US covered bonds uncovered 8 Katie Reeves
Deutsche Bank
© Deutsche Bank 2007
Covered bonds are an on-balance sheet funding strategy; loans that collateralise the bonds are not actually transferred off the books of the
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In September 2006 Washington Mutual Bank (WMB), which has a debt rating of A2/A/A, became the first US bank to issue a covered bond. WMB brought a total of $5.1 billion of five-year and 10-year euro-denominated covered bonds through the WMB covered bond programme (a Regulation S offering), backed by prime first-lien single- family residential mortgages. For European investors, the transaction offered an opportunity to diversify their mortgage investment exposure geographically with a familiar structure. WMB achieved further diversification of its investor base, at superior levels on an all-in basis to what could be achieved in the unsecured market.
The covered bond market is poised to grow for several reasons. First, with the WMB transaction completed, a legal and structural precedent has been set for US banks and a market has begun to develop to enhance liquidity for future issuers. More US banks will turn to the covered bond market to diversify away from their traditional unsecured debt investor base. European banks with established covered bond programmes are also expected to turn for the first time to the United States, in many cases tapping a completely new investor base. As the structuring technology evolves, it would be no surprise to see covered bonds expanded to include asset classes. In addition, covered bond issuance below the triple-A level is another potential source of growth.
What are covered bonds?
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issuing bank. Covered bonds are secured senior debt obligations and are paid from the bank’s general corporate cash flow. However, covered bonds are also highly structured, similar to asset-backed securities, in order to receive a rating higher than that of the issuing bank. Covered bond holders benefit from a first- perfected security interest in a specific pool of assets that are ‘ring-fenced’ on the issuing bank’s balance sheet (such assets are referred to as the ‘cover pool’). Banks establish a covered bond programme, which gives them capacity to issue multiple series of covered bonds, and the entire programme is supported by the cover pool. It is similar to a master trust in that the bank can substitute assets on an ongoing basis, subject to limits imposed by the rating agencies. Once the programme is established, the bank can issue individual series from that programme. The September 2006 transaction was WMB’s first series from its €20 billion covered bond programme.
Cover pool
Netherlands, the United States does not have regulations drafted specifically for covered bonds. As a result, case law and precedent drawn from structured finance and other types of secured financing underlie the structure used for the WMB covered bond deal. In many respects, the transaction looks similar to European covered bond programmes. A cover pool of assets on the bank’s balance sheet is selected and that pool is liquidated to pay covered bondholders if the bank is unable to make payments from regular corporate cash flow.
When a covered bond programme is established, prior to the first series of covered bonds being sold, the initial cover pool of assets is identified. These assets are typically high credit-quality loans to public sector housing entities (in some European covered bond programmes) or residential mortgage loans (in some European covered bond programmes and in the WMB programme). The rating agencies impose requirements on what types of loan may be included in the cover pool. The cover pool is dynamic, and similar to but more flexible than a traditional asset-backed securities master trust; assets may be added, removed and replaced over time subject to rating agency monitoring. In addition, the cover pool assets are marked to market periodically (monthly in the case of the WMB transaction) to ensure that the assets’ market value exceeds the outstanding covered bonds by at least the required over-collateralisation amount.
They will also be subject to Federal Deposit Insurance Corporation receivership in an insolvency. Therefore, constructs similar to those used for regulated US banks’ securitisations are also applied for covered bonds. Specifically, a first-perfected security interest in the cover pool assets is created under the Uniform Commercial Code. Periodically (monthly in the case of the WMB transaction), the issuer identifies the loans in the cover pool on its books. Those loans are identified as ‘pledged’, with the loans noted on the bank’s records. These records are updated on a monthly basis and the list of mortgages is also provided to the transaction trustee monthly. However, the loans stay on the balance sheet of the bank. The covered bond investors have recourse, through the first-perfected security interest, to the collateral in the cover pool in certain circumstances.
US covered bond structures
To protect covered bond investors from an insolvency of a US bank, a two-step structure is used. (This structure differs from most models seen in Europe). Using the WMB covered bond deal, as an example, WMB first issues mortgage bonds. These mortgage bonds are US dollar-denominated floating- rate (daily adjustment) bonds secured by the
The WMB covered bond deal was an important first step because, as in the United Kingdom and the
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However, there are some distinctions. US entities accessing the covered bond market will in all likelihood be banks regulated by one or more of:
the Office of the Comptroller of the Currency; the Federal Reserve Bank; and
the Office of Thrift Supervision.
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mortgages in the cover pool. A newly created trust that is unaffiliated with the bank buys the mortgage bonds and is the issuer of the covered bonds. The trust uses the money received from the covered bond issuance to purchase the mortgage bonds. In the WMB covered bond transaction, the covered bonds issued were euro-denominated fixed-rate securities. The unaffiliated trust entered into a swap to exchange the floating-rate US dollar-denominated mortgage bond cash flows (paid by WMB) into euros to make payments on the fixed-rate covered bonds.
Credit quality of cover pool
Each covered bond series has a direct interest in its own series of mortgage bonds, rather than in the cover pool. The mortgage bonds in turn have a pari passu claim (with other series) on the cover pool assets.
The cover pool in the WMB transaction is comprised of prime-quality, first-lien 5/1 hybrid adjustable rate mortgages (in which the interest rate is fixed for the first five years and then converts to an adjustable rate). The initial weighted average Fair Issac Corporation credit score was 742 and the loans had an average original loan-to-value ratio of 68.6 per cent. Sixty-one per cent of the loans were interest only. By geographic concentration, 47 per cent of the loans in the pool were originated in California.
Structuring to a triple-A rating
In the WMB deal a minimum of 7 per cent over- collateralisation was required. However, each month, WMB will conduct an asset coverage test to value the assets in the pool. The asset coverage test estimates a market value for the pool assets and compares it to the outstanding covered bond balance. Depending on the result, the over-collateralisation percentage may be higher than 7 per cent. For the purposes of this test, for each loan in the pool WMB takes the lesser of:
Historically there has been some variation among the rating agencies in their approach to covered bonds. Standard & Poor’s and Fitch have largely followed a structured finance approach, in that the merits of the cover pool, the legal jurisdiction and the transaction structure are evaluated with little explicit linkage to the corporate credit of the bank offering the transaction. Moody’s, on the other hand, has traditionally relied on its fundamental rating approach to guide its covered bond ratings process. The fundamental rating approach limits the number of rating notches that a covered bond issue can attain, relative to the rating of the bank issuing the transaction. For example, Moody’s states in its pre-sale report for the WMB transaction that if the senior unsecured rating of WMB (A2) falls below A3, the rating on the covered bonds may be exposed to additional rating pressure (Moody’s Investors Service pre-sale report for the WMB covered bond programme, September 5 2006). This linkage on the part of one rating agency notwithstanding, the rating agencies are able to assign a triple-A rating to covered bonds by considering elements found in many other asset- backed securities, as follows.
the actual outstanding loan balance; or
75 per cent of the indexed valuation of the loan (according to the Office of Federal Housing Enterprise Oversight House Price Index).
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Over-collateralisation
This effectively caps the current loan-to-value of mortgage loans that can be funded in the cover pool at 75 per cent.
If the asset value as calculated above falls below the outstanding balance of the covered bonds, the deal has failed the asset coverage test. If it is not remedied on or before the next monthly calculation date, an event of default of the mortgage bond issuer will be deemed to have occurred. The mortgage bonds are accelerated (ie, they become immediately due and payable) and the resulting proceeds are applied to a guaranteed investment contract established at the transaction closing. The guaranteed investment contract is then used to make payments on the covered bonds for the rest of the transaction. The
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purpose of the guaranteed investment contract is to maintain the original repayment schedule of the covered bonds.
in the guaranteed investment contract account is less than the sum of the aggregate principal and accrued interest on the covered bonds, the shortfall becomes an unsecured obligation of the bank. This could occur as a result of, for example, the Federal Deposit Insurance Corporation repudiating the mortgage bonds and there being a delay when the proceeds are forwarded to the guaranteed investment contract provider. During such delay the market value of the mortgage bonds may have declined. However, it is expected that the Federal Deposit Insurance Corporation will forward only the fair market value plus accrued interest as of the date when the Federal Deposit Insurance Corporation was appointed to be the receiver. However, the mortgage bonds are floating rate and are adjusted on a daily basis. This is a substantial mitigant to the risk that fair market value proceeds from the Federal Deposit Insurance Corporation would be less than the principal and accrued interest on the covered bonds. However, if there were a shortfall in the guaranteed investment contract, it would fail the proceeds compliance test and trigger a covered bond event of default.
Hedging of interest rate risk and currency risk
In the WMB covered bond transaction the cover pool was comprised of US-dollar mortgages, which back US dollar-denominated floating-rate mortgage bonds. As a result, the unaffiliated trust entered into a swap in order to convert the US-dollar cash flows into fixed-rate euro-denominated covered bond payments. There does not always need to be a swap. However, if there is a swap this can represent significant exposure for the covered bond investor. This is mitigated by stringent rating agency requirements for swap counterparties (and guaranteed investment contract providers).
According to the Fitch Ratings pre-sale report for the WMB covered bond programme (September 4 2006), a mortgage bond issuer event of default is deemed to have occurred if:
the issuer defaults on any series of mortgage bonds for more than three days;
the issuer breaches any covenant under the programme;
If any of the following events occur, the covered bonds are payable immediately:
a receiver, liquidator, assignee, conservator or other similar officer takes possession of the issuer, or a court enters a decree or order for relief in respect of the issuer which remains unstayed for 90 consecutive days;
default by the issuer on any series of covered bonds for more than seven days;
breach by the issuer of any covenant under the programme;
the mortgage bond indenture ceases to be in full force and effect or is declared null and void;
the asset coverage test is not satisfied on each calculation date (after the cured period that extends to the following calculation date); or
the winding-up, administration, bankruptcy or similar of the issuer;
the covered bond indenture ceasing to be in full force and effect or being declared null and void; failure to satisfy the proceeds compliance test on each calculation date following a mortgage bond issuer event of default; and
a mortgage bond issuer event of default occurs in respect of any other series of mortgage bonds (the cross-default provision).
failure by the mortgage bond indenture trustee to pay within 90 days mortgage bond proceeds equal to the outstanding principal of mortgage bonds plus accrued interests.
Any of these scenarios results in the mortgage bonds being accelerated and the proceeds applied to the guaranteed investment contract. If the amount
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Global Securitisation and Structured Finance 2007 I US covered bonds uncovered
Federal Deposit Insurance Corporation/insolvency risk in covered bond structures
An insolvency of the bank is considered a mortgage bond issuer event of default and not necessarily a covered bond event of default. In a bank insolvency, the Federal Deposit Insurance Corporation would put the bank into receivership. Three possible outcomes may occur:
is likely to diversify an issuer’s investor base through an alternative source of triple-A funding at more attractive levels than where traditional unsecured debt can be placed. Many of the large mortgage originators are highly rated banks which are not necessarily looking to sell off all their mortgage risk as in a securitisation - less than half of the $8 trillion of mortgages outstanding in the United States are securitised. Many of these banks are not significantly capital-constrained and have less incentive than lower- rated issuers to transfer loans off their books. This category of issuer is likely to find the covered bond market an attractive alternative source of on-balance sheet funding that utilises its mortgage portfolios.
Relative value framework
The Federal Deposit Insurance Corporation affirms the mortgage bonds - either the bank continues to make payments on the bonds, or the Federal Deposit Insurance Corporation arranges to transfer the assets to a third party. The Federal Deposit Insurance Corporation allows the mortgage bond trustee to enforce its security and sell the cover pool assets (the underlying mortgage loans). The proceeds will be applied to the guaranteed investment contract to make the interest and principal payments on the covered bonds.
The covered bond market has the potential to offer a sizeable new highly rated investment category for accounts looking for bullet maturities, 20 per cent risk-weighting treatment for regulatory capital purposes and risk linked to high-quality US banks, ultimately collateralised by prime residential mortgage debt. The credit risk of covered bonds is seen as a joint probability of default analysis. Investors must consider the joint probability that the institution becomes insolvent and the market value of the assets declines beyond the cushion provided by over- collateralisation. For lenders focused on one product area (eg, only mortgages), this joint probability is higher than would be the case for a highly diversified bank issuing covered bonds with a mortgage cover pool. Exposure to a swap counterparty, if one is used in the structure, can also be significant.
The Federal Deposit Insurance Corporation repudiates the mortgage bonds (according to the Federal Deposit Insurance Act). In a receivership, the Federal Deposit Insurance Corporation can repudiate any contract and request a stay for up to 90 days. It can also take “a reasonable amount of time” to decide whether to repudiate at all. In the repudiation scenario, the Federal Deposit Insurance Corporation would pay “actual direct compensatory damages” to the mortgage bondholders.
Although all three scenarios are possible and there is legal precedent for these outcomes, it is always difficult to predict with certainty what a regulator will do. Therefore, this is a transaction risk, albeit a remote one.
A comparable structured product asset class with which to compare covered bonds is top-tier triple-A credit card asset-backed securities. Like the WMB covered bond issue, credit card asset-backed securities are almost always structured as bullets. Today, five- year top-tier triple-A fixed-rate credit card asset- backed securities are trading at about swaps minus one basis point, and a five-year fixed-rate US dollar- denominated covered bond offering should price at around the same amount. To the extent that issuance
Issuer considerations
A number of factors are likely to impact on an issuer’s decision of whether to access the covered bond market. In the United States, issuing covered bonds
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increased significantly following an initial transaction, the product may ultimately be traded tighter than credit cards. US covered bonds have a hard bullet and the joint probability default aspect of covered bonds should carry incremental value. In addition, given the flattening of supply that has been seen in recent years in the credit card asset-backed securities market, the availability of issuance in a new comparable asset class is likely to be met with strong demand.
yet been offered in US dollars, it is reasonable to expect that covered bonds issued in the United States would offer a significant pick-up to agencies. Both covered bonds and agencies have 20 per cent risk weighting for regulatory capital purposes. However, agencies do not offer recourse to a specific collateral pool. One disadvantage for agency buyers, however, may be the fact that in the beginning covered bond issuance in the United States is likely to be offered on a Section 144A (rather than public) basis.
This chapter is taken from previously published Deutsche Bank research.
US agency buyers are also likely to find covered bonds attractive. At present, five-year Freddie Mac and Fannie Mae agencies (fixed-rate bullets) are trading at spreads of 16 basis points to 18 basis points through swaps. Although a covered bond transaction has not
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