Robert Campbell reports.
The Covered Bond market is looking further abroad for its newest members now that almost all of the euro zones countries have covered bond legislation. This, along with the credit market turmoil, could explain the drop in the number of new issuers in the market from 15 in 2006 to 12 in 2007.
However, even the recent proliferation of European covered bond issuers has caused some unease in what had previously been a tightly-knit community. Some within this club are concerned that the long, successful effort to establish the product could be swiftly wasted as any homogeneity in the market is washed away by a wave of new issuers claiming to belong to the family.
Ted Lord, global head of covered bonds at Barclays in Frankfurt, says that those looking to enter the market have to make sure they start at the very beginning.
"We have to start with the eternal question: what is a covered bond?" he says. "This a much-discussed topic and the European Covered Bond Council has a definition."
The important features are a dual recourse to the asset cover pool and issuing bank, a renewable asset pool backing the issue, the assets remain on balance sheet, there is a priority claim by the covered bond investor in case of insolvency, and that there is constant supervision through either official regulators and/or a covered bond monitor. "In short, they are safe instruments," he adds.
Lord feels that the appeal of emerging market covered bonds will not be limited to either traditionally cautious covered bond investors or to emerging market investors.
"Emerging market covered bonds can appeal to both the covered bond and emerging market buying points at an investing firm," he says.
Others agree that with emerging market covered bonds expected to receive ratings below triple-A, despite a potential ratings upgrade above the national ceiling, they will attract a very different kind of investor to the traditional buyers of covered bonds.
Analysts have targeted Mexico and Turkey as likely to be among the first to join the benchmark sized bond issuers. Turkey is expected to issue in the second half of this year with benchmark sized deals to follow next year, while Mexico is expected to emerge later, but as an equally important participant.
"Massive" housing deficit
As the largest issuer of residential mortgage backed securities (RMBS) in Latin America, Mexico is a natural starting point for covered bonds in the region.
The interest in covered bonds has been driven not just by the desire for a new product but high population growth and shifting living patterns.
Mexican President Felipe Calderón, speaking at Mexicos 21st Housing Meeting in July 2007, announced ambitious targets to meet these demographic challenges.
"For my government, housing policy is a strategic priority," he said. "The demographic trends in Mexico for the next 25 years show that an average of 650,000 new homes will have to be built each year."
The Mexican government estimates that 4m new houses will be required over the next five years. The government provides loans up to Ps180,00 ($16,850) to fund house purchases. Those at the bottom of the housing ladder can draw on a Ps43,000 subsidy.
A research report from Standard & Poors in September agrees that Mexico faces a challenge, describing the country as having a "massive" housing deficit and estimated the shortfall at 6m units.
Despite the growth of Mexicos RMBS market, new sources of funding are required to pay for these new homes.It was the sofoles (specialised mortgage lending institutions) Hipotecaria Su Casita and GMAC Hipotecaria that kickstarted the Mexican RMBS market in 2003 and the sofoles look set to lead the way in covered bonds as well because of restrictions on banks.These pioneers were eventually joined by five other sofoles, two commercial banks and government housing agency Infonavit in the RMBS market, although Infonavit is likely to claim a more prominent role this time around as it has come to dominate the residential mortgage market in recent years
Mexicos housing needs, according to S&P, are greater even than the Mexican governments figures, which considers 2.1m families already need new homes.
"Mexico has a huge housing deficit of about 5m homes," said Mark Zaltzman, finance and planning director, Hipotecaria su Casita at the IMN covered bond conference in January. "Demand for housing is about four times current supply."
Zaltzman said that Mexican financial institutions were becoming increasingly experienced in the financial markets, and were looking abroad for further funding.
"As of last year, were less reliant on government funding were now using the capital markets more," he said. "We issued $150m of RMBS last year; we intend to do $1bn this year.
"However, the domestic investor market is quite small and retreating into government bonds due to the recent turmoil, so we need international investors."
José de Jesús Gómez Dorantes, head of the Cedevis programme at Infonavit, the Mexican federal fund for worker housing, says that while Mexican covered bonds are at an embryonic stage, he wouldnt rule out a rapid gestation period.
"Talking about a Mexican covered bond just now is a theoretical exercise," he says. "However, I wouldnt be surprised if we saw a couple of issues by year end. There are 110m people in Mexico, many of them under 24 years old. We expect 750,000 new houses a year to be built in the near future as demand peaks. Demographics matter."
"The country has a need to finance this construction," he continues. "Infonavit was created in 1972 and is government sponsored. 5% of the salery of any worker in the formal sector is paid by the employer to Infonavit. The credit risk is reduced to 0% as long as a worker is formally employed. This helps mitigate credit risks despite current market conditions."
According to Zaltzman the Mexican market has now reached a critical mass where covered bonds make sense.
"Covered bonds offer several benefits," he says. "For example, transaction costs are much lower when refinancing on balance sheet. We have the capacity for covered bonds; we now originate enough mortgages for it to be worth it."Despite all this, regulatory problems still need to be ironed out for some potential issuers in Mexico, and the World Bank has been called in to level out an uneven playing field. The new sofoles are well set up to take advantage of adoption of covered bonds, while the established banks face limits on segregating assets that remain on their balance sheets.
"We are a non-bank bank," says Dorantes. "Were not regulated; we fund ourselves through the equity and capital markets. We dont have any restrictions, whereas banks are prohibited from pledging assets to a lender.
"The World Bank now has a mandate to advise on removing this obstacle to banks."These problems are exacerbated by the banks need to make up ground on the sofoles that came to dominate the property sector following the banks withdrawal from the market after the 1995 crisis.
Zaltzman says that the Mexican housing market is now solid, unlike those of some other nations, and that issuers across the property sector are keen for international involvement.
"There is no bubble in Mexican housing, just increases in line with inflation," he says. "This is because our price rises are driven by need, rather than investment or speculation. There is no spike in delinquencies and therefore no credit issue.
"At some point the domestic market will not be deep enough to fund the necessary growth in the housing sector. Therefore there are government and private efforts to issue covered bonds this year."
However, according to Ted Lord, Mexico is not alone in seeking to attract investors by issuing covered bonds. "Mexico is not the only country in the Americas exploring the covered bond market," he says. "Argentina and Chile are both investigating covered bonds. In fact, Chile has an old law which some specialists view as having a few covered bond features."
Closer to the assets historic investor base and with particularly strong ties to Germany is Turkey, which is expected to follow Mexico into the covered bond market later this year.
Turkeys new legislation relies mainly on the German Pfandbrief Act as well as some elements of the Irish Asset Covered Securities Act. Its arrival is well timed.
"The Turkish mortgage market has experienced not only major growth but also changes, as it was previously largely cash based," says Lord.
Talk in Turkey has been bullish, not just on mortgage covered bonds but also on pricing through the sovereign curve supported by public sector collateral.
However, Bernd Volk, head of covered bond research at Deutsche Bank is typical of the cautious voices emanating from the Old World of covered bonds.
"The relatively low ratings of Turkish banks [the Republic of Turkey is rated Ba1s/BB-s/BB-s] will make it difficult for Turkish covered bonds to reach very strong rating categories," he says in his report on February 13. "Hence, Turkish covered bonds might not be rated high enough to be interesting for typical covered bond investors. Generally, it may be difficult to sell Turkish covered bonds in euros at a significantly tighter spread than Turkish government bonds denominated in euros.
"On the other hand, external credit enhancements and the use of foreign law might help to achieve significantly higher ratings."
According to Moodys the ratings which could be achieved in Turkey are subject to two key constraints.
"[First] the foreign currency ceiling (Ba1), which could be pierced provided that certain conditions are satisfied," says the rating agency. "[Second] the local currency ceiling (A2). This ceiling is an indication of the maximum rating achievable in a given country."
As with Mexico, a variety of institution types will make up the Turkish market. Both banks and mortgage finance companies are allowed to invest in covered bonds under the new Turkish law the latter are supposed to concentrate on providing low risk financing and hence a lower bankruptcy risk than the banks.
These issuers may be supplemented by a multi-seller programme modelled on Spains cédulas market that would allow smaller banks to pool their assets to issue covered bonds. However, sources in Turkey say that such a move is now a long way off.
Hungary lights the way?
Emerging market issuers can take hope from the recent example of Hungarys OTP mortgage bank, demonstrating that it is not solely sub-Libor public sector Pfandbriefe that make the mouths of traditional covered bond investors water.
OTP successfully re-opened the primary covered bond market on February 19 with its first benchmark sized covered bond. The Eu1bn two year deal, the first jumbo from Hungary, priced at 65bp over mid-swaps and attracted a markedly different investor profile from OTPs usual buyers, who tend to buyers of senior debt issued by financial institutions.
The deal demonstrated what can be achieved by emerging market covered bonds. The Hungarian market has grown steadily from a A1 rated debut domestic covered bond to issuing its first jumbo sized deal, although Hungarian issuers have urged others to follow their example and begin with domestic and private transactions.
European emerging market investors have historically concentrated on sovereign debt or large, well known corporate bonds.
According to some observers, covered bonds are the next logical step for emerging investors. One banker suggested that if youre going to enter a market you dont know intimately, it is best to do so via an instrument where you know you have a prior claim.
As well as an association with the venerable Pfandbrief in its various incarnations, declaring that the Irish or Danish legislative framework provides the backbone of your legislation is becoming popular for new jurisdictions.
Familiarity is important to catch investors attention, but it is an even more pressing need for emerging market issuers in a troubled climate, as Bahadir Teker, general manager, Istanbul Capital, recognises.
"Pfandbrief is a brand name," he said at a conference in November. "We need to establish Turkish covered bonds to get good pricing. We had the advantage of late entry, examining the regulations of others."
Lord believes that covered bonds can serve two mutually compatible purposes for emerging market debt issuers.
"First, they can promote home ownership and support the funding of banks in the mortgage market," he said. "Second, covered bonds are a way for regional institutions to access international investors."Saying that something is a covered bond gives immediate recognition of the asset class."