It may seem interesting to say given the problems Europe faces with its economy, but there may be a product worth utilizing more in the US: the covered bond. Already common in Europe, covered bonds offer a way for treasurers to both reduce and diversify risk by increasing bank responsibility and ensuring quality collateral.
At the October meeting of the NeuGroup’s Treasury Investment Managers’ Peer Group, (TIMPG) Joe Benevento from DB Advisors gave members an outline of covered bonds, which were unfamiliar territory to 74 percent of the group (the same percentage that expressed interest in possibly purchasing them). Mr. Benevento began with an overview of how they work in Europe and then discussed how they might spread in the US.
Until recently, covered bonds were restricted to only those termed as qualified institutional investors under rule “144A,” of the Securities Act, which governs securities sales and places a cap on demand for the debt. But last spring, the Securities and Exchange Commission loosened restrictions on who can buy the bundled mortgage debt, clearing the way for wider US use.
In Europe banks have much bigger balance sheets than US banks, mainly because they keep mortgages on their balance sheets (something US banks don’t normally do; mortgages are bought by Fannie and Freddie) and deposits and wholesale funding are not enough to for overall funding. Thus, the banks issue bonds and collect service and other fees on the mortgages. Covered bonds are the resulting securities.
The covered bond has the backing of both the bank’s credit and that of the mortgage itself, which is backed by a covered pool of over-collateralized mortgages. Taken as one package, the covered bond is a tradable, negotiable security with underlying collateralized exposure to the bank.
As Fannie and Freddie shrink and become close to being an extension of the government, should US banks start heading in this direction? Probably. One of the great aspects of covered bonds is that the bank is never off the hook for the debt, so while post-crisis lending has already undergone some reform, increasing bank responsibility through covered bonds could be a good idea.
Asked how a Triple-A bond would hold up if not everything in the pool was Triple A, Mr. Benevento clarified that the investor is buying the package, but the bank is ultimately responsible if the bond doesn’t perform. In order to make sure that it does, the bank has to maintain the quality of the collateral. Therefore, it’s not a “stagnant pool” of assets, he said; if a part of that pool is paid off or changes in value, it is swapped out to maintain pool quality.
This works in Europe because types of acceptable collateral and their structure are highly regulated by country. Also, if the bank fails, the bond holder receives only principal and interest. Covered bonds are unencumbered assets, so they would remain outside of any bankruptcy, and the holder would have a claim back to the bank to fill shortages. One obstacle is that this is something with which the FDIC is said to have a problem, according to Mr. Benevento.
What about Mortgage-backed securities? Covered bonds can be useful for long-term funding, as they have maturities of up to 30 years, while mortgage-backed securities only go out five years, Mr. Benevento explained. Covered bonds also are mainly fixed-rate and specifically regulated by the government, while the degree of regulation for an MBS is limited. And finally, the cover pool is dynamic and managed by the issuer (see above), while the MBS asset originator defines assets, and the resulting pool can be static or dynamic.
If Fannie and Freddie shrink further or move away from government, Mr. Benevento suggested that using covered bonds would be a good solution. However the FDIC, while it still exists, has to be involved and is said to not like the idea of unencumbered assets. The FDIC wants best collateral they can get if a bank fails, and more broadly the country does not have the legal framework to deal with bankruptcies of banks that would issue covered bonds. However, there is a bill supporting covered bonds that Mr. Benevento described as “slowly winding its way through Congress,” so there could be wider use soon.