Covered Bonds

Covered bonds are securities that are created from either mortgages or public sector loans, and thus, they are much like mortgage-backed securities (MBSs) sold in the United States. Covered bonds have mostly been sold in Europe, but the market for covered bonds in the United States will soon be greatly expanded, since the recent financial meltdown caused by the credit defaults of many subprime mortgages, and the mortgage-backed securities based on them.

There is a significant problem with MBSs as developed in the United States: the way MBSs were structured allowed originating financial institutions, mostly banks, to pass on the credit default risk to the buyers of the MBSs (this is also true of most other asset-backed securities based on loans). Thus, what the original lenders of money discovered was that since they were making most of their money from the loan origination fees, points (interest paid up front), and servicing fees, and passing the credit default risk to the buyers of the mortgage-backed securities, they lowered their credit standards so that they could originate more loans to collect more fees. By extending credit to subprime borrowers who couldn't really afford the loans—even to the point of accepting so-called liar loans, where the originating lender allowed the borrower to simply assert his income without verification—they created a much greater demand for housing, expanding a real estate bubble until it popped. Then the subprime borrowers could not stay afloat, because real estate values plummeted, which prevented refinancing for better terms or more cash.

Covered bonds help to prevent this scenario by not allowing the originating banks to pass the credit default risk to the buyers of the covered bonds. The liability of the loans remains on the balance sheet of the originating bank, so covered bonds are not only supported by the underlying mortgages, but are also covered by the originating banks—hence, the name.

The exact workings of European covered bonds differ somewhat depending on the laws of the issuer's country. First issued in Germany in 1770 to finance public projects, German financial institutions are still the largest issuers of covered bonds.

Most covered bonds are backed by mortgages. Austria, France, Germany, and Spain allow backing by public sector loans, and Denmark and Germany allow backing by ship loans.

Before 2005, only specialized banks could issue covered bonds, but laws since then have expanded the number of issuers to include any financial institution that satisfies credit quality requirements. A license is required by the issuer to issue the bonds. Some countries, however, require issuers to specialize in particular areas, such as mortgages.

Covered Bond Structure

Covered bonds are backed by a cover pool, consisting of specific loans, either high quality mortgages or public sector loans.

Both asset eligibility and the procedures followed in a liquidation differ according to country. Covered bond laws typically specify:

Typically, covered bonds cannot be based on mortgages with a loan-to-value ratio of greater than 80%, borrower income must be documented, and no more than 20% of the mortgages can be from any single metropolitan area. If the issuer becomes insolvent, then the cover pool assets are separated from the other bank assets for the benefit of the covered bondholders.

Unlike MBSs, holders of covered bonds are paid by the issuing bank, which retains the covered bonds on its balance sheet. If any of the underlying loans goes bad, the bank must replace the bad loans in the cover pool with good loans.

Hence, covered bonds offer a high yield/low risk ratio. In the event of the issuer's bankruptcy, the bondholders would have a senior claim on the asset pool, ahead of all others. If the issuing bank does not pay the bondholders, then they would receive the payment stream from the underlying mortgages.

Investment Qualities

Covered bonds are highly rated—most are AAA or AA or equivalent, and generally have 2-10 year maturities, but the trend is for longer maturities.

In 2007, $3.3 trillion of covered bonds were outstanding. Until 2008, the only United States issuers of covered bonds were Washington Mutual and Bank of America.

The market for covered bonds has been limited due to their variable characteristics that were largely determined by the country of issuance. In 1988, the European Union founded the Directive on Undertakings for Collective Investments in Transferable Securities (UCITS) to establish minimum criteria for the covered bonds so that mutual funds and insurance companies can invest in the bonds without worrying about the particulars of the governing laws of the issuer. Mutual funds can buy up to 25% of UCITS-compliant covered bonds from a single issuer, while insurance companies can buy up to 40%. In 2006, banks were permitted to hold less reserve capital, originally 20%, now 10%, against UCITS-compliant covered bonds.

The main advantages to the issuers of covered bonds is that the issuer can gain access to more funding at a lower cost than it could if it issued unsecured bonds. Because covered bonds often have a higher credit rating than the issuer, they can be sold to the market for more money (lower yield) than unsecured notes. Institutional investors who are limited to buying high quality instruments can buy covered bonds. Covered bonds also have greater liquidity than other asset-backed securities.

Recently, since the economic problems caused by mortgage-backed securities that required bailouts of major financial institutions by the United States government, several federal agencies have been keen on promoting covered bonds to replace mortgage-backed securities in the United States. The Federal Deposit Insurance Corporation issued rules for covered bonds, including the right of bondholders to receive their money in days if the issuing bank were to fail. The United States Treasury also issued guidelines requiring issuing banks to disclose details of the cover pool, and to monitor the cover pool monthly for credit quality. The Federal Reserve may also accept covered bonds as collateral for emergency funds by banks.

Public Sector Covered Bonds

In the United States, most local public projects are financed by municipal bonds, but in Europe, covered bonds based on public sector loans finance many local projects, such as transportation projects, schools, hospitals, and utilities.

Covered bonds based on public sector loans are guaranteed by the public authorities benefiting from the bonds. Loans made to local governments or agencies are pooled together to back the covered bonds, which can then be sold to large institutional investors.

The advantages of public sector covered bonds over municipal bonds are that they can appeal to investors who want access to large issues and that have liquidity in the secondary market. Also, most global investors cannot take advantage of the tax advantages of municipal bonds, so the pool of investors, and therefore the demand for municipal bonds is limited, which increases the amount of yield that the bond would otherwise have to pay (although the tax advantage does lower the yield if the issuer can sell the entire issue to investors living in the state of issue). Such global investors include sovereign funds, central banks, and global pension funds. The limited number of investors for municipal bonds also makes them more illiquid.