New York's financial markets are looking east for inspiration, and they've found it in the covered bond market. Investors like this product because it represents a way to invest in triple-A-rated or close to risk-free assets at attractive spread levels. Market sources say the benefits are clear for issuers: It is a source of diversification of financing.
Washington Mutual's $25.6 billion transaction, secured by 5/1 hybrid ARM mortgages, was the first covered bond transaction completed in the U.S. Since its close last September, student loans have been targeted as possible collateral for future U.S. covered bond deals. European countries are beginning to secure large percentages of covered bond securities with commercial mortgages, said Elizabeth Padova Hanson, a director of covered bond and revolving-structure ABS origination for ABN Amro, at a recent American Securitization Forum Sunset Seminar on the asset class.
Everyone's excitement is understandable. These nifty, solid-sounding financial instruments essentially function like an issuing company's senior debt obligation, for which a specific portfolio of assets is pledged for repayment. The issuer must pledge its corporate proceeds to repay principal and interest on the outstanding bonds, and the asset portfolio itself is only tapped for bond repayment if the company becomes insolvent.
Industry observers expect the covered bond market to be as large as $100 billion in a year or two.
"I feel that with the growth of U.S. issuers coming," said Hanson, "all countries are realizing how much more we can push this market of covered bonds, and [they] are coming up with creative ways to expand this market."
That all sounds worthwhile, but it is hoped the covered bond market will not expand too quickly or be taken over by ever more complex, risky structures.
Covered bonds are not true securitizations, but the ABS market is paying attention because risk-averse investors find themselves paying up for razor-thin spreads on triple-A rated asset-backed paper - flat with Libor, in some cases. Covered bonds, by contrast, can pay as high as 15 or 20 basis points over Libor - without the risk traditionally associated with those types of spreads, as one market participant pointed out at the ASF event.
Securing covered bond deals with assets other than the traditional residential mortgages, RMBS, commercial mortgage loans, ship loans and government and agency debt sounds worthwhile. Government-backed student loans are getting the consideration they deserve from the market.
With investors and issuers on board, market participants have approached the Federal Deposit Insurance Corp. (FDIC), hoping to convince the regulator to develop a policy statement about the bonds and give the market guidance as to how the financing should be used. Indications are that the FDIC is willing to learn about them.
Perhaps the U.S. market - which is not married to any single concept of what should secure covered bonds - is ready to get more creative with the asset class and expand the market in dollar volume. Let's just hope it avoids the temptation to turn the next frontier of a prized asset class into a wild one.
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