Tim Skeet: U.S. is "Market of Tomorrow" for Covered Bonds

While the European covered bond market celebrates a record-breaking past week, Tim Skeet is looking ahead to new opportunities for this funding vehicle on the opposite shore of the Atlantic.

Tim SkeetIn a TV interview on CNBC Europe Friday (Oct. 2), Skeet said: "[As] we look into 2010, the U.S. market is the market of tomorrow for this product."

Skeet is head of covered bonds for Bank of America Merrill Lynch, based in London.  He also is a member of the elite Steering Committee of the U.S. Covered Bonds Council.  That organization — sponsored by the Securities Industry and Financial Markets Association (SIFMA) and The American Securitization Forum (ASF) — was formed in 2008 following efforts by (then) Treasury Secretary Henry Paulson to facilitate development of covered bonds as an aid to residential real estate funding here.

With regard to the U.S., Skeet said: "Potentially we have capital here looking at [covered bonds] very closely indeed." 

Skeet noted that at present, many investors are holding large amounts of agency paper.  This refers to debt issued for loan funding purposes by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks — government-sponsored enterprises that benefit from an implicit federal guarantee.

However, as Bloomberg reported last week, those entities are currently "paying down debt at a record pace" — reversing a decade-long growth trend and "creating a supply void in bond markets."

According to Skeet, "The question for [investors] is: What will they buy once the amount of agency paper diminishes?"

The potential is that investors will see U.S. covered bonds as a conservative investment vehicle that makes them feel secure while offering an acceptable yield, thus helping to fill the void.

Covered bonds have gained special visibility in recent months because issuance has roared back to life with only modest stimulus from the European Central Bank (ECB).  This contrasts with private-label securitization, which continues to struggle mightily.

The week ending October 2 has been called the biggest ever for new covered bond issues.  It capped a month of rocketing volume — reportedly about €28 billion (USD $41 billion) for September — along with dramatically narrowing spreads.

Discussing the appeal of covered bonds from an investor's standpoint, Skeet stressed their dual recourse feature, which allows bondholders to rely for repayment both on the issuing financial institution itself and on a reserved pool of independently monitored assets (called the cover pool).  "You're looking at the full creditworthiness of the financial institution, first of all, and then if things do go badly wrong, you've got the collateral [of the cover pool] on the back."

Of course, predictions of a bright U.S. future for covered bonds are not something new.   After Washington Mutual launched the nation's first covered bond program in 2006, an executive at Barclays predicted that within four years, issuance by U.S. financial institutions would exceed $100 billion per year.   But it didn't happen.  Total U.S. covered bonds outstanding today amount to less than $20 billion, with no new issuance since 2007.

One obvious unforeseen roadblock was the global economic meltdown.  Even covered bond issuance in Europe took a tremendous hit, with no new "Jumbos" (i.e., issues worth at least €1 billion) for months after the Lehman collapse.

Now, however, there seems to be increasing optimism that the time for U.S. covered bonds is finally coming. 

"[W]e think that we will have a [U.S.] domestic issuance base at some point," Skeet said in the CNBC interview, "[and] we will have international issuers going to that market. 

"But first, we have to explain what the [covered bond] product is to an audience that [doesn't] know it."

To view Tim Skeet's complete interview (about 5½ minutes) on CNBC's website, click here.