September 2008 VOL. 2

Did You Know?

Amid turmoil in the mortgage market and the broader credit crunch, regulators and the Bush administration have put their weight behind covered bonds in an attempt to increase mortgage financing and provide banks with a new and diversified funding source, according to A.M. Best Co., an Oldwick, N.J.-based credit reporting agency.

Covered bonds are a popular financing vehicle in Europe, where issuance is estimated at $3.3 trillion. However, only two U.S.-based institutions – Bank of America Corp. and Washington Mutual Inc. – have issued these securities, partly because of uncertainty over the regulatory environment and investors’ concerns over how covered bonds would be treated in the event of a bank failure.

Covered bonds are a somewhat more restrictive form of securitization in that banks continue to hold the mortgage pools that back covered bonds on their books. That is in contrast to the typical mortgage securitization in which bonds backed by a mortgage pool are issued through a bankruptcy-remote, off-balance sheet trust.

The mortgages in a covered bond transaction represent separate obligations of the bank that can be liquidated in the event of insolvency. But until the Federal Deposit Insurance Corp. (FDIC) issued a final policy statement in July, bond investors would have had to wait as long as 90 days to take control of the collateral in the event of an FDIC receivership of a failed institution. The new guidance now reduces that time to 10 days.

Covered bonds have been pitched as a potential new source of financing since banks have found it difficult to securitize their mortgage loans from off-balancesheet vehicles because of rising losses and delinquencies in the current environment. In late July, Bank of America, Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. said they would begin issuing covered bonds. The four banks announced their support for the FDIC’s guidance and a set of best practices prepared by the Treasury Department.

One feature of covered bonds that could make them more palatable to investors hit by losses from other mortgage- backed securitizations is that the issuing bank is able to change the loans in the pool if its credit quality deteriorates so that the bonds continue to receive interest payments. The FDIC’s guidance also allows banks to substitute cash, U.S. Treasury securities and agency securities for the initial collateral to “prudently manage” the cover pool.

Other elements of the FDIC’s guidance included revising the term limit for covered bonds to 30 years, up from 10 years initially proposed. In addition, mortgages that comprise the collateral pool for covered bonds must be underwritten conservatively. On that score, the FDIC resisted comments from banks and industry groups that sought to expand eligible mortgages for covered bonds to second-lien home equity loans and home equity lines of credit, among other assets.

Although the covered bond market has been viewed as a liquidity aid for banks and the troubled mortgage market, it is not expected to overtake the broader mortgage-backed securities market any time soon. That is partly because a bank’s issuance of covered bonds may not exceed 4 percent of its total liabilities, according to the FDIC’s guidance.

Covered bonds also are not immune to turmoil in credit markets. In November 2007, inter-dealer trading of European covered bonds was shut down for about a week because of an extreme widening of spreads for outstanding bonds. At the time, liquidity across many fixed-income markets had declined because dealers were concerned about trading with each other, higher funding costs and the need for cash to close their books with the approaching year end.