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U.S. Covered Bond Market Takes Flight
Asset Securitization Report--SourceMedia (June 18, 2007)
When it comes to covered bonds, the U.S. structured finance market is a quick study. Last September, Washington Mutual became the first American issuer to complete a covered bond transaction. The size of the program, 20 billion ($26.5 billion), got the U.S. covered bond market off to a spectacular start.
The issuance, however, was denominated in euros, signifying that although U.S. issuers had covered bond ambitions, the market lacked a fully prepped investor base that would have given it its full breadth.
Nine months after the WaMu transaction, it looks like the market has graduated. Bank of America priced a $2 billion covered bond transaction recently. It was the sole lead on the deal, but seasoned covered bond managers Barclays Capital and ABN AMRO acted as co-managers, along with Citigroup Global Markets and Lehman Brothers.
Backed by prime residential mortgages, the deal clearly highlighted keen U.S. investor interest for the product type, according to people familiar with the transaction. The five-year portion attracted the most investor demand, coming in at about two basis points under mid-swaps.
That pricing did just as well as the well-received $2 billion transaction from British bank HBOS, which priced last December.
Market sources close to the U.S. covered bond market said that the Bank of America deal is the first-ever dollar-denominated transaction of its kind from a U.S. issuer.
The American covered bond market is off to a running start. Market sources said that six or seven other transactions are in various stages of development, and that Morgan Stanley is working on four of the forthcoming deals. While most transactions should be backed by commercial or residential mortgages, talk has already turned to using auto loans and student loans to back the deals.
In addition to those trends, market sources said European issuers are looking to sell U.S. investors covered bond products from the latter's own market.
"We're seeing a lot of inquiry into selling U.S. mortgage-covered bonds into the U.S. market from European issuers," one market source said. "That has actually been hotly discussed."
Specifically, Northern Rock, the U.K.'s largest mortgage lender, and Spanish lender Caja Madrid are said to be mulling dollar-denominated transactions in the U.S., a market source said.
"They are all looking to tap the dollar market," that New York source said.
Although the covered bond market is expected to grow impressively, it is not likely to take away issuance from the RMBS market, sources said.
For starters, the covered bond structure appeals to those issuers that have assets eligible for securitization, but who elect to keep the assets on their balance sheets, said Kevin Ryan, a managing director at Morgan Stanley, who did not discuss word of the bank's specific plans to arrange covered bond transactions.
As for investors, they like the dual recourse aspect of covered bond structures. Covered bonds are repaid from the corporate revenues of the issuing company - thus far, large banks - but are also secured by a high-quality cover pool of assets that remain on the issuer's balance sheet and can be liquidated to meet outstanding bond obligations, said Rui Pereira, a managing director in Fitch Ratings' RMBS group, who also assessed the Washington Mutual program. As long as the issuing bank is solvent, the covered bond investor is getting paid back by the institution's corporate cash flow.
By comparison, RMBS investors have recourse only to the securitization asset pool and its cash flows, Pereira said.
Other technical aspects of covered bonds make them appealing in ways that do not pose a huge threat to the ABS market, industry participants said.
"The covered bond investor base is a different investor base than those that buy securitizations," Ryan said.
For starters, covered bonds are fixed-rate deals and are sold to investors looking for fixed-rate product. Instead of amortizing in a traditional way, a covered bond pays out the interest rate over a longer maturity than typical ABS transactions and makes a balloon principal payment at the end of the term.
Many ABS transactions, on the other hand, are floating rate, and the bonds repay through amortization.
"This is basically an interest-rate product," said Ryan, alluding to the repayment structure. "They are triple-A rated and secured. They have the backing of double-A and single-A banks. There is not a lot of credit risk to these deals."
Broader issues related to bank regulation could potentially affect covered bond issuance.
"The bonds being issued now are amazing products, and demand for them is certainly understandable," said Scott Stengel, a partner at Washington, D.C.-based international law firm Orrick, Herrington & Sutcliffe. "I think now in the U.S., the next step is to make these structures even more efficient."
An inefficiency, Stengel noted, was caused by the absence in the U.S. of a legal framework that would more completely isolate the cover pool of mortgage loans from a conservatorship or receivership of the issuing bank.
Another roadblock was created just last fall when Congress amended bank insolvency laws to include an automatic stay, for as long as 90 days, of any attempt to foreclose on a failed bank's property or to affect its rights under a contract.
The original intent was to provide the Federal Deposit Insurance Corp. (FDIC) with added breathing room to figure out what went wrong in such situations and make sure it doesn't worsen, Stengel said.
"That is understandable, but other means exist to achieve this end without imposing unnecessary costs on covered bonds and other structured financings," he said.
The language in that statute suggests that if the automatic stay provision applies to covered bonds, issuers might have to confront the cost of building in the right amount of overcollateralization, he said.
To be sure, new products that hit the U.S. capital markets are quite prone to heated expansion. Although the WaMu, HBOS and BofA transactions were successfully executed, professionals close to the covered bond market say that potential U.S. issuers have not formed their final conclusions about issuing covered bonds, said one market source. One reason is that their financing needs are already being met by securitization. Also, while U.S. investors clearly supported previous covered bond deals here, the buy-side is generally still busy assessing the product.
"The covered bond market first needs a unique investor base," one market source said. "The typical euro covered bond investor is a government paper investor looking for yield pickup. In the U.S., however, investors are still not sure of [covered bonds'] relative value."
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