The internationalisation of the covered bond market has been one of the major trends of the past few years. Investors routinely compare and buy bonds in different countries and issuers are becoming less reliant on domestic investors.
Until now, however, this dynamic development has bypassed the US. With no domestic covered bonds in existence only a few US investors have even taken the trouble to understand the product and, although a small number of European tranches have been sold in the US, it is a negligible investor base for the asset class.
That is about to change: the first structured covered bonds will hit the market this year. Similar to the groundbreaking HBOS deal in the UK in 2003, arrangers are working on structured covered bonds in the absence of US covered bond legislation.
European rating agency analysts are already working with colleagues in New York on the first deals for two US institutions. And bankers say that the arrangers in the frame to bring the debut deal to market include Barclays Capital and ABN AMRO.
With the first deals imminent, all the bankers approached declined to comment for this article. Off-the-record, however, they see the US market as an exciting addition to the global covered bond market.
US banks have been watching the success of the European covered bond product and the fast growing global investor appetite, and they want to tap into a new source of funding. Bankers argue that domestic offerings will serve as a good introduction to the structured covered bond product for US investors, even if the first issues are marketed to Europeans who are familiar with the product.
The first US deals will be sold mainly in Europe with some bonds being placed with Asian investors, say sources. On subsequent deals, there will be a major marketing effort aimed at the US investor base.
Long time coming
Why has it taken so long to introduce the covered bond concept to the US? The reason is largely lack of incentive: public sector borrowers and mortgage originators have traditionally had very good direct access to the capital markets in the US. Unlike in Europe, where banks make vast amounts of public sector loans that they use as collateral for public sector covered bonds, in the US, public sector borrowers such as municipalities access the capital markets directly. The vast and well-established market for ‘muni’ bonds therefore already provides cheap funding.
The focus of European arrangers is not public sector-based covered bonds, though, but the mortgage-backed variety. And one of the reasons why they see an opportunity for the covered bond product relates to the accounting scandals over the past few years at the housing-related government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
The GSEs buy mortgage loans originated by banks across the US. They keep some in their retained mortgage portfolios, while others are packaged up into mortgage-backed securities (MBS) and sold to institutional investors. Bonds guaranteed by Fannie Mae and Freddie Mac are regarded as quasi-government debt, having the implicit support of the US government.
Accounting scandals
But in recent years both Fannie Mae and Freddie Mac have been hit by accounting scandals related to the use of derivatives, and inaccurate reporting of earnings. Both have resulted in the resignation of top executives and the restatement of earnings from previous years.
There have been probes into Fannie Mae by the Securities and Exchange Commission, Justice Department, Internal Revenue Service, Labour Department and the Office of Federal Housing Enterprise Oversight.
Meanwhile, in Washington there is legislation pending – the version passed in the House last October includes much tighter control over Fannie Mae and Freddie Mac, and a provision whereby a newly created regulator will be able to dictate their ability to grow their portfolios. The Senate is working on its own version and a combined bill will then be sent to the White House, which favours stricter controls over the GSEs.
Against such a backdrop, it is hardly surprising that investment banks seeking to establish covered bonds in the US feel that the time is ripe to persuade regulators that a new form of cheap funding for mortgage lenders will benefit the banking sector, and help to keep up a steady flow of funding to Americans wishing to buy their own homes. With Fannie Mae and Freddie Mac between them having more than $1000bn worth of outstanding MBS, European investment banks clearly believe that even a small slice of the US mortgage cake will be worthwhile business.
However, there is no US covered bond law, so the route being chosen is the same as in the UK, that of structured covered bonds that have been enthusiastically accepted by investors since the first deals back in 2003.
Footsteps to follow
The first US offerings should benefit from the scarcity of US paper because covered bond investors like geographical diversification. Nonetheless, US issuers will do well to follow in the footsteps of European issuers and mount extensive road-shows. Such has been the investor appetite for covered bonds in recent years that there is a tendency to believe that they will simply fly off the shelves unaided, anywhere around the globe. On the contrary, preparation and extensive road-showing, including one-on-one meetings with important investors, are essential to develop a long-term investor base.
In January, Germany’s Aareal Bank carefully laid the groundwork for its first jumbo pfandbrief offering by sending out three teams on a two-week road show across European financial centres, making presentations about the bank’s strategy and funding requirements. Other more established European issuers have already taken the next step: extensive road shows across Asia.
If some European issuers, which have seen tremendous global demand for their offerings, lack enthusiasm about the entry of rival US issuers into the market, many bankers argue that the effect of a domestic covered bond market developing in the US will be to broaden the investor base dramatically for all global covered bond offerings.
The first taste
The first step for US investors will be to buy domestic covered bonds. The pattern seen in countries across Europe is that as soon as domestic covered bonds appear, more local investors take the time to look closely at the broader covered bond product.
The UK is a classic example. Prior to 2003, covered bonds could be a tough sell for lead managers, with few institutional investors placing orders in spite of their marketing efforts. But when the first UK deal came from HBOS, these same investors felt compelled to examine it closely, as an important deal in their home market. They bought some bonds, and followed this up by participating when other UK banks followed HBOS’s example and came to market. After that they wanted to look for relative value and compare UK covered bonds to those from other jurisdictions. The local introduction of the instrument was absolutely crucial to getting them interested in the first place.
Regulator support
The banking regulators in the US will need to be convinced, but the pattern of events over the past few years in the UK suggests that they will be won over by financial services industry supporters of covered bonds. The UK’s Financial Services Authority (FSA) was initially wary of the emergence of structured covered bonds, because the cover pools create structural subordination to deposit holders and bank creditors in case of bankruptcy.
At one time, such were the concerns at the FSA that rumours spread through the UK covered bond market that a ceiling of 4% of total assets would be allowed to be placed into cover pools. But last August, in a letter to the British Bankers Association, the FSA suggested that it would be comfortable with up to 20% of bank assets being in cover pools before any review of individual capital ratios would be necessary. And in February this year, the FSA made a ruling that UK covered bonds will soon require only a 10% risk weighting, bringing them into line with EU rules. In addition, UK banks buying foreign covered bonds such as pfandbrief need use only a 10% risk weighting.
Vote of confidence
This all amounts to a vote of confidence in the covered bond product and shows that in the absence of covered bond legislation, arrangers need to present their case to regulators.
One of the clinching arguments for the FSA was the way in which covered bond offerings give banks excellent access to cheap funding even in times of stress. Over the past few years, there have been several examples of banks facing downgrades or being dogged with bad news that have then had difficulties in issuing senior unsecured bonds. But they have successfully sold covered bonds with only a small penalty of a few basis points.
From a prudential point of view this is a very positive result for bank regulators, who always have concerns about short-term liquidity crunches for struggling banks, which need some time to sort out their problems. Thus the US regulators are likely to take a positive view of the arrival of structured covered bonds.
When the debut deal closes, it will provide a comparatively rare example of a new asset class being developed in Europe and then exported to the US.
