Covered Bonds Made Simple

NEW YORK CITY-In Europe, covered bonds represent a “bread and butter” financing vehicle for lenders and a $3-trillion investor base. To US lenders and investors, they’re largely unfamiliar. That may be changing soon: CBs are now being viewed as a significant new funding source, one that wouldn’t replace CMBS but could give lenders another vehicle.

Actually, “new” may be a misnomer in the case of CBs, which were introduced to the world in 1769 by King Frederic the Great of Prussia. Since then, they’ve been in widespread use across Europe.

Domestically, the bond market took a different evolutionary path and CBs haven’t been issued by US lenders since 2007, and those were reportedly the first domestic CBs since the 1930s. By contrast, European and Canadian banks have issued more than $16 billion worth of CBs in the US so far this year—a greater sum, in fact, than the year-to-date total of new CMBS here.

CBs differ from CMBS in a number of ways, said experts at a panel discussion held Tuesday at the Midtown offices of law firm Morrison & Foerster LLP, moderated by Mark Edelstein, partner in the firm’s real estate/workout practice. For one thing, they’re secured by a revolving pool, in contrast to the static pool of assets underpinning mortgage-backed securities.

Assets can be added to a CB’s “cover pool,” or taken out as necessary to maintain the pool’s coverage requirements. For another thing, should a CB deal go into receivership, investors have recourse to both the bond’s issuer and to the pool—not so in the case of CMBS.

Why CBs in the US, and why now? “We’re seeing a coalescence of events,” said Anna Pinedo, partner in MoFo’s capital markets practice. She pointed out that covered bonds have withstood the financial crisis better than CMBS, whether domestically or in the European Union.

Covered bonds are also seen as attractive because they’re simpler than CMBS. “There’s no tranche-ing, interest-only or other complicated pieces,” Pinedo said. While CBs wouldn’t replace mortgage securitization in the US, they would provide a nice addition to the toolkit and could take some pressure off the GSE system.

A key factor in the success of CBs in Europe is the statutes governing the bonds and the cover pools. Among other things, the statutes require high-quality assets in the pools and regular measurement of each pool’s asset coverage, usually on a monthly basis. Typically, the assets are residential mortgages, although panelist Yehudah Forster, VP with Moody's Investors Services, pointed out that about half a dozen European countries, notably Germany and Spain, have CB programs containing more than 25% commercial mortgages.

In the US, there is no statute in place. As a result, any CB issues that do occur among US lenders entail a costly contractual structure that tries to “mimic” the statutory requirements seen in EU countries.

H.R. 5283, a bill introduced by Rep. Scott Garrett (D-NJ), proposes a statutory structure for CBs in this country. However, Garrett first introduced the bill in 2008 and again in 2009, and will most likely have to re-introduce it after the next Congressional session begins in January; panelists said its chances of being enacted during the lame-duck session following the midterm elections were slim. A consensus prediction among panelists at Tuesday’s discussion was late-2011 passage of Garrett’s bill. To date, no equivalent bill has been introduced in the US Senate.

Once such legislation is enacted and takes effect, MoFo’s Jerry Marlatt, senior of counsel in the capital markets practice, predicted that regional lenders would make widespread use of CBs, more so than money-center banks. He pointed out that for issuers, CBs offer more flexibility regarding collateral than does CMBS, and with longer maturity periods—generally seven to 10 years, and prior to the credit crisis some ran even longer than that—CBs can help banks extend the maturity of their wholesale debt.

For investors, Marlatt said, CBs are viewed as safe investments, comparable to sovereign debt or agency debt. In fact, panelists pointed out that CMBS and CBs really appeal to two different classes of investors, and that typically CB buyers will not buy asset-backed securities of any kind.