Last week, Treasury Secretary Henry Paulson and a consortium of leading banks echoed what many investors have been considering for months now - the potential liquidity benefits of a growing covered bond market.
However, the announcement, combined with the final policy statement from the Federal Deposit Insurance Corp. (FDIC), is the perfect storm needed to jump-start issuance in the sector, market players said.
"What we have is a combination of FDIC clarity, Treasury participation concerning what will constitute best practices and industry leaders stepping forward," said James Tanenbaum, a partner at Morrison & Foerster. "In aggregate, that is a very powerful combination."
After the release of the Treasury Department's guidelines for the development of a covered bond industry, The Securities Industry and Financial Markets Association (SIFMA) announced the formation of a U.S. Covered Bonds Traders Committee for both the primary and secondary trading markets. Banks currently active in the committee include Banc of America Securities, Barclays Capital, BNP Paribas, Citigroup, Deutsche Bank Securities, Goldman Sachs, HSBC Securities, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS Greenwich Capital and UBS. More are being added to the list, a market participant said.
Tradeweb, an over-the-counter multi-asset class online trading platform owned jointly by Thomson Reuters and 10 global dealers, announced last week that it would add an online marketplace for covered bonds backed by pools of U.S. residential mortgages. Bloomberg also said it is actively working with issuers and dealers to bring price transparency to and provide issue information for the trading of these new securities.
Also last week, the Information Management Network (IMN) announced the launch of its first Covered Bonds-Americas summit, which is set to take place on Oct. 21 in Miami. It will run concurrently with IMN's ABS East conference.
The lack of confidence in the MBS market is circumvented by the perceived safety in the structure of these transactions, which, when combined with the market's efforts to increase deal transparency, should help bring back liquidity to the mortgage sector.
Confidence in Transparency
Though initiatives like the American Securitization Forum's project RESTART are working to improve disclosure in the securitization market, covered bonds are less susceptible to concerns about transparency and, as a result, are an attractive asset for investors.
"I think the issues being addressed by the ASF in project RESTART are less cumbersome in covered bonds, where you have dual recourse to a regulated financial institution and to a cover pool of financial assets," said Scott Stengel, partner at Orrick, Herrington & Sutcliffe. "Investors are not investing in a credit product dependent entirely on a pool of mortgage loans; they are investing in a financial institution that is securing its obligation with a pool of mortgage loans."
Cheaper in the U.K.
Banks should see better pricing in the covered bond market relative to spreads for senior unsecured debt, according to a JPMorgan Securities report last week.
In the U.K., where the covered bond market is much more established, a five-year covered bond currently trades around swaps plus 80 basis points, while triple-A RMBS trades at Libor plus 170 basis points, and senior unsecured debt trades at Libor plus 150 basis points.
The bank said that covered bonds could trade as much as 50 to 75 basis points tighter than the unsecured debt, but this will depend on the issuer and collateral. Interest in these deals is expected to come mainly from corporate investors, who may not give as much credit to the underlying collateral, the bank said.
The biggest hurdle is that mortgage loans backing covered bonds remain on banks' balance sheets and do not offer issuers any risk mitigation or capital relief, like securitization does, JPMorgan said. The bank noted that covered bond issuance is currently limited to 4% of the issuing institution's total liabilities. As a result, estimated issuance will be no more than $500 billion. But the limit could be raised as the market develops, JPMorgan said.
Indeed, when these banks start to
offer covered bonds on a regular basis, it will begin to attract more issuers to the market, Tanenbaum said.
Part of the confidence in a blossoming market comes from the comprehensive set of "best practices" for issuing covered bonds, which market players expect to be a jumping-off point not only for mortgage-backed covered bonds but also perhaps for other asset classes as well.
"It is clear from reading the policy statement and best practices that they have been informed by all of the different constituencies, including the issuers, the dealers, the rating agencies, other government regulators and investors," Stengel said. "The best practices provide a wonderful framework from which this market can spring."
But covered bonds will not replace structured finance vehicles, although they may play a critical role in the market's recovery. "I expect a robust covered bond market to exist alongside whatever emerges in the structured finance world. It is an additional tool in the liquidity arsenal," Tanenbaum said.
He predicted that the covered bond industry could see growth within the next sixth months. It will first be lead by market leading institutions, and then it will be followed by a wider range of issuers.
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