"In the US, if you want to make mortgage loans, one of the most used ways of funding is to borrow from the FHLB," says Ajay Rajadhyaksha, head of US fixed-income strategy at Barclays Capital in New York. "As their cost of funding moves lower the absolute rate they are charging banks also moves lower. At this point, given where corporate debt stands and bank debt stands, covered bond funding is not competitive by a large margin with FHLB funding."
Even before the government stepped into the Fannie and Freddie situation, funding through the FHLBs was a better deal than covered bonds. Before the intervention, the home loan banks were lending money at between Libor plus 10 basis points and Libor plus 20bp. Covered bonds would trade 10bp tighter than unsecured bank debt.
"You’re still looking at a gap of 80bp to 90bp in funding," he says. "If you’re a bank that can borrow money from the FHLB that is what you will do nine out of 10 times."
Other options
Although economics make covered bonds less appealing, there is no doubt the US Treasury would like to see these instruments in use. In a July statement announcing covered bond best practices, US Treasury secretary Hank Paulson noted that more financing options could help the US mortgage market, which is dominated by funding from the GSEs, the FHLB system and the Federal Housing Administration. Those entities account for 70% of residential mortgage funding.
| "Covered bonds are conservative instruments, but fundamentally the market needs this" Tim Skeet, Merrill Lynch |
In his remarks, Paulson noted that the other avenue of mortgage funding – securitization – had also come under pressure. He said that while the private-label securitization market should evolve in response to the current crisis and reopen, it is useful to explore additional mortgage financing options to complement more traditional funding models. "One option we have looked at extensively is covered bonds, which are a $3 trillion market used widely in Europe for mortgage funding," said Paulson on July 28. "I believe covered bonds have the potential to increase mortgage financing, improve underwriting standards, and strengthen US financial institutions by providing a new funding source that will diversify their overall portfolio."
Paulson used his clout as Treasury secretary and his Wall Street connections to rally some big names behind his covered bond initiative. Bank of America, Citi, JPMorgan and Wells Fargo are all on board and expected to start issuing covered bonds within the coming months.
"A third leg to the mortgage sector is needed in the US," says Tim Skeet, head of covered bonds at Merrill Lynch in London. "The US needs a genuine private sector alternative to securitization. No one’s saying this is how the market will be saved. Investor confidence must be rebuilt, and the markets, which are terrified, need to be stabilized."
Being linked to an issuer’s unsecured debt and to a pool of mortgage assets, covered bonds offer investors double protection.
"Covered bonds are a bit of a jump backwards," says Skeet. "They are conservative instruments, but fundamentally the market needs this." This kind of protection could attract investors looking for safe bets that offer a pick-up over treasuries or agency debt. Bankers expect US covered bonds to appeal to those investors that have stayed out of the markets since the extent of the sub-prime crisis became apparent. However, investors need to be willing to do their homework and get the covered bond concept past the risk management committee.
Even with the large banks backing Paulson’s push for covered bonds, smaller banks won’t be able to use the product. These issuers will have to wait for the broader market to stabilise and will continue to access FHLB funding where possible.
The few covered bond issues – from WaMu and Bank of America – were not done for funding advantage. Instead the purpose was to expand the banks’ investor base and were sold, largely, to European investors. Now that times are tough, banks’ motives are simple – secure funding as cheaply as possible.
"Right now all Paulson’s initiatives have been to introduce a new way of funding in the US marketplace," says Rajadhyaksha. "I find it difficult to believe covered bonds will do well right now. What would need to happen for covered bonds to really take off as a serious asset class in the US would be for bank debt to tighten in sharply. Until that happens, it is unlikely they will take off."