A BNA, INC.
REAL ESTATE !
LAW & INDUSTRY
VOL. 3, NO. 11 REPORT JUNE 1, 2010
Since the securitization markets collapsed in 2008, many have asked if covered bonds
might offer a suitable alternative to commercial mortgage-backed securities (CMBS) and
other kinds of asset-backed securities. Introduced more than two centuries ago, the bonds
have proven safe and reliable ﬁnancial instruments in Europe, but so far have not caught
on in the United States. Here the author provides a ‘‘primer’’ on covered bonds—their his-
tory, how they work, their key characteristics. He compares them to U.S. securitization and
explores the prospects for new policies that could help them stake their claim in the West.
Westward Ho: Covered Bonds Make Their Way to the Land of Opportunity
BY RICHARD ZAHM nancial conduct in the first decade of the 21st century
bore an uncanny resemblance to behavior seen in the
istorians looking back on our era a hundred years
last half of the 19th century.
from now might puzzle over our mortgage finance
predicament. Because, in many ways, our country ‘‘The Great Recession of 2008-2011,’’ they could
has traveled this trail before. With the benefit of hind- write, ‘‘marked the end of The Mortgage Frontier. Tra-
sight, our descendents might be able to see that our fi- ditional financing models were finally adopted that pro-
vided the mechanisms needed by borrowers, investors,
and lenders, providing just enough stability to allow a
Richard Zahm is a direct lender and portfolio gradual recovery.’’
manager based in Connecticut and Califor- One of our conceits is that securitization is a brain-
nia. He may be reached at richzahm@ child of our generation. It’s not. Securitization in one
gmail.com. form or another was tried—and abandoned—six times
between 1870 and 1940. The results differed from our
COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 1944-9453
recent iteration only in the magnitude of our latest de- and France (obligations foncieres), covered bonds have
spoilment. financed everything from public works projects to re-
Financing principles have been developed over time. building cities. They’re common in more than 25 devel-
Investors really only require three things: oped countries across Europe. They work.
s Careful underwriting and adequate assurances of In contrast to the virtual vaporization of securitiza-
safety; tion since 2007 in the United States, covered bond origi-
s An ability to manage risks correlated to varying nations in the European Union are tracking only
interest rates, prepayments and credit quality; and slightly below record figures set in the first quarter of
s Transparency of underlying assets. 2006.
These principles were forgotten. Covered pools offer ‘‘dual recourse’’ for payment.
Bondholders have recourse for payment of principal
Mortgage Finance and the Open Range. Mortgage origi- and interest from two sources. The first is the issuer of
nators, rating agencies, securities issuers, government the bond—generally, a financial institution. In the event
regulators—all have their antecedents. They bear a that the issuer defaults, recourse is to the assets in the
striking resemblance to the financiers, fortune seekers, cover pool itself. The assets span the financial spec-
and feckless administrations in our history. Seeing only trum: residential and commercial mortgages, student
boundless opportunity—and immediate need—the fo- loans, auto leases, public debt.
cus was on plunder, now, consequences be damned. They’re also ‘‘dynamic.’’ Unlike mortgage-backed se-
From hydraulic placer mining, blasting rock and de- curities, the pool is actively managed to maintain the
stroying rivers, to forest clear cutting, to the destruction pool’s value. As assets within a pool mature or decline
of entire species (not to mention Native Americans), in value, they are replaced and augmented by new as-
we’ve got a well-established pattern of shortsighted- sets of equal or better quality. The focus is on over-
Mortgage finance in the late 20th century was noth- The dynamism comes from the cover pool remaining
ing particularly new. But what was new was the global on the issuer’s balance sheet. The pool remains sepa-
reach of a system that seemed to be expressly designed rate from the issuer’s other assets. It’s to be used exclu-
to disregard outlooks, expectations, obligations, and es- sively for the benefit of the covered bond holders.
tablished investment and lending practices developed Because issuers are wedded to the pools they create,
over hundreds of years. common sense kicks in. The assets aren’t tucked away
Lenders were able to originate loans free from the in special-purpose vehicles. Issuers are responsible for
worry of having to carry them on their balance sheets. making payments on the bonds regardless of the per-
Investors swallowed the fiction that they were secure, formance of the assets. Assets are monitored and up-
that a handful of individual defaults would have a mini- dated each month. Underwriting standards become
mal impact on the value of a portfolio. And borrowers tighter. Lenders emphasize quality control and due dili-
would enjoy lower interest rates. gence.
We’re suffering through the effect of that particular Conflicts of interest issues are minimized by checks
medicine show. And as we stagger around ghost towns and balances created by the ongoing participation of in-
(literally), as we survey the damage inflicted by the dependent trustees, asset monitors, and master ser-
shoot-em-up mortgage cowboys, we might be seeing vicers. Covered bonds are transparent by nature, pro-
salvation coming over the horizon. Covered bonds. viding loan-level details that are in sharp contrast to
weighted-average pools inherent in mortgage-backed
Frederick the Great’s Legacy. Covered bonds are debt securities structures.
obligations that are secured or ‘‘covered’’ by a pool of
The key advantage of covered bond programs is that
assets. Reputedly fathered by Frederick the Great of
borrower and investor interests come before those of
Prussia in 1789 as a means of paying for the Seven
the lender or issuer—the reverse of our current circum-
Years War, they’ve stood the test of time. Covered
bonds have weathered multiple wars and revolutions,
If financing structures have characteristics (safe,
and have survived financial meltdowns, including ev-
volatile, toxic), they can also have personalities. Cov-
erything from depressions and stagflation to massive
ered bonds are stolid, staid, open-handed, dependable.
They’re the Ingalls family of Little House on the Prairie,
They’ve expanded across nations and across a host of
rolling by the card sharks and cancan girls smoking in
legal, economic, and religious systems, with only slight
the Mortgage Backed Saloon.
variations. From Germany (pfandbrief), Denmark (re-
alkreditobligateur), Spain (Cedula Hipocateclarias), Comparison to Mortgage-Backed Securities.
Covered Bonds MBS
Pool Structure Skin in the game. Dual recourse. ‘‘Originate to distribute.’’ Mul-
Collateralized by pool and issu- tiple classes and tranches, with
er’s assets. Single class. varying credit risks.
Pool Management Dynamic management with is- Investors bear risk of asset de-
suer responsible for payment. terioration within static pool. No
Asset substitution required. recourse to originator.
6-1-10 COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. REAL ISSN 1944-9453
Balance Sheet On balance sheet. Pool assets Off balance sheet, packaged,
segregated for exclusive beneﬁt sold.
Payment Sources Bank cash ﬂows. Proceeds of assets in pool.
Principal Return Bullet at maturity. Returned as assets mature.
Prepayment Risk Reduced due to asset substitu- Passed through to investors.
Disclosure & Governance Assets monitored by indepen- Commingled roles, weighted av-
dent trustees. erage pool data.
Compliance Review Legal, regulatory & trust: heavy. Legal: heavy. Asset monitoring
& trust compliance: light.
Wagon Trains Forming. ‘‘The curious element,’’ histo- also were made in the Senate to attach an amendment
rians might write, ‘‘is that covered bonds were recog- to the financial reform bill. H.R. 4884 proposes a com-
nized as providing a viable solution for the financing pliance framework for U.S. covered bonds.
mess they’d made. But they were slow on the uptake, The proposal is straightforward, focusing on eligible
perhaps focused on transitory issues, like oil spills and assets and their quality requirements; the size of cover
the future of the ill-conceived government-sponsored pools relative to bonds and the calculation of over-
enterprises. . .’’ collateralization; investor rights and the management
Despite their lengthy track record in Europe, only of the pool in the event of default.
two covered bond issuances have been made in the The measure was not included in either the House or
United States, one by Washington Mutual (2006) and Senate versions of the reform bill. There is conjecture,
one by Bank of America (2007). however, that it could be included in the compromise
The covered bond market in America doesn’t lack for bill being drafted by the House-Senate conference com-
supporters—Congress, the Securities and Exchange mittee: Garret could me a member.
Commission (SEC), and the Federal Deposit Insurance Asset classes would include residential and commer-
Corporation (FDIC) to the National Association of Real- cial mortgage loans; auto loans and leases, student and
tors (NAR), the Commercial Real Estate Finance Coun- small business loans; credit card receivables and public
cil (CREFC), and the Securities Industry and Financial sector debt. Cover pools would be made up of single as-
Markets Association (SIFMA)—everyone seems to be in set classes.
favor of covered bonds. Covered bond legislation is a crucial component, but
What the market lacks is regulatory guidance. It cur- it’s interrelated with other broad issues, and all of these
rently depends entirely on contractual provisions, giv- are in motion: the future roles (and fates) of Freddie
ing rise to an interesting banding together of financial Mac and Fannie Mae, for example, as well as the Fed-
institutions. Like sodbusters grouping their wagons for eral Home Loan Bank (FHLB) system.
safety before heading west, Bank of America, Citigroup, The most apparent covered bond doomsayers appear
J.P. Morgan Chase, and Wells Fargo are creating stan- to be rating agencies. Moody’s Investors Service takes a
dardized documentation for covered bond offerings. market-driven approach for collateral, while Standard
Their goal is to make it easier for investors to analyze & Poor’s and Fitch Inc. focus more on bondholder re-
offerings. The first three lenders would also be prospec- covery in the event of issuer default. Despite the agen-
tive underwriters. cies’ experience in covered bond ratings in Europe, the
freshness of the legislation and the newness of the U.S.
market is somehow off-putting. (Looking forward, cov-
Like sodbusters grouping their wagons for safety ered bond ratings would appear to be the least of the
agencies’ worries . . . )
before heading west, Bank of America, Citigroup, European commentators suggest various improve-
ments for the legislation, including stricter eligibility re-
J.P. Morgan Chase, and Wells Fargo are creating quirements; more detailed asset management match-
ing, monitoring, and management; and greater clarifi-
standardized documentation for covered bond cation of results stemming from various default
scenarios. We’ll get there.
offerings. Their goal is to make it easier for
Looking Under the Canvas. A critical element for cov-
investors to analyze offerings. The ﬁrst three ered bonds is the dynamic nature of the pools. The as-
sets contained in the pools are providing collateral not
lenders would also be prospective underwriters. direct income. As a result, the nature and value of the
assets are under constant scrutiny. As assets are re-
tired, they’re replaced with new collateral of the same
or superior quality.
Reps. Scott Garrett (R-N.J.), Spencer Bachus (R- This necessitates transparency and loan-level infor-
Ala.), and Paul Kanjorski (D-Pa.) March 18 introduced mation, something lacking in the MBS world. Investor
The United States Covered Bond Act of 2010 (H.R. Reporting Packets (IRPs) provided by servicers have
4884) as a standalone bill (3 REAL 181, 3/23/10). Efforts been the bane of accountants. In April, the SEC pro-
REAL ESTATE LAW & INDUSTRY REPORT ISSN 1944-9453 BNA 6-1-10
posed disclosure and reporting requirements descend- whisky, then used as a barter currency. But when stan-
ing to the loan level, a move the industry described as dards can be set, matters can move forward.
‘‘tectonic,’’ a ‘‘tsunami.’’ Covered bonds in Europe are regulated by individual
Reports would include a description of the impact of countries and by the EU. Minimum credit standards are
waterfalls and a ‘‘shelf-eligibility’’ standard would be established and specifics are set out as to the availabil-
established. This entails issuer certification that the as- ity of cover pool assets in the event of cover pool de-
sets could reasonably produce cash flows and that un- fault. Around 90 percent of European covered bond is-
derwriting standards were sound. suance is rated Aaa. For most of their existence, they
Frederick the Great would be proud. carried no ratings.
Stringing Fence. The mortgage stampede of the past The primary rating drivers are the strength of the
10 years is behind us, leaving a disheveled, milling herd sponsor bank and the quality of the cover pool. Bank
of investors, lenders, and borrowers foraging for suste- strength factors include the degree of involvement in
nance. The pause in the real estate market allows the servicing, cash management, and hedging. Pool quality
covered bond regime to usher in a structure that brings is determined in basically the same manner as
distinct advantages compared to securitization. mortgage-backed securities. Refinancing risk variables
In a time of exceptional unease, covered bonds offer include asset type; credit quality of the assets; strength/
higher credit ratings, owing to tighter regulatory con- liquidity of the market; and time available for refinance.
trols, higher quality of collateral, and dual recourse. Be- Covered bonds could provide an interesting long-
cause credit ratings are higher, funding costs are lower. term benefit: they could de-emphasize the power of
Reasons: interest payments are less and issuers enjoy Fannie Mae and Freddie Mac and provide a path for the
greater pricing power owing to superior liquidity. shrinkage of the their importance.
Financing better coincides with the expected lives of
the assets. Covered bonds have maturities of seven Eureka. Speculation of the form CMBS 2.0 will take
years or more, compared to medium-term notes that points directly towards attributes long contained by
only extend for three to five years. covered bonds. Securitization ‘‘structurally made
sense.’’ It ‘‘just got ahead of itself.’’ Improvements in-
Sheriffs and Mounties. The most lasting legacy of the clude: more thorough underwriting, greater transpar-
financial meltdown of the ‘‘Great Recession’’ could be
ency, simpler deal structure, an outside forum oversee-
the altered awareness of regulation and the roles—and
ing rating agencies, and issuers retaining a stake in the
limitations—of government trying to ride herd over the
assets and holding more first loss risk.
vast range of real estate finance. Can tight controls be
developed and implemented without strangling the As Native Americans might have asked early explor-
market? ers: ‘‘We’ve lived here for years. You’re discovering
In the Old West and Canada, the sheer size of territo- what?’’
ries mandated tight control, specifically applied when Using 221 years of European experience as a guide,
feasible. Quality and conformity to common specifica- covered bonds could provide the ultimate private mar-
tions was uncommon, except for gold and, perhaps, ket solution.
6-1-10 COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. REAL ISSN 1944-9453