Any number of banks in the United States have been courting, in a desultory sort of way, the covered bond. The Street has been scratching its head for many years trying to determine whether a U.S. covered bond could be done and, if so, whether it would be good. Congressman Garrett, who certainly can’t be faulted for lack of effort, has repeatedly introduced covered bond legislation, the most recent one of which was captioned the United States Covered Bond Act of 2011. As those with nothing better to do than follow the covered bond sausage-making know, an effective U.S. covered bond market really does require enabling legislation, which we do not have for a number of reasons, including the unremittant hostility of the FDIC.

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