As ABS industry participants scour the market for new deals, covered bonds remain a beacon of potential liquidity for the desiccative pipeline. One question, however, remains: Where are these new programs?
Earlier this summer, when the Federal Deposit Insurance Corp. (FDIC) released a final policy statement on the covered bond market and the U.S. Deptartment of the Treasury announced a push for issuance in the sector with the release of a "Best Practices" document, market participants cheered. The thought was that this new source of funding could provide the credit markets a necessary jump start.
In an effort to assemble industry experts for new deal flow, legal heavyweights in the ABS market - including Cadwalader, Wickersham & Taft, Baker & McKenzie, Andrews Kurth, Mayer Brown, Katten Muchin Rosenman, and Heller Ehrman - have all launched covered bond groups in the last month.
However, despite these efforts, new issuance is lingering in the wings. The U.S. is still trying to build the sector from the ground up, which may be part of the reason new covered bond programs have yet to emerge, market participants said.
"My understanding is that the FDIC and the Treasury would like to see a U.S.-based designed and structured covered bond market and that the investors are U.S.-based," Huxley Somerville, group managing director and head of U.S. RMBS at Fitch Ratings.
"[Covered bond investors] are typically a different investor to RMBS investors. For covered bonds to be successful in the U.S. will require a liquid and deep covered bond market. Starting from scratch, it may take time to achieve that."
Despite the nitty-gritty, sources said that the U.S. should see a program out from at least one issuer by the end of the year.
New Features
One of these programs' new components will be direct issuance off the bank's balance sheet versus issuance through a special purpose vehicle (SPV). The only two financial institutions to issue covered bonds in the U.S., Washington Mutual and Bank of America, employ an SPV.
While the SPV system was established to mitigate the credit risk to the issuer and the acceleration of the bond in receivership, there was uncertainty as to how the assets could be seized if the bank was put into receivership. Industry participants were concerned over how quickly assets could be moved to the trust and reinvested to make up the remainder of the payments on the covered bond in place of the issuing bank.
In the direct issuance approach that the U.S. is currently working toward, the structure is simpler. However, it still relies on the dual recourse framework - first to the issuing bank and then to the covered pool - which should bode well for new investors in the asset class, market participants said.
"Under the new covered bond framework, there is going to be increased flexibility to access a broader range of investors, and the fact that we may be able to do this as a directly issued instrument should also help facilitate access to new investors." Denise Pieck, managing director and head of the financial institutions solutions group at Barclays Capital, said last week, speaking on a Webinar hosted by ASR and McKee Nelson.
It will take time to put new structures into action. "This will need to be documented and thought through. You cannot cut and paste previous documentations as they are dual tier. There are also SEC dispensations required if the process is to be straightforward," Somerville said.
Finding the Right Mix
While it is clear these deals will differ from the European-based approach used overseas, as well as the more recent SPV-based programs, they will also differ from the U.S. transactions of the 1970s and 80s, which took the form of mortgage-backed bonds.
Among the key changes are the necessary overcollateralization levels, said Dick Rudder, a veteran of the mortgage-backed bond space and head of Baker McKenzie's covered bond practice. Rudder noted the difference between overcollateralization levels of 5% that are required in the Treasury "best practices," and the levels of anywhere from 140% to 200% that are necessary for a triple-A mortgage-backed bond.
Overcollateralization might also be part of the delay in rolling out these new programs. "In buying back into an asset class that has been devalued over the last twelve months, it is likely investors will want something that is designated triple-A in terms of safety," Rudder said.
Rating agencies will need to determine what overcollateralization levels are necessary for certain ratings levels.
"The Treasury proposal made a suggestion assuming that if you were going to do a deal that was rated, the rating agencies would look at all of the issues and in particular overcollateralization, and they may have their own views on what is appropriate [for a certain rating]," Rudder said. "My guess is that some of the reason why it is taking so long is because the market needs to reconcile the approaches of the different banks and rating agencies."
He added that rating agencies have to be particularly careful and must come up with their own standards. But the standards of one rating agency might conflict with those of another.
Rating agencies have a lot to consider in these new programs. Foremost among their concerns is the collateral quality of the pool, which is determined through modeling and cash flow analysis, and the structure of the program itself.
"There maybe some delay due to ensuring that everyone understands the intent. It is all very well having the policy statements, but the areas not mentioned are the hardest to determine. For instance, while we may get comfortable on day one that the pool is eligible according to the guidelines, in five years time we also need to know that the pool is eligible," Fitch's Somerville said. "Therefore there also need to be mechanisms to confirm this at day one."
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