Covered Bonds-A Timely Alternative: With the Mortgage-Backed Securities Market Still Pretty Frozen, Banks and Other Lenders Might Consider Issuance of Covered Bonds as an Alternative Financing Method

By Klein, Bruce | Mortgage Banking, October 2008 | Go to article overview

Covered Bonds-A Timely Alternative: With the Mortgage-Backed Securities Market Still Pretty Frozen, Banks and Other Lenders Might Consider Issuance of Covered Bonds as an Alternative Financing Method


Klein, Bruce, Mortgage Banking


With the current stall in the securitization markets and the issue of liquidity gaining predominance, it may be a good time for banks to explore a different option for leveraging the mortgage collateral held on their balance sheets. Covered bonds offer a vehicle for a financial institution to issue debt that is backed (or covered) by a pool of mortgages. Unlike in securitization, these mortgages remain on an issuer's balance sheet, but the collateral security that they provide allows the debt to be issued at a lower cost than other funding vehicles. Covered bonds are a mature product in Europe, but are just starting to draw interest in the United States with both Seattle-based Washington Mutual (WaMu) and Charlotte, North Carolina-based Bank of America (BofA) having dabbled in the market over the past few years. The Federal Deposit Insurance Corporation (FDIC) also recently weighed in with a long-awaited policy statement on their treatment. Covered bonds have a long history in Europe for financing various asset classes dating back to the 1700s. Contemporary use of covered bonds for mortgage funding took off in 1995 with about 20 billion euros in issuance, and has since grown rapidly with more than 200 billion euros in issuance in 2007. *

To give a sense of the growth potential for covered bonds in the United States, today 17 percent of the total European Union (EU) residential mortgage volume is funded by covered bonds, according to the European Mortgage Federation, Brussels, Belgium. If funding of U.S. residential mortgages via covered bonds were to grow to this level, it would translate to almost $2 trillion of covered bond issuance, based on an overall home mortgage volume outstanding of $11.1 trillion (as per the Federal Reserve Board's Statistical Supplement to the Federal Reserve Bulletin, June 2008).

This article explains how covered bonds work, the regulatory challenges around them and how U.S. branches of foreign banks and U.S. banks themselves can get started in creating a covered bond program.

Background

A covered bond can be thought of as a hybrid of a corporate bond and a mortgage-backed security (MBS). It is backed by the general credit of the issuer, like a corporate bond, but in case of corporate insolvency it is further secured by a pool of mortgages known as the "cover pool."

Assets can be moved in and out of the cover pool as long as the new assets meet whatever collateral standards have been defined. Unlike a regular corporate bond that is unsecured, covered bonds offer investors the extra protection of a pool of assets with a cash flow that can be utilized to maintain their interest payments in case of a corporate insolvency.

Different frameworks are utilized to give the covered bonds a privileged position in a bankruptcy situation, thereby protecting investors' interests and leading to higher debt ratings for the covered bonds than for regular unsecured debt. Unlike a mortgage-backed security, covered bonds remain on an issuer's balance sheet, and the cash flow of the mortgages is not directly tied to bond holder payments except in the case of insolvency.

If an insolvency situation does arise, there are many creditors that will be looking to be repaid. How can the covered-bond holder be ensured that the cover pool will be used to fund the bond holder's interest payments?

In most cases, the answer is special legislation that protects the covered-bond holder and puts a virtual fence around the cover pool assets such that they can be only used for purposes of paying the covered-bond holders. The legislative framework serves to protect the interests of covered-bond investors and results in higher debt ratings for the covered bonds than for regular unsecured debt, making it a cheaper source of funding.

The legislation differs by country and is most mature in Germany, where covered bonds are known as Pfandbriefe and have been used for many years. …

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