Mortgage securitization in the U.S. has all but ceased, freezing credit markets in their tracks. Rising default rates and illiquidity in the credit markets have resulted in demand destruction for mortgage and other asset-backed securities (ABSs). A dearth of buyers at B-rated assets and unrated tranches has led to the demise of the mortgage-backed securities (MBSs) market.

Tutorial: The Basics of Bonds

However, there is an old-world financing method that might be the panacea for the securitization market. Covered bonds are a financing vehicle that is also backed by a pool of mortgages. But unlike today's MBS securities, these bonds cover the risk of default by allowing assets to move in and out of the pool. First used to finance municipalities in the 1700s, they are still used in Europe and are now gaining the interest of U.S. banks and other finance institutions. (Read more on bonds in our related article, Advantages Of Bonds.)

Securitization Issues
Once totaling a trillion dollars, the mortgage securitization market in the United States grew out of a need for low-cost mortgage funding. Through securitization, mortgage lenders did not hold the mortgages they originated. Instead, they sold them to investment banks for fee revenue which allowed them to recycle the capital to fund new loans.

In order to monetize the purchased loans, investment banks pooled them and sold the default risk in various tranches to investors as MBSs. Investors relied on the underwriting and due diligence of mortgage originators and credit enhancements to mitigate default risks. Because an investor could not perform their own due diligence on all the mortgages in the pool, they relied on the abilities of rating agencies to determine the credit worthiness of the assets that collateralized the securities. In this process, a significant portion of loan origination moved from the banks, an area that was highly regulated and scrutinized, to one where complexity and volume obscured associated risks.

As the housing market in the U.S. declined, and rating agencies failed to adequately estimate the default potential of mortgage pools, investors took on more default risk than anticipated. Inadequate risk assessment of securitization had decimated the MBS market and has lenders looking for new ways to raise mortgage capital. (For more on MBS, see The Risks Of Mortgage-Backed Securities.)

In an attempt to loosen the domestic credit markets, several U.S. banks have introduced covered bonds, a financing technique that has been used to finance banks and fund mortgages for centuries.

European Covered Bonds
Even before America broke from English rule, Germany was using covered bonds to finance agriculture. Created in Prussia in 1769 by Fredrick the Great, pfandbriefe were secured by real estate and sold by estates to finance public works projects. By 1850, German banks were refinancing mortgages with the proceeds of debt secured by other mortgage loans.

Since that time, 24 other European countries have adopted the use of the covered bond, although each has unique laws governing their structure. By the 1990s, the covered bond market was booming in response to the need for increased liquidity in the mortgage market. Originally, only mortgage and public sector banks could issue covered bonds, but by 2005 new laws began allowing all licensed credit institutions meeting minimum credit hurdles.

After government bonds, covered bonds are the next largest segment of the European bond market. According to the European Covered Bond Council (ECBC), 2.4 trillion euros worth of covered bonds were outstanding in March 2011. The European Central Bank estimates that new issues approximate 15% of the European bond market or approximately 220 billion euros annually.

Covered Bond Basics
Covered bonds provide an alternate method for institutions to convert illiquid mortgages into a funding source. Covered bonds are bonds issued by banks or municipalities that are collateralized by a dedicated pool of mortgages. This collateral, referred to as the cover pool, enhances the credit of the borrowing institution by providing security against default and reinvestment risk. Financial institutions are able to issue these bonds at a lower interest rate because a portion of the cash flow to investors is secured by the liquidity and value of the cover pool.

Unlike the securitization process that passes ownership of pooled mortgages to investors, the cover pool stays on the holding company's balance sheet to reserve against potential mortgage losses. Because the issuer retains control over the cover pool, it can exchange assets in order to improve credit quality and to lower borrowing costs. It also takes on the obligation of replacing troubled or prepaid loans with performing ones to maintain the risk mitigation properties of the pool. Because the assets in the pool provide collateral, and not the cash flows to service bond payments, investors do not take on a direct exposure to the real estate market. Issuers can provide additional credit enhancement, like insurance, or make contractual arrangements with third parties to continue interest and principal payments in the event of insolvency by counterparty. In the event of insolvency, the pooled loans are placed in a separate entity from the bond issuer and used to repay the obligation to the bond holders.

Most laws governing covered bonds address the quality of loans that can be placed in the pool (usually loan-to-value ratios not exceeding 80%). They also address the amount of collateral needed to cover the bond, how it will be monitored and how investors are protected in the event the issuer goes bankrupt.

Although there is a growing trend to issue bonds of greater maturity, most covered bonds are issued with maturities of two-10 years. Most are loans that pay out from the revenue of the issuer and do not amortize like asset-backed securities. In this case, they pay a fixed rate over a long period and a balloon payment at maturity. By using high quality loans in the cover pool, institutions can issue paper that is rated higher than its own credit rating (usually AAA or AA), and rates below its senior unsecured debt. Because the bonds are usually rated higher than corporates, they attract more investors while exposing them indirectly to mortgage securities without reducing the credit quality of their fixed income portfolios. (For more on bonds, see our Advanced Bond Concepts Tutorial.)

Covered Bonds in the U.S.
In September 2007, Washington Mutual became the first American bank to issue covered bonds when it completed a euro-denominated program worth about $26 billion. Nine months later, Bank of America issued the first dollar-denominated issue valued at about $2 billion. Other American banks have led issues with co-management from European banks seasoned in issuing this type of product. European banks have also shown interest in creating euro-based bonds with high quality American mortgages in order to tap the dollar market.

The promising start of the American covered bond market was not without speed bumps. The American legal framework did not allow for the complete isolation of the cover pool from conservatorship or receivership of the issuing bank. It became more complicated when Congress amended bank insolvency laws to include a 90-day automatic stay to allow the FDIC to analyze the banks operating issues. In its Covered Bond Policy Statement, the FDIC has set the guidelines under which bond holders can perfect their rights in the face of bank insolvency and the requirements that bond issuers must follow to receive federal approval. (For more on FDIC, see The History Of The FDIC.)

On July 28, 2008, U.S. Treasury Secretary Henry Paulson announced that the U.S. Government would try to kick start a market for covered bonds as an alternative form of mortgage-backed securities. Soon after, JPMorgan Chase, Bank of America, Wells Fargo and Citigroup announced they would begin issuing covered bonds. The Federal Reserve also announced that it would consider highly-rated covered bonds as collateral for emergency fund requests. The FDIC has also suggested making changes to its Temporary Liquidity Guarantee Program by extending current guarantees from three to up to ten years, and to include all debt issues covered by collateral.

Are Covered Bonds the Answer?
Despite the government's efforts to facilitate the issuance of covered bonds, the market has been relatively slow to respond. The largest dilemma facing covered bonds is that they attract a differing type of clientèle than MBS investors.

If covered bonds do catch on in the U.S., banks should be able to raise additional capital to fund high quality mortgages. Once banks can generate enough income, it should free up capital for other types of mortgage lending. Even though covered bonds may loosen credit for the housing market, they won't alleviate the bank's exposure to toxic assets as they will not be allowed to be part of the cover pool for any new issues.

In addition to helping revive the housing market, some issuers believe that covered bonds can be used to provide capital for infrastructure development. Public sector covered bonds have been used effectively in Europe as a cornerstone for infrastructure finance. With federal, state and local governments striving to fund basic infrastructure, covered bonds could evolve to help finance approximately $1 trillion worth of domestic infrastructure. Maybe covered bonds are the answer to some of America's credit issues. (For more on bonds, see our Bonds Basics Tutorial.)

Related Articles
  1. Investing News

    Bill Gross: It's a Xanax Existence for the 99%

    Read about the investment letter from famed bond king Bill Gross for 2016. See how he says the 99% are living a Xanax existence while the 1% prosper.
  2. Mutual Funds & ETFs

    Pimco’s Top Funds for Retirement Income

    Once you're living off the money you've saved for retirement, is it invested in the right assets? Here are some from PIMCO that may be good options.
  3. Mutual Funds & ETFs

    3 AllianceBernstein Funds that Are Rated 5 Stars by Morningstar

    Discover the top three mutual funds administered and managed by AllianceBernstein that have received five-star overall ratings from Morningstar.
  4. Retirement

    Is it Safe for Retirees to Invest in Technology?

    Tech stocks are volatile creatures, but there are ways even risk-adverse retirees can reap rewards from them. Here are some strategies.
  5. Mutual Funds & ETFs

    Is Morningstar’s Star System An Effective Ranking Tool? (MORN)

    Learn why Morningstar's star rating system is not always a great predictor of future performance, and why investors should not pick funds on star ratings alone.
  6. Stock Analysis

    The Top 5 Oil and Gas Stocks for 2016 (XOM, BP)

    Read detailed analyses of the top five oil and gas stocks, and learn why they may be poised to rise in 2016 after a dismal 2015.
  7. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  8. Retirement

    Retirees: How to Survive When Interest Rates Drop

    Low interest rates are a portfolio killer if you're living off of investment income. Some strategies for dealing.
  9. Mutual Funds & ETFs

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  10. Mutual Funds & ETFs

    3 PIMCO Funds Rated 5 Stars by Morningstar

    Learn about three fixed income mutual funds managed by Pacific Investment Management Company (PIMCO) that have received five-star overall ratings from Morningstar.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  3. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  4. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  5. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  6. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
Trading Center