CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

Quick background for those with a life. The covered bond business has been extant in Europe since the 18th century, with the leading participants being the Germans, whose program is known as the Pfandbrief program. Generally, covered bond programs exist in most EU countries and all have roughly the same configuration. A bank legally isolates a pool of low-leverage mortgage loans (and in some cases governmental loans, maritime-based loans, and other more quirky assets but, for our purposes, we’ll focus on mortgage loans). Typically, low leverage means 60% loan-to-value or less. The bank issues bonds which are both the obligation of the issuing bank and have a priority claim on the economics of the isolated pool of mortgage loans. By virtue of statute, if the bank were to become insolvent, the creditors of the bank would not have a claim on the assets isolated in the covered bond structure until the related bonds were repaid. Bonds get the benefits of both the banks’ unsecured promise to pay and the pool of isolated mortgage loans and, hence, trade very tight to risk-free sovereign paper. The bonds are highly rated even though the credit rating of the bank is several ticks below terrific. Whereas in the United States, we’re used to the notion of a co-dependent rating structure where if there are multiple credit inputs into a transaction, the lowest rated input will tend to drive the rating of the ultimate product, the covered bond business has not been so burdened.

Like Generalissimo Franco, the U.S. covered bond structure is still dead and is likely to stay that way for the foreseeable future. The FDIC loathes this idea. And now the Euro Zone covered bond business is in peril. While not likely to ever actually die, the business in the EU is likely to shrink precipitously. And that has consequences.

The European covered bond business is going to shrink because the banks are in terrible shape, and regulators and the equity markets are increasingly intolerant of high quality assets plucked from the balance sheets and hived away from bank creditors to support these bonds. When no one dared to think the thought that a European bank could be insolvent, anxiety over asset allocation resulting from the covered bond business was low. That’s not where we are at now. Moreover, as European banks continue to retreat from traditional banking, gorging on sovereign debt, shedding “non-core assets” (e.g. anything not in our back yard – a reverse NIMBY), shrinking balance sheets to meet Basil III and parking liquidity at the ECB, there is going to be less and less to cover.

When a cycle is long enough, it’s indistinguishable from a secular change. EC bank balance sheets will repair but, for many, they will not fully repair for so long, it will be essentially a secular change in the European banking environment. The covered bond business is going to shrink, and shrink rapidly, and shrink, for all intents and purposes, indefinitely. This is going to massively disrupt capital formation for commercial real estate businesses across Europe. It will significantly increase the cost of funds to support commercial real estate lending by European banks and eliminate the cost advantage that the European banks have had both in Europe and in North America. No more will U.S. banks grouse that German banks swooped in to take low LTV, high-quality assets far inside the best the U.S. banks could do because they had Pfandbrief execution.

The shrinking of the Pfandbrief business, together with Europe’s new fascination with core (e.g., domestic) assets, and the dedication of large hunks of the European banks’ balances sheets to sovereign debt (least they can do for the pols, right?) means that the U.S. markets will not see Pfandbrief financed European bank lending anytime soon. Moreover, the needs of the commercial real estate markets in Europe will now far exceed the capacity of the European domestic banks to provide that capital. The Wall Street Journal reported on August 29 that Euro Zone lending was down 43% from a year ago and a whopping 68% from 5 years ago. Therein lies a whopping funding gap, estimated by some at €250 billion, for 2013 alone. It is real and is here for a long time.

Non-EC banks have recently been moving into the European market place to provide credit. Well, to be honest, tiptoeing into a market is closer to the mark. European markets continue to look rather fraught with recession, but as the Pfandbrief trade unwinds, the case for jumping in with both feet will become more and more compelling. So pack your bags, U.S. banks desperately seeking assets, looking for spread and fee income. Join your high yield and distressed fund clients in the EC pool. The Pfandbrief barricades are coming down around Europe and markets are open.
 

By: Rick Jones

Oh, don’t get me wrong, I’m a serious fan. Representing issuers on this product will be fun. While this has been a booming business in Europe for a while (like, the last 300 years), it does not translate well in the US. In Europe, broadly, every mortgage loan is originated with the expectation that all or a part of it will be financed in the covered bond market (in German parlance, the Pfandbrief market), that reflects the capital markets environment in Europe where covered bonds are a critical part of every financial institution’s capital structure.

That’s not what we’ve got here. US banks have the benefit of robust deposits, of deep equity markets and unsecured borrowing to provide needed capital. The fundamental economic problem for this product here in the United States is that, if an institution is sufficiently highly rated so that the co-dependency problem when the institution issues covered bonds will not be overwhelming, it could raise money more efficiently in the unsecured debt market. Consequently, covered bonds are negatively accretive to the cost of funds. On the other hand, if the covered bond economics are accretive, the bank’s unsecured ratings are probably insufficiently high to support the structure. So we have a Goldilocks problem. One issuer is too good and one issuer is too bad, is there one in the middle? Maybe, but it can’t be a big market. Compounding this problem is the hostility of the equity analysts who don’t cotton to ring-walling assets away from the general creditors of the institution, and of the FDIC, which broadly hates the whole thing. From the FDIC’s viewpoint, covered bonds dip into its pocket to steal assets from the rainy day fund. There’s been some potential compromise discussed with the FDIC, but it will remain a daunting roadblock to getting something done.

Net, net, I’m not holding my breath for birth of a real covered bond market here in the United States. But if anyone can explain to me the compelling need to which this is a compelling answer, I would love to hear it. In the meantime, maybe it’s simply worth enjoying the fact that our elected representatives have found an issue on which they can just get along.

By: Rick Jones

The Golden Turkey for the Best All-Around Performance: Europe

I defy anyone to explain European monetary and fiscal policy. No amount of magical thinking or psychotropic drug therapy can make this make sense. The explosive dysfunctionality of common monetary and fractured fiscal policies have been baked in the cake since inception and ignored by a sheer act of will. The inevitable denouement from this toxic brew was certain; not whether but when. While perhaps a common currency made sense from the perspective of keeping German troops out of Belgium, it was a disaster in a world where the business cycle was alive and well. The profligacy of European economies, the attendant sovereign debt crisis, the European banking crisis, world banking tensions and European recession can all be laid at the feet of the profound suspension of reality that this was some sort of a good idea.

The Golden Turkey for Pouring Gasoline onto Fire: Basel III

OK, I get the notion that banks need more capital, that the socialization of risk needs to be decoupled from market rewards, and that the system really did go casters up. But…on the cusp of a recovery, we have: the SIFIs (for the blessedly uninitiated, systemically important financial institutions), the Volcker Rule, Skin in the Game and Basel 2.5, Basel 3.0, and on and on. While we are desperately trying to re-start the economy, it seems ideologically bold, to be charitable, to embark simultaneously on dozens of untested, game-changing linked policy initiatives that will, if they do nothing else, constrain capital formation. Isn’t that a bit like citing the Titanic’s kitchen’s for unsanitary brioche pans?

The Golden Turkey for the Abbot Arnaud-Amaury Lookalike Contest

The good Abbot has won notoriety through the ages for the investiture of the City of Béziers during the Albigensian heresy. For, when confronted with the fact that many of the good citizens of Béziers were non-heretical Christians, he said something along the lines of, “Kill them all, God will choose the innocent”. Our illustrious chattering class seems to have concluded, on both the red meat right and the loony left, that trashing bankers makes good copy and good politics. Sticks and stone are bad enough, but an un-relenting policy of demonization makes for fertile ground for bad policy prescriptions, opportunistic litigation, and prosecutorial grandstanding. Whack the bankers, whack them all! Whack a mole! One would not be shocked if our banking sector was left with precious little energy for the aggressive pursuit of capital formation. The fact that the banking sector is working hard to do its job and support commercial real estate with capital is a tribute to our bankers.

The Golden Turkey for Unintended Consequences: 17-g-5

This is a very crowded category. The more we try to prescriptively engineer financial and market outcomes with legislation, the more we encounter the goblin of unintended consequences. You’d think at some point we’d create an OMB for unintended consequences to make a sustained effort think through the chances for unintended consequences before our elected representatives pose behind the President to get their picture taken and cop a commemorative pen. And then we all get to regret the legislative product. And the winner is: Rule 17-g-5. This is a rule introduced earlier this year which required issuers to maintain password protected data sites accessible to all NRSROs to see all the information in connection with a structured finance product rating recorded in these sites so that other, unretained rating agencies could analyze the data, publish an unsolicited rating and, therefore, keep everyone honest. Certainly, the Hobbesian instinct behind this notion to utilize the power of raw market capitalism to achieve the goal of breaking the perceived cozy relationship between rating agencies and bankers was estimable, but it didn’t work. To my knowledge, no unsolicited rating has occurred. And it’s pretty clear why. The cost of producing a rating on a CMBS transaction is enormous. If no one’s going to pay you for it, it’s hard to understand why an agency would undertake all that work to make a point. Moreover, here’s what makes this prize so well earned: the requirement that all information made available to the retained agencies be made simultaneously available to all NRSROs has meant that banks have had to become punctilious about controlling information flow to avoid violating the shared information rule.  In consequence, the NRSROs are getting much less information as conversation has been cut off and everything has been reduced to written submission. Moody’s showed courage this year by writing a thought piece that said 17g-5 was reducing the quality of ratings. They are right.  Now that's a useful outcome, right?

The Golden Turkey for the Best Idea Ever, that doesn’t Work: Covered Bonds

In the past few weeks, the companion bill to the U.S. Covered Bond Bill 2011 has been introduced into the Senate. The Senate bill tinkers with the version re-introduced by Congressman Garrett into the House earlier this year and, in some respect, improves the enabling legislation. We’ve been introducing covered bond bills and talking about covered bonds for years. Not much has happened. No one has actually made a compelling case that there are major financial institutions in the United States of America that want to use covered bonds. No one has ever made a compelling argument that this is accretive to the cost of capital without an offsetting negative impact on the market. Finally, there is no evidence that anyone in our dysfunctional bicameral legislature actually thinks a bill will pass anytime soon. Now don’t get me wrong, we at Dechert love the covered bond, and hope one day to be retained by serious players with serious budgets to make one of these transactions really work. But frankly, and to misquote Winston Churchill, “Never has so much been said by so many about so little”.

The Golden Turkey Send off: Here’s to you Mr. Politician

Whether you are a Keynesian economist (like many politicians pretend not to be) or a follower of F. A. Hayek (like all of the Republican potential nominees proclaim to be), one thing is for certain, we can all agree that the markets are volatile and 2011 is not the year to be an incumbent politician. So, with Thanksgiving right around the corner and the end of the year drawing closer, we at Crunched Credit would like to give a friendly send-off to those politicians who have done much to keep the news entertaining but little to calm the markets. To all of “them” (we all know who they are, even if they don’t) and to the rest of “them” still standing, “It’s the Economy, Stupid”!!!

By the Crunched Credit Team.

Again, the crux of the legislation is certainty on the treatment of covered bonds in the insolvency or receivership of the covered bond issuer. The bill seeks to provide this certainty through a framework that, at certain points in default or insolvency, isolates covered bond programs’ cover pool assets and liabilities into separate estates by the operation of law. Generally, the issuer (or receiver) retains a claim to the residual interest in the cover pool and the bondholders retain claims (contingent in receivership) for deficiencies on their bonds.

Before receivership, if an issuer defaults on a covered bond program, a separate estate is created. If appointed receiver before an issuer default, the FDIC has the option to transfer a covered bond program to an eligible issuer within 180 days or to elect to cease performance. If the FDIC (i) fails to transfer the program within the 180 days, (ii) elects to cease performance or (iii) fails to perform, or cure any arising issuer default, on the program, a separate estate is created. A separate estate is also created for a covered bond program if anyone other than the FDIC is appointed as receiver, trustee, conservator, etc. for the issuer.

The new bill will of course be the big theme at today’s covered bonds hearing before the House Capital Markets Subcommittee, chaired by Representative Garrett. You can find the witness list and access to their testimonies and the webcast (as posted) here. We will be looking for clues in how it is received as to how far it will go or whether, in the end, it will be just another bill on Capitol Hill.

By Stewart McQueen and John Bumgarner.

As Professor Kenneth Snowden noted in his testimony before the Senate (available here), the U.S. has made several abortive attempts to create covered bonds markets, from the 1870s to the 1930s.  These past attempts either failed to find the right formula to attract investors or ran afoul of established regulatory authorities and market participants.  We have investor demand, which is currently serviced by “Yankee issuances” from foreign issuers; U.S. investors reportedly sent $22 billion last year abroad in search of these safe assets. This time around the push for covered bonds is foundering on the FDIC’s concerns about adequate collateralization and access to the cover pool in the resolution of failed issuer banks.

The FDIC is concerned to preserve its current authority in resolving failed banks’ contracts.  Currently, just as with any other issuer, when covered bond issuers are placed in receivership, the FDIC has the authority either (i) to perform and make payments on the bonds, (ii) to repudiate and pay par plus accrued interest through the date of insolvency, and reclaim the collateral, or (iii) to do nothing and let the covered bonds default.  The FDIC, speaking for depositors and other creditors (also before the Senate Committee on Banking, Housing and Urban Affairs, available here), argues that it must have the option to access cover pools in receivership.  So the argument goes, absent the FDIC’s current flexibility to repudiate covered bond programs and access the cover pool to maximize recoveries, recoveries will be suboptimal and losses will be transferred to the Deposit Insurance Fund and the taxpayer, and the moral hazard abounds.  However, without legislation giving certainty on the FDIC’s treatment in issuer receivership, U.S. issuers cannot offer covered bonds on terms competitive with other forms of financing, including those so called Yankee issuances. 

With the continued lobbying efforts of certain industry groups and the shift in the balance of power in Congress, we do not expect the push for covered bond legislation to die any time soon.  We understand that Representative Garrett plans to reintroduce legislation in the House (which must first travel back through committee) and has already circulated a discussion draft to members of Congress and securitization market participants (please see this Dechert OnPoint (pdf) for a more in depth discussion).  The House Capital Markets Subcommittee is keeping the ball rolling with another hearing scheduled for the 11th, and covered bonds remain on the radar of the Senate Banking, Housing and Urban Affairs Committee.  Even the Obama Administration (pdf) has given a nod to working with Congress to explore covered bond legislation in the context of GSE reform.  We will be looking for signs of bigger and better things to come.

If our legislators and regulators can make haste, slowly of course, toward integrating covered bonds into our financial system, U.S. issuers may have an opportunity to tap into investor demand and give the European issuers a run for those Yankee dollars, and I may have the opportunity (or privilege) to visit my in-laws and watch college basketball and NASCAR without interruption… unless, of course, I'm working on a covered bond transaction.

By Stewart McQueen and John Bumgarner

You might recall that Representative Garrett almost succeeded in getting covered bond legislation into the Fin Reg package that passed last month . Lacking one vote (pdf), and facing scrutiny from the FDIC, the language found itself on the cutting room floor when Fin Reg ingloriously exited the reconciliation process. Notwithstanding these setbacks, Garrett’s latest attempt to push this legislation through appears to have some momentum in the Senate as well—Senator Bob Corker (R. Tenn.) has asked for the Senate Banking Committee to hold hearings on the topic. In addition, H.R. 5823 has drawn the strong support of industry groups such as the Commercial Real Estate Finance Counsel, SIMFA and the American Securitization Forum.

Covered bonds function as a cross between an unsecured corporate bond and an asset-backed security, representing both a direct-recourse obligation of the financial institution that issued the bond, and an obligation secured by a specified pool of assets that remain on the financial institution's balance sheet. They are old (like, centuries old) and safe (well, they are supposed to be). Under H.R. 5823, eligible issuers (including FDIC insured depository institutions, bank holding companies and other approved non-bank financial companies) would be permitted to issue covered bonds secured by a pre-defined set of eligible assets (such as commercial or residential mortgage loans) pursuant to an approved covered bond program.

Although H.R. 5823 (again, which is likely to continue to morph as it works its way through the House and Senate and into the Oval Office) is similar in many respects to the previously introduced versions, there is one key pragmatic difference worth highlighting—a difference that will certainly delay the establishment of a covered bond market in the United States. Representative Melissa Bean (D-Ill.) introduced an amendment in the committee process requiring multiple Federal agencies (instead of the Comptroller of the Currency as originally proposed in H.R. 5823) to jointly establish a covered bond regulatory oversight scheme. Workable? Hardly … it’s a bad idea. Given what Fin Reg has already saddled the agencies with, when will they get around to a jointly produced workable oversight scheme? I am not overly optimistic.

Aside from what H.R. 5823 provides in its current form, the more interesting debate is whether any covered bond legislation will create a robust new alternative source of capital for banks and other eligible financial institutions. With deals getting done in 2009, and several more in the pipeline before year end, it’s not at all clear that issuers will jump on the bandwagon. Although there appears to be investor appetite for covered bonds in the United States, and the structure of covered bonds accomplishes Congress’ desire for skin in the game, it’s just not clear eligible issuers will want to keep all of their skin in this game, or whether a covered bond market will provide a cheaper (or even a cost competitive) source of capital. Only time will tell, assuming H.R. 5823 ultimately becomes law. For our part, we welcome the opportunity to do new types of deals.

The good news for proponents of covered bond legislation is that both the House and the Senate seem interested, at least for now, in passing some form of covered bond legislation. We will continue to monitor this proposed legislation as it works its way through the House and the Senate.

Stay tuned…

By Stewart McQueen.

The FDIC is also pressing for the ability to immediately take control of collateral assets to the extent of any over-collateralization, and to extend the period of time allowed for the FDIC to find a purchaser for the failed-issuer’s covered-bond program. Nonetheless, the FDIC appears very open to getting some sort of deal done. Industry groups – including the American Securitization Forum and the Securities Industry and Financial Markets Association – are watching these developments closely and appear encouraged by the ongoing discussions.

For my part, the desire by the industry and regulators alike for a robust domestic covered bond market has reached a critical mass, and we can expect legislation (in some form) to arrive before fourth quarter.
 

Representative Garrett indicated last week at the CREFC conference in New York that he intended to introduce a covered bond proposal.  The proposed amendment directs the Treasury Department to establish a covered bond regulatory oversight program. (NOTE:  A link to the text of the proposed covered bond amendment is contained in this article from the Atlantic).  Under the proposed amendment, eligible issuers (which include FDIC insured depository institutions and bank holding companies) would be permitted to issue covered bonds pursuant to a covered bond program approved by the Treasury.  The issuance would be required to have an original term to maturity of at least 1 year and to be secured by a "cover pool" of eligible assets (and certain substitute or ancillary assets) from a single eligible asset class.  The eligible asset classes include, among others, residential mortgage loans, commercial mortgage loans, student loans, credit card receivables and car loans.

Although far from a done deal, the amendment seems to have some support, and we are optimistic that a regulatory framework for a covered bond market will be part of the final financial reform legislation.  A vibrant covered bond market could provide additional liquidity and financing sources to financial institutions which can only help to spur the recovery of the capital markets.  In addition, the structure of covered bonds seem to accomplish a lot of the stated goals of the financial reform legislation - particularly Congress's desire for "skin in the game", as all of the assets in the "cover pool" will remain on the financial institution's balance sheet.

We will continue to monitor the proposed legislation as it works its way through the reconciliation process.

Stay tuned ...