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Banks Join Forces in Covered-Bond Effort
Asset Backed Alert, Harrison Scott Publications Inc. (September 12, 2008)

Bank of America, Citigroup, J.P. Morgan and Wells Fargo have teamed up to draft a blueprint for covered-bond issues in the U.S., an uncommon move for institutions that are usually engaged in heated competition.

The formation of the banks' joint effort comes about two months after they separately said they would aid in a government push to create a market for covered bonds in the States - a move aimed at helping to open a new funding source for the battered home-loan industry.

As part of the initiative, the institutions are working together to create standardized documentation for covered-bond offerings, which combine characteristics of mortgage-backed securities and corporate debt. Part of the goal is to make it easier for investors to analyze the on-balance-sheet transactions, thus making them more appealing to a broader audience and streamlining the offering process.

Doing so would help allay one of the primary concerns for the emerging covered-bond market in the U.S.: that the deals would only appeal to a small group of sophisticated investors that have expressed interest so far, including BlackRock, Pimco and TIAA-CREF.

Unless broader demand emerges, those buyers would likely insist on generous yields to take on the bonds, which runs counter to the reasoning behind efforts to establish a market. One industry player said issuers would only enter the market if yields on such instruments were below 6%, which is less than prevailing levels for many types of traditional mortgage-backed issues these days.

Given that BofA, Citi, J.P. Morgan and Wells Fargo typically compete for the attention of investors, their willingness to work together demonstrates how urgently the mortgage market needs fresh liquidity. Of course, the banks individually stand to benefit from a healthy covered-bond market as well, as each would likely fund their mortgage holdings through such issues. BofA, Citi and J.P. Morgan would also be prospective underwriters of the deals.

The four banks pledged to begin bringing covered bonds to market in the U.S. following a series of government actions that included a July 15 policy statement from the FDIC on those transactions and the July 28 release of "best practices" guidelines from the U.S. Treasury Department. Treasury secretary Henry Paulson expressed support for the formation of a covered-bond business at the same time.

However, creating a uniform template for covered bonds is proving to be a complex process, individuals involved in the talks said. And that could cause delays in establishing issuance programs.

Indeed, the talk is that it's unlikely any offerings are imminent. Part of the reason for the apparent holdup stems from the fact that the U.S. push is largely based on well-established covered-bond markets in European countries, including France and Germany. Those nations have specific laws defining bondholders' rights, which the U.S. lacks. Rep. Scott Garrett (R-N.J.) introduced a bill called the Equal Treatment for Covered Bonds Act on July 30 that is an attempt to more clearly define covered bonds in legal terms. But it is unlikely the proposal will pass in time to affect current issuance efforts.

In the meantime, structuring professionals will have to take into account all possible scenarios in which an issuer might fail. That's because the risks associated with covered bonds are tied directly to the health of their issuers, who must compensate noteholders for any losses within the underlying mortgage pools.

Another possible source of delays: working around differing rating-agency standards for evaluating covered bonds in the U.S. "Moody's has taken more of a market-value approach for the collateral," one source said, noting that S&P and Fitch are looking more at the amounts bondholders stand to recover if an issuer fails.

What's more, BofA, Citi, J.P. Morgan and Wells Fargo are talking to the rating agencies about structuring the deals differently from separate issues that BofA and Washington Mutual completed a few years ago. WaMu's bonds were downgraded several times earlier this year as the Seattle bank showed signs of folding under heavy mortgage-related losses. Part of the rating agencies' concern is that if the FDIC takes over the bank, it would pass the underlying mortgages along to bondholders, forcing them to hold fire sales of the assets at losses. BofA's transaction had a similar structure.

Now, rating agencies and banks are discussing ways to remove market-value risk from covered bond offerings - talks that are of key importance given how home-loan values have remained depressed following last year's industry implosion.

On top of all that, negotiations between banks and their lawyers are simply bound to take longer than a unilateral effort by one institution. Still, one securitization attorney said some of the banks started working seriously on covered-bond programs about a year ago - and that they ought to have been able to bring an offering to market by now.

The holdups won't be welcome news for market participants, who have been starved for mortgage funding since traditional home-loan bonds became nearly impossible to sell a year ago. That need became even more pressing this week, after the newly created Federal Housing Finance Agency seized Fannie Mae and Freddie Mac and said the agencies would scale back the volume of loans they fund.

Ultimately, however, traditional mortgage securitization must resume for the U.S. to have a sufficient flow of home-loan funding, said Richard D. Simonds Jr., a partner at the law firm of Thacher Proffitt. "Covered bonds can't fill that void." v



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