What is it about covered bonds that is different from other bonds? Why are they so popular in markets that are under stress?
Covered bonds appeared in Europe in the late 1700s and were first used by Prussia's Frederick the Great to finance the rebuilding of residential and commercial real estate in the wake of the highly destructive Seven Years War.
Since then they have spread to some 28 countries and have become widely popular in the European markets. The bonds are popular because they combine the best characteristics of bank bonds and securitizations.
In 2006 and 2007, two U.S. banks issued covered bonds in Europe. And more recently, leading U.S. institutions are said to have considered covered bonds. However, issuance has not picked up, in part, because of uncertainty about regulations.
In July 2008, as the credit crisis began to come to a boil, then-Treasury secretary Henry Paulson unveiled an initiative to create a U.S. market for covered bonds and was supported by Citigroup, JPMorgan, Bank of America and Wells Fargo.
In a joint statement, the banks declared: "A robust U.S. covered-bond market would provide an additional stable and cost-effective funding source for banks to originate and hold mortgages on their balance sheets."
However, since then, U.S. banks have struggled to weather the crisis and have not turned to covered bonds, although this year Canadian banks have issued more than $10 billion worth of covered bonds into the U.S. market.
Covered bonds are purchased by central banks, banks, and other investors that typically buy sovereign or agency debt.
So why do these conservative investors get comfortable with covered bonds? Why is it that investors who usually will not buy an asset-backed security will buy a covered bond?
The answer is that a covered bond is not a securitization and does not present the risks of a securitization.
For example, the convexity risk of a typical residential mortgage-backed security, or RMBS, is not present. Instead, a covered bond looks like a typical corporate bond issued by a bank, but with certain additional protections that are attractive to conservative investors.
A covered bond is a full recourse obligation of the issuing bank. And the bank must be a regulated financial institution, whose bond issuances are overseen and approved by a bank regulator.
The bonds are secured by a "cover pool" of financial assets (typically residential mortgage loans) that is tested monthly to ensure that there is sufficient asset coverage to pay the bonds. There must be sufficient excess collateral in the cover pool to absorb losses from defaulted loans.
But as long as the bank is solvent, defaulted mortgage loans are removed from the pool each month and new loans are added. So to start with, the bonds are safer than unsecured bank debt.
Additionally, however, if the bank fails and is taken over by receivers, the cover pool is separated from the bank and is administered so that the collections and proceeds from the sale of assets in the cover pool are used to pay interest and principal on the bonds on their scheduled payment dates. No other creditors of the bank may claim any of the collections or proceeds until the bonds are paid in full.
Finally, in the event that the cover pool is unable to pay the bonds in full, the bondholders hold an unsecured claim against the remaining assets of the estate of the failing bank and their claims will rank equally with other unsecured creditors of the bank. So, in effect, the holder of a covered bond holds a corporate obligation of an issuing bank that converts into a virtual securitization with a clean, refreshed pool of collateral in the event of the insolvency of the issuing bank and with a contingent claim against the failed bank's estate if the cover pool proves insufficient to satisfy their claim.
The combined effect of these features is to give comforting certainty to investors that their investment will be paid in full at the scheduled maturity date and not accelerated in the event of the insolvency of the bank. As an additional benefit, throughout much of Europe, banks are encouraged to invest in covered bonds of European Union banks by the favorable capital treatment provided to covered bond investments under the EU capital-requirements directive. The result is that EU banks will have significant investments in covered bonds. Accordingly, European regulatory authorities tend to support the covered bond market because of its significance to the capital base of EU banks.
This was evidenced by the covered bond purchase program introduced by the European Central Bank during the recent financial crisis in an attempt to maintain an open covered-bond market so that banks could continue to obtain funding through the market and to protect the value of covered bonds held in bank portfolios.
This implicit government support is an important feature of covered bonds to investors and is viewed as providing important additional stability to the market.
Jerry Marlatt, senior counsel at Morrison Foerster, specializes in corporate finance with a focus on structured capital markets, representing issuers, underwriters and placement agents.
