US banks pay for covered charge
At the recent Euromoney US Covered Bond Conference in New York there was a clear sense of excitement among investors, bankers and market commentators about the future of covered bonds. What used to be principally a German backwater has become, over the past decade, the biggest, most liquid and highest-rated part of the non-sovereign bond market in Europe. New markets and new segments of existing ones are opening all the time. Recently established markets are maturing, and older markets are updating themselves. It is finally becoming truly global, with investors in Asia, and especially in the US, starting to acknowledge the virtues of covered bonds.
Since the first US domestic covered bond issue, from Washington Mutual, in September, interest in the product among US investors has been increasing. "There has been an overnight change in the US covered bond market," says Derry Hubbard, head of covered bonds at BNP Paribas. "European covered bond issuers have long been trying to deepen penetration into the US investor base."
Stumbling blocks
However, one group that was notably undersubscribed at the conference were the issuers themselves. The potential for domestic, dollar-denominated issuance is huge, as the US mortgage market is so much larger than equivalent European markets. At $13.03 trillion, it is roughly three-and-a-half times the size of the entire European mortgage market. But there are stumbling blocks that could hamper the growth of covered bond issuance in the US.
Recently published research by Credit Suisse suggests that developments in global financial markets have tempered the enthusiasm of investors for US covered bonds. The research argued that investors’ demand for US housing exposure had fallen, and consequently demand for covered bonds backed by US residential mortgages, such as the WaMu issue, had also subsided.
If this is true, investors are guilty of flawed logic. Problems in the US housing market are mostly confined to sub-prime mortgages. WaMu has a large sub-prime mortgage business, but its covered bond is backed by exclusively prime residential mortgages and is robustly structured. Investors should glance at their history books. No covered bond has ever defaulted.
Because US domiciled covered bonds are new, the reception of an issue will be dependent on the parent bank’s reputation among investors. It is likely that investor interest in US covered bond issuance will initially be limited to large, very well respected financial institutions.
Bank of America certainly meets that description. The Charlotte-based bank started a two-week, pan-European roadshow in the second week of March, presenting a €20 billion covered bond programme. "Our objective is to introduce the programme to the widest possible range of individual investors," says Ian Harjette, head of financial institutions at Bank of America.
Evolution
So why is Bank of America instigating a covered bond programme now, when other US institutions seem reluctant to do so? Its officials explain that investor diversification is the key objective. Bank of America’s main funding source has always been deposits, accounting for some 40% of the bank’s funding, which reaches about $30 billion annually. But Bank of America has just under 10% of all US domestic bank deposits. This indirectly acts as an effective cap on potential acquisition because although it is allowed to grow this number organically there are legal restrictions that stop it from buying a bank and increasing its market share over the 10% threshold.
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Sub-prime mortgage turmoil affecting US covered bond spreads |
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As of March 2, 2007 |
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Source: Credit Suisse |
With a loan portfolio of $240 billion, covered bonds are a feasible funding solution for Bank of America. "This is a natural evolution of the mortgage market," says Adam Glassner, global structured finance at Banc of America Securities.
The bank might also be looking to increase the level of its non-dollar-denominated funding activities. Historically, it has had very little in the way of non-dollar funding. In 2006, however, 35% of the bank’s funding was non-dollar-denominated. This figure will rise with the first issue of the covered bond programme, which will be a euro-denominated issue. The bank will diversify the issues to include dollar-denominated covered bonds at a later date. "Our initial focus is on the established European market, but this will eventually be a multi-currency issuance programme," says Harjette. "Our objective is not to rely on any single marketplace."
Bank of America is not planning to overwhelm any one investor group with supply. "We have a €20 billion shelf, which is a big number, but we plan to use it in a responsible way," says Chris Halmy, senior vice-president, corporate treasury, at Bank of America. "We will not be using any sub-prime residential mortgages." Halmy says that he understands that reporting is important and that the bank will align itself with accepted market practices. That said, Glassner points out that the bank does include a significant amount of disclosure in its regular public reporting anyway.
Comparisons will no doubt be drawn between Bank of America’s programme and that of WaMu, both being backed by exclusively prime residential mortgages. Although the two institutions’ business models are different (Bank of America has no sub-prime mortgage business), their respective covered bonds are very much on a par with each other in terms of structure, based on securitization technology and banking regulations in use. Both banks pledge assets to the cover pool but these assets remain on the balance sheet.
Legal issues
The lack of a legal framework and the nature of banking regulations in the US is a major topic of discussion. The strength of the US regulators’ endorsement of this financing tool was a frequent topic of discussion. But it is clear that most market participants believe the existing legal framework is structurally sufficient.
The success of the Bank of America covered bond will also be extremely important for the prospects of further issues by US institutions. Several questions remain unanswered. Will potential US issuers look to issue dollar-denominated bonds, which would mean that the US investor base will be their main target? So far WaMu and Bank of America – with a diversification objective – have sought out euro-denominated transactions.