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Washington Mutual’s Covered Bonds – Case Solution
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Washington Mutual Bank (WaMu) was the 6th largest savings institution in the United States of America. By 2008, Washington Mutual has been downgraded by all three major credit rating agencies and many of WaMus fixed-income securities, namely Washington Mutual's Covered Bonds, traded at a substantial discount to previous prices. This case study describes a covered bond and its difference from an unsecured obligation. It looks into whether WaMu’s covered bonds is a good investment in 2008.

?DANIEL B. BERGSTRESSER; ROBIN GREENWOOD; JAMES QUINN
HARVARD BUSINESS REVIEW (209093-PDF-ENG)
MARCH 13, 2009

Case questions answered:

How does a covered bond compare to an unsecured obligation of a financial institution? To mortgage-backed security? How is the structure of the Washington Mutual's Covered Bonds program?
Using data from the case, what is your best estimate of the value of covered bonds (you may need to make assumptions, and considered several scenarios of possible developments)?
In September 2008, would you recommend WaMu’s covered bonds as an investment (try to avoid hindsight bias)? From the perspective of today, what is now your recommendation?
In late July 2008, the U.S. Treasury Secretary said that covered bonds had the “potential to increase mortgage financing, improve underwriting standards, and strengthen U.S. financial institutions.” Do you agree (and why or why not)?
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Case answers for Washington Mutual's Covered Bonds

Founded in 1889, in the year of 2006, Washington Mutual Bank (WaMu) was the 6th largest savings institution in the United States of America. With more than USD 300bn in assets, WaMu provided a whole range of financial services.

By 2008, Washington Mutual has been downgraded by all three major credit rating agencies, reflecting distress in the American housing market and the emergence of the financial crisis. After Freddie Mac and Fannie Mae have been placed into conservatorship through the U.S. government, many of WaMus fixed-income securities, namely covered bonds, traded at a substantial discount to previous prices.

Accordingly, many analysts were puzzled by the question, whether the securities are underpriced. In the following, the characteristics of covered bonds will be analyzed in comparison to traditional bonds and asset-backed securities, and their value will be determined. Furthermore, it will be evaluated whether covered bonds constituted a good investment in 2008 and if they indeed have the potential of improving the situation of U.S. financial institutions. (Bergstresser et al., 2009)

1.1 How does a covered bond compare to an unsecured obligation of a financial institution? To mortgage-backed security?

While covered bonds are a relatively new phenomenon in the United States, they have been common throughout Europe for a long time. In 1988, the European Union set up guidelines for transactions of covered bonds, which granted investors the right to increase the amounts of assets, they put into covered bonds.

The basic concept of a covered bond is rather simple. As unsecured bonds, it is a fixed-income security that constitutes a liability to the security’s issuer. It is used by the issuer to raise funds and provides a predetermined stream of cash-flows to the investor until eventually the principal is redeemed. The difference between a covered and a non-covered bond does not lie in their cash flows, but in the degree of collateralization and therefore their riskiness.

Traditional debt instruments, issued by a company, provide the holder, according to the security’s seniority, with a residual claim on remaining assets, should the issuing company default on its debt. The seniority of different debt instruments, which determines which residual claim comes first, is not bound to specific assets of the company, and neither are the cash flows.

Covered bonds, on the other hand, are covered by distinct assets, which means that the assets covering the bonds serve as direct collateral. Companies may issue covered bonds to raise funds in order to finance investments into certain assets, typically mortgage loans. The income that these investments generate, e.g., through mortgage payments, is then again partially used to pay out the covered bond investors.

For investors, covered bonds are an attractive asset as they come with low riskiness through dual default protection. Firstly, the covered bonds are a debt obligation to the company, and non-payments will result in the company’s default, which the issuer will seek to prevent. Secondly, in the case of default, the covered bond investors’ residual claim on the pool of collateral, backing the covered bonds, is senior to the claims of other, traditional, debtors. Accordingly, covered bonds often received the highest credit rating by all three rating agencies.

Mortgage-backed securities (MBS) are a special type of asset-backed security (ABS), with mortgages loans serving as collateral. They are in certain ways similar to covered bonds, as they result from the desire of investors to isolate themselves from the creditworthiness of the issuing company. Instead, cash flows and the risk profile should match individual assets or asset pools that serve as collateral.

MBS are different from covered bonds, as they involve the creation of a special-purpose vehicle (SPV). SPVs are legal entities, separate from the bond issuer, that are created for the sole purpose of bankruptcy remoteness. In the case of MBS, the original company passes the asset pool, the mortgage loans, on to the SPV, and thereby removes them of its balance sheet. The SPV receives a credit rating that is independent of the original company, and further payment obligations are only between the investors and the SPV.

Even in the case when the issuing company defaults on its debt, the SPV is, in theory, unaffected. Therefore, the risk of credit loss for MBS is solely concerned with the riskiness of the collateral pool that lies in the SPV’s balance sheet. If the risk in the SPV is minimized through credit enhancement techniques, the SPV may have a better credit rating than the issuer.

The distinct difference to covered bonds lies in fact, that the MBS completely isolates riskiness and cash flows to the investor from the original company. Covered bonds, on the other hand, are issued by the company, and the collateral of covered bonds remains within the issuer’s balance sheet.

Covered bonds may be seen as a hybrid financial instrument, combining features of secured corporate bonds and asset-(mortgage-) backed securities. Like secured corporate bonds, they are a direct obligation of the issuer. However, covered bonds are, like MBS, also derivative securities, in the sense that their cash flow derives from certain assets.

1.2 How is the structure of the Washington Mutual’s Covered Bonds program?

In the year of Washington Mutual was the first non-European bank to issue covered bonds. The total issue was about EUR 4bn and comprised two tranches of bonds. The initial placement was very popular with investors and four times oversubscribed. It is assumed that the majority of owners are European institutional investors and banks.

The covered bonds, after issuance, traded at a yield of 3.9%, resembling a risk-premium of only 0.28% over the German 5-year Bunds, reflecting their low riskiness. The structure of Washington Mutual’s covered bond program is outlined in the following:

Washington Mutual's Covered Bonds

The covered bonds are issued by the Washington Mutual’s Covered Bonds Program (WMCB), a fiduciary company. Via placement agents, they are sold to institutional investors. The fixed-income securities are backed by…