Securitization: Covered Bonds
The use of covered bonds as a source of home-mortgage funds is being encouraged by the U.S. Treasury Department and the Federal Deposit Insurance Corporation (FDIC) because they offer much greater certainty for the bondholders with respect to damages and rights.
Covered bonds contain a key element that is missing in many commercial mortgagebacked securities (CMBS), i.e., a double layer of protection for investors, with the asset being backstopped by the issuer of the securities. The key difference between CMBS and covered bonds is that the latter requires lenders to retain the default risk. On the other hand, covered bonds fail to provide a good option for private labels because they require a capital base to retain loans on balance sheets and do not provide the higher level of leverage that was available with CMBS.
Simply stated, covered bonds are recourse debt obligations of an insured depositary institution (M1). The bonds are secured by a dedicated pool of mortgage loans known as a “cover pool.” Although covered bonds have been widely used in Europe, only two banking institutions appear to have issued such bonds in the U.S., according to the Treasury, which said it was looking for ways to increase the availability and lower the cost of mortgage financing to accelerate the return of normal home financing and refinancing activity.
Covered Bond-MBS Comparison
Covered bonds, issued by banks and other depositories, are collateralized by a pool of residential mortgages, but they differ in a number of ways from traditional mortgagebacked securities (MBS). Whereas mortgages packaged and sold to investors through MBS usually are removed from the issuer’s balance sheet, mortgages in covered bonds must remain on the balance sheet of the lender, thus tying risk to those responsible for issuing the bonds. The cover pool securing the bonds consists of a portfolio of actively managed residential mortgages that exceeds the amount of the bonds. If any of the mortgages in the pool become non-performing, they must be replaced by the issuer of the bonds.
Although the bondholders have a security interest in the mortgage pool, they receive payments from the issuer’s general cash flow, rather than simply receiving pass-through payments on the underlying mortgages. Also, in the event of an issuer default, if the pool is insufficient to redeem the bonds at par, bondholders retain an unsecured claim on the issuer along with other unsecured creditors. Under Treasury’s best practices policy, covered bond issuers could be either depository institutions and/or their wholly owned subsidiaries or a newly created, bankruptcy-remote special purpose vehicle. Under either of these structures, the cover pool would be owned by the depository institution, and its assets and liabilities would be clearly identified on the institution’s books. Covered bonds could account for no more than four percent of an issuer’s liabilities (inclusive of the bank’s), and each covered bond would have to have a specified investment to prevent acceleration of the bond in the event of the issuer’s insolvency.
Collateral
Collateral in the cover pool would have to be first-lien one-to-four-family mortgages underwritten with documented income of the borrower and, for adjustable-rate mortgages, at the fully indexed rate. The maximum loan-to-value ratio for a mortgage is in the pool would be 80 percent, and negative amortization would not be permitted. Mortgages would have to be current when added to the pool, and any mortgages that become more than 60 days past due would need to be replaced. Issuers at all times would need to maintain over-collateralization of at least five percent of the outstanding principal balance of the bonds. Issuers would need to perform a monthly asset-coverage test to ensure the quality of the collateral and the proper level of overcollateralization and make any necessary substitutions in the pool.
Conclusion
It should be noted that while the use of covered bonds could help stabilize the U.S. home-mortgage market, most private analysts do not view covered bonds as a cure-all for the many problems facing the market, especially in light of the rating methodology recently published by Standard & Poor’s for covered bonds. Because the U.S. does not have covered bond legislation or a proven tax record for the bonds, S&P has proposed to place covered bonds in the highest risk category. This may change if new legislation is enacted. Nevertheless, covered bonds may become a powerful source of liquidity in mortgage markets because they offer a unique combination of stability and return.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Anthony La Malfa is a manager in the Real Estate and Hospitality Services Practice in BDO's New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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