Here’s a not-so-quick note on covered bonds.? What is a covered bond?? It is a form of secured lending, where a bank borrows money and offers a security as collateral.? That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.

It is not a passthrough, it is a bond.? The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.? The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.? Only in default does the value of the security for collateral matter.? If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.

Okay, so we’re talking about a type of secured lending, or secondary guarantee.? That exists in many places in different forms:

• Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
• Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.? Same for auto loans.
• Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
• Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
• Insurance companies in certain large states can set up guaranteed separate accounts.? If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.? The separate account is tested quarterly for sufficiency of assets over liabilities.? If there isn’t enough of a positive margin, more securities must be added.? If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.

That last example, obscure as it is, is the closest to the way a covered bond functions under the current Treasury Department’s statement on best practices for covered bonds.

Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):

Under the current SPV Structure, the issuer?s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.

Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.

In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool?s assets, liabilities, and security pledge on its books and records.

Further collateral requirements:

• Performing mortgages on one-to-four family residential properties
• Mortgages shall be underwritten at the fully-indexed rate
• Mortgages shall be underwritten with documented income
• Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
• Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
• Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
• Mortgages must be first lien only
• Mortgages must have a maximum loan-to-value (?LTV?) of 80% at the time of inclusion in the Cover Pool
• A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
• Negative amortization mortgages are not eligible for the Cover Pool
• Bondholders must have a perfected security interest in these mortgage loans.

Other major requirements (not exhaustive — stuff copied from the report in italics):

• Overcollateralization of 5% must be maintained.? It must be measured each month.? If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
• For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.? If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
• Currency mismatches between the collateral and the currency that the bond pays must be hedged.? Interest rate mismatches may be hedged.
• Monthly reporting with a 30 day delay
• If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
  information to investors.
• The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
• The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.? The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
• The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors? rights in the collateral in the event of an issuer?s insolvency.
• Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer?s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.? As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer?s controls and risk management processes.
• Covered Bonds may account for no more than four percent of an issuers? liabilities after issuance.
• Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a ?Specified Investment?) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.? The purpose of the Specified Investment is to prevent an
  acceleration of the Covered Bond due to the insolvency of the issuer.
• Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.

My Stab at Analysis

The four percent limitation takes a lot of wind out of the sails of this for now.? The regulators are taking this slow.? They want to see how this works before they let it become a large part of the financing structure of the banks.

So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.? In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.? Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.? That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.

Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.? This should provide some support to the jumbo loan market; I didn’t see any size limits.? It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.? Maybe some Alt-A could be done, but I’m not sure.? With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.

For underwriting, an LTV of 80% or better is acceptable.? Other underwriting guidelines are left implicit to guidance given in the past on lending practices.? It’s possible that appraised values could be stretched to meet the 80% hurdle.? It’s happened before.

AAA-rated mortgage bonds are an interesting twist here as well.? I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.? Could a bank contribute a AAA home equity loan to the pool?? I doubt it, but…

Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.? When the securitization market comes back, covered bonds should reduce considerably as a financing source.? Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.? If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.? That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.

Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.? Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.

Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.? They are starting with higher quality collateral; it might get expanded later.? The banks would probably like that.

Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.? Only medium-to-large banks could be able to use it.? I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors. 😉

Second, the inclusion of of a Specified Investment is interesting.? It further constrains what can be done with the proceeds of the bonds, which could be a big negative.? Are banks going to buy GICs from insurers?? BICs from other banks?? I don’t know.? Maybe I am misundstanding that part.

My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.? Why?

• Small size of the program.
• High overcollateralization.
• Mostly (90%+) high quality mortgages can be pledged.
• Capital requirements don’t change because the loans stay on the books.
• Need for the Specified Investment.
• Marginally increases the yields on unsecured debt.

But the benefit they get is a cheap-ish borrowing rate.? Would this get a AAA yield and rating?? Probably.? Is that enough to overcome the negatives?? Well, let’s watch and see, but I would expect it to have less impact than many expect.

PS — One other note: I read this elsewhere today, but Yves Smith points out that covered bond markets can have panics too.? Good to know; nothing is a panacea.