Bert Ely's Viewpoint "Unleashing Covered Bonds in the U.S." [June 13] gave a great overview of covered bonds as an asset class and their potential to become a major source of mortgage funding in the United States, pending regulatory clarity.
Some institutions here do not need to wait before getting into covered bonds — the U.S. branches or subsidiaries of banks in European countries that already have a mature bond program. U.S.-based banks can use the European model to prepare for their own eventual issuances.
Many European countries have legislation governing covered bonds. The legislation differs by country and is most mature in Germany, where the bonds are known as Pfandbriefs and have been utilized for many years.
Many U.S. branches or subsidiaries of European banks are working furiously to get their commercial mortgage assets into their parents' covered bond pools; some will not even originate loans that cannot be funded in this manner. With country-dependent variations, this process entails the following types of activities.
Determining eligibility. In the initial underwriting stage, a loan must be evaluated to see if it is eligible for the pool under the legislation of the country in question.
Eligibility involves meeting certain risk tolerances: a maximum loan-to-value ratio of 60% in Germany, Aaa-Aa2 ratings in the Netherlands, etc.
Ensuring consistent underwriting. The mortgages must be underwritten consistently within and across property types, so that aggregate cover pool reporting is meaningful.
Ensuring independent valuations. For German bonds, an individual with appropriate credentials from the union of issuing banks must create an independent mortgage valuation. Banks with an appraisal group that is independent and separate from the mortgage origination function can do this internally.
Preparing documentation. A full loan package will need to be sent to the appropriate pool monitor or trustee in the home country for review of eligibility.
U.S. banks looking to issue covered bonds should adopt the following "best practices" of some of the European programs and provide the same type of framework that make European issuances feel safe to investors.
Quarterly data disclosure. Unlike securitization, assets can go in and out of covered bond pools. Disclosing the pool's loan content each quarter ensures transparency, so that the required asset-quality level is maintained (e.g., no trying to slip subprime loans into the pool and hope no one notices).
Minimum overcollateralization. Covered bond legislation tends to require overcollateralization of anywhere from 2% all the way up to 8%.
Standard & Poor's Corp. took a "dynamic" approach to the U.S. covered bond offering by Washington Mutual Inc., where the amount of overcollateralization required could be adjusted quarterly according to their analysis of the pool's current makeup.
Ongoing asset monitoring. The pool will need to be subject to a periodic asset coverage test to ensure that the adjusted aggregate loan amount is equal to or greater than the aggregate principal amount of the outstanding bonds, not including any overcollateralization requirements.
An independent asset monitor should be appointed to test and verify the asset coverage. (Deutsche Bank Trust Co. played this role for the Wamu deal.)
European financial institutions have often wondered why the United States was never interested in emulating their successful covered bond experience, and U.S. institutions typically have looked at those programs as staid and unexciting.
In the current credit crisis, staid and unexciting products are just what investors are looking for, and U.S. covered bonds are well positioned to meet this demand and provide a new source of liquidity for mortgage lenders.