What is a Covered Bond?

What is it about covered bonds which makes them so impervious to English? Hank Paulson had nice things to say about them today, but if you didn’t know what they were already, the WSJ explanation would hardly shed much light on the matter:

Covered bonds, which are widely used in Europe, are a mortgage-backed security that usually provides funding to a commercial banks through a secured debt instrument collateralized by a pool of residential mortgage loans that remain on the issuer’s balance sheet. Interest is paid to investors from the issuer’s cash flow, as Mr. Paulson noted.

In an FT article at the end of June, John Murray Brown described Irish covered bonds thusly:

The Irish covered bond – branded as an “asset covered security” or ACS – is a bond underpinned by Irish legislation and backed by a ring-fenced pool of assets on the issuer’s balance sheet.

It is essentially a secured debt instrument that enjoys special status under the European Union’s rules – specifically the directive for undertakings for collective investments in transferable securities, known as Ucits, introduced in 1988…

Maybe the problem is that these things are basically German, and no one can translate German into English:

Mr Parker says it is a well-established funding tool in continental Europe, particularly in Germany where initially it was used to finance public sector loans but later evolved as a means to refinance residential mortgages, as well as for ship financing. The German Pfandbrief bond was the model for the Irish ACS.

Mr Parker, who was a member of the team that drafted the Irish legislation, says there was no English translation of the German code. “It was very difficult to find out how the code actually worked because for many people it was almost an act of faith,” he says.

Since I’m in Germany right now, maybe I can do better.

Banks have assets and liabilities. If the bank borrows money from individuals, the liabilities are called "deposits". Alternatively, the bank can borrow money from other banks, in the interbank market, or from the Federal Reserve. All of those borrowings are unsecured, and more creditworthy banks pay lower interest rates than less creditworthy banks in the interbank market. Banks can also issue bonds, if they want, which are also unsecured, and which can have much longer tenors – sometimes they’re even perpetual.

Recently, the market has been having a lot of concerns about the creditworthiness of banks in general. Interbank borrowing costs have gone up, while the prices of banks’ bonds have gone down. In such a situation, one way of bringing down borrowing costs is to borrow against collateral – secure the debt, rather than issuing unsecured debt.

Now historically, banks haven’t done this. If they have a pool of assets they want to secure, they’ll securitize it – basically, sell the assets outright to an off-balance-sheet special purpose entity for which they have no legal responsibility. In return for the assets they get cash on the barrelhead – they’re not borrowing money they’ll have to pay back in future.

But the securitization market, too, is broken right now. Investors have very little trust in the banks’ assets, which are things like mortgage loans. If the banks try to sell the loans outright, they won’t get much money for them.

Enter covered bonds.

With a covered bond, the bank doesn’t sell its assets (in this case, its mortgages); rather, it continues to own them, and it borrows money against them. If the bank ends up going bust, the lender can take possession of the underlying assets – the mortgages. But until then, the lender doesn’t own the mortgages, it just has a debt obligation of a bank.

There are two good things about covered bonds. The first is that because they’re secured rather than unsecured, they’re less risky than plain vanilla bank debt, which means that they constitute low-cost funding for the bank in question. And the second is that because the mortgages remain on the bank’s balance sheet rather than being securitized and sold off into the market, no one’s trying to sell mortgages in an environment in which the very concept is borderline toxic.

Now it’s true that covered bonds are, technically, mortgage-backed. But all the mortgages could default and go into foreclosure tomorrow, and so long as the bank remains in operation, the covered bond will pay out as normal. Similarly, if the bank blows up for some non-mortgage-related reason, investors in the bond will still get paid back in full. Their main risk is that the bank blows up because the mortgages blow up, and they’ll be left holding a bag of damaged loans – but because two things have to happen rather than just one, that risk is relatively low.

Could covered bonds be part of the solution to the current credit crisis? Paulson thinks so, and so do I. They’re not a panacea, by any means. But they certainly can’t do any harm, and they might be able to do some good.

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