Uncovering the Covered Bond
Misplaced among the turmoil of credit discussions and instrument illiquidity in July 2008, was a U.S. Treasury foundational report entitled “Best Practices for Residential Covered Bonds.” Press releases, television coverage, and congressional announcements hailed the arrival of a 230 year old financial instrument to U.S. markets in late July. Yet what was a “covered bond?”
The recent adoption of covered bonds represented a new “arrow” in the government’s and lender’s rebalancing quiver to melt frozen secondary and private label securitization efforts -- beyond the increasingly burdened GSE’s and their balance sheets. Yet, why now and for what purpose will covered bonds yield to market makers lacking a quality consumer base and fresh capital? Can covered bonds aid with the restoration of the “pillars of faith” that have been destroyed by opaque risks and egregious lending practices?
Globally, covered bonds represent nearly $3 trillion in USD valuation for mostly European entities. These bond classes have a distinctly unique set of intertwined characteristics that include covered pools, over-collateralization, regulatory oversight, required disclosures, on-going individual asset performance, trustees, and SPV (special purpose vehicles) to name but a few.
Operationally, its on-going viability and conformance are managed both quantitatively and qualitatively at a granular level to ensure it retains its senior debt rankings, which remain on the issuing organizations balance sheet. It has a familiar investment “sound” but the “score” to obtain and maintain harmonious investor and market relationships are very different than the MBS approaches (i.e., “originate, tranche, and forget”) of just a few years ago.
Whereas, covered bonds may make good sense for insured, well-capitalized institutions (defined by the Treasury report as “IDI’s”), a pessimist might ask, “Do we have the oversight, processes, and data (i.e., end-to-end solution sets) necessary to maintain the desired AAA ratings assigned to these financial instruments? ” If this question was asked a decade ago, the answer probably would have been “no.”
At that time, the mortgage industry lacked robust standards and data interoperability capabilities needed to ensure the on-going management of a covered bond without extensive manual procedures. Furthermore, the siloed, operational mindset that permeated industry leadership of this period would have probably avoided a “secure” or “senior debt” product in favor of ones with higher returns and off-balance sheet benefits.
Fast forward to what “was the worst month for mortgage-backed bonds since the beginning of the crisis, ” (i.e., July 2008) and the lessons learned are pervasive and numerous. Nonetheless, today we possess the architectonic tools, data, incentives and significantly heightened survival instincts that were unavailable when we entered this millennium.
Driven by visionary individuals and strong industry associations, we now are working with and deploying orchestrated touch point solutions that are not singularly beholden to any one player or market participant. These multiple standard sets are not perfect -- but they have become inherently viable and adaptable in the face of this lengthening credit freeze. Or, to state it another way, standards have found relevancy in the face of growing insolvencies, buy-backs, and loan “supply-chain” or due diligence challenges.
In spite of the sometimes euphoric interest in these “old” financial instruments, moving towards the release of widespread cover bond issues will not be comfortable – for many U.S. depository institutions, investors, and regulators the issuance and monitoring processes are unfamiliar path (see Figure 1).
Figure 1
It is a channel which should be defined collaboratively with oversight authorities, registered securities specialists, and legal advisors to name just a few stakeholder groups. Whereas, the covered bond instrument is intriguing for our distressed markets and their purchase by conservative investors, of greater interest are on-going implications brought to the forefront with their adoption.
The actual deployment and continuing maintenance requires data and operational linkages that have traditionally been fragmented or non-existent. For business operations and the underlying technology, the downstream demands revolve around superior data integrity, exception handling, reporting, and tight interoperability with individual, monthly loan servicing results (see Figure 2).
Figure 2
For covered bond management to work efficiently, mutual exclusivity of data sources and uses will hinder not only investor confidence, but their traditional barrier retention may end up breaching covenants regarding the continuous performance of pledged assets. Furthermore, new knowledge processes must be not only defined, but integrated into existing control structures.
For the decade long standards battles and determinations, it appears that a real test case (e.g., an end-product) may have arose providing the collaborative proving ground for market consistency and wide-spread acceptance. Whereas, “e”-options within the end-to-end processes represents a quantum leap in information accessibility and cost avoidance, the lack of a common end-product needed for leverage was not widely available prior to this.
Although, the infrastructure and applications will be adapted or up-scaled to meet the data and process needs, the real challenge will be surrounding internally available knowledge and clear operational processes. For providers of domestic covered bond services and integrated product offerings (i.e., true knowledge process outsourcing – KPO), covered bonds represent a new effort that intertwines point-based offerings into a holistic one.
The challenge for both the sourcing organization and the third-party provider will center on a quick ability to reach a performance contract with clear gain-sharing attributes. After all, with a nascent market and evolving assumptions, the contractual arrangements of prior efforts may prove of little value or guidance.
Moreover, the often desired command and control governance relationships may prove a huge barrier for lasting success. Look for variable-driven models with risks and operational implementation spread into special purpose vehicles (SPV’s) to aid with the management and on-going conformance of covered assets. A material question is who will be or is prepared to offer sustainable and adaptable assistance in the time periods demanded? Will the operational reality come from internal or external teams?
Covered bonds are a unique offering for a troubled market and skittish investors – regardless of our individual views on disposition of the GSE’s. However, we cannot allow our enthusiasm to overshadow the covered bond’s limited current usage and evolving regulatory demands. They are not a panacea. It is worth noting, that when Secretary Paulson, per his recent statements, steps down in January 2009, his leadership, vision, and managerial skills in transforming arcane 20th century rules into 21st century relevancy will leave a void that must be quickly filled.
Per an American Securitization Forum presentation in February 2008, “Unlike notes and certificates issued in a true securitization, a covered bond is a rate product rather than a credit product. It provides a bullet maturity with little exposure to prepayment or acceleration risk, even if the sponsoring institution were to become insolvent. Since taking its modern form in 1899, no default on a covered bond has been recorded.”
For 2008 MBA entries, click here