Download Covered Bonds-Are they the future?

Deborah M. Higgins
President
Higgins Capital
CMTA Advanced Workshop
Pomona, CA
January 31, 2013
www.HigginsCapital.com (800) 716-6510
[email protected]
 Covered Bonds are debt instruments secured
by a “cover pool” of either mortgage or
public sector loans.
 Investors have a preferential claim to the
debt from the issuer, which is subject to
public supervision and regulation.
 They are a type of derivative investment.
 They are similar to, but considered much
safer than, asset-backed (ABS) and
mortgage-backed (MBSs) securities.
 The covered bond business has been around
in Europe since the 18th century. They were
first issued in Germany in 1770, to finance
public projects. German financial institutions
are still the largest issuers of covered bonds.
 For simplicity, think about a covered bond as
a standard corporate bond, issued by a
financial institution, but with an extra layer
of protection.
www.HigginsCapital.com (800) 716-6510
[email protected]
 The bonds are backed by the
cash flows generated from the
underlying investment pool:
 1) A bank buys and combines
cash-generating investments
 2) A bank issues a bond that is
supported by the cash flow
from the investments
 3) The “cover pool” is that
collection of cash-generating
assets, either MBSs or publicsector loans
 4) Cash flows are not directly
tied to the cover pool
www.HigginsCapital.com (800) 716-6510
[email protected]
 MBSs developed in the US were structured
allowing originating financial institutions,
mostly banks, to pass on the credit default
risk to the buyers of the MBSs.
 These institutions made their money on the
loan origination fees, passing the risk on,
allowing them to make riskier and riskier
loans (ex. liar loans).
 Covered bonds differ in that the loans
backing them remain on the banks’ balance
sheets. If a bank goes bankrupt, investors
retain their access to the “cover pool.”
 Covered bonds are not only covered by the
underlying mortgages, but are also covered
by the originating banks, with a stronger
incentive to make loans that will perform
well over time.
 The pool of assets backing the covered bond
is usually larger in principal value than the
bonds themselves (over-collateralized).
www.HigginsCapital.com (800) 716-6510
[email protected]
 Covered bonds and ABS are
complements, not substitutes.
 ABS are a vehicle to package and sell
exposure to private credit risk with
higher returns expectations for that
risk.
 Covered bonds are a means for banks
to raise long-term funding at a lower
cost than unsecured debt.
 Covered bond assets enhance the
issuer’s promise to pay. They are not
intended to offer exposure to the
underlying pool.
 ABS typically pay floating rates &
pass through any early redemptions
whereas covered bonds typically pay
a fixed interest rate with a fixed
maturity date.
www.HigginsCapital.com (800) 716-6510
[email protected]
 The European Covered Bond Council (ECBC) was
created by the European Mortgage Federation in
2004. It is the forum that brings covered bond
market participants together:
http://ecbc.hypo.org/Content/default.asp?PageID=4
56
 The European Capital Requirements Directive (CRD),
issued UCITS (Undertakings for collective investment
in transferable securities) 52(4) which defines the
minimum requirements that provide the basis for
privileged treatment of covered bonds in different
areas of European financial market regulation.
 Covered bond programs exist in most EU countries
and all have roughly the same configuration:
 1) Legally isolate a pool of mortgages or other
low-leverage assets
 2) Bondholders have a priority claim on the
isolated “cover pool” of mortgage or other loans
(priority to unsecured credits)
 3) The issuer has an ongoing obligation to
maintain sufficient assets in the pool to satisfy
bondholder claims at “all times”
 4) The issuer’s obligations to the cover pool are
supervised by the public or other independent
entities
 These common characteristics are achieved under a
special-law based framework or a common-law
based framework.
www.HigginsCapital.com (800) 716-6510
[email protected]
 Bullet repayments-cash flows are not directly
tied to the covered pool
 Transparency and simplicity with a simpler
structure and single cover pool
 Preferential weighting for liquidity for bankshigher demand for those assets with higher
liquidity
 Improved asset-liability management due to
fixed funding duration
 UCITS(Undertakings for Collective Investments in
Transferable Securities) 52 (4), the European
directive that allows a framework for retail
investment funds
 Solvency II-The 0.6% spread risk factor assigned
to AAA-rated regulated covered bonds under
UCITS is lower than the 0.9% factor assigned to
AAA-rated senior unsecured corporate bonds
(lower losses in a shock scenario)
 Higher credit quality expectations as issuer “on
the hook,” since assets “stay on the books.”
www.HigginsCapital.com (800) 716-6510
[email protected]
 Some Issuer discretion in replacement
asset quality for covered pools
 Lack of standardization of covered
bonds
 Interest rate strategy-mostly fixed rate
issuance and limited floating rate
issuance
 Valuation of positions more difficult
due to sovereign/originator default risk
 Triple exposure in sovereign, issuer and
assets—limited hedging ability via CDS.
www.HigginsCapital.com (800) 716-6510
[email protected]

Covered bonds are currently viewed as senior secured bank debt.

Evaluating risks in covered bonds:

1) Liquidity

2) Cash flow valuation of the cover pool assets

3) Seniority of the unsecured holders

4) Bank credit risk analysis
 A) structure and stability of a banking system
 B) Performance and risk appetite
 C) Range and stability of funding options
 D) Government’s support tendencies

5) Sovereign risk
 A) Strengths and weaknesses of an economy & banking system
 B) Government’s policy flexibility

6) Currency risk

Despite EU structures that are roughly the same, each country has
specific features that must be assessed in rating its covered bonds.
Here’s the link to a January 2013, report by DBRS, Methodology…Rating
European Covered Bonds:
http://www.dbrs.com/research/253894/rating-european-coveredbonds.pdf

European Covered Bond Council (ECBC) Fact Book 2012:
http://ecbc.hypo.org/Content/Default.asp?PageID=501

Rating methodologies for covered bonds are conducted by:
 Fitch
 Moody’s
 Standard & Poor’s
 DBRS
www.HigginsCapital.com (800) 716-6510
[email protected]
 Fitch covered bonds rating
methodology steps:
 Discontinuity risk analysis
 Asset Segregation (45%)
 Liquidity Gap (35%)
 Alternative Management (15%)
 Covered bonds Oversight (5%)
 Adjustment for Privileged Derivatives
 Static Asset Analysis & Cash Flow Modeling
 Recoveries Given Default
www.HigginsCapital.com (800) 716-6510
[email protected]
 The countries with lower
sovereign and bank credit risk:









1) Australia
2) Canada
3) Switzerland
4) Germany
5) Finland
6) Luxembourg
7) Norway
8) New Zealand
9) Sweden
www.HigginsCapital.com (800) 716-6510
[email protected]
 Countries with lower sovereign
credit risk and higher bank
credit risk:
 1) Austria
 2) Denmark
 3) Korea
www.HigginsCapital.com (800) 716-6510
[email protected]
 Countries with higher
sovereign credit risk and lower
bank credit risk:




1) Belgium
2) France
3) Japan
4) U.S.
www.HigginsCapital.com (800) 716-6510
[email protected]
 Countries with higher
sovereign and bank credit
risks:







1) Spain
2) UK
3) Greece
4) Ireland
5) Italy
6) Netherlands
7) Portugal
www.HigginsCapital.com (800) 716-6510
[email protected]
 EUR-benchmark covered bond
gross supply:
Source: Credit Suisse. *Gross supply from 1 January 2012 to 25 November 2012.
www.HigginsCapital.com (800) 716-6510
[email protected]
 USD-benchmark covered bond
gross supply:
Source: Credit Suisse. *Gross supply from 1 January 2012 to 25 November 2012.
www.HigginsCapital.com (800) 716-6510
[email protected]
 Benchmark covered bond gross supply in
2012 was around EUR 80 billion and USD
35 billion.
 Mortgage covered bonds accounted for
around 94% of EUR- and 97% of USDbenchmark gross supply in 2012.
 Supply is expected to grow in 2013 to
around EUR 100 billion while USD supply
remains around 35 billion.
 More than half of covered bond
issuances in 2012 were from outside
Europe.
 Mortgages continue to be the most
common type of asset to be funded via
covered bonds.
 Demand for high-quality assets continues
to exceed supply.
 Investors must pay acute attention to the
regulatory changes, especially asset
quality.
www.HigginsCapital.com (800) 716-6510
[email protected]
 The U.S. buyers of covered bonds:
 1) Banks
 Flush with cash, put $ to work
 2) Central Banks
 Tend to buy @ issue & hold
 3) Some corporations
 The 3 big issuers for U.S. covered
desks are:
 1) Australia
 2) Canada
 3) Nordic countries
 U.S. issuance participation is
hindered due to legislative
restrictions, types of MBSs into the
pools, quality (who gets the
“crappy” ones), housing reform,
etc.
www.HigginsCapital.com (800) 716-6510
[email protected]
Security
A Price YTM Bench SPD ASW Sz(M)
------------------------------------------------------------------------------------ NACN 1.65 01/30/14 101.402 0.268 2YR
1.0 -5.27 10MM
(National Bank of Canada, 144A)
 CFF 2¼
03/07/14 102.111 0.359 2YR
10.0 3.32
5MM
 CM 1½ 12/12/14 102.084 0.388 2YR
(Canadian Imperial Bank, 144A)
13.0 1.02 1.5MM
 CFF 2½ 09/16/15 104.110 0.923 3YR
54.0 47.26
5MM
 DNBNO2.9 03/29/16 106.409 0.853 3YR
 (DNB Boligkreditt AS; Norway, 144A)
47.0 33.04
5MM
 SPABOL 2⅝05/27/16 105.622 0.913 3YR
53.0 35.65 10MM
 NACN 2.2 10/19/16 105.340 0.748 3YR
36.5 10.68
 ANZ 2.4 11/23/16 105.469 0.943 3YR
(Aust & NZ Banking Group, Regs)
56.0 28.55 10MM
 BNS 1¾ 03/22/17 103.426 0.909 5YR
13.0 17.90
5MM
9MM
 RY 1.2 09/19/17 100.185 1.159 5YR
 (Royal Bank of Canada, Regs)
38.0 31.01 10MM
 SHBASS 1⅞ 10/02/19 100.240 1.837 7YR
57.0 51.91 10MM
 INTNED 2⅝ 12/05/22 99.907 2.636 10YR
77.0 72.73 10MM
www.HigginsCapital.com (800) 716-6510
[email protected]
 Evaluations are expected to remain rich due to regulatory
changes in the form of Basel III, central banks’ collateral
frameworks, the European Capital Requirements Directive
(CRD), to name a few.
 With the financial crisis, investors have a more home-country
bias.
 Covered bonds yields declined nicely in 2012 and are not
expected to decline further from these levels. Note current
yields from the last slide are 0.35 for 1y, 0.50 for 2y, 1.30 for
3y, 1.50 for 5y and 3.35 for 10y.
 Sovereign and bank credit risks continue to drive yields. With
sovereign ratings under pressure, we have seen yields range
from 13.9% (Greek SLB covered bonds) to a 0.2% (Swiss SLB
CHF-mortgage covered bonds).
 Investors discriminate between mortgage and public covered
bonds. Given the risks inherent in the collateral, a yield
differential between public and mortgage covered bonds is
reasonable.
 But collateral type will not be the driving force for yields in
2013…the regulatory environment will take “center stage.”
www.HigginsCapital.com (800) 716-6510
[email protected]
 In 2006, two U.S. banks issued covered bonds,
 Bank of America and Washington Mutual; they were the only U.S.
issuers in 2008.
 On July 15, 2008, the FDIC issued its final policy statement on the
treatment of “covered bonds” in the event of a bank failure:
http://www.fdic.gov/news/news/press/2008/pr08060a.html
 In July 2008, the Treasury issued it’s “Best Practices for
Residential Covered Bonds:”
 http://www.treasury.gov/about/organizationalstructure/offices/GeneralCounsel/Documents/U.S.CoveredBondBestPractices.pdf
 The Treasury department issued its best practices as a
complement to the FDIC’s policy statement with cover pool
disclosure guidelines and monthly credit quality monitoring.
 The Financial Crisis of 2008 hit in October and the Street is still
trying to determine whether a U.S. covered bond can be done.
www.HigginsCapital.com(800) 716-6510
[email protected]
 Congressman Garrett has repeatedly introduced covered bond legislation. The
most recent on March 8, 2011. H.R. 940 is called the United States Covered Bond
Act of 2011: http://www.gpo.gov/fdsys/pkg/BILLS-112hr940rh/pdf/BILLS112hr940rh.pdf
 In June 2011, the House Financial Services Committee had voted 44-7 in favor of
an amended bill to establish a regulatory framework for a U.S. covered bond
market.
 In November 2011, S. 1835 was introduced into the Senate and referred to the
Senate Committee on Banking, Housing and Urban Affairs for consideration.
 In November 2011, The Securities Industry and Financial Markets Association
(SIFMA) issued a statement on its strong support of the US Covered Bond Act
introduced by Senators Hagan, Corker, Schumer & Crapo.
 The January 1, 2013, international agreement deadline for new Basel-based rules
in all countries was not met by the European Union and US (only Japan met the
deadline). Below is a link on testimony by the Fed on November 14, 2012 about
Basel III:
http://www.federalreserve.gov/newsevents/testimony/gibson20121114a.htm
 Once the United States has its primary legislation in place, we could see the
beginnings of a covered bond regulatory oversight program and lenders could
start developing programs to fit their needs.
 Key issues remain, mostly on the role of the FDIC in the event of a bankruptcy for
issuer banks. Many expect to see progress and bill adoption in 2013.
www.HigginsCapital.com (800) 716-6510
[email protected]
 US covered bond issuance has been
on hold since June 2007.
 In September 2008, JPM Chase
acquired the assets and most of the
liabilities of Washington Mutual,
including covered bonds.
 There were a total of 7 US-issued
covered bonds, $13.5B total, with
maturities ranging from 3- to 10years.
 6 of the 7 US-issued covered bonds
were in EUR currency.
 Only 2 remain outstanding:
 JPM 4.00 09/27/16, EUR, 10yr, MBS
collateral, Current ratings: S&P A+, Fitch AA BAC 4.25 04/05/17 EUR, 10-yr, MBS
collateral, Current ratings: A1/A+/AAwww.HigginsCapital.com (800) 716-6510
[email protected]
 A successful US covered bond market will
depend on the product’s price
competitiveness to other funding avenues
for the issuer.
 Currently, the issuance structure is more
complex and costly than other structures
to achieve the level of creditor protection
found in other jurisdictions.
 We need to get our primary legislation in
place; then set up a covered bond
regulatory oversight program.
 We must comply with both UCITS 52(4),
to benefit from higher investment limits,
and the European CRD to compete
globally.
 We need to resolve the broader issues on
housing finance reform.
 US has a multi-trillion dollar securitization
market that can’t be replaced by onbalance sheet funding.
www.HigginsCapital.com (800) 716-6510
[email protected]
 Only 1 of the 7 US-issued covered
bonds was in US dollars:
BAC 5.5 6/14/12:
 1) Market of Issue: Private Placement
 2) Country: US
 3) Currency: USD
 Expect US legislation to drag
out....housing reform ties
 Currently, no global bank desks
polled had any public agency
covered bond buyers, in CA or
any other state
 No US-issued covered bonds are
traded.
 Think of a US-issued, USD
covered bond as a standard
corporate bond, issued by a
financial institution, but with an
extra layer of protection.
www.HigginsCapital.com (800) 716-6510
[email protected]
 Disclaimer Higgins Capital does not guarantee nor make any
representation as to the accuracy of any projections, rate of
returns or outcome from any information or scenarios
presented.
 Sales and trading department personnel are not research
analysts, and the information in this communication and all
attachments (collectively, the “Presentation”) is not intended
to constitute “research” as that term is defined by applicable
regulations. Unless otherwise indicated, any reference to a
research report or research recommendation is not intended to
represent the whole report and is not in itself considered a
recommendation or research report. Please contact your Firm
representative for a copy of the referenced research report. All
views, opinions and estimates expressed in this Presentation (i)
may change without notice and (ii) may differ from those views,
opinions and estimates held or expressed by the Firm or other
Firm personnel.
 This presentation is provided for information and discussion
purposes only. It does not constitute an offer or solicitation to
purchase or sell any financial instruments, and does not take
into account the investment objectives or financial situation of
any particular person. Investors should obtain advice based on
their own individual circumstances from their own tax,
financial, legal and other advisors before making an investment
decision, and only make such decisions on the basis of the
investor's own objectives, experience and resources. The
information contained in this presentation is based on
generally available information and, although obtained from
sources believed by the Firm to be reliable, its accuracy and
completeness cannot be assured, and such information may be
incomplete or condensed.
 Investments in financial instruments carry significant risk,
including the possible loss of the principal amount invested.
Financial instruments denominated in a foreign currency are
subject to exchange rate fluctuations, which may have an
adverse effect on the price or value of an investment in such
products. No liability is accepted by the Firm for any loss
(whether direct, indirect or consequential) that may arise from
any use of the information contained in or derived from this
presentation.
 Past performance is not a guarantee or indication of future
results. Any prices provided in this presentation (other than
those that are identified as being historical) are indicative only
and do not represent firm quotes as to either price or size. You
should contact your local representative directly if you are
interested in buying or selling any financial instrument, or
pursuing any trading strategy, mentioned herein.
 None of the financial instruments mentioned in this
presentation (unless expressly stated otherwise) are (i) insured
by the Federal Deposit Insurance Corporation or any other
governmental authority, or (ii) deposits or other obligations of,
or guaranteed by, Higgins Capital or any other insured
depository institution.
www.HigginsCapital.com (800) 716-6510
[email protected]