Focus on Questions at Washington, DC Covered Bond Event

WASHINGTON, D.C. — At "Why the U.S. Needs Covered Bonds," the focus was not on presentations from the panelists but on questions from the audience.  The nature of those questions cast some light on the concerns of U.S. organizations interested in this funding tool.

Registrants for the event — held at the City Club of Washington (Jan. 29) — included investment and commercial bankers, federal housing finance officials, financial sector consultants and trade association representatives.

From left: Marlatt, Tolckmitt, Skeet, Jimenez, PowerThe panel was moderated by Tim Skeet, Head of Covered Bonds at Bank of America Merrill Lynch (London).  The other panelists were Jerry Marlatt, Senior Of Counsel at Morrison & Foerster (New York); David Power of Royal Bank of Canada (Toronto); Jens Tolckmitt, Executive Director, Association of German Pfandbrief Banks (Berlin); and Mercy Jiménez, Cofounder, Covered Bond Investor™ (Washington, DC).  Skeet and Marlatt also serve on the Steering Committee of the U.S. Covered Bond Council.

The panelists' opening remarks included the following points:

• Tim Skeet noted that the current push for covered bonds in the U.S. marks the third such initiative.  The first push came when Washington Mutual and Bank of America became the first U.S. financial institutions to issue covered bonds.  The second came under the auspices of the U.S. Treasury Department in 2008.  (Both of those initiatives came to a halt as the economic crisis deepened.)  Skeet expressed optimism that the current push will be "third time lucky."

• Jerry Marlatt explained that covered bonds "are an instrument issued by a regulated bank, secured by a pool of high grade collateral — most commonly mortgage loans but also (quite commonly in Europe) public sector loans." A distinguishing feature of covered bonds is that (because of direct recourse against the cover pool) investors have protection against issuer insolvency — "and it's that feature that brings a different investor base to this bond than you would find for typical bank debt."

• Jens Tolckmitt emphasized the resilience of covered bonds as a funding tool in Europe — and especially Germany — during the global financial crisis.  Using graphs and charts, he showed (among other things) that German issuers were able to tap capital markets by this means even in autumn 2008.  Discussing the success of German covered bonds, Tolckmitt said "it is essential that the underlying legal framework [requires] high quality."

• David PowerDavid Power pointed out that Canadian banks have been issuing covered bonds since 2007 in Euros, Canadian dollars and most recently U.S. dollars.  He stressed that in a world of limited choices for funding, financial institutions need to access all options available, including covered bonds in addition to securitization and wholesale bank funding.   According to Power, covered bonds have "broad-reaching interest right now from the [Canadian] banking community."

• Mercy Jiménez said: "We've been very blessed in this country to have access to the Federal Home Loan Bank line, to Fannie Mae, to Freddie [Mac], to the FHA [Federal Housing Administration] — but unless you think the world will remain exactly the same as it always has ... the time has come to look at an alternative cost-efficient funding source like covered bonds."  To put it another way, "past access to funding is no guarantee of future access to funding."

Audience included Lawrence Yun, Chief Economist, National Association of Realtors® (2nd from right)Here is a sample of questions from the audience, together with portions of panelists' responses (mostly paraphrased):

Why is it important to have a covered bond statute in the U.S.?  What does that add to the development of a covered bond market?

• "Both on the expense side and the funding side, legislation would take a lot of expense out of issuing U.S. covered bonds," Marlatt said.  The current legal situation here would require the cover pool of collateral to be liquidated immediately in the event of the issuer insolvency.  High overcollateralization and other measures to mitigate the resulting risks make U.S. covered bonds "very expensive" in the absence of a corrective legal framework.  Also, from the investor's perspective, legislation would remove uncertainty about exactly how the cover pool assets would be treated by the FDIC in an insolvency event.

• Specific legislation establishes an important element of standardization in a covered bond product, according to Tolckmitt.  This gives investors confidence, facilitates a market, and makes covered bonds much easier to explain to potential buyers.

• Banks in the United Kingdom and Holland both started issuing covered bonds without the benefit of a specific legal framework — but both have since passed covered bond legislation, Skeet added.

What are the implications of covered bond financing for consumers?

• The conservative loan-to-value (LTV) ratio required for covered bonds does not necessarily make a difference to consumers, Tolckmitt explained.  In Germany, a borrower's Tolckmitt (left) and Skeetpurchase may be financed with a 60% LTV first loan to be funded through a covered bond — together with a second loan for an additional 20% of the purchase price that is funded through unsecured bank debt or securitization.  From the borrower's perspective, there is no practical difference in this arrangement — it's just a matter of signing the necessary legal papers.  "Looking at [how] the German banks handle Pfandbriefe (covered bonds) compared to other funding sources, it is always a decision of what is the cheapest funding source at the moment — and then they decide upon how they actually handle certain loans that they get," Tolckmitt said.  "The system is flexible." 

• "I think of this as not very different from today, when an originator or midsize bank or large bank is thinking about the Jimenez (left) and Powerdifferent channels that a loan goes through," Jiménez said.  "If it's a retail channel, [the loan] may in fact end up on that bank's balance sheet.  If it's a securitization target, it may go through a different [investor] channel, etc."  Because the underwriting for mortgages that qualify for use in covered bonds is typically "more conservative and tighter," a loan for that channel "will have its own type of [delivery] profile, but it wouldn't feel very different" than an originator that has a variety of different delivery channels today.

In Germany, what is the difference between the ten-year government bond rate and the rate that mortgage borrowers typically pay?

"The difference between the mortgage bond and the government bond is normally between 50 and 70 basis points ... which remained quite stable during the [economic] crisis," Tolckmitt said. "Then you add about one percent, and you come to the financing conditions for a mortgage loan."

What is the potential for funding rental housing with covered bonds?

Jerry Marlatt"In Europe, commercial mortgage loans are an important part of the asset base for covered bonds," Marlatt said.  He noted that Deutsche bank recently issued a covered bond that was comprised of some 60% mortgage loans. "In the proposed [U.S.] legislation, commercial loans would be eligible collateral.  I think — a number of people think it could be an important type of financing for the commercial mortgage market."

Please define what you mean by "high quality" in the context of covered bonds.

• "A covered bond can only be as good as the underlying assets," Tolckmitt said.  With the German Pfandbrief (covered bond), there is a 60% statutory loan-to-value requirement.  Beyond this, German government agencies strictly monitor cover bonds, including ongoing monitoring of the cover pool.  Finally, in the event of issuer insolvency, German law provides for the cover pool to continue separately as a going concern.  "If the bank is no longer there, there is an administrator that is named by the supervisory authority ... and his duty is to fulfill the claims of the Pfandbrief holders when the Pfandbrief comes due on a timely basis and in full."

• David Power noted that the contrast between covered bonds and senior bank debt is "sharp."  For example, when Washington Mutual became insolvent, senior bank debt was "wiped out to zero."  (By contrast, Washington Mutual's covered bond program, established in 2006, was transferred to JP Morgan and remains in place to this day.)

"Why the U.S. Needs Covered Bonds" was sponsored by the Association of German Pfandbrief Banks (vdp), Clayton Holdings Inc, Covered Bond Investor™ LLC, Morrison & Foerster LLP and PricewaterhouseCoopers.  The event was held in collaboration with the Mortgage Bankers Association, National Association of REALTORS® and the U.S. Covered Bond Council.