Now more than ever the case for developing a U.S. covered bond sector has become easier to make as investors want the security of a high-quality product.

Covered bonds allow the ring fencing of assets in a shape and form that investors are familiar with, and the law would simplify the decision-making process for investors and issuers in the case of an originating bank falling into trouble.

"At the start of this people said that investors wouldn't bite, but the crisis has itself made a case for covered bonds in the U.S., and with legislation we would have a very workable covered bond market," said Tim Skeet, head of covered bonds for Bank of America Merrill Lynch who is based in London. He is also a member of the U.S. Covered Bond Council. "A covered bond market would mobilize private-sector money to consumer and mortgage financing markets. The appetite exists judging from the three covered bond issues that have already come to market this year. There is liquidity and a need for a high-quality product. Covered bonds are part of the answer."

Moody's Investors Service indicated that the introduction of the proposed statutory structure for U.S. covered bonds would be credit positive for the U.S. covered bond market because it would satisfactorily address the main uncertainties around the product by providing predictability and clarity on how the cover pool would be treated upon issuer default. This is likely to support spreads of the outstanding U.S. covered bonds that may fall under the new legislation.

 Paving the Way for Market

In July 2008, Treasury Secretary Henry Paulson, the Federal Deposit Insurance Corp. (FDIC) and four banks announced their support in creating a covered bond market that would help create liquidity.

A congressional hearing on covered bonds was held by the House Financial Services Committee in December 2009. The hearing followed Representative Scott Garrett's (R-NJ) introduction and subsequent withdrawal of a covered bonds amendment during the Financial Services Committee mark-up of the Financial Stability Improvement Act of 2009. The amendment aimed to help facilitate a robust covered bond market in the U.S. to add liquidity and certainty to our nation's housing market.

In March 2010, Representative Garrett introduced a covered bond bill into the House of Representatives for the fourth time since the beginning of the financial markets crisis. This latest bill - the United States Covered Bond Act of 2010 - was co-sponsored by Representative Paul E. Kanjorski (D-PA) and Representative Spencer Bachus (R-AL).

The bill aims to provide the basis for a special-law-based U.S. covered bond market. The timing of the adoption and implementation of such a law is still uncertain. "Alone it is a necessary but not sufficient condition for the development of a U.S. covered bond market - in our view, the fate of Fannie Mae and Freddie Mac, and the future role of the Federal Home Loan Bank System, will all together determine how a U.S. covered bond market emerges and thrives," said Sabine Winkler, a covered bond analyst at BofA Merrill.

The United States Covered Bond Act of 2010 is similar to Representative Garrett's proposed amendment to the Wall Street Reform and Consumer Protection Act of 2009 that was introduced in November 2009. There is bipartisan support for the creation of a statutory structure, though there was some disagreement at the December hearing on the prospects of a covered bond market in the U.S. as to how strict the statutory requirements should be.

The latest bill - as it stands at present - is meant to provide a funding alternative for a wide range of assets, much wider than in other covered bond laws, without imposing a uniform issue template. Covered bonds could be offered via private and public placements.

Skeet said that the response to the legislative language has been a very good one, but the process has been one like watching an egg hatch. "The chicken is sitting on the egg, but now it's wait and see until it hatches," he said.

"It's a great time for investors to put in order their portfolios," Skeet said. "There is an openness that has arisen from the ashes of the crises on where investors put money and how they measure risk, and on the back of this proposal there has been a lot of keen interest from institutional investors."

The main issue that has come up in headlines is that the U.S. version includes a variety of asset classes that move beyond the more traditional residential loans seen in European covered bonds. Skeet said that while unusual for the European investor base, the U.S. law has logically been tailored to appeal to a domestic investor base.

The U.S. is in the position to draw from what regulators have done in other jurisdictions. "The U.S. has the chance to create the balance between what issuers need and what investors need, but at the moment the draft legislation seems to be geared more toward the requirements of issuers," Winkler said.

Winkler said that the U.S. investor base has gone to great lengths to get up to speed with European legislation and has been eager to collect information on covered bond products.

 European Spreads Hold, But Market's Unsteady

As for the potential impact of a burgeoning U.S. market on European spreads, Winkler believes that it's hard to tell given the interplay of various drivers of covered bond spreads.

At the very base, however, introducing more covered bonds could shift the supply-and-demand pattern, and how that plays out depends on the magnitude of supply once U.S. paper begins to hit the pipeline and on investor appetite at that time.

"It is logical to say that the absorption of a potential wall of issuance will depend on the capacity of current and new investors to take up supply," she said.

In Europe the story has developed optimistically. According to BofA Merrill, the market has so far this year seen more than 60 new Jumbo covered bond issues. Jumbo gross supply year-to-date has reached around investor appetite at that time.

The market, while clearly open for business, still has to price up issues to get deals done, especially if the credit quality of an issuer is inferior, if the quality of the cover pool is called into question or if there are uncertainties surrounding the fiscal quality and credit strength of the jurisdiction where an issuer is incorporated.

"Most of the issuance in 2008 had an initial maturity of below five years, and the main issuance had an initial term of two years, so we are looking at a large amount of redemption coming in at over 658

Winkler said that the European Central Bank indicated in its annual report that the outlook for the stability of the euro-area banking system is not very positive. "If investors become concerned, then issuance might slow down. It could be a complicated year, and it is certainly difficult to predict how issuance and spreads will unfold in light of these developments."

So far, most European spreads are relatively sidelined, but if concerns intensify Winkler expects spreads to widen. "What's clear is that investors see investment opportunities from a growing spread differentiation by product, issuer and program, which has never been seen before."

All Eyes on U.S. Covered Bond Investor Base

If the proof is in the pudding, then legislators have to look no further than two recent deals done in U.S. dollar-denominated tranches that were placed with U.S. investors, even though the deals were overseas.

Sabine Winkler, a covered bond analyst at Bank of America Merrill Lynch, said that the U.S. covered bonds investors are currently more than ever keen on understanding how the market functions. These buyers have also been readily working toward becoming players in the covered bond arena.

Among the issues seen this year that tapped the U.S. investor base is the Royal Bank of Canada's $1.5 billion of five-year U.S. dollar-denominated covered bonds. The joint lead managers on the sale were Barclays Capital, Goldman Sachs and RBC Capital Markets.

Compagnie de Financement Foncier has also sold $2 billion of covered bonds in the 144A private placement market, according to market reports. Citigroup, Barclays, BofAML, HSBC and JPMorgan were the joint bookrunners on the deal.

Canadian Imperial Bank of Commerce (CIBC) announced Jan. 25 a covered bond denominated in U.S. dollars. The $2 billion Series CB5 offered covered bonds with a coupon rate of 2.0% and a maturity date of February 4, 2013.

The type of U.S. dollar-denominated covered bonds now contemplated by CIBC are issued under the laws of the issuer's home country - not the U.S. Such bonds might be marketed to U.S. institutional investors if they receive an exemption for that purpose from the Securities and Exchange Commission (SEC).

And Canada is looking to keep up by taking steps to ensure that it's up to speed with U.S. legislative developments.

As earlier reported by ASR Web site StructuredFinanceNews.com, the Canadian federal government said in its March 4 budget that it would add legislation setting out rules for covered bonds backed by assets such as mortgages. The legislation aims to "increase legal certainty" for investors, according to the budget documents.

Canadian banks have been selling covered bonds since 2007. This was after Canada's banking regulator set conditions for lenders seeking to issue the debt. However, the market is currently not supported by specific legislation.

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