A second shot at the big prize

With draft covered bond legislation being discussed in Washington and a benchmark having been sold to US investors for the first time in 2-½ years, hopes that the US will give the asset class another chance appear well founded. Neil Day reports.

  • 16 Mar 2010
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That past performance is no guide to the future performance of a financial product is normally meant as a warning. But when it comes to US covered bonds, proponents of the asset class are hoping rather than fearing that this is the case.

What should have been the first breakthrough for covered bonds turned into a disaster, albeit a mitigated one, when Washington Mutual collapsed in September 2008, putting holders of its euro denominated covered bonds through a rollercoaster ride until JPMorgan Chase took them on. US investors had already been left wondering just what type of "rates product" they had been sold when liquidity in their Depfa and Northern Rock dollar denominated covered bonds dried up in the second half of 2007.

Even a well-meaning promotion of covered bonds by the US Treasury had little, if any concrete effect when Best Practices guidelines were published in July 2008. Coming in the dying days of the Bush administration, the initiative was perhaps doomed to failure.

But in spite of these setbacks covered bonds are both back on the campaign trail in Washington and finding their ways into US investors’ portfolios again.

Covered bonds’ day on Capitol Hill came on December 15, when the House Financial Services Committee (HFSC) held a full hearing titled "Covered Bonds: Prospects for a US market going forward". A commitment to such a hearing from HFSC chairman Barney Frank had been secured by Republican congressman Scott Garrett in November, when he had proposed covered bond legislation as an amendment to the wider Financial Stability Improvement Act of 2009.

Speaking to The Cover, EuroWeek’s sister publication, ahead of the hearing, Garrett — who has publicly supported covered bonds since July 2008 — said that he sees covered bonds as one part of the solution to getting private sources of finance for the mortgage market flowing again."Obviously in our country our housing market, our mortgage market took a huge hit over the last year or so and we suffered in some areas because we do not have as diversified a field of [financing] methodologies for the housing and mortgage markets," he told The Cover. "So I believe that covered bonds offer us an alternative.

"Realistically, it’s not one that is going to supplant it, but be a piece of it. And I believe we can do it. What I always try to advocate is a free market approach, as opposed to yet another government-type programme to prop up the housing market."

It was the collapse of the securitisation market that necessitated the government intervention that Garrett and his fellow Republican’s find hard to swallow, and his support for covered bonds is not at the expense of what is often characterised as a competitor.

"Securitisation, as you know, for all intents and purposes seized up and is just in the inkling, beginning phases of coming back, but really hasn’t been there," he said. "My hope would be that as we grow ourselves and replace some of the structures that we have in our institutions right now that the securitisation market will re-establish itself as a significant source of funding in the marketplaces."

But although Garrett does not see covered bonds and securitisation as mutually exclusive, he and other supporters of the legislation have stressed advantages the on-balance sheet product could offer the US mortgage finance system relative to securitisation, whose originate-to-distribute model was seen as a cause of indiscipline.

"Better lending will be one of the principal benefits of covered bonds because covered bonds will be backed by loans that lenders make and then keep on their balance sheet rather than selling those loans into the securitisation marketplace," said Bert Ely, a consultant on issues such as GSEs and the FDIC, in testimony at the hearing. "Lenders keeping the loans they make will eliminate the moral hazard inherent in the securitisation process in which lenders shift all of the credit risk of the loans being securitised to investors in the liabilities issued by securitisation trusts."

This feature of covered bonds has been oft-mentioned by supporters of the asset class since it chimes with much post-sub-prime crisis rhetoric. "Properly aligned incentives" were one of four core principles necessary for the future of housing finance set out by Elizabeth Duke, a member of the board of governors of the Federal Reserve, in a speech ahead of the hearing, for example.

Covered bonds also appeared to have the potential to sit comfortably with the other three principles cited by Duke: adequate consumer protection, transparency and simplicity. She nevertheless delivered no verdict on whether it might be covered bonds, securitisation or another model that would prevail.

Keeping it bipartisan

Although no further House time had been set aside for the covered bond initiative by the time this report went to press, Garrett said in February that he was getting ready to finalise the legislation. However, it was yet to be decided whether it would be presented as a standalone bill or as part of a broader package of financial reforms, and he noted that even though he was confident that progress through the House of Representatives would not be problematic, any legislation would then face the Senate’s "arcane" systems of rules governing proceedings.

The House Financial Services Committee was scheduled to hold a hearing on the future of housing finance on March 2, to discuss private and public participants in the sector, including the Federal Housing Administration, Ginnie Mae, Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and private lenders and securitisers, with Frank having invited Treasury Secretary Timothy Geithner, Housing & Urban Development Secretary Shaun Donovan and others to discuss the topic.

Several market participants say that while covered bonds would be pertinent to such discussions, it is best to keep the push for legislation separate from any reform of Fannie Mae and Freddie Mac for fear that this will get bogged down in Washington.

"The covered bond legislation is seemingly a bipartisan issue," says one banker in New York, "with increasing access to consumer credit being something that both Democrats and Republicans want. Getting that caught up in a partisan issue like agency reform would not seem to make sense."

Proponents of covered bonds are nevertheless cognisant that the fate of the instrument in the US cannot be separated from the GSE debate.

"There is a lot of talk of reform around the whole GSE sector, and inasmuch as that evolves, it may impact the relevance of covered bonds," says one. "It is our view that, if nothing else, legislation should be enacted to give banks the option to use covered bonds."

While not everyone agrees that bipartisan support for the introduction of legislation is a done deal, supporters can at least take heart from Frank having described the covered bond initiative as "a very good idea" when committing to the hearing. Although one Washington source notes that Frank’s support for the hearing was given mainly as a quid pro quo for Republic support for a different Democrat measure, Garrett’s initiative had already got Democrat Paul Kanjorski to sponsor a previous version of his legislation when it was put forward as the Equal Treatment For Covered Bonds Act in June 2009. Kanjorski is chairman of the subcommittee on capital markets, insurance and Government Sponsored Enterprises.

Born in the USA

What those committed to the covered bond cause are in agreement on is that, unlike first time around, legislation is necessary for a market to flourish.

"The best way to lower cost, to lower the spreads, what have you, is to have as detailed a framework as possible," said Garrett, "which again is like you folks in Europe have done."

The covered bond initiative has had input from European market participants, through their membership of bodies such as the US Covered Bond Council and meetings with representatives such as the Association of German Pfandbrief Banks’ executive director, Jens Tolckmitt.

The biggest difference between the legislation proposed by Garrett and European frameworks is that it envisages a broad range of assets being eligible as collateral for covered bonds. The draft prepared ahead of the hearing listed residential mortgages, home equity, commercial mortgages, public sector assets, auto loans, student loans, credit or charge cards, small business loans, and "such other eligible asset class as may be designated by the covered bond regulator".

While some of these might be anathema to European purists, those involved in the US push say that the list makes political sense and should provide no practical difficulties to the market.

"It differs somewhat in terms of the assets that may be eligible as cover and there has been some noise out of Europe to this effect," says Ben Colice, head of covered bond origination for the Americas at Barclays Capital, and a member of the USCBC steering committee. "There is growing recognition in the US of covered bonds as a new source of financing consumer assets, which is helping to provide additional support for the legislation.

"Also, different asset classes would have to back different programmes."

In testimony prepared for the hearing Ely aggregated various types of credits that could potentially be funded through covered bonds in the US and came up with a staggering total of $21.513tr (Eu15.878tr).

"Statutorily authorising numerous covered bond asset classes would permit greater asset diversification by lenders," he said. "That is, instead of a lender being highly concentrated in just one or two classes of assets funded by covered bonds, the lender could have multiple classes of such assets."

Like night and day

The legislation is also very different to and more detailed than that introduced by Garrett in his earlier pushes for covered bond legislation in July 2008 and June 2009.

Moody’s praised the later draft, saying that the proposed "comprehensive" legislation was "robust" and, unlike the previous version, would provide "very strong" protection to covered bondholders in the event of an issuer default. This contrasted with the rating agency’s verdict on the earlier draft, which Moody’s said failed to address liquidity risk, which it described as a key credit risk of covered bonds.

Market participants have whole-heartedly welcomed such improvements to Garrett’s proposals. Jerry Marlatt, a lawyer in Morrison & Foerster’s capital markets group in New York and a member of the USCBC’s steering committee, says that the difference between the old and new proposals is "like night and day".

A lawyer at another firm in New York agrees.

"What was put forward was very interesting," he says "in that it was a much more complete solution than we had seen in the Treasury’s Best Practices or any of the other proposals we have seen. It seemed to address a lot of the problems that exist in the US covered bond structure — though it still leaves a lot of open questions, just because there are so many loose ends right now as to what direction financial regulation in general is headed."

Brad Brown, senior vice president, corporate treasury, at Bank of America — only one of two US financial institutions to have issued a covered bond — says that the legislation would lower costs for issuers and reduce uncertainty for investors. In particular, the way in which a cover pool could be hived off in the event of insolvency under the proposed legislation rather than liquidated was welcomed by Brown as well as Moody’s.

"In our structure the cover pool would need to be liquidated within 120 days of an insolvency event," he said, "and liquidation market value risks reside with the investors in this scenario. However unlikely, it’s not easy for covered bond investors to underwrite that risk.

"Removing that element from US structures would be a positive, not only from a rating agency perspective, but also from an investor point of view."

The uncertainty is removed by restricting the flexibility that the Federal Deposit Insurance Corporation currently enjoys, but proponents are hopeful that the FDIC can get comfortable with the legislation.

"I think we’ll see more support from chairman [Sheila] Bair and the FDIC in general for it," Garrett told The Cover, "so that we’ll get a finished product that’s actually effective and one that banks, financial institutions will be able to effectively roll out and be useful to the marketplace."

CIBC clears the air

While the political appetite for legislation will not be fully proven until legislation is passed, US investors have already given the asset class a vote of confidence, buying 85% of the first covered bond to be targeted at them in 2-½ years.

Canadian Imperial Bank of Commerce in late January launched the $2bn three year transaction via bookrunners Bank of America Merrill Lynch, HSBC and Royal Bank of Scotland, with CIBC as joint lead. The level of US sales was close to the peak achieved in late 2006 and early 2007 by issuers such as HBOS.

Last time around, however, the timing could not have been worse. Several months later the financial crisis struck and, with names such as Northern Rock and Depfa having been among those that made the transatlantic trip, the standing of the asset class quickly suffered.

"The big issue first time around was, at the end of the day, the timing, which was less than ideal, at best," says one banker. "We had problems in Europe with liquidity as well at the time, but in the US there was a complete lack of liquidity for three to six months.

"That left a bad taste with investors."

But CIBC showed that the US investor base is willing to give the product a second chance. Its deal was priced at 30bp over mid-swaps, translating to around mid-swaps flat in euros — well inside what the Canadian issuer might have been able to achieve in euros at the time.

Although no follow-up had emerged by the time this report went to press, Compagnie de Financement Foncier has met with US investors after setting up a 144A MTN programme last year and names such as Commerzbank’s Eurohypo have shown an interest in dollar issuance. Bankers say that the prospects for any such supply look good.

"The feedback we have had on the CIBC issue and in other discussions with investors has been very positive," says Tim Skeet, head of covered bond origination at Bank of America Merrill Lynch. "Covered bonds suffered last time around only when there were things going wrong in a lot of markets and it was not necessarily through any fault of their own."

He says that the main question investors now face is in which portfolio covered bonds fit, but adds that this is an issue for other instruments, too. However, he is confident that there is a place for the asset class and Colice at Barclays agrees.

"There is a desire for high quality triple-A assets in dollar format, particularly with less agency product available and the end of the Temporary Liquidity Guarantee Program," says Colice. "A number of investors have become more comfortable with the asset class and are now in a position to evaluate individual issuers."

Canada budgets for legislation

Although CIBC’s issuance had a sovereign link, it was not based on specific covered bond legislation. However, the Canadian government announced in its 2010 budget in early March that it is planning to introduce covered bond legislation.

"One of the lessons of the global financial crisis is that financial institutions need to have access to a variety of funding sources," it said. "The government will help federally regulated financial institutions diversify their funding sources by introducing legislation setting out a framework for covered bonds.

"Covered bonds are debt instruments that are secured by high quality assets, such as residential mortgages. The legislation will increase legal certainty for investors in these debt instruments, thereby making it easier for Canadian financial institutions to access this low-cost source of funding."

David Power, an executive in Royal Bank of Canada’s treasury department and chair of the Canadian Bankers Association’s Covered Bond Specialist Group, says that the government’s move is a "tremendous development".

"We have been advocating for covered bond legislation for only a short time, and the government has recognised its importance and responded quickly," he says. "Legislation will enable both small and large Canadian financial institutions to access the covered bond market more efficiently.

"We will seek to work with the government on the technical elements of the legislation, in consultation with investors and industry experts from both Europe and North America."

In October 2009 RBC launched the first domestic Canadian covered bond, a C$750m (Eu501m/$709m) five year deal priced at 49.7bp over the Canadian government curve on the back of a C$1bn order book. The issue was almost entirely sold to Canadian investors, with just 1% going to European accounts.

Bankers say that this domestic support should also help investors elsewhere have more confidence in Canadian issuers, which could enable them to achieve more competitive funding.

"This evidence of a domestic investor base gives Canadian issuers additional legs to stand on whether they are talking to European or US dollar investors," said one syndicate official based in the US, "but, irrespective of that, it also just gives them an alternative funding source at very attractive levels relative to other potential markets."

  • 16 Mar 2010

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 102,994.82 409 8.29%
2 Citi 96,697.47 362 7.78%
3 Barclays 82,826.79 294 6.66%
4 Bank of America Merrill Lynch 82,541.75 313 6.64%
5 HSBC 66,026.80 322 5.31%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
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1 Bank of America Merrill Lynch 8,946.93 17 9.40%
2 Deutsche Bank 6,056.30 15 6.36%
3 Commerzbank Group 5,474.20 22 5.75%
4 BNP Paribas 5,160.94 25 5.42%
5 UniCredit 4,424.51 19 4.65%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 2,328.59 11 11.04%
2 Morgan Stanley 2,132.71 13 10.11%
3 Bank of America Merrill Lynch 1,598.67 7 7.58%
4 JPMorgan 1,544.99 8 7.32%
5 UBS 1,229.93 7 5.83%