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Capital Markets

US covered bonds: The British are coming

As WaMu issues the first US covered bonds, Ben Maiden looks at the legal implications.

(This article appears courtesy of International Financial Law Review,  sign up for a free trial here)

They've conquered Europe, raising billions of euros for mortgage lenders and banks, and now covered bonds are poised to take on the US. Last month Washington Mutual, often referred to as WaMu, became the first US financial institution to sell covered bonds. In doing so it raised €4 billion ($5.1 billion) and, observers believe, opened the door for a new group of issuers.

New financial instruments are often developed in the US and then exported, giving the law firms that helped structure the first deals a head start in winning follow-on work. The WaMu deal suggests, however, that covered bonds could provide a rare and interesting opportunity for UK firms with US law capabilities and top tier securitization practices to move into the mainstream US structured finance arena.

In the short term US issuers are expected to tap the existing European investor base with New York law-governed bonds. This will give firms such as Allen & Overy, Clifford Chance and Freshfields Bruckhaus Deringer a chance to demonstrate their expertise to a new set of potential clients, which they will hope to hang onto if and when US covered bonds become purely domestic products in the world's largest capital market.

Covered bonds have been a feature of the European financial landscape since pfandbrief were first issued in Germany in 1769 to help rebuild the country following a costly war. Denmark followed suit later in the 18th century in the wake of a devastating fire, and more recently countries such as France (credit foncière) and Spain (cédulas hipotecarias) have created their own forms of the instrument.

Although largely confined to European issuers, the covered bonds market has grown rapidly (see chart below). Worth an estimated $1.7 trillion in outstanding notes, the annual rate of global issuance rose by 78% between 2001 and 2005, according to Dealogic. German pfandbrief continue to be the dominant format, accounting for 40% of all covered bonds issued in 2006 so far. But other countries have joined or are looking to join the fray. Although the first UK deals only launched in 2003, for example, so far this year UK issuers have already raised $15.8 billion, or 6.2% of the international market.

Covered bonds take a variety of forms across Europe and have no global definition. But they share a number of characteristics and are commonly described as debt instruments with recourse to both the issuer and a pool of collateral that is separated from the issuer's other assets. They offer potentially cheaper financing than traditional mortgage-backed securities (MBS) and give financial institutions a new means to diversify their portfolio of debt instruments.

First US issuer

These benefits were key for WaMu when it became the first US issuer to sell covered bonds in September. WaMu, one of the country's largest consumer and small business banks, was also targeting a deep pool of hungry investors. Although the bonds are governed by New York law, they were sold to European issuers under Regulation S. The deal is the first offering of a programme that could raise €20 billion over the next few years, said WaMu treasurer Robert Williams in an interview.

Covered bonds draw on securitization technology but also have different structural features, depending on the specific deal and the country under whose laws they are issued. In UK covered bonds, for example, a pool of loans is transferred to a bankruptcy-remote subsidiary that acts as their guarantor. This is done because the pledging of assets on balance sheets is not possible under English law. In the WaMu deal, by contrast, the loans stay on the bank's balance sheet and are pledged to pay the bonds. Rather than use the residential mortgages in the pool as direct collateral, a mortgage bond is created and sold to a special-purpose entity (SPE) to act as collateral for the covered bonds that the SPE issues in turn.

Keeping the mortgages on the balance sheet is a further advantage to WaMu of using covered bonds rather than traditional MBS financing. Doing so enables the bank to retain control of its assets, which gives it flexibility in dealing with its retail mortgage customers.

As the first US issuer of covered bonds, WaMu was not only breaking new ground financially but was also stepping into a regulatory void. Some European countries, including Germany, Spain and Ireland, have statutory regimes governing covered bonds. Italy recently introduced regulations that should enable deals to start being made by the end of 2006. Other countries, such as the Netherlands and the UK, do not have specific legislation governing the instruments, although many of these are looking to implement laws.

The US also does not have laws that apply directly to covered bonds. In preparing the WaMu deal, therefore, the bank, its arrangers and lawyers had to engage in lengthy discussions with the Federal Deposit Insurance Corporation (FDIC). As has been seen with hybrid securities over the last year, the deal pipeline for new types of instruments can quickly be turned off if regulators make statements or give treatments that are deemed unfavourable by issuers or investors. In the WaMu case, people involved in the talks say that the regulators were curious but generally receptive, although they could not give guarantees as to how they would treat similar offerings in the future.

If, as expected, covered bonds take off among US issuers, law firms will be looking to position themselves to take advantage. The experience of lawyers in the UK over the past few years gives some insight into how this scenario might play out in the US, not least because many of the firms involved are the same and have both US and UK law capacities.

Although the WaMu transaction was very different from a typical UK structure, both sides looked to firms with experience in UK covered bonds. Sidley Austin acted as issuer and transaction counsel on both US and UK matters. Partner Michael Durrer of the firm's London office led the team, which also included Daniel Rossner, Robert Kreitman and William Goldman in New York who advised on US bank regulation, tax and insolvency issues respectively. Clifford Chance was brought in to advise the arrangers, Barclays. Jerry Marlatt in New York led the US team with assistance from Richard Coffman on bank regulatory issues. Debashis Dey of the firm's Dubai office led a group advising on UK law and European covered bond practices. WaMu's in-house counsel on the deal were Charles Smith, Robert Monheit and Cliff Shapiro.

Since the inaugural HBOS Treasury Services offering in July 2003, a handful of firms with top-flight securitization practices have dominated the UK covered bond market, namely Clifford Chance, Allen & Overy, Freshfields and Sidley Austin. Allen & Overy, for example, has advised on the HBOS, Northern Rock (opposite Freshfields) and Bradford & Bingley programmes, generally as issuer counsel. Sidley also acted for Citigroup and Goldman Sachs on the HBOS deal.

This concentration of mandates is due to the specialist nature of the work and also the fact that there have been relatively few clients to go around. Although roughly $50 billion in covered bonds have been issued so far in the UK, this has come from a handful of institutions making repeat draw-downs under multi-billion dollar programmes. Clients rarely change horses during such races and the happy circle of firms that started out has benefited.

While certainly prestigious and a welcome new source of work, as with any new product covered bonds will, over time, become commoditized if and when the sector takes off in the US, as has happened in Europe. Similarly, setting up programmes also involves more work than follow-on offerings. Each deal requires firms to deploy a combination of lawyers with experience in securitization, MTNs, derivatives, bank regulation and tax. Despite this, according to Alan Newton, head of structured finance at Freshfields, if anything covered bond deals are less labour intensive than many securitizations. It is worth noting, however, that although vanilla corporate bonds and MTN programmes have also become commoditized, quick and non-labour intensive, they have also proved to be invaluable backbone streams of work for the large UK and US firms. If the US market releases anything like its potential for covered bonds, firms will want to make sure they can take advantage.

Legal ceiling

But how far can US covered bonds go? The mood so far is bullish. Analysts and bankers have been quoted in press reports describing the market's potential in glowing terms, and the rating agencies (which gave the WaMu deal AAA/Aaa/AAA verdicts) are similarly positive. So are lawyers. "I would expect to see more deals by the end of the year," says David Krischer, a securitization partner with Allen & Overy in London. "Most of these will be sold into Europe, at least initially, which makes sense as that's where the real investor base is."

One factor that could hold back the US market is the lack of statute. Lawyers say they do not anticipate any specific US covered bonds legislation to be introduced in the short term, as the market is too small and too young. The European example, however, suggests that new laws could be on their way within a few years if the bonds take off.

The absence of a formal legal framework can deter nervous issuers and adds to the costs and time involved in doing deals, but need not stop a new product. "The success of the UK covered bonds market has shown that you can develop the necessary structures if you have a bit of regulatory cooperation," says Krischer.

In the absence of suitable legislation, however, UK covered bonds do not comply with the EU's Undertakings for Collective Investment in Transferable Securities (Ucits) Directive, which means that they receive a 20% risk weighting as opposed to the 10% risk weighting enjoyed by legislated bonds such as the pfandbrief. Although there has been sufficient investor demand to keep pulling deals along until now, in the longer term this creates a potential ceiling to growth.

The UK's Treasury views covered bonds favourably and has been working with the country's securities regulator, the Financial Services Authority (FSA), to develop a regime that will enable them to comply with Ucits. "UK covered bonds are based on well-accepted market standards and benefit from a high level of legal certainty," said Ed Balls, economic secretary to the Treasury, earlier this year. As part of these efforts a legal working group including Allen & Overy, Freshfields and Clifford Chance is working with the FSA to determine what, if any, regulation is necessary. According to a letter sent by the FSA to industry groups such as the British Bankers Association in February, the consultation phase is due to close during this quarter and plans for meeting Ucits will be released early in 2007.

In the meantime, lawyers say it is still too early for firms to do much to gear up for the US covered bond market. Even those firms that have been active in the UK market since 2003 have avoided setting up formal covered bond groups, preferring to use ad hoc teams that come together under the leadership of a handful of partners with experience on similar transactions. Now they will be hoping to follow the work as new US issuers step forward.


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