets have been the only ones to remain fully functional throughout the downturn. While the markets in Sweden, Norway and Denmark are each distinct, they continued to function because of the solid foundations upon which they are built: a strong banking system; an extremely supportive regulatory environment; high quality issuers; and, above all in the cases of Sweden and Denmark, a faithful and reliable investor base, ensuring liquidity. Issuers have therefore not had to look further than their home base for their funding needs. These factors remain decisive, according to Ola Littorin, first vice president and head of long term funding at Nordea in Stockholm. They will continue to ensure the future performance of the region’s domestic covered bond markets, which remains far more important as a source of funding for issuers than the international capital markets. “The domestic markets have a much longer history than the international benchmark market, which for us serves more as a complementary source of funding,” said Littorin. Covered bonds are the heart and soul of the Nordic financial system, particularly in Denmark (the region’s oldest market) and Sweden. Norway’s covered bond regulation came in 2007 and oversees a much smaller domestic market. A number of important factors support covered bond ratings in the region, said Massimo Catizone, vice president and senior credit officer at Moody’s Investors Service in London: a rigorous underwriting criteria; a high degree of transparency; and a well-established, covered bond specific, legal framework. One important element of the latter is the Danish Balance Principle, compelling issuing banks to strike a nearly perfect match between assets and liabilities. Yet no system is perfect. The Balance Principle in Denmark, for instance, means issuers often need to uphold a specific overcollateralisation level to maintain their covered bond ratings, Catizone said, forcing them to have more assets than liabilities on their balance sheets. It means banks can face difficulties maintaining their covered bonds target rating if they have to seek out assets: in theory asset quality deterioration, and weakening credit strength of an issuer could potentially drag the ratings of a covered bond down with them. Because their cover pools are dynamic, the overcollateralisation in covered bond programmes is also dynamic, said Suzanne Albers, senior director at Fitch Ratings in London. If overcollateralisation levels increase, for example due to deteriorating credit quality within the pool or increased costs in liquidating the same assets, ratings pressure can arise. As yet Fitch Ratings hasn’t issued any downgrades due to weaker asset liquidity, but “we are reviewing certain rating criteria regarding the liquidity of assets,” Albers said. Despite this, No

Before the global economic crisis hit its peak, the Treasury and the FDIC were advocating a vibrant US covered bond market. At that time there had only been two deals, but expanding the market was seen as an important fillip to the US residential housing market. By allowing mortgage-lending banks to issue bonds collateralised by a covered pool of mortgage assets – a structure similar to RMBS – they hoped to lower the cost of mortgage financing. The plan was overtaken by economic events and the idea of fostering a relatively untested asset class became untenable, at least temporarily. Even the market for covered bonds in Europe, a natural benchmark for its development in the US, lost steam. The US market couldn’t grow in that environment. The return of more stable liquidity levels, and the boom in the bond market, has encouraged potential covered bond issuers, investors and dealers to consider the securities again. Several hurdles remain, but there is a new confidence that the market will take shape soon. "Globally there is a lot of excellent momentum on covered bonds," said Ben Colice, head of covered bond origination, Americas, at Barclays Capital in New York. "For some time, banks were focused on staying solvent and remaining in existence. Now they're starting to shift their focus to longer-term funding, which has led them to re-examine covered bonds." A lot of groundwork was done in preparation for growth. Last July the FDIC approved a final policy statement, providing bondholders fast access to collateral if the FDIC declined to step in to meet the liabilities of an issuing bank in the event of a collapse. The US bond industry never tested the new guidance. Also in July, the US Treasury published best practices for residential covered bonds, while the Securities Industry and Financial Markets Association created the US Covered Bonds Traders Committee. In December, SIFMA and the American Securitization Forum created the US Covered Bonds Council to help the development of market policies and practices to foster public confidence in the securities and lobby policymaking bodies. But some fundamental questions remain before issuers, dealers and investors chart a clearer course for the market. Investors require more transparency on how the FDIC, whose mandate is to support depositors, will respond in a failed bank scenario than was provided last July. It set a precedent in September when Washington Mutual collapsed, and the FDIC said that JP Morgan had acquired “the assets and most of the liabilities, including covered bonds and other secured debt, of Washington Mutual Bank from the FDIC as receiver for Washington Mutual Bank". Some investors believe WaMu’s situation was a relative anomaly and call for more clarity. It’s unclear whether US legislation would follow the lead of Europe. Some investors have further concerns about relative value. Because issuance has been sparse, they do not know how to value covered bonds. Investors have dual recourse: to the issuer and the pool over covered assets. (RMBS differ in that investors have recourse only to specific assets.) There is some confusion regarding how to value that compared to risk from a bank’s senior credit, as well as other securities in the wider market. In January the FDIC recently made a further mention of its strategy to develop covered bonds, in what was one of the last utterances to be made on the subject. Buried in a press release about support for Bank of America as it acquired Merrill Lynch was a comment that it was considering extending the very successful Temporary Liquidity Guarantee Program from three to up to 10 years. It said it would only do this “where debt is supported by collateral and the issuance supports new consumer lending.” It was later understood that this structure was specifically being considered to pave the way for a covered bond market, which would support consumer lending. However, the originally constructed TLGP was such a success that banks

With a history dating back over 200 years and a total worth of over €800bn - practically one fifth of the entire German bond market - one may well ask why it took Germany's leading bank so long to catch on to the Pfandbriefe craze. Before borrowing costs commenced their upward spiral Deutsche Bank, a strong Double A rated issuer, could typically rely on a relatively low cost of funding. It did not make economic sense to enter the covered bond market due to the "not inconsiderable cost of setting up the programme without any significant funding advantage," said Jonathan Blake, global head of debt issuance at Deutsche. The massive jump in the spreads of senior, unsecured debt finally gave Deutsche an incentive to establish itself in its home covered bond market. Its decision to turn to the asset class for the first time was seen as the ultimate validation for the product which, along with other covered bonds, has seen significant deterioration both in terms of issue volumes and spread since the crisis took hold. The bank announced board approval for the establishment of its Pfandbrief programme late last year, and was granted a licence from Germany's banking regulator BaFin in April. It's roadshow with select European investors was quickly followed by a jumbo deal in June, hailed a big success by covered bond professionals. Deutsche Bank's €1bn 3.75% seven-year debut mortgage Pfandbrief, backed predominantly by commercial mortgages, achieved a very punchy spread of 55bp over mid-swaps. With orders close to €5.5bn through nearly 180 single orders - the largest order book seen in covered bonds this year - clearly investors were perfectly comfortable with this level. All loans included in the €1.57bn cover pool are at 60% of mortgage lending value. According to Blake, the rationale was that existing residential mortgage loans were not originated with a view to putting them in the cover pool, but that new residential mortgages may well end up in the mix at some point in the future. The commercial cover pool also gave rise to an interesting price discovery process, though Blake said that investors ultimately favoured the name and strong credit ratings of Deutsche Bank. The weighted average remaining term in the cover pool is just under five years, 95% of which matures prior to the maturity of the Pfandbrief - giving a well matched funding structure. The programme is rated Triple A by Moody's and Standard & Poor's. In the same week BNP Paribas made its debut in Obligations Foncieres with a transaction offering a shorter five-year maturity and backed by higher quality public sector assets. It priced at a spread of 77bp over mid-swaps, underlining Deutsche’s achievement. The 55bp level gave Deutsche Bank an even more eye-watering saving of some 100bp relative to what it would have paid to issue a comparable senior, unsecured deal. Before the crisis this cost advantage would barely have offered a fifth of this figure. For a bank that has vowed not to turn to Berlin for help with its funding, this shift in pricing offered a financing opportunity that was simply too hard to ignore. Deutsche Bank has indicated is long-term commitment to the market but envisages annual issuance of €2bn to €3bn. If this proves accurate, it will enjoy the status of a relatively rare issuer, increasing investor interest. A typical funding year for Deutsche Bank is probably in the €20bn to €25bn region. This year the bank targets €16bn in the capital markets, of which it has already raised €8bn, leaving it ahead of schedule. Deutsche predicted Pfandbriefe will account for up to €2bn of this figure. "Given that we have so little capital market issuance to do over the course of 2009, the Pfandbrief may be the only opportunity to buy Deutsche Bank in liquid format during the course of the year," said Blake. He would not rule out some activity in the senior, unsecured space later in the year, but stressed that this "looked unlikely from a current perspective."

For BNP Paribas, diversity is king. According to officials at the bank, it is constantly looking at ways to expand the breadth of its debt issuance, in its covered bonds offering and beyond, to diversify its funding sources, its investor base, the products available to existing investors and the currencies in which it issues debt. This diversity is not reflected in the collateral pools of BNPP’s covered bonds issuance, which are grouped to give pure exposure to one part of the business. This provides a means for professional investors to take on exposure to a specific part of the bank’s business as an alternative to lending to the bank at a senior unsecured level. BNPP officials argue that investors’ need for diversification requires highly specific products that cater to their specific risk requirements. That view is borne out by the response of investors to BNPP covered bond programmes that have always identified strong performing, low risk businesses. The collateral underlying the recent €15bn BNP Paribas Public Sector SCF covered bonds launched in June 2009 comprise sovereign bonds with government guarantees from France, the UK, Germany and the US. They were consequently issued centrally from the Paris office, making it possible for the bond to be structured within the Obligation Fonciere (OF) framework. The programme included issuance of both benchmark and private placement bonds. The deal came at an opportune time for investors, according to Christopher Drennen, head of FIG DCM for France and Benelux at BNP Paribas. Government guaranteed debt is very hot in terms of supply, while investors have shown enormous interest in assets perceived to have very low risk – government guaranteed bonds have a zero per cent risk weighting. The deal is rare, if not unique, in comprising sovereign government guaranteed credit, said Drennen: other comparable offerings have contained a broader mix of municipal and local government debt. Structuring the public sector covered bond took two years, with much of this spent negotiating the transferability of the government guarantees. Being written on sovereign bonds, the guarantees did not easily transfer to other entities in order to be utilised in the cover pool. BNP Paribas Public Sector SCF saw responses from 95 investors – the majority of its traditional covered bond investor base, which was gratifying for the bank on the back of a miserable year for the asset class in terms of issuance. The OF snub Back in December 2006, BNP Paribas had reopened its covered bonds programme with a €2.5bn five-year deal on home loans directly guaranteed by Credit Logement, the leading French guarantor of home loans. Being structured outside the OF framework, the deal raised eyebrows at the time of issuance. The move was seen by many as a snub to the French covered bond law. But it also enabled BNPP to use assets not eligible under the OF law. According to Drennen, the OF regime works well when structuring covered bonds where the underlying collateral is originated in the same geographical area, but is less appropriate where the underlying loans are spread over a broader area. In the December 2006 deal, the home loans were issued by branches all over France, unlike the bonds in the cover pool for the latest public sector deal, which all originated from Paris. Other banks have since followed BNPP in issuing outside the OF format, benefiting from the bank’s 11 months of negotiations with the central bank and the regulator in creating the new structure. The deal was led by BNP Paribas, HSBC and UniCredit. It went out with initial guidance in the mid-swaps less 1bp area, the structure being perceived as somewhere between the French OF regime and the UK offerings, as represented by an HSBC deal at around that time. Following a total order book well north of €4bn, it eventually priced at mid-swaps less 2bp, the tighter end of the less 2bp–1bp guidance to which it was revised in the interim. At the group level, BNP