The rapid demise of the residential mortgage-backed securities market in the early days of the financial crisis, back in the summer of 2007, was not wholly disagreeable to many proponents of one of its rivals: the covered bond market. Traditionalists had long argued that their product was superior to securitisations and were happy to have been proved in their eyes, at least correct.
Around the world covered bond bankers pushed the product as a safe alternative method of mortgage finance, and enjoyed a degree of success in winning around governments, regulators and potential issuers.
But as the crisis persisted, and particularly after the collapse of Lehman Brothers, the benchmark covered bond market itself came to a grinding halt and these arguments sounded less credible. Protests that the market was suffering no more than asset classes such as peripheral eurozone government bonds or senior unsecured debt fell on deaf ears as practical, rather than theoretical solutions were being sought. The market spluttered along in fits and starts unconvincingly for the first four months of the year.
Then, on May 7, the European Central Bank suddenly thrust covered bonds back into the limelight by announcing that it would buy Eu60bn of covered bonds to boost the eurozone financial system. That it did so in an announcement where no other surprising or dramatic initiatives were revealed only gave the news more prominence.
Suddenly everyone was talking about covered bonds again.
Even if observers struggled to work out just how much impact the ECBs action would have on the market and the eurozone economy given that details of the plan were not due to be announced until June 4 its move was hailed as an endorsement of covered bonds.
"The important thing for me is that the ECB did not state that its rationale was to push down rates, as has been the case with asset purchases in the US, but to help get liquidity back into a very important market, to help banks to issue," says Claus Tofte Nielsen, senior portfolio manager at Norges Bank Investment Management.
Spreads immediately tightened an average of around 20bp from multi-cédulas tightening as much as 50bp to Pfandbriefe perhaps 10bp bringing covered bond funding costs down to a level at which issuers were ready to issue, while investors took comfort from what was expected to be the equivalent of a Eu60bn ECB backstop bid.
The result was Eu12bn of new issues in the following two weeks more than the Eu9.5bn of new issuance in the first four months of the year and after an April when no new jumbos at all had hit the market. That the first issue was a Eu1.5bn five year cédulas hipotecarias for Santander, after almost a year of zero issuance from Spain and four months of supply almost exclusively from France and Germany, was all the more encouraging for market participants.
A way out of the crisis
One of the nine issuers that contributed to the Eu12bn of supply was Dexia Municipal Agency. While several of the banks issuing in the wake of the ECB announcement have turned to their governments for financial support, among them the Dexia group had perhaps suffered the most fallout from the collapse of Lehman Brothers, being rescued by the Belgian, French and Luxembourg governments at the end of September the day after Hypo Real Estate and its Depfa arm had to be bailed out.
Like many other banks, Dexia had since then only been visible in the public markets through government guaranteed issuance, but after its Eu1.5bn 12 year obligations foncières issue Véronique Hugues, the groups global head of long term funding, said that she was delighted to be back in the covered bond market.
"We can now achieve a nice mix of state guaranteed funding, which is limited to maturities up to 2011, and covered bonds, which remain a very solid credit for investors, especially on our side where we are still exclusively concentrating on the public sector," says Hugues.
"I really do not see why this product would not be an interesting alternative for investors looking for safety and at the same time duration. This really is the perfect product for them."The belief that the ECB sees covered bonds as part of an exit strategy from crisis measures in general and government guaranteed issuance in particular was reinforced by a report published days after it announced its Eu60bn plan prepared by its banking supervision committee, EU Banks Funding Structures and Policies.
The report cited the lack of a clear way out of government guaranteed issuance and expressed concern at the asset-liability mismatches. "All in all, the growing imbalance between the longer term lending to customers and the shorter term funding of banks activities created a maturity mismatch in banks balance sheets and exposed banks to increased funding and counterparty risks," said the report, which also noted the short term nature of retail deposits.
This asset-liability mismatch has also not escaped the notice of the rating agencies. "The focus of the rating agencies was previously on capital," says Andrew Porter, global head of covered bond origination at HSBC in London, "but recently they have been looking at liability profiles. That is an issue that is going to become an increasing priority."
However, covered bonds cannot start taking regulators support for granted. The Financial Services Authority, for example, in October tightened its grip on the UK market by requiring that issuers pre-clear any new deals while it reviews its policy on covered bond issuance. Although the public markets had been closed, UK banks had been printing billions of pounds of issues to access the Bank of Englands liquidity facilities. Meanwhile rating agencies had been demanding higher levels of over-collateralisation to maintain covered bond ratings as issuers were downgraded and the outlook for house prices deteriorated.
Primary flowing, secondary frozen
While the ECB spurred the primary market into action, it did not help the secondary market, which market participants say had been gradually improving before the announcement.
This was not what the ECB had been hoping for.
"As regards the re-opening of securitisation and covered bond markets more specifically," said the ECBs report, "while it is essential that simple and transparent secured structures be established, it is also of vital importance to investors that liquidity be restored to these markets."
Indeed investors disappointment at the lack of liquidity that covered bonds have offered had been perhaps the key reason why the market had not lived up its potential. Not only were investors not able to buy and sell bonds in a way that they had hoped, but the inter-dealer market-making agreements that were supposed to ensure liquidity had pushed spreads wider.
Led by the European Covered Bond Councils market related issues working group, market participants have been working to develop electronic systems that could help restore liquidity. Although progress has been slow, the first concrete results of these initiatives are expected to be piloted in June when daily auctions of covered bonds are set to be held on a Eurex Bonds platform.
This will bring together dealers to quote bids and offers on baskets of different maturities of bonds in two minute periods, at the end of which any prices that cross will result in transactions, the prices of which will then be published to bring greater price transparency to the market.
Laurent Ortiz, general manager of Eurex Bonds, says that gaining the support and participation of the market will be key to the success of the enterprise.
"We have a system that we believe can help restore liquidity in covered bonds," he says. "However, our system alone will not make this happen; there needs to be a combination of factors, including the support of banks and the restoration of confidence in the asset class.
"Will it work? It will if we manage to get the major participants to be present. And we believe they will be."
The buyside is engaging with dealers through the creation of the Covered Bond Investors Council (CBIC), which was unveiled by the International Capital Markets Association in March. Comprising investors, the CBIC is chaired by NBIMs Tofte Nielsen.
"It was logical that we should turn to ICMA to parent the council as part of its activities," said Tim Skeet, head of covered bond origination at Bank of America Merrill Lynch and chairman ICMA UK & Ireland region. "It is an important initiative to re-establish confidence in the asset class."
No, we cant?Meanwhile covered bonds claims to represent a more attractive alternative to RMBS appear undiminished. "Covered bonds dont have the problems that securitisations do," says Richard Kemmish, head of covered bond origination at Credit Suisse in London. "In the so-called originate-to-distribute model the lack of interest of the originator in the performance of the assets has been perceived to have been a problem.
"The fact that the European Commission is requiring originators to retain a 5% first loss piece speaks to the need to have skin in the game now."
It is not only in the covered bonds home of Europe that this view is widely accepted; the products avoidance of the pitfalls of securitisation are a key reason why the product has won over some influential supporters in the US, where the originate-to-distribute model caused the most damage.
Sheila Bair, chairman of the Federal Deposit Insurance Corporation (FDIC), has been a high profile figure in the debate over the future of finance and banking in the US and has kept covered bonds in the public eye in spite of similar concerns to those expressed by the UK FSA. Most recently, Bair in April said that she still sees potential for a covered bond market in the US.
Despite being lobbied by the Securities Industry & Financial Markets Association (which has set up a US Covered Bond Council) and politicians such as Republican congressman Scott Garrett, who has pushed to introduce legislation, concrete progress towards a US covered bond market has been limited since the US Treasury, under the Bush administration, last July set out its Best Practices for Residential Covered Bonds.
"You hear favourable mentions from time to time, even from Sheila Bair, but everythings still kind of frozen," says Bert Ely, a financial and monetary policy consultant at Ely & Company and self-professed FDIC watcher in Washington. "Its not dead, but its not going anywhere."
He says vested interests in the US have meant that restarting the securitisation markets has been given the priority that perhaps restarting the covered bond market has enjoyed in Europe. On top of this, the future roles of Fannie Mae and Freddie Mac remains unresolved.
North of the border, more progress is being made. The Office of the Superintendent of Financial Institutions Canada has been considering a proposal for a legislative framework that the Canadian Bankers Association (CBA) submitted in February. David Power, chair of the CBAs covered bond working group, said in February that although Canadian covered bonds do not need a legislative framework given that the existing framework is robust and has met with approval from many market participants a covered bond law is "the natural evolution for a country that permits its banks to issue the product".
Call it what you wantRather than North America, it is in Asia that covered bonds have made their biggest breakthrough in the new era. And although Japan was for some time the frontrunner in the race to issue the regions first covered bond, South Korea in early May crossed the line first.
Kookmin Bank sold a $1bn five year issue structured by HSBC, joint bookrunner with Citi, after approval from the Korean Financial Services Commission.
"We believe covered bonds can be a viable funding tool for Korean Banks," says Kang Chung-won, Kookmins chief executive. "We hope that covered bonds will provide us with a long term, stable funding tool."
The pricing of 500bp over mid-swaps, equivalent to 550bp over US Treasuries, was the subject of fierce debate, with some market participants questioning the economics behind the deal. Covered bond bankers also questioned the deals qualification for the asset class, given its structure and the inclusion of credit cards in the cover pool alongside residential mortgages.
However, these were no obstacle to the investors targeted by Kookmin: not traditional European covered bond buyers, but credit investors familiar with Asian sovereign and bank debt.
Even bankers involved in covered bonds play down the debate over the deals status, looking instead to the future possibilities the transaction highlights.
"It is a super-senior bond that gives market access in decent size to those issuers that might not otherwise have such deep access to the public markets," says Mauricio Noé, global head of covered bonds at Royal Bank of Scotland in London.
"I wouldnt necessarily call it a covered bond in the traditional European sense, but it points the way to how issuers can get their deals ratings up to a level where they can access markets in size in a stressed environment."