Prior to the onset of the credit crisis in 2008, covered bonds were seen by investors as a generic triple-A quality asset class. Valuations were homogenous across all jurisdictions and reflected assumptions of near zero default probability and negligible loss severities due to their long history since their advent in 1769.
Covered bonds are securities issued by a financial institution and backed by a group of loans residing on the balance sheet known as the “cover pool”. The assets in the pools can consist of high-quality private mortgage loans or public sector loans or a mix of the two. Central to the success of the asset class, and correspondingly valuations, is the dual recourse characteristic in which covered bond investors are given a priority claim to a segregated on-balance sheet pool of assets parallel with a senior claim to the issuer which ranks pari passu with senior unsecured creditors.
Traditional covered bond investors showed high confidence in the asset class by requiring a low risk premium to “risk-free” assets such as U.S. Treasuries, which are generally considered to be risk-free because they are backed by the U.S. government. All investments contain risk and may lose value. In hindsight, this view of covered bonds could be seen as non-commensurate with the actual credit, refinancing and liquidity risks inherent in covered bonds. These risks have revealed themselves in recent episodes of market stress as the credit strength of issuing entities and the quality of cover pool collateral were questioned.
During the financial crisis, the credit strength of the financial credit sector as a whole came under scrutiny and, as is commonly known, central to the problem was nonperformance of mortgage assets resulting from loose origination standards, complex securitization techniques and deteriorating underlying macroeconomic variables such as declining house prices and rising unemployment. More recently, credit risk of public sector loans from distressed European economies is experiencing a similar reassessment.
The natural consequence of weakening collateral performance and issuer credit fundamentals has been the scrutiny of structural features of individual covered bond programs. Although simplistic in comparison to asset-backed securities (ABS) or mortgage-backed securities (MBS), as covered bond structures are on balance sheets and do not utilize securitization techniques such as “tranching” or subordination, covered pools are dynamic open structures -- the issuer may add and remove cover pool assets (i.e. mortgage loans) and/or issue or retire liabilities (covered bonds). Thus the cover pool is “live” and continuously mutating.
Credit enhancements features, asset liability amortization mismatches and collateral performance thus change with time. Consequently, a concern associated with covered bonds is less-than-perfect transparency.
However, the market is expanding rapidly, both in terms of secondary market liquidity and primary market supply. This growth has been fueled by three main factors:
- Strong demand from a large investor base of natural buyers.
- Regulatory developments such as Basel III and Solvency II.
- Explicit support from central banks like the European Central Bank (ECB) via its Covered Bond Purchase Program (CBPP).
This combination has created a vibrant environment and global momentum for covered bonds.
Privileged Treatment Could Stimulate Supply and Demand
Basel III looks to restrict how global banks operate and finance themselves. The three pillars of the Basel III framework are capital, funding and liquidity -- the latter two having specific implications for covered bonds.
- Funding. Basel III requires long-term funding (liabilities greater than one year) to be at least equal to the bank’s long-term assets as measured by the Net Stable Funding Ratio (NSFR). The NSFR effectively incentivizes banks to reduce refinancing risk via long-term funding with a bias to covered bonds due to favorable factor weighting vs. alternative funding sources.
- Liquidity. The Basel III Liquidity Coverage Ratio (LCR) establishes a 30-day liquidity buffer to withstand a simulated stressed scenario like a deposit run. The LCR classifies covered bonds as Level 2 assets, second only to cash reserves and sovereign debt. Banks can hold up to 40% of these Level 2 assets at a haircut of just 15%. The effect on covered bond demand, however, will not be universally positive. For example, in countries like Germany, where banks are traditional buyers of covered bonds, the 40% limitation may be already exceeded. Thus, the degree to which institutions have a home bias for their covered bond investments and their current balance sheet composition will determine the impact the LCR ratio has on demand.
On balance, while NSFR may generate covered bond supply in the five-year and longer maturity range, we believe this increased supply will ultimately be constrained by the available quantity of collateral assets. The LCR will broadly stimulate demand, as banks represent about 50% of the covered bond investor base. Thus, the potential exists for Basel III to have a structurally net positive demand dynamic, creating technical support for valuations.
Solvency II Implications for Demand
Solvency II establishes capital adequacy requirements for European insurance institutions. The relevant aspect of Solvency II for covered bond investors is the introduction of economic risk-based capital requirements which are a function of asset class, rating and duration. Insurance companies thus have an asset allocation bias for risk assets that are highly rated and of shorter maturity.
Additionally, Solvency II applies a lower capital charge for covered bonds than for unsecured debt. This likely will translate into an increase in aggregate demand for covered bonds but could have potentially negative consequences for longer-dated covered bond (seven years or longer) where the insurance sector is traditionally a large part of the investor base.
EU Resolution: Above the Line, But with Limitations
Earlier this year the European Commission’s consultation paper on bank resolution and recovery gave further support to covered bonds by proposing “bail-in” exemption via exclusion from private sector participation in post insolvency burden sharing. More importantly, the framework has implications for covered bond issuance capacity by limiting secured debt as a function of minimum post-issuer insolvency recovery rates for unsecured debt. In short, the objective of the framework is to prevent excessive subordination of depositors without bearing excessive losses on unsecured creditors.
Although difficult to quantify with any precision, the impact on investor and issuer behaviors as a result of European regulatory developments has already begun to play out, despite the fact that compliance with Basel III is tentatively scheduled for 2018, Solvency II in 2013 and the EU resolution in 2014. It is highly coincidental that record issuance of covered bonds in 2011 (€130 billion through mid June, according to RBS) was received with strong demand from European and global investors.
U.S. Prospects Remain Bright
This new interest in covered bonds has resulted in a surge of U.S. dollar denominated covered bonds from American, French and Scandinavian issuers ($30 billion issued in 2010, according to RBS) and also caught the attention of U.S. legislators. In March, two members of Congress introduced the Covered Bond Act of 2011 (H.R. 940), which would allow covered bonds to pool traditional assets, including residential and commercial mortgages. Unlike the established European market, U.S. covered bonds would also include auto loans, credit card receivables, student loans and government guaranteed small business loans. Recently the House Financial Services Committee voted in favor of the U.S. Covered Bond Act to establish a regulatory framework. The FDIC has expressed concern that additional legal protection for certain classes of secured creditors could harm the recovery of the Deposit Insurance Fund (DIF) during a bank resolution.
Still, the prospects for a large U.S. covered bond market remain bright. Large traditional European issuers have tasted success and are planning on expanding their covered bond programs. And similar success has been experienced by other foreign issuers that have not yet tapped the USD market. Australia, Canada and the UK are seeing the benefits of covered bonds for stable funding of their banking system and have also seen the introduction of legislation that is supportive of covered bonds. As their banks already use USD explicit government guaranteed issuance for funding, that debt could conceivably be rolled over into USD covered bonds.
More USD issuance will likely encourage legislators to push forward the U.S. Covered Bond Act. Once enacted, it may alter the way regional banks have relied on the Federal Home Loan Bank (FHLB) system for funding, becoming a powerful source of issuance as well as demand for U.S. covered bonds.