PRIMER: covered bonds
IFLR looks at covered bonds, regulations affecting them in the EU and why they haven't been widely adopted in the US
What are covered bonds?
Covered bonds are regular debt issuances from a banking or mortgage institution that are backed by a pool of assets. In the case of failure, the issuer can cover redemption at any point of time.
Covered bonds originated in Germany in the 18th century. They were used after the Seven Years War to rebuild towns and farms that had been destroyed during the war. Following the introduction of the euro in 1999 they spiked in popularity, as the launch of a new region-wide currency expanded the market in Europe. Covered bonds started being adopted in countries like the UK, the Netherlands and Spain, before spreading further afield to Australia. However, only two banks in the US have so far issued covered bonds, both pre-crisis.
Covered bonds are seen as having a risk profile similar to sovereign debt issuances, because they are covered by a pool of assets, normally residential mortgage loans. In the event a bank that issues the bond fails to make the necessary coupon payments, particularly if the bank becomes insolvent, a pool of collateral is separated from the bank and is used to continue making payments on the bonds through to their maturity. The expectation is that the bonds are never going to be accelerated because of the issuer’s insolvency, like sovereign debt, an acceleration clause is a contract provision ensuring borrowers must repay all of an outstanding loan if certain requirements aren’t met.
What are the benefits of a covered bond?
A covered bond is a form of secured debt and functions as such. But unlike traditional secured debt where if the debtor becomes insolvent bondholders seize the collateral pool and sell it, here the collateral pool is separated from the debtor and used to continue making payments.
One key difference between covered bonds and secured debt is who utilises them as they are mostly always issued by regulated financial institutions. “From an investor’s point of view, this is part of the appeal, because they only have to deal with an entity that has statutory capital requirements that are regulated to international standards,” said one US partner. “This provides investors with confidence as it’s highly unlikely that the issuer is going to become insolvent.”
"This provides investors with confidence as it’s highly unlikely that the issuer is going to become insolvent"
Covered bonds are primarily used to finance residential mortgage loans in Europe. This is of particular importance because there are no quasi-government organisations performing that function, like Fannie Mae or Freddie Mac in the US, so covered bonds act as the principal source of capital market financing for mortgage loans.
Are they widely used in the US?
While European covered bonds are well received by investors in the US, there have been no US issuances since 2008. “It goes without saying that one of the key reasons for that was the financial crisis, but in addition to this the passage of the Volcker Rule imposed sharp limitations upon banks and what they were able to invest in,” said the partner. Banks were no longer able to hedge funds, which had been an important fundraising activity for them.
As a result, residential mortgage loans have become a more attractive asset for a bank than they used to be. Additionally, both Fannie and Freddie Mae were taken over by the government at this point, because they became insolvent, and were used to sustain residential housing prices by allowing the organisations very expansive authority to purchase residential mortgage loans.
This authority continues now though there is a political tension between the Democrats and the Republicans about what to do with Fannie and Freddie, who remain in conservatorship after 10 years. The Democrats have used and want to continue to use Fannie and Freddie to support low income housing, while the Republicans think the pair should be used for their original purpose - providing a liquid secondary market for residential mortgage loans.
However, increasing activity levels in this area are another reason banks are not issuing covered bonds - when they need financing they generally get it elsewhere. Residential mortgage-backed securities (RMBS) issuances in the US have been very meagre through the last 10 years, in part because they can expose investors to prepayment and credit risk.
Do any regulatory developments, past, future or pending, impact covered bonds?
Earlier this year, the European Commission issued a directive on covered bonds that sets down the conditions that this type of debt has to respect in order to continue to be recognised under EU law. The proposal strengthens investor protection by imposing specific supervisory duties, and an enabling framework. Additionally, the Commission has proposed a regulation that amends the Capital Requirements Regulation, as part of the Capital Markets Union action plan.
“An enabling framework for covered bonds at EU level would enhance their use as a stable and cost-effective source of funding for credit institutions, especially where markets are less developed, in order to help finance the real economy in line with the objectives of the Capital Markets Union,” reads the memorandum.
There is an effort in Europe to establish EU wide standards for covered bonds. Previously, regulation of covered bonds in Europe had been established by a statute in each jurisdiction. “At the policy level covered bonds are important source of financing for banks. If requirements for covered bonds are common across all of the countries, from an investor’s point of view it makes sense to analyse what to invest in,” said the partner. The principle purpose behind covered bonds is provide capital markets access to all countries in the EU that are financing residential mortgage loans.
In the US, however, there has not been any legislation governing covered bonds – largely because they are rarely used. In July the Trump administration issued a reorganisation plan that included plans to reform Fannie Mae and Fannie Mac, notably moving the support for low income housing into the department of housing and development so that it becomes a non-balance sheet activity for the federal government. The two entities would become one combined, private entity, and would lose their federal guarantee.
“If that plan goes forward it will remove a lot of the tension between the Democrats and the Republicans about what to do with Fannie and Freddie,” said another US partner. “It might actually happen, but we seem to have plenty of other things to distract this government, so whether this plan actually moves forward or not is uncertain.”
At the moment there is no urgency amongst US banks to have covered bond legislation as they can raise whatever financing they need through Fannie and Freddie. But if RMBS grows in the US, then there will perhaps be some interest in covered bond legislation, so these are tied together.
What is the investor base?
The investor base for covered bonds is very different to others, like securitisation or senior debt. Banking institutions and central banks make up approximately 70 to 75% of the investor base, and the remainder is funds, often retirement and pension funds. The same types of investors buy sovereign debt. For banks with an RMBS programme for example, the attractiveness of covered bonds is that it allows you to reach a different investor base, and to diversify funding that way.
Issuance of covered bonds into the US ebbs and flows. In 2011 and 2012 there were in the region of $60 billion of issuances a year, while 2018 has been particularly low. What determines issuance into the US is primarily but not entirely, cross-currency swap costs. Issuers typically swap the proceeds of an issuance back into their home country currency.