On July 28, 2008, United States Treasury Secretary Henry Paulson announced best practices for the development of a covered bond market in the United States. Secretary Paulson stated that “covered bonds have the potential to increase mortgage financing, improve underwriting standards and strengthen US financial institutions by providing a new funding source that will diversify their overall portfolio.”1 This statement coincided with the publication, by the United States Department of the Treasury, of a Best Practices Guide for US Residential Covered Bonds2 (the “Best Practices Guide”), which is intended to promote simplicity and homogeneity in the covered bond market, using high-quality mortgages as collateral. The Best Practices Guide complements the Federal Deposit Insurance Corporation’s (the "FDIC") Policy Statement dated July 15, 2008 (the “FDIC’s Statement”),3 in which the FDIC clarified the circumstances under which it would make available collateral pledged for covered bonds in the event of an FDIC receivership or conservatorship of any issuer of covered bonds that is subject to the Federal Deposit Insurance Act. The Best Practices Guide addresses only covered bonds that will be issued by depository institutions subject to the Federal Deposit Insurance Act.4

Many market participants are hopeful that covered bonds will help revitalize the debt markets in the United States, by creating a new source of liquidity for US financial institutions and by encouraging investors to return to the market for mortgage-related securities. A little perspective on how the United States came to import this largely European financial device called a “covered bond”5 may be helpful in charting the path forward.

How It All Started

Numerous factors contributed to the perfect credit storm of the last year; one of which is simple: lenders lost their traditional focus on the creditworthiness of borrowers. With a mortgage lending model of originating mortgage loans and distributing them in the form of securities, and with less focus on the ability or the willingness of the borrower to pay his or her mortgage, originators became more concerned about fitting each loan in a standard box for securitization than about the quality of the loan.

As lenders continued to package their mortgage loans into rated securities and place less emphasis on reviewing borrowers, the securities ultimately backed by the mortgages began to experience problems as housing prices fell, mortgage interest rates reset to higher levels and the economy deteriorated. Investors soon realized that the statistical models used to provide credit ratings for securities backed by mortgages were not infallible. Once investors lost confidence in their ability to understand fully the risks underlying structured finance securities, they became uncertain and fearful. Since the second half of 2007, investors have largely sat on the sideline, avoiding new investments in structured products. Lack of confidence and suspicion spilled over into other markets, including the financial institution debt market, as investors wondered what potential problems lay beneath the numbers on the balance sheet.

As a result of several factors, including the inability to establish risk premiums with any confidence, the US debt market struggled through the last year. Investments that were once considered predictable and safe were viewed as volatile and undesirable. One of the primary sources of liquidity for financial institutions and other borrowers became severely limited.

The Potential Solution

Bring on the covered bonds. The covered bond market originated in Europe centuries ago and has proliferated there over the last 10 to 15 years. European regulatory authorities have established a legal framework for the issuance and treatment of such bonds. Covered bonds are debt instruments issued by a depository institution (the “issuer”) for which recourse exists against the issuer and that are secured by a perfected security interest in a specific pool of collateral that remains on the issuer’s balance sheet. The collateral pool is referred to as the “cover pool.” To the extent the cover pool is insufficient to repay the covered bonds, the holders thereof retain an unsecured claim against the issuer for the deficiency.6 The covered bonds provide funding to the issuer and the interest on and principal of the covered bonds are paid to the investors from the issuer’s general cash flows.

The introduction of covered bonds to the US market has, at the heart of the proposal, some basic strategies for restoring investor confidence:

  1. Two Sources of Credit Are Better Than One. Investors in a covered bond have two sources of credit for repayment of their investment: (1) the corporate credit of the financial institution —because covered bonds are intended to be paid from the general cash flows of the financial institution and not from the pledged collateral and (2) the cover pool—because, in the event of a failed payment by the financial institution or insolvency of the financial institution, investors can receive payment on their covered bonds from the pool of residential mortgage loans. Simply put, there is some diversity in the two different sources of credit that should lower the investors’ risk of default and loss.
  2. Return to What We Know. The covered bond harkens back to the days of disciplined credit analysis. Wall Street knows corporate credit analysis and has been performing it for well over one hundred years. Investors can return to the oldfashioned analysis of a financial institution’s ability to generate sufficient cash to repay its debt. As a bonus, investors receive the benefit of identifiable pledged collateral, providing them with a margin for error on their credit analysis. Any investor who may be suspicious of complex derivatives lurking on an institution’s balance sheet will have the additional comfort of the cover pool—collateral that has historically been reasonably well known and predictable. While not explicitly stated in the Best Practices Guide, we note that by using mortgages in the cover pool, investors are encouraged to become re-acquainted with mortgages as a potential source of repayment for their investment.
  3. Simplify, Standardize and Verify. If anything, the covered bonds contemplated by the Best Practices Guide are the antithesis of the complex and opaque world of credit derivatives and leverage upon leverage from which the recent and ongoing credit crisis was born. The Best Practices Guide embraces simplicity and transparency, with set principal payments7 and mandatory reporting8 on the collateral. It rejects the model of the unique “one-off” and illiquid transaction of the recent years, encouraging standardized structures9 and mandating standardized collateral10, making covered bonds both easy to understand across many issuers' transactions and, hopefully, in the process, more liquid. Finally, the Best Practices Guide contemplates an independent third-party to monitor the cover pool on behalf of the investors11—someone to verify the collateral tests—countering some of the structures of recent years where persons with mixed incentives were responsible for monitoring and reporting on the collateral.

What Might We Find?

Certainly the most interesting part of the covered bonds analysis is gazing into the crystal ball. While no-one can predict what will become of this well-intentioned proposal, we can speculate on its future:

A Compelling Reason to Issue. Banks may find a compelling reason to issue covered bonds: the Treasury “requests” it—“an offer you can’t refuse.” Patriotic duty has called US financial institutions to action.12 The Treasury has certainly taken steps to encourage institutions to participate in the market, and we may find that institutions feel less than subtle pressure to participate.

The Four Percent Limitation. The FDIC’s Statement limits issuances of covered bonds to four percent of the liabilities of the issuing financial institution. The FDIC maintains that a limit is necessary to preserve its ability to wind-up insolvent financial institutions.13 The four percent limit may create a disincentive for smaller banking institutions to pursue the strategy because the “start-up” cost of the initial transaction is not capable of being spread out over numerous transactions.14

Will Pricing Change? For those investors comfortable with the basic credit of standardized mortgage loans, the covered bond truly offers a credit benefit over an unsecured obligation of a financial institution. Might there be sufficient benefit to lead to better pricing on covered bonds than on a financial institution’s unsecured debt? It should, especially for financial institutions that have lower credit ratings from rating agencies. In fact, savvy institutions may use the covered bond structure to showcase their high underwriting standards and their best performing mortgage assets. Theoretically, those financial institutions that produce superior mortgage pools for their covered bonds should, over time, be recognized by the market and achieve a distinct pricing advantage.15

Expansion of Assets. Europe has a variety of assets that are eligible for covered bonds under several jurisdictions’ regulatory regimes.16 The mortgage market needs liquidity; without liquidity in the mortgage market, risk premiums for mortgages will remain high and continue to adversely pressure the US housing market. Thus, consistent with the simplicity theme, the Best Practices Guide limits collateral to mortgages, providing the market help where it is needed most and allowing all to focus on this one asset class.17 If the covered bond market proposed in the Best Practices Guide develops, then there will likely be a push for other asset types18 to be eligible for covered bonds.

What Are We Recommending?

In these uncertain economic times, it is time to return to first principles. Consistent with that idea, White & Case recommends the following:

Go With What You Know. The securities markets have seen ups and downs over the decades. Both we and many of our clients have been active in the markets for corporate and asset-backed securities, private and public, as counsel, issuers, underwriters and placement agents. A framework for corporate issuances and asset-backed securities exists, and little more than the tools used in the past is needed to structure a covered bond issuance.

Keep It Simple and Transparent. In an effort to build confidence in the covered bond market, make the structure, the offering materials and the collateral reporting clear and simple. Restore confidence through transparency. Allow investors to return to fundamental credit analysis and regain confidence that they can fully appreciate, understand and assess the credit risk.

Educate. Provide a clear explanation of the covered bond’s structure. Educate investors with comparisons to both the corporate debt market and the mortgage-backed securities market.

Go For Liquidity. Where possible, create standardized markets and large issuances. Create confidence that a liquid market will develop; liquidity will reduce the fears relating to that initial investment step and will lower the psychological barrier and risk premium to stepping into this new market.

Go With Experience. While the covered bond market may be new to the United States, Europe traces the first covered bonds back to Prussian King Frederick the Great in 1769. We have been active in the covered bond market for many years, having advised on hundreds of issues in several jurisdictions, including, for example, Germany (Pfandbriefe) and Luxembourg (Lettres de Gage). While local regulatory variations exist across the covered bond regimes of Europe, the primary legal principles and market standards remain consistent. Knowledge of the global covered bond market is crucial to those entering this new market in the United States, especially as regulators and market participants in the United States seek solutions to issues using other jurisdictions’ regulatory regimes. We will bring our practical approach, our global experience and our regulatory knowledge to our clients and this market.