Covered bonds

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See also securitization.


Senate Banking Committee holds hearing Sept, 15, 2010

  • FDIC says need for law on covered bond market unclear
  • Some lawmakers, industry supports formal framework
  • Time running out to pass legislation this year

A top banking regulator on Wednesday questioned the need for legislation intended to speed development of a U.S. covered bonds market.

Supporters of boosting this market argue it would provide a safer and more stable method for banks to raise funds and in turn provide credit to consumers for mortgages and other loans.

They are pushing legislation that would further define how such a market would work.

But a limited legislative calendar and doubts about the need for formal congressional action make it unlikely that a law will be passed soon.

An official from the Federal Deposit Insurance Corp told the Senate Banking Committee on Wednesday that existing guidance from federal regulators may be all that is needed for this market to thrive.

"Given the FDIC's existing statement of policy, the Treasury Department's companion Best Practices, and the prior successful covered bond programs developed in the cooperation with the FDIC, it is unclear that legislation is necessary to re-launch the market," said Michael Krimminger, deputy to the FDIC chairman.

Krimminger added that the agency "supports a vibrant covered bond market in the U.S." and that it could get behind legislation so long as it meets certain criteria such as ensuring that taxpayers would not be on the hook to pay for any failures in the market.

Covered bonds are debt securities backed by flows from mortgages but, unlike loans that are securitized, they remain on the issuer's balance sheet and thus are seen as safer than non-guaranteed mortgage securities.

Since issuers have to hold on to these mortgages rather than moving them off their books, they have "skin in the game" with regard to whether the mortgage is repaid.

A representative from another U.S. banking regulator was more supportive of the push for legislation.

"We are encouraged by the continuing interest in establishing a statutory structure for covered bonds in the U.S.," Julie Williams, chief counsel at the Office of the Comptroller of the Currency, testified.

"Such a step, prudently structured and implemented, holds promise as an additional, complementary funding source for financial institutions, and a catalyst for sound competition among the financial product funding alternatives available in the U.S."

Industry representatives pushed lawmakers to move legislation soon.

"Dedicated covered-bond legislation and public supervision, from the perspective of market participants, creates a degree of legal certainty that regulatory initiatives just cannot replicate," testified Scott Stengel, who was representing the Securities Industry and Financial Markets Association (SIFMA).

A bill sponsored by Republican Scott Garrett is pending in the House of Representatives but given the lack of time on the congressional calendar any legislation faces long odds of being enacted this year.

Democrats promised to hold the hearing earlier this summer after Republicans agreed not to try to force the issue during final negotiations over the Dodd-Frank Act, the sweeping overhaul of the financial regulatory framework enacted in July.

Rep. Garrett introduces "United States Covered Bond Act"

Original posted on the Housing Wire by Jacob Gaffney:

The mortgage-finance alternative to securitizations, covered bonds, came one step closer to larger acceptance in the US secondary markets with the introduction of the highly-anticipated United States Covered Bond Act by Rep. Scott Garrett (R-NJ).

In the February issue of HousingWire magazine, Garrett is featured in a lengthy Q&A on his push to get legislative and regulatory recognition for covered bonds, products that are collateralized typically by prime mortgages. Covered bonds are so named for the dual recourse provided, where the issuer is on the hook to pay out regardless of whether or not the collateral performs as expected.

Usually, covered bonds hedge this risk by using over-collateralization as credit enhancement. This allows for non-performing mortgages to be pulled from bonded pools and replaced with performing mortgages.

The platform is Europe’s oldest form of structured finance and has yet to see triple-A defaults. So in that sense, covered bonds remain to be vigorously tested. However in an e-mail to reporters, Garrett, along with support from co-sponsors Rep. Paul Kanjorski (D-Pa.) and Financial Services Committee Ranking Member Spencer Bachus (R-Ala.), says the bill will establish regulatory oversight of covered bond programs, includes provisions for default and insolvency of covered bond issuers and subjects covered bonds to appropriate securities regulations by federal regulators.

Alberto Basu, the head of the US (dollar-denominated) covered bond trading at JP Morgan (JPM: 43.64 -0.34%) remarked that such legislation is necessary to show support for the product in the market place. And the Securities Industry and Financial Markets Association (SIFMA), a secondary market trade group, agrees.

“SIFMA’s US Covered Bond Council is pleased to see the increased momentum for a dedicated legislative framework for covered bonds that is fundamental to building a vibrant US covered bonds market,” said Sean Davy, managing director at SIFMA, in a statement. “We thank Congressman Garrett for his leadership on this issue and are pleased to see Reps. Kanjorski and Bachus join him in this effort.”

The United States Covered Bond Act is the legislative follow-up to Garrett’s original legislation, The Equal Treatment for Covered Bonds Act, first introduced in 2008. The US Treasury also lists the options on Federal Deposit Insurance Corp. (FDIC) policy concerning what investors can expect if the bank that ‘covers’ the bonds itself goes out of business.

Garrett’s Act list eligible assets for covered bonds as residential property, home equity assets, as well as auto, commercial and student loans. Credit cards, public sector assets and small business assets are also eligible. The established regulator, if passed, will be required to approve all covered bond platforms, and list on a single website, and establish over-collateralization minimums.

As Garrett discussed in his Q&A, obstacles to introducing the legislation included not only getting co-sponsors, but also satisfying some concerns of the FDIC. One solution seems to be that, in the case of bank failure, the FDIC will have 15 days to shift the platform to another issuer. Thereby disallowing investors from seeking recourse from the FDIC

Covered bonds need legal framework, Congress hears

"While a covered bonds market in the US could create a new asset class, attract private liquidity and aid in the origination of new loans, the system would require a sound legal framework to give investors certainty, expert witnesses told lawmakers Tuesday at a House Financial Services Committee Hearing.

The discussion comes as the House considers legislation establishing a groundwork for legal treatment of covered bonds — debt instruments covered by a pool of loans that remains on the issuer’s balance sheet. An attempt was made in mid-2008 to get a US covered bonds market off the ground, but the worsening liquidity crisis in following months prevented any substantial efforts to facilitate the market.

covered bonds offer investors dual recourse in both the assets used as collateral and the underlying institution. This dual recourse system where the issuer maintains all the risk, along with the high underwriting standards of the loans in the covered bond pool, give investors confidence and can provide for liquidity in the US mortgage market, according to Rep. Scott Garrett (R-NJ), who recently introduced an amendment to establish a legal framework for a US covered bonds market.

Garrett added to comments he made in a teleconference Monday by noting the prospect for modifications under a covered bonds structure are favorable to the securitization process, where loans are not held by the issuer. Modification of loans within securitizations is complicated by conflicts of interest held by multiple note holders. With covered bonds, the loans remain with the issuer, who has an interest in keeping the loans performing.

Garret’s previously introduced amendment would create a detailed statutory framework to facilitate the use of covered bonds in the US. This would give investors surety in recourse, he said in the hearing Tuesay. His amendment defines asset classes that could participate in covered bonds — not only residential mortgages but others like commercial mortgages and auto loans. The Treasury Department would act as covered bond regulator.

Witnesses at the hearing indicated a legal framework for the facilitation and oversight of US covered bonds would return Fannie Mae (FNM: 1.12 -5.08%) and Freddie Mac (FRE: 1.3887 -6.17%) to a competitive market by creating a new channel for private liquidity.

Alan Boyce, CEO of Absalon, George Soros’ joint venture with the Danish financial system to organize a standard mortgage-backed securities (MBS) market in Mexico, recommended that any US covered bonds market keep the interest of the issuing institution better aligned with those of the borrowers and investors. He said in cases where the institutions must pull nonperforming loans from covered pools, cash should be the only substitute.

Bert Ely, a principal at financial institutions and monetary policy consulting firm Ely & Co., said covered bonds offer better credit risk management through 100 risk retention, since firms keep loans on their balance sheets. He said covered bonds offer borrower protection, as lenders keep the loans they make. He added lower interest rates are attainable through covered bonds, as transaction costs are lower to lenders. Finally, a substantial new supply of high-quality debt attracts international investors.

Wesley Phoa, senior vice president of Capital International Research, agreed that covered bonds are an attractive investment. Asset management firms currently investing mainly in Government bonds sacrifice diversity and make investments more sensitive to policy changes, he said. Investing in covered bonds would provide a private sector alternative, as “safety comes from good collateral, not government support,” Phoa said.

“Investors can live with economic uncertainty,” he said. “That’s our job. But uncertainty about institutions and policies is problematic. Sound investment analysis relies on a clearly defined framework of rights and duties. That’s a critical element of investor confidence.”

He called for fundamental soundness and liquidity in a US covered bond market. He also noted the importance of adequate returns for investors, good oversight of the system and legal and policy certainty to secure a broad investor base.

Scott Stengel, partner at Orrick, Herrington & Sutcliffe on behalf of the US Covered Bond Council, noted that institutions participating in covered bonds keep 100 percent “skin in the game” by keeping loans on their balance sheets. He recommended any legislation on covered bonds in the US define eligible asset classes to include not only residential mortgages, but home equity loans, commercial and multi-family loans, public sector, auto and student loans, credit or charge cards and small business loans.

Christopher Hoeffel, managing director at Investcorp International Inc. on behalf of the Commercial Mortgage Securities Association (CMSA), said covered bonds could aid in the tightening of credit felt in commercial real estate (CRE) and commercial mortgage-backed securities (CMBS).

“While covered bonds should not and cannot replace CMBS as a capital source for the CRE mortgage market, facilitating a commercial covered bond market will be additive,” Hoeffel said.

Rebuilding the US mortgage market

"Once upon a time, stocks were risky and collateralized securities were safe. That time is over, as the breakdown of the American mortgage securitization market has shown.

For years, hundreds of billions of new mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) generated from them were sold to the world to compensate for the lack of savings in the United States and to finance American housing investment. Now virtually the entire market for new issues of such securities – all but 3% of the original market volume – has vanished.

To compensate for the disappearance of that market, and for the simultaneous disappearance of non-securitized bank lending to American homeowners, 95% of US mortgages today are channeled through the state institutions Fannie Mae, Freddie Mac, and Ginnie Mae. Just as there was a time when collateralized securities were safe, there was also a time when economies with so much state intervention were called socialist.

Most of these private securities were sold to oil-exporting countries and Europe, in particular Germany, Britain, the Benelux countries, Switzerland, and Ireland. China and Japan shied away from buying such paper.

As a result, European banks have suffered from massive write-offs on toxic American securities. According to the International Monetary Fund, more than 50% of the pre-crisis equity capital of Western Europe’s national banking systems, or $1.6 trillion, will have been destroyed by the end of 2010, with the lion’s share of losses being of US origin. Thus, the resource transfer from Europe to the US is similar in size to what the US has spent on the Iraq war ($750 billion) and the Afghanistan war ($300 billion) together.

Americans now claim caveat emptor : Europeans should have known how risky these securities were when they bought them. But even AAA-rated CDOs, which the US ratings agencies had called equivalent in safety to government bonds, are now only worth one-third of their nominal value. Europeans trusted a system that was untrustworthy.

Two years ago, Ben Bernanke, chairman of the US Federal Reserve, argued that foreigners were buying US securities because they trusted America’s financial supervisory system and wanted to participate in the dynamism of its economy. Now we know that this was propaganda intended to keep the foreign money flowing, so that US households could continue to finance their lifestyles. The propaganda was successful. Even in 2008, the US was able to attract net capital inflows of $808 billion. Preliminary statistics suggest that this figure has now fallen by half.

For years, the US had a so-called “return privilege.” It earned a rate of return on its foreign assets that was nearly twice as high as the rate it paid foreigners on US assets. One hypothesis is that this reflected better choices by US investment bankers. Another is that US ratings agencies helped fool the world by giving triple-A ratings to their American clients, while aggressively downgrading foreign borrowers. This enabled US banks to profit by offering low rates of return to foreign lenders while forcing foreign borrowers to accept high interest rates.

Indeed, it is clear that ratings were ridiculously distorted. While a big US rating agency gave European companies, on average, only a triple-B rating in recent years, CDOs based on MBSs easily obtained triple A-ratings. According to the IMF, 80% of CDOs were in this category. And according to an NBER working paper by Efraim Benmelech and Jennifer Dlugosz, 70% of the CDOs received a triple-A rating even though the MBSs from which they were constructed had just a B+ rating, on average, which would have made them unmarketable. The authors therefore called the process of constructing CDOs “alchemy,” the art of turning lead into gold.

The main problem with US mortgage-based securities is that they are non-recourse. A CDO is a claim against a chain of claims that ends at US homeowners. None of the financial institutions that structure CDOs is directly liable for the repayments they promise; nor are the banks and brokers that originate the mortgages or create MBSs based on them.

Only the homeowners are liable. However, the holder of a CDO or MBS would be unable to take these homeowners to court. And even if he succeeded, homeowners could simply return their house keys, as they, too, enjoy the protection of non-recourse. As home prices declined and one-third of US mortgage loans went under water – that is, the property’s market value sank below the amount of the loan – three million US homeowners lost their homes, unable to meet their payment obligations, making the CDOs and MBSs empty shells.

The problem was exacerbated by fraudulent, or at least dubious, evaluation practices. For example, homeowners signed cash-back contracts with builders to feign a higher home value and receive bigger loans, and brokers’ fees were added to mortgages and the reported values of homes. Low-income people who could not be expected ever to repay their loans were given so-called NINJA credits: “No income, no job, no assets.” Such reckless and irresponsible behavior abounded.

The US will have to reinvent its system of mortgage finance in order to escape the socialist trap into which it has fallen. A minimal reform would be to force banks to retain on their balance sheets a certain proportion of the securities that they issue. That way, they would share the pain if the securities are not serviced – and thus gain a powerful incentive to maintain tight mortgage-lending standards.

An even better solution would be to go the European way: get rid of non-recourse loans and develop a system of finance based on covered bonds, such as the German Pfandbriefe . If a Pfandbrief is not serviced, one can take the issuing bank to court. If the bank goes bankrupt, the holder of the covered bond has a direct claim against the homeowner, who cannot escape payment by simply returning his house key. And if the homeowner goes bankrupt, the home can be sold to service the debt.

Since their creation in Prussia in 1769 under Frederick the Great, not a single Pfandbrief has defaulted. Unlike the financial junk pouring out of the US in recent years, covered bonds are a security that is worthy of the name."

$27B in US covered bond deals for Y-T-D 2010

This week saw the third largest US-dollar covered bond offering on record with the $2.5 billion offering from Bank of Nova Scotia. With 27 offerings so far this year and total proceeds of $27.4 billion, 2010 has already broken all full year records for US-dollar covered bond issuance. In 2009, total US-dollar issuance reached $2.8 billion from 10 offerings for the entire year.

Issuance of Euro-denominated covered bonds has reached $250.9 billion from 273 offerings, accounting for 85% of total issuance in 2010, while US-dollar covered bonds account for 10% of the market, the highest year-to-date percentage on record. Euro covered bond issuance is up 45% from the same time last year, and global issuance has seen a 47% increase with total volume at the highest year-to-date level since records began.

SIFMA US Covered Bond Council participates in Washington panel discussion

Industry experts gathered in Washington this past Friday at the City Club in Washington for a well attended panel discussion entitled; “Why the US needs Covered Bonds”. The timing of the panel proved opportune given the recent issuance of a Canadian Imperial Bank of Commerce (CIBC) USD $2 billion, three-year landmark dollar-denominated covered bond. The events widespread sponsorship reflected the growing and broad based interest and support for the development of a US Covered Bond market and the dedicated legislative framework believed to be instrumental to success.

Panelists agreed that covered bonds represent an exciting potential source of liquid private funds to complement other U.S. mortgage market funding sources and remain hopeful that a legislative framework will receive further support on Capital Hill. A Congressional Hearings on covered bonds was held by the House Financial Services Committee in December 2009. The hearing followed Rep. Scott Garrett’s (R-NJ) introduction and subsequent withdrawal of a covered bonds amendment during the Financial Services Committee markup of the Financial Stability Improvement Act of 2009 . The amendment “aims to help facilitate a robust covered bonds market in the US to add liquidity and certainty to our nation's housing market”..

The Panel was hosted by the Association of German Pfandbrief Banks (vdp), Covered Bond Investor LLC, Morrison & Foerster LLP, Clayton Holdings Inc, sponsored by Clayton Holdings Inc, Covered Bond Investor LLC, Morrison & Foerster LLP, PricewaterhouseCoopers LLP, vdp, and produced in collaboration with National Association of REALTORS®, Mortgage Bankers Association®, and the SIFMA U.S. Covered Bond Council.

Eurosystem's covered bond purchase program

From 1 March to 31 March 2010, the Eurosystem purchased eligible covered bonds with a total nominal value of €5,921 million under its covered bond purchase programme (CBPP).1

Of this total, €2,114 million was accounted for by purchases in the primary market and the remaining €3,807 million by purchases in the secondary market.2 The total nominal value of all covered bonds purchased by the Eurosystem since the programme was fi rst started stood at €44,898 million on 31 March 2010. In March, activity in the covered bond market picked up considerably, especially in the primary segment, as sovereign credit concerns diminished somewhat and swap spreads declined.

In the primary market, after a relatively quiet February, when activity was restricted to just a few countries, March saw new covered bonds issued in Germany, Spain, France, Luxembourg, the Netherlands, Austria, Portugal and Finland, with substantial issuance also in non-euro area countries. Moreover, the recovery in government bond markets improved refinancing conditions for covered bond issuers. With 25 new covered bond issues in the euro area, including six taps, the volume of new issuance of CBPP-eligible covered bonds, mainly with maturities of between three and seven years, amounted to €19 billion. Overall, the new issues were well received, despite the abundant supply, which was concentrated towards the end of the month.

Activity in the secondary market was relatively quiet over the last weeks of the reporting period, as investors seemed to focus on new issues, which, in the secondary market, traded around or slightly below the spreads at issuance.


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