Towards the end of Monday at the American Securitization Forum conference, I attended a break out session on covered bonds. I thought this would be a particularly interesting topic, because right before I left banking in 2008, covered bonds were said to be the next big thing. Then that whole financial crisis thing happened and the market came to a grinding halt. So much for covered bonds. But now that finance has come back to life, the push for covered bonds is back too. They could help.
First, what is a covered bond? First, imagine a regular unsecured bond from a bank. An investor buys that bond and hopes that the bank is able to stay in business and pay him as promised. If it goes bankrupt, then the court will divide up all the bank's assets and award him some portion of what he's owed based on his debt's seniority. Since there's no specific asset that the bond the investor held was referenced to, the debt is considered unsecured.
Next, think about a mortgage-backed security. An investor buys the MBS and hopes that the mortgages in the pool that are referenced by his bond do well. The investor gets periodic payments of principal and interest, based on the bond's structure and the mortgage pool's performance. This is a secured bond, since the investor technically has a claim on some portion of the pool of mortgages.
A covered bond sort of blends these two ideas. Remember that bank bond? Imagine it was exactly the same, but now it's also secured by a pool of mortgages. So the investor still gets his payments, just like with the bank bond before. Here's the twist: if the bank goes bankrupt, then the investor has a claim to some portion of the pool of mortgages that back covered bond. But as long as the bank is able to pay its debt, the mortgages are just held like any other assets on its balance sheet.
Get it? A covered bond behaves a lot like an unsecured bond, except that if the bank goes under, then whoever holds the bond has a claim on the mortgages that back the bond. It's essentially like the bank bond, but much safer, because it's secured by the pool of mortgages. So for the investor to lose money, you'd need a sort of perfect storm, where not only does the bank go bankrupt, but all the mortgages also turn out bad.
In fact, with covered bonds, this possibility is even more remote, because the mortgage pools used tend to be pristine. Remember, these are mortgages that the bank keeps 100% on its balance sheet. So the bank has all of its skin in the game when it comes to that pool. Clearly, it isn't going to want to knowingly hold bad assets. For this reason, covered bonds are generally considered to be among the safest of corporate bonds.
The problem is that we don't really have much of a covered bond market in the U.S. As the session I went to yesterday explained, Bank of America attempted to lead the way in getting the covered bond market going in the summer of 2007. Unfortunately, it had pretty bad timing, as the mortgage market collapsed a few months later. The following year, the financial crisis hit and there was no market for anything -- especially not anything having to do with mortgages.
In Europe, however, the covered bond market is far better developed. France, Germany and Spain have been issuing them for years. In fact, the covered bond's origins can be traced back to the year 1770. Why haven't they caught on in the U.S.? For a few reasons.
First, the U.S. has the government-sponsored entities like Fannie Mae and Freddie Mac. They either purchase or guarantee the most pristine mortgages, so banks don't have any trouble securitizing them. But European nations don't have GSEs, so covered bonds are a great way for their banks to lower their borrowing costs and enhance liquidity, while still keeping the mortgages on their balance sheets.
But there's another problem: U.S. law. Currently, there are regulatory barriers that make covered bonds harder to create in the states. As a matter of law, it isn't that easy for a bank to issue debt backed by a specific pools of assets it still owns. A large portion of yesterday's session consisted of a progress report on the legislative effort in Congress to pass regulatory changes which would allow the covered bond market to flourish in the U.S. Luckily, those on the panel explained that the effort to reform the law to better accommodate covered bonds is doing well in Congress. There have been hearings in the House of Representatives, and the proposal appears to have bipartisan support.
Covered bonds could be a great way to solve several of the problems facing the financial industry and mortgage market today. First, any mortgages used would be prudently originated, which is something that many fear isn't the case with securitizations where entire pools are sold as bonds. With covered bonds, the bank keeps all the mortgages on its balance sheet. Second, it's a good longer-term funding strategy for banks. The mortgage pools are dynamic, and the bonds generally last anywhere from two to ten years. Third, they could help investors to get comfortable with mortgage securities again. When done right, covered bonds lack the complexity of many securitized bonds and are very, very safe -- even safer than the most pristine of corporate bonds and just about as simple. Finally, they could help to lessen the market's dependence on the GSEs. They would provide additional funding and liquidity to issuers, without the need for a government guarantee or purchases.