Yearly Archives: 2015

The Volcker Rule and Covered Bonds

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The Volcker Rule became effective on July 21, 2015. There are two aspects to the Volcker Rule: a prohibition on proprietary trading and a limitation on sponsoring or investing in a ‘covered fund.’ It is this second aspect of the Volcker Rule that concerns investors in covered bonds. The Volcker Rule applies to banks in the United States, including the branches, subsidiaries and affiliates of foreign banks. Even if the investor in a covered bond is not a bank subject to the Volcker Rule, if investment in the covered bonds is subject to the Volcker Rule,the secondary market liquidity for the covered bond can be adversely affected.

If the prospectus for the covered bond does not disclose whether an investment in the covered bond is limited under the Volcker Rule, how can you determine whether the Volcker Rule applies? This can be quite a complex analysis. Fortunately, Morrison & Foerster has written a helpful article on analyzing whether a covered bond is subject to the Volcker Rule. See A user’s guide to Volcker Rule complexities.

Why is CB legislation tied to GSE reform?

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Why is the adoption of covered bond legislation linked to housing finance reform? Housing finance reform is all about the role of the GSEs. While covered bonds certainly can be used to finance residential mortgage loans, they do not require any form of government support. The consideration of the proper role of the government in housing finance can occur independent of covered bonds. However, I hear from many sources that covered bond legislation would only be considered after GSE reform had been adopted or perhaps considered with GSE reform.

There is no apparent logic to this position. Covered bonds are a private sector financing technique that has proved very effective in other jurisdictions. There is nothing in GSE reform that would be a necessary predicate to the issuance of covered bonds by U.S. banks. Covered bond legislation would not touch the status of the GSEs. It is possible that covered bond issuance by U.S. banks could develop into an attractive alternative to financing through the GSE and thus reduce the tension in GSE reform, but that would be beneficial to GSE reform.

It seems as though both sides are determined to keep as much pressure on GSE reform as possible in order to achieve their objectives and not permit any private sector initiatives to sidetrack the discussion until the role of the government in housing finance has been solved. But this seems to put the cart before the horse. Shouldn’t the government intervene only where the private sector is not functioning properly? Wouldn’t it make sense to let private sector initiatives develop first before assigning the government a role? If we can agree that the answer to those two questions is yes, why not adopt covered bond legislation and see how the market develops while we debate how to wind down the GSEs and what would be the appropriate future structure for the government’s role in housing finance?

Certainly we can have a fulsome debate on how the government can support housing access for those who need assistance independent of how covered bond legislation is drafted. Certainly if covered bonds, RMBS and the federal home loan banks fail to provide adequate private sector funding for residential mortgage loans there may be a need to consider a larger government role.

It is not essential that covered bonds be enabled through legislation as it is possible to achieve covered bond issuance through securitization techniques, as has been done in other countries. See, e.g., Time for a US alternative. However, investors will have more confidence in a covered bond sector established through legislation and the market may be expected to develop quicker with legislation. Enacting legislation for covered bonds would be a low cost experiment that would have no harmful side effects. Covered bond legislation, therefor, should be enacted before GSE reform is attempted so that we have a better chance to assess what works in the private sector before designing the government’s role in housing finance.

Why do investors like covered bonds?

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Why do investors like covered bonds?

What is it about covered bonds that investors like? Even U.S. investors who have plenty of other fixed income investment opportunities. In Europe there is more than €2 trillion in covered bonds outstanding. Even in the U.S., which has no statute to enable its banks to issue covered bonds, there is $150 billion of covered bonds outstanding.

What is it about these bonds and who is buying them?

You can find out who the investors are at The Cover or The Covered Bond Report. Both publications provide a breakdown of type and location of investors by offering. And what the data shows is that banks and central banks are between 50% and 80% of the investors, depending on the offering. The remainder goes to funds, asset managers and insurance companies. While not a distinct class of investors, the composition is quite different from the class of investors in bank senior debt or securitizations. Why? And why central banks? Aside from QE, of course.

The answer lies in the nature of covered bonds. Covered bonds are a different kind of investment. They are more than senior bank debt because there is recourse to the cover pool. They are more than securitization because there is recourse to the issuing bank. Covered bonds are a dual recourse instrument, which raises an investor’s confidence in their safety. Importantly, in Europe covered bonds are not subject to bail-in, while senior debt is.

And in Europe, covered bonds receive favorable capital treatment under the bank capital rules, attracting only half the capital that a senior bond from the same institution would attract. But that only makes sense given the dual recourse nature of covered bonds compared to senior debt. And of course central banks are not subject to the capital rules anyway.

So what appears to attract banks and central banks and other investors is the high level of safety with covered bonds combined with a yield that exceeds similarly rated sovereign debt. And covered bonds have a similar risk profile – no defaults in 250 years. Quite a record.

There are other details about covered bonds that are also considered important.

Covered bonds are issued by regulated financial institutions and the covered bond programs of the institutions are separately regulated.

The quality of the assets in a cover pool is high and subject to regulation. Any assets that default or become delinquent must be replaced on a monthly basis. The bank has 100% “skin-in-the-game.”

The bonds are simple, bullet pay instruments with either a fixed or floating rate. If the issuing bank were to become insolvent, the assets in the cover pool are intended to continue payments on the bonds through their maturity. No pre-payment risk.

Each series of covered bonds is a single class, so there is no complex class structure and complex payment waterfall to analyze. The credit analysis is primarily an analysis of the strength of the issuing bank and for this there is a huge community of analysts to assist an investor and a wealth of analytical experience covering more than 100 years of corporate credit analysis. The lack of experience and analytical talent was one of the prime failings of securitizations leading up to the crisis.

So what’s not to like? A risk profile like sovereign bonds and a better yield. No wonder there is a €2 trillion market. But will the United States Congress like them?

Why not covered bonds?

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Why not covered bonds?

Why not pass legislation for covered bonds in the United States? It is easy to do and there is basically no cost to the Treasury. In 2011, covered bond legislation passed the House Financial Services Committee by a vote of 44 to 7, a very strong bi-partisan vote. The only dissenters were hoping to implement provisions requested by the FDIC that were rejected by the majority. The dissenters were unable to retain even members from their own party on the final vote. Probably more than any other development, this demonstrates that covered bonds are not a partisan concept, they are not divisive and they have broad support.

Covered bonds will bring private funding to residential mortgage loans, but there is no good reason that passage of covered bond legislation should be tied to GSE reform. There is nothing about covered bonds that would implicate GSE reform, except that by bringing private funding to the market they could reduce the dominate role of the GSEs. And there is no credible evidence that either party in Congress believes that a continued dominate role for the GSEs is a policy mandate.

An unlike securitization of residential mortgage loans, no concerted effort is needed to get investors to participate. Investors are wary of residential mortgage securitization as a result of the financial crisis, which was precipitated by mortgage securitization. There are many efforts underway to convince investors to return to the RMBS market. Covered bonds carry no such baggage. Covered bonds have been readily sold to U.S. markets since 2010 and investors remain eager for more.

Covered bonds are more transparent to regulators.

Covered bonds are a simpler investment analysis for investors.

Covered bonds are proven financing technology with worldwide acceptance.

Covered bonds are friendlier to mortgage borrowers because the originator retains the right to modify loans to assist borrowers in working out difficult loans.

What’s to lose? Maybe covered bonds could develop into a vibrant private sector funding alternative for residential mortgage loans. If not, no loss. And no cost. But if it works, it’s a plus all around.