The rise of the covered bond appears inexorable. Newly created, updated or structured, covered bonds in one form or another are playing a growing role in the international markets. Cheaper funding for mortgage lenders? Diversification for investors? Fees for lead managers? The covered bond is being touted as the answer. And given its success of recent years, it is hard to disagree.
Had the idea of a Fannie Mae for Europe been floated two years ago as a way in which to improve the liquidity of the continent's secondary mortgage markets and thereby cut costs, it might have had a fair hearing.
The issuance programmes of the two US agencies were then setting new standards of liquidity, while their quasi-government status reinforced their Treasury-surrogate credentials.
In Europe, meanwhile, Germany's Pfandbrief market, which had attempted to position itself as a benchmark product for the euro, was facing one of its worst crises. Financing costs for some mortgage banks were ballooning and liquidity in jumbos was drying up.
But when the idea of a European mortgage finance agency project was actually floated last November, its prospects of becoming reality appeared thin. So what has happened in the past two years to turn the story around?
If the idea of 15 - and soon 25 - European Union members agreeing to create such an entity were not enough, the constant questioning of the Treasury-surrogate credentials of the US agencies and then Freddie Mac's problems with arithmetic certainly did the idea of a Euro Mae little good.
More importantly, however, Europe has understood and begun to unlock the full potential of its own solution to improving mortgage financing: the covered bond. Not only has Germany's Pfandbrief market come out of a difficult period older and wiser and with its reputation for security intact, but the product has been winning new fans across the continent.
Nowhere has the idea of the covered bond as a market solution to the problem of mortgage financing been more evident than in the UK. As chancellor Gordon Brown was charging Professor David Miles to review the country's mortgage market in April 2003, HBOS was opening up new options not only to UK mortgage lenders, but those across the world.
While Germany's mortgage banks had already created an international audience for covered bonds, HBOS had created a template that - with regional tweaks - could allow mortgage lenders across the world to tap into.
Covering the globe
In countries such as Australia, with its established residential mortgage backed securities (RMBS) market and similar legal framework to the UK, the idea of creating a covered bond product is now being taken seriously.
Meanwhile the countries of central and eastern Europe were quick to examine covered bonds as a way of boosting mortgage financing in their growing economies. While issuance has already started in accession states, activity could pick up later this year with transactions from several more jurisdictions, possibly including structured elements to improve credit quality.
Even China is said to be bearing covered bonds in mind as it reviews the prospects for its own mortgage market.
In the EU itself, momentum is building. Portugal is expected to be the next country to enter the market, with Caixa Geral de Depósitos leading the way. Although structured covered bonds from the country are said to be an option, the ironing out of problems with the country's draft law before issuance under legislation is most likely.
In Italy, banks may follow HBOS's lead and rather than wait for the politicians, produce structured issues. With the Italian government apparently unhappy to face competition from a potentially more highly rated product, structured covered bonds may well prove the best option.
While the idea of structured issuance is being considered by mortgage lenders in other countries, such as the Netherlands, some are instead looking at how to best unlock the potential of established, but outmoded covered bond laws by bringing their standards up to those of internationally accepted markets.
Sweden's mortgage bond market is the third largest in Europe, but in July it will introduce a new version of the covered bond that offers greater bankruptcy-remoteness and other security aspects international investors have come to expect and which the rating agencies have made a pre-requisite for top ratings.
Simultaneous with the use of covered bonds in mortgage finance has been a broadening of their use in public sector finance. After the success of its cédulas hipotecarias market, Spain last year introduced cédulas territoriales, backed by loans to the public sector.
And the latest covered bond product to enter the international arena was Austria's fundierte Schuldverschreibung. Kommunalkredit and then Bawag have since last September approached the international investor base with jumbo issues backed by loans to the public sector in Austria and have been welcomed with open arms.
For investors, the creation of new markets has presented welcome diversification opportunities. "What investors like is something that can offer them diversification," says Christian Reusch, head of syndicate at HVB in Munich. "So when there are these new markets being created across Europe they are happy to be able to diversify their portfolios further."
According to Achim Linsenmaier, vice president in debt capital markets at Deutsche Bank in Frankfurt, this is one reason why the Austrian debutants were so successful. "The Bawag and Kommunalkredit deals were seen by many investors as a welcome opportunity to diversify their holdings," he says. "German insurance companies, for example, sometimes find that they are already holding a substantial portion of German covered bonds and are keen to invest in covered bonds from other countries because they have to diversify not only by name, but also by region."
The growing number of issuers seeking investors' attention means that competition is greater than ever. And with banks enhancing bonds issued under weaker legislation with structured finance techniques and an increasing volume achieving triple-A ratings, the battle is being played out not just in terms of credit quality, but also issuance strategies.
The key weapon being used by ever more issuers in their bid to position themselves at the top end of the market is the pot system of syndication. "There is a clear difference between how those issuers that use the pot and those that use competitive biddings are received," says Hermann Behrends, head of debt syndicate at Dresdner Kleinwort Wasserstein in Frankfurt.
Jeremy Walsh, head of frequent borrower syndicate at ABN Amro in London, agrees. "Investors are becoming increasingly selective in looking at borrowers' issuing strategies," he says, "the way they bring their deals to the market, whether they put out their deals to competitive bid or award negotiated mandates. That sort of information is now well known in the investor community. They can tell what is a properly bookbuilt transaction, one that has been thoroughly prepared and well distributed."
Those that are not using the pot system, or at least adopting a consensual approach to pricing in the primary market, are meanwhile finding life increasingly difficult as investors stay on the sidelines.
"At the beginning of this year we saw two or three deals that widened just after pricing," says a syndicate manager in Paris. "That is not a good thing for the market because investors then wait to pick up paper in the secondary market, which is not what you want when you are trying to preplace a new issue."
The level of supply from a jurisdiction was also demonstrated to be of great importance at the beginning of this year when spreads on cédulas hipotecarias widened several basis points as market participants realised just how booming the Spanish market had become. Supply concerns are equally important when considering individual names, as well as whether new issue sizes reflect the level of demand in the market.
"Investors will increasingly look at how many times an issuer is likely to come to the market," says one syndicate manager. "They will also look at whether a new issue will be Eu1.5bn or Eu3bn.
"As long as the size is over Eu1bn, that is enough for liquidity, and investors would much rather have an oversubscribed deal that is firmly placed, with a good spread performance, than a larger deal that might be more liquid six months down the line, but which is poorly executed and placed."
After all, if issuers want to position themselves at the high end of the market, they must adopt the same market practices as benchmark issuers like the European Investment Bank (EIB), KfW, US agencies, and even governments themselves.
"In Europe, Asia and the US we run these transactions in exactly the same format as we would a syndicated issue for, say, Belgium or Austria, or an agency deal for KfW or a supranational like the EIB," says ABN Amro's Walsh. "We apply the same principles to covered bonds."
In many cases, covered bonds are being marketed as an alternative to such credits. In particular, the regulated nature of the product is seen by many market participants as a key selling point.
"What does a covered bond really offer an investor?" asks Ted Lord, managing director at Barclays Capital in Frankfurt. "You have a high credit rating, liquidity as a result of the market-making agreements, and a spread over government bonds. But what is also important is that you have diversified risk in the asset pools backing the issues.
"If you buy a government bond, you live and die on the basis of the finance policies of a particular finance ministry. So if you are a central bank with large portfolio investments in government bonds, you probably want to diversify. And whereas governments can spend as much as they like, covered bond issuers are very controlled in what they can do."
Such arguments can be persuasive and are winning around more investors outside Europe, particularly in Asia, where central banks and other investors are participating in a growing number of credits. Demand from the region has been further boosted by investors' desire to diversify away from US agencies.
"One Asian investor said to us that when a US agency is redeeming, he is not putting his money back into US agencies," says one DCM official in London. "Instead, he is trying to diversify and covered bonds are one of the products that is benefiting."
All of which is music to the ears of Europe's covered bond issuers. "Everyone sees the success that Depfa, for example, has had in Asia," says one syndicate manager in Frankfurt, "and treasurers across Germany and elsewhere would love to be able to achieve 25% sales to Asian central banks. Not everybody is going to be able to do that, but several are moving in the right direction."
Such wishes are not difficult to understand. "I spend a good part of my time working on opening up new investor markets," says Lord at Barclays, "because at the end of the day, if I'm an issuer and there is greater demand for my bonds than bonds available, the price of my bonds is going to go up and my funding costs down."
And in their mission to broaden distribution, covered bond issuers are seeking new territory. Furthest down the road to new accounts is Depfa, which has already launched two of its Irish asset covered security issues into the global dollar bond market. So far dollar supply from other issuers has been concentrated in the Eurodollar market, but WestLB Covered Bond Bank has stated its intent to access the US investor base and others are likely to follow.
Bankers say that the time for penetrating the US is right. "Since Fannie Mae and Freddie Mac have had their issues, investors in North America have realised that an agency is not a US Treasury with a good spread," says one covered bond banker in Frankfurt. "They are realising that they need to have limits on agency paper and that has opened up a lot of liquidity for covered bonds."