Tim Skeet: Mapping the Future of U.S. Covered Bonds

How essential is passage of federal legislation in order to develop a U.S. covered bond market?  If Congress provides a legal framework, how soon might new U.S. covered bonds be issued?  What is the prospective investor base?  Where do the first opportunities lie?

Tim SkeetThose are some of the questions addressed by Tim Skeet — one of the covered bond industry's best-known figures — in this exclusive interview with Covered Bond Investor™.

Skeet is Head of Covered Bonds at Bank of America Merrill Lynch, based in London.  In Europe, he is on the governing board of the International Capital Markets Association (ICMA).  In North America, he is a member of the Steering Committee of the U.S. Covered Bonds Council. 

Do you think we're going to make any significant progress toward a covered bond market in the U.S. until and unless current efforts on covered bond legislation result in passage of a law?

It's clearly desirable to have a legislative framework.  In view of recent events and current investor thinking, I think we really do need one. 

We want to be able say, "Here is a framework that is favorable to investors.  You, the investor, should be able to sleep easy at night if you put covered bonds in your portfolio."  To achieve this adequately a law is required, particularly given the patchwork of regulatory oversight and involvement manifest in the U.S. financial services sector.

Some tremendous work has already been done on a bipartisan basis, culminating with the Congressional hearings [by the House Financial Services Committee Dec. 15] — thanks to Chairman Barney Frank [D-MA] and the work that Congressman [Scott] Garrett [R-NJ] and his team have done.  I think that is all incredibly positive.

What are the chances of persuading U.S. investors that they should be looking at this product without a strict regulatory framework?  Well, there's usually a price for everything (under normalized market conditions!).  But I strongly suspect that the kind of price that you would extract from the market without the regulatory framework would make it more marginal and largely unattractive to issue.  

It may just be that the best advice would be, "Well, if a legislative push isn't working at this time, let's just wait until it does work." Passing a covered bond law will be the defining moment for this product.  That's when it's going to get interesting and we will see domestic covered bonds launched.

Prospective U.S. issuers themselves want to wait until we get clarity on what the legislative framework will be.  It would be foolish to try and second-guess a political process. We all need clarity and certainty.

Suppose Congress does establish a legal framework for covered bonds.  How long do you think it would take before covered bonds actually started to play a significant role in U.S. funding?

The answer has to be that initially it's going to be a marginal product because it has to build up in terms of outstandings.  It's going to ultimately be a volume-driven product.  If you're talking liquidity, you can't have liquidity without volume.  What that number is, is difficult to judge, because it will depend on many, many circumstances.  Let's be modest with our initial expectations and try and surprise ourselves.

From the time a covered bond law is enacted, how long would it take before the first new U.S. covered bonds were issued?

Even if you anticipate what the law is going to look like and you're kind of ready for it, there are still mechanics that need to be dealt with to really get a program into a "ready-to-roll" mode.  What is important is that it's done properly and diligently, in a way that people have confidence in the process.  So I think it's going to take a month or two even from the point you've got the law in place before people can actually start issuing.

If a covered bond law is passed in this Congressional term, we might for instance start having domestic issuers some time toward the summer. This is probably optimistic. Nevertheless, by the end of the year, it would be nice to see that we actually have what I call a meaningful issue calendar, with volumes starting to build up into the billions of dollars from multiple issuers.

Where will the best opportunity lie for initial covered bond issuance in the event that legislation is enacted?

Realistically, I think it will be in residential real estate.  I'm sure that will be the right place to start.

As we've always emphasized, covered bonds are an additional instrument.  It's not going to replace existing markets.  The ABS [Asset-Backed Security] market will return in some shape or form, and the GSEs [Government-Sponsored Enterprises, e.g. Fannie Mae & Freddie Mac] will continue with the work they do.  What we do know is the GSEs will likely be funding significantly less as time goes on. 

Therefore, there will be a need and an opportunity for banks engaged in the mortgage business to issue covered bonds to investors that might previously have been buying the GSE or indeed government guaranteed debt.  What this does do is provide an additional weapon in the arsenal of financial institutions — this asset class will increase their flexibility and also give them access directly to the U.S. domestic investor base for mortgage finance. 

I think that's the important point.  Many banks have not had that direct access, in this form, to fund their own mortgage books.  They've always had to go to other third parties, who then in turn will fund themselves.

Anyone who believes that covered bonds could provide a fresh source of money — a fresh way of getting to investors with a high quality product  — should now take a close look at this opportunity, do their homework, and get involved.

If the initial post-legislation U.S. covered bond issuances are likely to be in residential real estate, are you suggesting that the asset class would be in the area of what in this country are called "nonconforming" loans — i.e., loans that for one reason or another do not fit within the guidelines of Fannie Mae and Freddie Mac?

The only thing I would say is that we do need to go for high quality.  We need to give investors a very clear idea of what they're going to get.  We don't want to do anything which might essentially dilute the value of the instrument or the value of the cover pools. 

People will need to see the very high quality to start with.  Moreover, we need to make it very clear how we maintain that quality. 

If there are going to be pools of lesser quality, we need to have transparency so that investors are very clear on what they may be buying.  We need to be very disciplined in differentiating and delineating the different pools and the different degrees of risk within those pools.  Issuers and intermediaries must not just muddle through or fudge the difference between them. 

So I think we start with good quality, we maintain good quality.  By and large, this has to be a market of very high quality, although we could envisage distinct parts of the market aimed at higher spreads for less perceived quality in certain underlying asset classes in due course, perhaps.

What about prospects for commercial real estate funding with covered bonds?

There will be opportunities for U.S. commercial real estate at some stage.  In Germany, banks have increasingly turned to covered bonds ("Mortgage Pfandbriefe") for commercial real estate funding.

In terms of commercial real estate, we need to look at the whole on- or off-balance sheet debate and the accounting rules which are coming in, which will force banks to take assets onto their balance sheets which they might previously have moved off-balance sheet through the securitization process. Lets see where developments might take us, but we need to keep an open mind as to what we will be able to design into the asset class.

How would you describe the prospective investor base for U.S. covered bonds?

A broad investor base is a vital element.  You don't want it to be a very super-concentrated, small group of one or two big buyers. This would leave us in a position whereby it would be very difficult to achieve and maintain  liquidity.

The European investor base is an interesting split.  You've got insurance companies, money managers, all kinds of buy-and-hold investors that are investing their own or other people's money into an asset class which is seen as safe and reasonably liquid.  But you've also got a group of central banks, and you've got a large chunk of financial institutions buying covered bonds, representing at times almost 40% of demand.

In the U.S., what we want to do is pick out the big money managers and insurance groups, mutual funds — all of these people in various parts of the States who are the traditional "rates" buyers.  We use the old language of "rates" versus "credit," bearing in mind that in the wake of the economic crisis, everything has become a mixture of both elements to a greater or lesser extent. This will no doubt be reflected in investment decisions, pricing, and into which investor portfolio the product ultimately drops.

In a few words, how would you define a "rates" financial product as opposed to a "credit" product?

A "credit" product is broadly where people are focused on taking credit risk and obtaining credit spread to remunerate them for this.   In the "rates" world, you're much more fixated on safety from a credit risk perspective and making a total return based on market movements.  "Rates" investors want to have credit safe money put away where they don't have to worry about the counterparties or underlying issuers getting into trouble.

We would like to position the U.S. covered bond product as being as least credit-intensive as possible.  It's like "credit lite," because it comes with a lot of checks,  balances, belts and braces to make it much more like a "rates" product — and behave that way.

As you know, in Europe the so-called "benchmark" issuance size for covered bonds — typically expected in international trading — is a billion euros.   What do you envision as the benchmark issuance in the U.S.?

In Europe, yes, the benchmark "jumbo" has developed as a billion euro issue [about USD $1.42 billion] — although we've seen quite a number of more modest deals come in at the 500 million euro mark.  We have been redefining what we really mean by liquidity and observe that there are times when smaller transactions have better received.  

For the U.S. market we would, however, expect deals to be in the $1 to $2 billion size range in order to be large enough to offer some minimum level of secondary market liquidity.  A parallel private market for smaller deals might well emerge, and there may be opportunities for smaller issuers to pool their assets to achieve larger issue sizes.  We should keep an open mind here.

Naturally, the right size for deals in the US is something we will want to hear back from investors on.  Let's take a look at the color of their money, as we fix the key parameters for issues of covered bonds in the U.S.

You are on the Steering Committee of the U.S. Covered Bond Council, which was formed in 2008, in response to efforts by then-Treasury Secretary Henry Paulson to help develop covered bonds as a funding source for U.S. residential real estate.  What role do you see for the U.S. Covered Bond Council now?

The U.S. Covered Bond Council is a very valuable piece of machinery. It represents a comprehensive forum that groups all the interested parties around covered bonds. 

Unlike its successful longer established [European] counterpart that largely represents issuers, the USCBC has taken the opportunity to bring potential issuers, investors, lawyers and others around the table. There are a number of working groups including a potentially vital group bringing the traders together.  This was set up under the auspices of the Council right from the beginning and will aim to encourage debate over secondary market standards and procedures for the asset class.  

We really need to get the trading desks to get their heads together and say, "Well, how are we going to trade it?  Where are we going to post prices?  What screen services and electronic platforms do we use?"

The Europeans are now trying to do this through various initiatives.  The USCBC also groups the technical and legal expertise that is going to be vital as the politicians roll out a proposed covered bond legal framework and look for comments and ideas.

The USCBC has potentially much to do in 2010. Hopefully the presence of experts and interested parties on the Council will allow for rapid consensus forming and problem resolution. We need to be mindful, however, that there is no [U.S.] covered bond market as of today, and the Council exists to represent a broad range of interests to pilot this project successfully on its way.

This is precisely why the establishment of the Council was one of the initiatives that formed a part of the 2008 Treasury "Template" proposal [i.e., in conjunction with the Treasury Department's "Best Practices" guidelines for residential covered bonds].  It was logical, moreover, that the Council be set up as an offshoot of SIFMA [Securities Industry and Financial Markets Association] with the support of a strong administrative and industry base.  My colleague Brad Brown from the Bank of America Treasury is Chairman, and Sean Davy from SIFMA has done a great job pulling everything together as point person.

Even in the absence of a tangible market, work has been done.  Investors have been involved along with lawyers and various other people who are in and around the product including issuers as well as investment bankers.  There have been several meetings and a variety of calls demonstrating that people in the industry have shown a willingness to commit time to this cause already. This should ensure that the USCBC hits the ground running when the market opens up.

Any parting thoughts on the topic of developing a U.S. covered bond market?

We want to emphasize at every stage, "Let's not overhype this, but be modest in the goals we set ourselves — in what our expectations are."

Let's just say, "Here is something we expect to be of interest to a variety of potential users of the market.  We expect it to be compelling for mainline U.S. investors to get involved with this product.  And we expect it to be cost-effective and competitive for issuers in the fullness of time.  But all of these things are objectives we need to work towards — they won't happen overnight."

What we don't want to do is start giving anyone the impression this is some silver bullet or magic solution to some very real issues that have impacted other parts of the market.

But I think once you put the U.S. covered bond out there — once it's created — then it's up to the imagination and our collective entrepreneurial spirit to take the market wherever it will go.

Here is something that is beginning to take form.  We can discern the form as the mists begin to clear, but there are still mists.  There is still a lack of clarity, but we can make out for the first time an outline of something very useful, very practical, very applicable. This is tremendously exciting.

Let's make it work, and then figure out where we take it.

Note: The interview above was adapted from oral and written communications from Dec. 23, 2009 to the present.

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