deborah m. higgins president higgins capital cmta advanced workshop pomona, ca january 31, 2013 ...

Deborah M. HigginsPresident

Higgins Capital

CMTA Advanced WorkshopPomona, CA

January 31, 2013

Covered Bonds-Are they the future?

www.HigginsCapital.com (800) 716-6510 [email protected]

http://www.higginscapital.com/

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.

What are Covered Bonds?



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 public-sector loans

4) Cash flows are not directly tied to the cover pool

Covered Bonds Concept



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).

US MBS vs. Covered bonds



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.

ABS and Covered Bonds are

Complements



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=456

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.

Covered Bonds Structure


http://ecbc.hypo.org/Content/default.asp?PageID=456

http://ecbc.hypo.org/Content/default.asp?PageID=456


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 banks-higher 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.”

Benefits for Investors



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.

Limitations for Investors



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-covered-bonds.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

Covered Bonds Ratings Structure


http://www.dbrs.com/research/253894/rating-european-covered-bonds.pdf



http://ecbc.hypo.org/Content/Default.asp?PageID=501

http://ecbc.hypo.org/Content/Default.asp?PageID=501


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

Rating Methodologies



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

Country Risk Assessment



Countries with lower sovereign credit risk and higher bank credit risk: 1) Austria 2) Denmark 3) Korea




Countries with higher sovereign credit risk and lower bank credit risk: 1) Belgium 2) France 3) Japan 4) U.S.




Countries with higher sovereign and bank credit risks: 1) Spain 2) UK 3) Greece 4) Ireland 5) Italy 6) Netherlands 7) Portugal




EUR-benchmark covered bond gross supply:

EUR Supply Market History


Source: Credit Suisse. *Gross supply from 1 January 2012 to 25 November 2012.


USD-benchmark covered bond gross supply:

USD Supply Market History


Source: Credit Suisse. *Gross supply from 1 January 2012 to 25 November 2012.


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 USD-benchmark 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.

Market Trends-2013



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.

“Covereds” U. S. Trading Dynamics



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 13.0 1.02 1.5MM (Canadian Imperial Bank, 144A)

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 47.0 33.04 5MM (DNB Boligkreditt AS; Norway, 144A)

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 5MM

ANZ 2.4 11/23/16 105.469 0.943 3YR 56.0 28.55 10MM (Aust & NZ Banking Group, Regs)

BNS 1¾ 03/22/17 103.426 0.909 5YR 13.0 17.90 9MM

RY 1.2 09/19/17 100.185 1.159 5YR 38.0 31.01 10MM (Royal Bank of Canada, Regs)

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

USD Covered Bond Offerings

dated 01/22/13



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.”

“Covereds” 2013 Expectations



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/organizational-structure/offices/General-Counsel/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.

US-issued Covered Bonds

www.HigginsCapital.com(800) 716-6510 [email protected]

http://www.fdic.gov/news/news/press/2008/pr08060a.html



http://www.treasury.gov/about/organizational-structure/offices/General-Counsel/Documents/USCoveredBondBestPractices.pdf




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/BILLS-112hr940rh.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.

Current Legislation


http://www.gpo.gov/fdsys/pkg/BILLS-112hr940rh/pdf/BILLS-112hr940rh.pdf

http://www.gpo.gov/fdsys/pkg/BILLS-112hr940rh/pdf/BILLS-112hr940rh.pdf

http://www.federalreserve.gov/newsevents/testimony/gibson20121114a.htm

http://www.federalreserve.gov/newsevents/testimony/gibson20121114a.htm


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 10-years.

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+/AA-

Outstanding US-issued Covereds



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 on-balance sheet funding.

US Competitiveness



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.

CA Public Agencies



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