Preparing the Ground for a U.S. Covered Bond Market: Recent Steps

Editor's Note: Jerry Marlatt helped engineer the first issuance of covered bonds in U.S. history (by Washington Mutual).  Currently senior of counsel in the New York office of the Morrison & Foerster law firm, he also serves on the Steering Committee of the U.S. Covered Bonds Council. Today, in the third of a four-part series, he recounts steps taken to prepare the ground for such a covered bond market in the U.S. home financing arena.

Jerry MarlattSince the 1930s, U.S. government-sponsored enterprises (GSEs)—most prominently Fannie Mae—have dominated the secondary market for home mortgage loans in this country.  Despite this federal dominance, the growth of the covered bond market in Europe began to attract the interest of U.S. banks.  It was hard to ignore an untapped €3 trillion market as large as the entire asset-backed securities (ABS) market in the U.S.  

The first U.S. bank covered bond offering was issued by Washington Mutual in September 2006 in Europe.  The offering was extremely well received; the initial offering was about four times oversubscribed and the initial €2 billion offering was doubled.
 
This was followed by an offering in Europe by Bank of America in April 2007 and then by several follow-on offerings by both banks in Europe.  In June 2007, Bank of America also placed $2 billion of covered bonds with U.S. investors.  Parts of covered bond offerings were also placed in the U.S. by a number of European banks under Rule 144A  (which allows sales to large institutional investors in the absence of registration under the U.S. Securities Act of 1933).

In 2007, several other U.S. banks started to establish covered bond programs, but these efforts stalled as the credit crisis gathered force.

U.S. covered bonds also began to attract the attention and some support from U.S. federal regulators.  In April 2008, in the first foray into covered bond regulation by the U.S. government, the FDIC released a Statement on Covered Bonds, clarifying the treatment of cover pools in the event of the insolvency of an issuing bank.  And in June 2008, the U.S. Treasury Department, in an effort to encourage the development of a U.S. covered bond market, called a meeting in Washington, D.C. of investors, issuers, underwriters, dealers and rating agencies to identify steps that could be taken to advance that initiative.  This was followed by the Treasury's publication of its Best Practices for Covered Bonds.

In July 2008, at the request of Treasury Secretary Paulson, four of the major U.S. banks committed to the Treasury that they would issue covered bonds.  These were: Bank of America, Citigroup, JPMorgan and Wells Fargo.  These commitments were overtaken by the credit crisis and have not been fulfilled.

Effect of Credit Crisis

The credit crisis began with the rapidly declining performance of subprime mortgage loans in late 2006 and early 2007.  By late June 2007, this had blossomed into a severe liquidity crisis as asset-backed commercial paper conduits around the world were unable to roll their commercial paper financing.  This in turn spread very quickly to structured investment vehicles (SIVs).  One SIV, which only began issuing securities in May 2007, was in enforcement by September with $7 billion of assets. 

The speed of the contagion was astonishing.  By the fall of 2007, the monoline insurance companies were in capital trouble resulting from their coverage of collateralized debt obligations (CDOs) and their credit default swap activity.  And banks, broker dealers and hedge funds were watching their capital erode as various mortgage related products were marked to a rapidly declining market.

The spring of 2008 saw the rapid deterioration of Bear Stearns and ultimately its forced sale.  The summer brought us the nationalization of Fannie Mae and Freddie Mac.  And then the cataclysmic collapse of Lehman Brothers.  This was followed closely by the rescue of AIG, with its enormous credit default swap book.  With that, interbank lending ground to a halt, evoking a plea to Congress by the Treasury and the Federal Reserve for $750 billion of emergency funding to preserve the U.S. banking system.

What followed was a proliferation of emergency federal financing programs, including TSLF, CPFF, AMLF, MMIFF, TARP, TALF, and TLGP.  We also saw massive dollar swap lines for foreign central banks and a number of other programs. 

In this same period, the European market in covered bonds evaporated, various European bank issuers were downgraded and many rescued by their governments.  It was not until January of this year that another covered bond was issued in Europe.

In this turmoil, the ASF (American Securitization Forum) and SIFMA (Securities Industry and Financial Markets Association) formed the United States Covered Bond Council to provide a focused forum for the development and presentation of policy initiatives that could encourage the emergence of a significant U.S. covered bond market. 

So, despite the surge of interest in early 2008, no covered bond has been launched in the U.S. since the pioneering Washington Mutual and Bank of America issuances.  Even so, I believe it is only a question of time until more are issued.

Read the other commentaries in this series:

• Part One: "How Covered Bonds Could Extricate the U.S. Government From Residential Mortgage-Backed Securities"

• Part Two: Why a Covered Bond Market Did Not Develop Sooner in U.S. History

• Part Four: Prospects for a Future Covered Bond Market to Finance Home Mortgages in the United States

Mr. Marlatt's comments are adapted from his remarks as keynote speaker at the Second Annual Covered Bonds Forum in Toronto earlier this year.  They do not necessarily reflect the views of Covered Bond Investor^TM.

Copyright © 2009 by Jerry Marlatt.  All rights reserved.