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"JPMorgan had the option not to take on the covered bonds but wanted the assets attached to them... but if it had not taken on the secured liabilities, it could not have taken on those assets"
Fritz Engelhard, Barclays Capital |
The failure of Washington Mutual does not just spell the end of the largest savings and loan in the US, but also of one of the nation’s two covered bond issuers. At a time when Treasury secretary Hank Paulson is trying to facilitate the launch of domestic covered bonds in the US as a viable mortgage-funding tool, the rescue of WaMu by JPMorgan could have significant implications for that sector. In taking over WaMu, JPMorgan was able to pick and choose which of the failed bank’s liabilities it wanted to take on. It has not taken any unsecured or subordinated debt but it has taken on WaMu’s outstanding covered bonds. "JPMorgan had the option not to take on the covered bonds but wanted the assets attached to them," says Fritz Engelhard, director of European fixed-income strategy at Barclays Capital. "Legally, it was free to decide. But if it had not taken on the secured liabilities, it could not have taken on those assets."
That JPMorgan did indeed take on those liabilities suggests that covered bonds do have a future among US institutions. In such volatile times, it is unlikely that the bank would have taken on the covered bonds had there been any question about their quality. When any party assumes ownership of a bank and its assets, its main interest lies in maximizing returns on those assets. JPMorgan’s absorption of WaMu’s covered bond programme is proof, though an indirect one, that the legal protection on the cover pool assets is strong enough to allow for a takeover of the respective liabilities. This can only be seen as a plus for Paulson’s initiative.
But it is not as positive as all that, and the chances of seeing a functioning US covered bond market in the near future are broadly similar to what they were before WaMu’s collapse. That Fitch subsequently upgraded WaMu’s covered bonds – from triple-B plus to double-A minus – probably had far more to do with JPMorgan’s credit position than with the strength of the covered bonds themselves. "I’d have preferred to see a full stress test on the legal structure, on the cover pool and on whether respective assets would prove sufficient to cover investors," says one analyst.
Tradition of assistance
But the tradition of the covered bond market is that if an issuer does get in trouble, someone will step in and take over, as JPMorgan has for WaMu. Although covered bonds are secured such as to ensure continued payment on the bonds even without a supporting institution, it is far more preferable that they find one. Otherwise, the cover pool becomes static and the bonds assume the dynamics of a traditional ABS structure. In that, the assimilation of WaMu’s covered bonds by JPMorgan shows that the legal structure put in place by the treasury’s best practices guidelines is sound enough to create the right incentives to hold, and ultimately to issue, covered bonds.
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Victim of volatility |
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WaMu 5-year covered bond Q3 2008 spread performance |
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Source: Bloomberg |
In the UK, the nationalization of Bradford & Bingley has offered similar assurances for holders of covered bonds. Although the bulk of the bank’s covered bond issuance has been used as collateral in the Bank of England’s special liquidity scheme, about £9 billion ($16.2 billion) in covered bonds has been sold externally. Although these bonds are protected under the government’s guarantee, it was not immediately apparent that they would be. In the first Treasury statement on the rescue, the Bank of England said that the secured claims of creditors were protected by the guarantee to the extent that the security provided would prove insufficient but covered bonds were explicitly excluded from this protection. However, this seems to have been an oversight, as a follow-up statement some hours later did include covered bonds under the guarantee. "This was only because the people involved don’t really know what a covered bond is," comments a covered bond head.
The latest statement conforms to what covered bond participants had hoped for from the UK Treasury and, along with JPMorgan’s assumption of WaMu’s outstanding issues, is a positive move that goes some way to assuring investors of the safety of the covered bond product and the commitment of governments to seeing it prosper. "Investors should take a huge amount of comfort from this," says Tim Skeet, head of covered bonds at Merrill Lynch. "They will be relieved and pleased to see two Anglo-Saxon governments responding to their needs."