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 partner and capital markets expert with Morrison & Foerster, believes the emergence of such schemes has reduced the need for banks to issue covered bonds to the commercial market. “A lot of banks have been availing themselves of the government guarantee schemes to raise finance, which means there is less need for them to issue covered bonds,” he said.
That will probably only be a short term phenomenon. “Banks ultimately want to fund in the market,” said Michelle Bradley, a covered bonds analyst with Morgan Stanley in London. “That’s the sustainable way for them to fund their balance sheets in the long term.”
In fact, by some measures covered bond issuance is on the up, at least in terms of issuance that has been originated purely for use as central bank collateral. In its latest covered bonds report, the Comparative Study of Covered Bonds 2008/09, Fitch Ratings observed the growing popularity and economy of covered bonds as collateral for repo business with central banks, despite the lack of public placement of jumbo covered bonds at the end of last year. This led to an increase in the numbers of financial institutions issuing covered bonds, it added.
The number of Fitch publicly rated covered bond programmes at the end of April had almost doubled from the equivalent number in the middle of 2007, to 105 programs issued by 90 financial institutions. The volume of rated covered bonds increased by 12% to €1.17trn.
So despite the disappearance of large public placements in late 2008, government intervention in the lending markets encouraged more institutions to establish covered bond programmes for use as collateral with central banks. In the case of the UK, for example, the number of issuers has grown from seven to 21, reports Fitch, specifically as a result of building societies and other financial institutions use of the Bank of England’s Special Liquidity Scheme. It seems that the use of covered bonds as collateral at central banks has never been so popular.
This is ironic, given the way the commercial side of the market has performed. Since the credit crunch kicked in, both the primary and secondary covered bond markets have struggled to maintain liquidity. Indeed, commercial buyers of covered bonds disappeared completely in November 2007 when, at one stage, the European Covered Bond Council had to suspend inter-bank market-making for a few days. Today, even with the ECB’s announcement, uncertainty remains surrounding the market, not least because rating agencies are currently tightening their ratings methodologies for covered bonds. There is a real prospect of mass downgrades – both Standard & Poor’s and Fitch have announced proposals, in February and March respectively, to more closely link the rating of a covered bond to the rating of its issuer while increasing required overcollateralisation.
Still, central banks are sticking by covered bonds and betting on a market recovery. If that happens and liquidity in the primary and secondary markets for covered bonds picks up, a smaller proportion of new issuance should find its way into central banks as collateral for borrowing. As markets recover, banks should have less need for central bank financing.
Meanwhile, that recovery could be helped by regulatory changes that make covered bonds more attractive in relation to other forms of asset-backed securities. Regulators across the globe are looking to crack down on complex structured credit products. In Brussels, European parliamentarians voted on May 6 to amend the Capital Markets Directive to make European banks by 2010 retain 5% of the securitised products they originate and sell. Parliamentarians are pressing the European Commission to include a clause in the directive that will allow for a possible increase in the retention rate in future, depending on international developments. Such a move favours the on-balance sheet covered bond market.
The Basel Committee on Banking Supervision has also proposed updates to its Basel II Capital Accord that will clamp down on complex securitisations. It wants to see risk weights for what it terms “resecuritisations” – securitisations that reference other securitisations – to be set at 20% for AAA-rated senior tranches and 30% for non-senior tranches. The earlier 2006 Basel II framework did not discriminate between securitisations and resecuritisations at all and, under the internal ratings-based approach to measuring credit risk, applied a risk weighting of 7% for AAA-rated senior tranches. If adopted by national regulators, these rules will make it considerably more expensive for banks to sell complex structured credit products.
“The cost to banks when it comes to the amount of capital they have to hold against securitisation obligations is generally increasing,” concluded Jennings-Mares.