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Chapter 7
Alternative Funding Sources
§ 7:1 Reasons for Issuers to Consider Covered Bonds
§ 7:1.1 Generally
§ 7:1.2 Issuer Advantages
[A] Generally
[B] Competitiveness Versus FHLB Advances
[C] Diversification
[D] Longer Maturity Financing
[E] Operational Flexibility
[F] Overcollateralization
§ 7:1.3 Issuer Disadvantages
[A] Capital Relief
[B] Prepayment, Default, and Interest Rate Risk
[C] Consequences of Default
[D] Regulatory Risk
[E] Counterparty Risk on Swaps
[F] Issuance Limit
§ 7:1.4 Investor Advantages
[A] Generally
[B] Dual Recourse Structure
[C] High Credit Quality
[D] Lack of Prepayment Risk
[E] Attractive Yield
[F] Liquidity
§ 7:1.5 Investor Disadvantages
[A] Generally
[B] Lack of Legislative Framework
[C] Decline in Appetite for U.S. Financial Sector Exposure
§ 7:2 Historic Funding Model for U.S. Mortgage Loans (Housing Finance)
§ 7:2.1 Development of GSEs
§ 7:2.2 FHLB
[A] Generally
[B] History
[C] Ownership Structure
7–1
§ 7:1 COVERED BONDS HANDBOOK
[C][1] Generally
[C][2] Dividends
[D] Financing
[E] Advances
§ 7:2.3 GSE and Private Securitization
[A] Early Days of MBS
[B] CMOs
[C] Structuring Non-Agency MBS
[D] Credit Enhancement
[E] Subprime Market
§ 7:2.4 Growth of the Securitization Market
[A] Growth of the Agency and Non-Agency Markets
[B] Factors Driving the Growth of Mortgage Securitization
§ 7:3 Securitization Compared to Covered Bonds
§ 7:3.1 Recourse and Credit Enhancement
§ 7:3.2 Prepayment Risk
§ 7:3.3 Accounting
§ 7:3.4 Liquidity
§ 7:3.5 Ratings
§ 7:3.6 Assets
§ 7:3.7 Investors
§ 7:4 FHLB Advances Compared to Covered Bonds
§ 7:4.1 Assets/Collateral
§ 7:4.2 Recourse
§ 7:4.3 Member Credit Limits
§ 7:4.4 Term Structure
§ 7:4.5 Potential for Regulatory Reform
§ 7:4.6 Funding Cost
§ 7:5 Prospects for Covered Bonds in the Post Financial Crisis Economy
§ 7:1 Reasons for Issuers to Consider Covered Bonds
§ 7:1.1 Generally
Covered bond issuance provides an opportunity for U.S. mortgage
finance institutions to diversify their funding sources at competitive
rates, extend their liability profile, and gain certain operational flex-
ibility.1 To date, U.S. issuer experience has also identified strong investor
interest for both Euro and U.S. dollar denominated issues. The mature
covered bond market in Europe and the nascent U.S. market represent
untapped sources of funding for mortgage finance institutions. Although
covered bonds are not a familiar asset class in the United States, their
long track record and broad appeal to EU and international investors
1. Alex Chambers, Washington Mutual Pushes on the Funding Frontiers,
EUROMONEY, Nov. 1, 2006 [hereinafter Chambers, WaMu].
7–2
Alternative Funding Sources § 7:1.1
make them a competitive source of finance for U.S. issuers in Europe
and a source that has growth potential in the United States.2
For the last thirty years, a large portion of residential mortgage
lending in the United States has been financed through Agency
securitization. The preferential status of the Government Sponsored
Enterprises (GSEs), so called because they were established under
government charter, specifically the Federal Home Loan Bank System
(FHLB) and three agencies: Fannie Mae, Ginnie Mae, and Freddie Mac
(the “Agencies”), lowers their cost of funds, and has allowed them to
develop economies of scale. These institutional features of the U.S.
housing finance market do not exist in Europe where, partly as a
result, covered bonds play a more dominant role. However, with the
viability of U.S. covered bonds proven, U.S. originators may now
consider covered bond issuance as an alternative to securitization,
FHLB Advances, or even unsecured debt issuance.3 Originators face
five main financing options:
• fund mortgage lending without selling the loans or using them
as collateral (for example, with unsecured debt);
• keep the mortgages on their balance sheet, and fund lending by
taking an FHLB Advance with loans as collateral;
• keep the mortgages on their balance sheet, but fund by issuing
covered bonds with loans as collateral;
• perform a private securitization; or
• sell the mortgages to a GSE (for conforming loans) or to another
issuer of mortgage-backed securities (MBS).
As described in chapter 8, the U.S. covered bond structure was
pioneered by Washington Mutual (“WaMu”) and Bank of America
(BOA). An “Institution” using this structure to set up a covered bond
program establishes a Trust, which issues the Covered Bonds.4 Unlike
a special purpose vehicle (SPV) used to issue MBS, the covered bond
Trust does not hold the collateral pool of mortgages. The cover pool
remains on the Institution’s balance sheet and is used as collateral for
2. Central banks around the world invest in non-Euro denominated covered
bonds to diversify their growing currency reserves. By 2006, the out-
standing balance of U.S. dollar denominated covered bonds approached
$60 billion. Ted Packmohr & Dresdner Kleinwort, Covered Bonds Going
Global, in ECBC EUROPEAN COVERED BOND FACT BOOK (Aug. 2007)
[hereinafter EUROPEAN COVERED BOND FACT BOOK], at 50–51.
3. See, e.g., BERND VOLK, DEUTSCHE BANK GLOBAL MARKETS RESEARCH,
FIXED INCOME, OVERVIEW COVERED BONDS, NO HOMOGENEOUS MARKET
(Feb. 13, 2008) [hereinafter DEUTSCHE BANK 2008], at 174.
4. In contrast, the U.K. and Dutch model involves the bank itself issuing the
covered bonds. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 20.
7–3
§ 7:1.1 COVERED BONDS HANDBOOK
floating rate Mortgage Bonds of the same face value as the Covered
Bonds. The Mortgage Bonds are sold exclusively to the trust in return
for the proceeds of the Covered Bond offering. The Trust uses a swap
agreement with a third party to exchange floating rate U.S. dollar
income from the Mortgage Bonds for fixed rate Euro denominated
coupon payments paid on the Covered Bonds.5 A similar structure is
illustrated in Figure 6-6.6
The Trust uses a guaranteed investment contract (GIC) or an
equivalent deposit agreement to ensure Covered Bond coupon pay-
ments continue to be made in the event of an acceleration of the
Mortgage Bonds. In this case, the Mortgage Bond proceeds are
invested in the GIC (or under a deposit agreement), and a pre-
determined rate of interest income from the GIC is paid to the relevant
swap provider that in turn pays the interest due on the relevant series
of Covered Bonds.7
The Institution can substitute assets in and out of the dynamic
cover pool as long as the pool assets pass the Asset Coverage Test. 8
Accordingly, the aggregate principal amount of mortgages in the pool
is equal to or greater than the agreed multiple of the aggregate unpaid
principal amount of the outstanding Mortgage Bonds. The recom-
mended minimum multiple of collateral to bond principal is 1.05—
that is, overcollateralization of at least 5%.9 Assets must also be added
to the pool in the event of mortgage defaults or prepayment. 10 The
Institution retains prepayment risk and to the extent that fixed rate
mortgage loans make up the cover pool, an interest rate mismatch
5. The swap provider is also required to make payments on the Covered
Bonds on behalf of the Issuer for up to ninety days after the appointment of
the FDIC. This makes it possible for the FDIC to facilitate the acquisition
of the cover pool and Mortgage Bond liabilities without acceleration of the
Covered Bonds. See BANC OF AMERICA SECURITIES LTD., BASE PROSPECTUS
(Mar. 29, 2007) [hereinafter BOA PROSPECTUS], at 108–09.
6. A similar structure was used in the Bank of America €20 billion March
2007 Covered Bond Program. See BOA PROSPECTUS, supra note 5, at 1.
7. The integrity of the Covered Bonds is further protected by provisions of the
swap agreement that require the swap provider to continue to make
Covered Bond coupon payments in the absence of interest from the
Mortgage Bonds for up to ninety days after the appointment of the FDIC
as receiver or conservator. This provides a window of opportunity for the
FDIC to arrange a transfer of the cover pool and Mortgage Bond liabilities
to a successor institution and to avoid Mortgage Bond acceleration.
8. BOA PROSPECTUS, supra note 5, at 3.
9. U.S. DEP ’T OF TREAS., BEST PRACTICES FOR RESIDENTIAL COVERED BONDS
(July 2008).
10. Either Eligible Mortgage Loans or Substitution Assets may be added to the
cover pool. Substitution Assets may not exceed 10% of the cover pool
assets, but may consist of cash, government or corporate securities of
sufficient credit quality, or U.S. dollar MBS. See, e.g., BOA PROSPECTUS,
supra note 5, at 115.
7–4
Alternative Funding Sources § 7:1.2
between fixed rate mortgages and the floating rate Mortgage Bonds,
which is not hedged by the structure.11 An unhedged asset-liability
mismatch also results from any difference between the weighted
average maturity of the mortgages and the maturity of the Mortgage
Bonds. Cash collections are commingled with other funds of the
Institution, except in the event of downgrade of the Institution, 12
which triggers the segregation of cash collections from the cover pool
into a separate Mortgage Bond account.
§ 7:1.2 Issuer Advantages
[A] Generally
The first U.S. issues have shown that covered bonds can provide a
competitive source of finance for U.S. institutions. They also offer
other advantages described further below, specifically: diversification of
funding, longer maturity financing, operational flexibility, and poten-
tially less burdensome collateral rules.
So called “Jumbo” (or “benchmark”) covered bonds were first intro-
duced in 1995 in Germany (“Jumbo Pfandbriefe”) and soon became a
recognized asset class with participation of issuers from other European
countries starting in 1999.13 The innovative application of structured
finance in 2003 first enabled the critical dual recourse feature to be
engineered without covered bond legislation.14 These events contributed
to the growth in interest in covered bonds and attracted issuers of
different nationalities to the market. From 2001 to 2007, the number of
different countries originating covered bonds expanded dramatically
such that the share of Jumbo covered bond issuance represented by
German Pfandbriefe dropped from 87% to 36%.15 By 2007, structured
covered bonds represented 32% of Jumbo issuance.16
11. DEUTSCHE BANK 2008, supra note 3, at 174–78.
12. In the case of BOA, a change in the long-term senior unsecured credit
rating to or below “Baa1” by Moody’s or a reduction in the short-term
credit rating to or below “A-2” by S&P or “F2” by Fitch. BOA PROSPECTUS,
supra note 5, at 93.
13. Distinct from traditional Pfandbriefe, which were originally issued by
specialist mortgage banks under special public supervision, Jumbo covered
bonds must meet certain industry defined criteria designed to attract
international institutional investors, and support secondary market trad-
ing. Jumbo Pfandbriefe must have a volume of at least 1 billion Euros and
the market making commitment of at least five investment banks. These
are obliged to quote bid and ask prices frequently to ensure tradability. See
Association of German Pfandbrief Banks (“Verband Deutscher Pfandbrief-
banken” or “vdp”) Home Page, available at www.pfandbrief.de/cms/_internet.
nsf/tindex/en.htm.
14. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 20.
15. DEUTSCHE BANK 2008, supra note 3, at 17.
16. Id. at 1.
7–5
§ 7:1.2 COVERED BONDS HANDBOOK
It took three years following the first structured covered bond issue
for the first U.S. institution to enter the market. Since then issuance by
U.S. institutions has not grown as it has elsewhere.17 This is no doubt in
part due to the continuing dominance of U.S. mortgage finance by the
GSEs, including the FHLB, that enjoy a lower cost of funds by virtue of
the government guarantee implicit in their charters.18 The incipient
growth in covered bond issuance by U.S. institutions,19 which resulted
in several new issues in 2007, was also stunted by the collapse of the
subprime market and ensuing financial crisis.20
[B] Competitiveness Versus FHLB Advances
FHLB Advances are similar to U.S. covered bonds in that they
provide financing for a pool of mortgage assets that remains on the
institution’s balance sheet but is pledged as collateral. However, the
collateral requirements imposed by the FHLB differ from those asso-
ciated with U.S. covered bonds and may be more restrictive. Further-
more, the available credit from the FHLB System to particular
members (for longer maturity Advances in particular) is limited,
making covered bonds more attractive for institutions that would
otherwise be heavily reliant on the FHLB. As with the collateral
pledged to the FHLB as security for Advances, mortgages used to
collateralize covered bonds need not conform to the requirements for
Agency MBS issuance.
As shown in Figure 7-1 below, notwithstanding their novelty, the
first U.S. covered bond issued by WaMu on September 27, 2006, were
priced at 3 basis points above the swap rate for the five-year maturity
issue.21 These issues were fixed rate, triple A-rated, Euro denominated
bonds,22 and had yields somewhat higher than a representative
Pfandbrief for one of the major German issuers.23 This compares to
prevailing FHLB Advance rates of about 10 basis points, and A-rated
unsecured bonds for financial institutions of about 20 basis points.
These relative spreads above the swap rate remained about the same
on average through the onset of the financial crisis on August 9, 2007,
17. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 19.
18. See infra section 7:2.
19. In addition to WaMu and BOA, Wachovia was reported, as early as October
2006, to be preparing to issue covered bonds. Alex Chambers, Covered
Bonds: Wachovia is the Next US Issuer, EUROMONEY, Oct. 1, 2006.
20. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 20.
21. DEUTSCHE BANK 2008, supra note 3, at 174.
22. Id.
23. Deutsche Pfandbrief AG is the issuer of one of the ten largest covered bond
transactions (listed by Bloomberg Finance L.P. as the issuer of the January
2004 Hypo Real Estate Holding AG issue) during the five years ending
August 2008. Press Release, Dealogic, Dealogic Covered Bond Review
(Aug. 20, 2008) [hereinafter Dealogic Press Release].
7–6
Alternative Funding Sources § 7:1.2
when the U.S. Federal Reserve cut its discount rate to avert a stalling of
the entire banking system.24
Figure 7-1
WaMu and BOA Covered Bond Yields
The FHLB System, like the other GSEs, enjoys a privileged status
that lowers its cost of borrowing, making it an attractive low-cost
source of mortgage loan financing. However, heavy reliance on FHLB
Advances, as has been common for the large U.S. mortgage banks, 25
can expose bank borrowers to liquidity risks. FHLB banks determine
the credit and terms available to its members, and these terms can
24. On August 6, 2007, American Home Mortgage Investment Corp. declared
bankruptcy, a week after it announced its inability to fund lending
obligations. On August 9, 2007, BNP Paribas froze redemptions for three
investment funds, due to inability to value structured products. Following
this event, a variety of market signals showed that money market parti-
cipants had become reluctant to lend to each other. A wave of inter-bank
market illiquidity started on August 9, causing LIBOR to rise and the
freezing up of the inter-bank market on August 9. In response, the
European Central Bank injected €95 billion in overnight credit into the
inter-bank market, with the U.S. Federal Reserve injecting an additional
$24 billion. Markus K. Brunnermeier, Deciphering the Liquidity and Credit
Crunch 2007–2008, 23 J. ECON. PERSPECTIVES 84–85 (Winter 2009).
25. Chambers, WaMu, supra note 1.
7–7
§ 7:1.2 COVERED BONDS HANDBOOK
change as a result of market conditions or the performance of a given
member.26 The terms of credit for FHLB banks also depend on the
concentration of the banks’ own portfolio of Advances outstanding.
Consequently, FHLB member banks with the largest exposure offer
loan terms that reflect the greater credit risk these borrowers pose,
creating additional incentives for diversification.
The actual terms of FHLB Advances to WaMu illustrate the relative
appeal of covered bonds in 2006. As shown in Figure 7-2 below, at the
end of the year, the $44 billion in outstanding FHLB Advances bore a
weighted average interest rate more than 1 percentage point higher
than the rate for their outstanding covered bonds and were secured
with significantly more collateral.
Figure 7-2
WaMu Interest and Collateral Terms of
FHLB Advances and Covered Bonds
26. “The FHLBanks generally establish an overall FHLBank credit limit for
each borrower, which caps the amount of FHLBank credit availability to
such borrower. This limit is designed to mitigate the FHLBanks’ credit
exposure to an individual borrower, while encouraging borrowers to
diversify their funding sources.” FHLB, CONSOLIDATED FINANCIAL STATE-
MENT (2007) [hereinafter FHLB CONSOLIDATED FIN. STATEMENT], at 100.
7–8
Alternative Funding Sources § 7:1.2
[C] Diversification
Covered bonds provide an opportunity to diversify sources of
finance by accessing the European market through secured debt
offerings that are familiar and appealing to a broad base of previously
untapped investors. Although a domestic market may yet develop,
U.S. dollar denominated covered bonds have historically had a small
domestic client base, but are sold to Asian central banks investing
their currency reserves.27 By establishing a European covered bond
program, U.S. issuers have the ability to issue a series of Euro
denominated bonds at future dates, thereby providing a source of
standby liquidity outside the U.S. market. According to the Associa-
tion of German Pfandbrief Banks:
Because the Pfandbrief ’s credit quality is recognized at home and
abroad, issuers are also able to raise liquidity in more difficult
times […] The Pfandbrief market as a “market of last resort”
mobilizes liquidity in situations in which it is otherwise not
available, or available only at appreciably less favorable
28
conditions.
The benefits of diversification were illustrated during the months of
August to December 2007—the onset of the financial crisis—when the
Pfandbrief banks raised a total of €58 billion (more than a proportional
share of the total annual issuance in 2007 of €135 billion), including
€8 billion in Jumbo issues and add-ons, representing 14% of the
total.29 Typically, Jumbo covered bonds represent about a third of
Pfandbriefe issues, so evidently the Jumbo market was more adversely
affected by the financial crisis than the traditional market, but
continued to support new issues.30
[D] Longer Maturity Financing
More than half of all FHLB Advances are due within two years; only
31% are due in more than three years; and 15% are due in five or more
years.31 This aggregate profile of redemption terms and the member-
specific credit limits imposed by FHLB may explain why it was
difficult to obtain Advances with maturities longer than three years,
according to WaMu at the time of their inaugural covered bond issue. 32
27. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 20.
28. Association of German Pfandbrief Banks, Presentation: The Pfandbrief—A
Premium Product (Feb. 26, 2008).
29. Id.
30. Id.
31. FHLB CONSOLIDATED FIN. STATEMENT, supra note 26.
32. Chambers, WaMu, supra note 1.
7–9
§ 7:1.2 COVERED BONDS HANDBOOK
Covered bonds, on the other hand, are commonly issued in Europe
with five- and ten-year maturities.33 As such, they provide a means for
mortgage banks to extend their liability profile to match more closely to
the average maturity of mortgage assets. Rating agencies look for issuers
to reduce the mismatch in the average maturities of financial institu-
tions’ assets and liabilities. Doing so reduces the need for repeated
shorter-term financing, which imposes refinancing/liquidity risk.
[E] Operational Flexibility
Retaining mortgage assets on a bank’s balance sheet provides opera-
tional flexibility to substitute specific pledged assets in and out of the
dynamic cover pool, thus allowing the bank to modify the use of specific
assets as business conditions change over time. Rules governing cover
pools are typically less restrictive than rules governing collateralization
of FHLB Advances. Thus, covered bonds offer additional operational
flexibility over FHLB financing.34 For example, covered bonds allow a
bank greater freedom to deal with its customers, including changing the
terms of individual mortgages through modifications or workouts,
which would not be allowed for assets pledged to the FHLB.35
[F] Overcollateralization
The Federal Deposit Insurance Corporation (FDIC) Covered Bond
Policy Statement limits covered bond collateral at the time of issuance
to first-lien mortgages on one-to-four family homes and AAA-rated
MBS (up to 10% of the pool).36 The mortgages must be underwritten
in accordance with interagency guidance. The Treasury Department
Best Practice specifies a minimum overcollateralization rate of 5% and
maximum loan-to-value ratios of 80%.37 Collateral arrangements for
FHLB Advances vary based on borrower credit quality, but are generally
more burdensome. Categories of collateral eligible to secure Advances
include: single or multifamily mortgage loans or securities represent-
ing such mortgages, Agency securities, cash or deposits with the
33. In the first half of 2006, the average European Jumbo Covered Bond issue
had a ten-year maturity. Since then average maturities have declined. BERND
VOLK, DEUTSCHE BANK GLOBAL MARKETS RESEARCH, FIXED INCOME, OVER-
VIEW COVERED BONDS, ADJUSTING TO THE NEW MARKET (Feb. 4, 2009)
[hereinafter DEUTSCHE BANK 2009], at 7–8.
34. The risk of adverse selection by an institution through substitution of low-
quality for high-quality assets in the pool is limited by the monitoring of
the cover pool by the independent Asset Monitor. See, e.g., BOA PRO-
SPECTUS, supra note 5, at 112.
35. DEUTSCHE BANK 2008, supra note 3, at 6.
36. FDIC, Covered Bond Policy Statement, Final Statement of Policy, 73 Fed.
Reg. 43,754 (July 28, 2008) [hereinafter FDIC Policy Statement].
37. The maximum loan-to-value ratio of mortgages in the JPMorgan/WaMu
issue is 75%. DEUTSCHE BANK 2008, supra note 3, at 174.
7–10
Alternative Funding Sources § 7:1.3
FHLB, and certain qualifying securities or real estate-related collat-
eral.38 The FHLB collateralization rates also vary over time with
changes in market conditions and borrower credit quality. For single
family mortgages, 15% to 30% overcollateralization is typical. 39 For
WaMu, as shown in Figure 7-2 above, their collateralization rate for
FHLB Advances was higher than its Covered Bond issues.
§ 7:1.3 Issuer Disadvantages
[A] Capital Relief
The mortgage assets used to collateralize U.S. covered bonds
remain on a bank’s balance sheet and, consequently, impose a capital
charge. This is also the case for the collateral pledged against FHLB
Advances, but capital charges can be avoided when loans are sold to
GSEs. When used as collateral in private MBS, the mortgage loans are
sold to a SPV and, therefore, do not impose a capital charge. However,
equity or subordinated tranches commonly held by issuers are subject
to risk-based capital charges. Under Basel II, keeping mortgage assets
on-balance-sheet will become less costly because associated capital
requirements have been reduced from a risk weighting of 50% (under
Basel I) to a risk weighting of 35%40 (under the Basel II “standardized
approach”), or as low as 13% (under the Basel II “internal ratings-based
approach”).41 The equity tranche of any securitization is deducted 50%
from Tier 1 and 50% from Tier 2 capital. The net effect of these changes
is to make on-balance-sheet strategies superior to securitization
from the perspective of capital charges, unless issuers can sell equity
tranches to the market.42 Market conditions alone would make this
hard to do, but in addition, regulatory reforms are quite likely to require
greater risk retention by MBS issuers.43 Thus, Basel II, in addition to
providing capital relief for on-balance-sheet mortgage financing, has also
reduced capital arbitrage possibilities that were “often an important
driver of the use of RMBS under Basel I.”44
38. FEDERAL HOME LOAN BANK, CONSOLIDATED FINANCIAL STATEMENT 99
(2007).
39. See infra section 7:4.1. MORRISON & FOERSTER LLP AN UPDATE ON
,
COVERED BONDS (Apr. 1, 2009) [hereinafter MOFO, AN UPDATE ON
COVERED BONDS].
40. DEUTSCHE BANK 2008, supra note 3, at 8.
41. Application of the standardized approach or internal rating approach
depends on the level of sophistication of risk management systems.
EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 27.
42. DEUTSCHE BANK 2008, supra note 3, at 8–9.
43. See, e.g., MORRISON & FOERSTER LLP FDIC EXTENDS SECURITIZATION SAFE
,
HARBOR AND PORTENDS FURTHER SECURITIZATION REFORMS (Nov. 18, 2009)
[hereinafter MOFO, FDIC EXTENDS SECURITIZATION SAFE HARBOR].
44. DEUTSCHE BANK 2008, supra note 3, at 8–9.
7–11
§ 7:1.3 COVERED BONDS HANDBOOK
Retaining mortgage assets on the balance sheet, as collateral for
covered bonds or Advances, increases leverage,45 so potential new
limits on bank leverage could discourage covered bond issuance. The
Basel Committee on Banking Supervision is discussing the use of
leverage ratios in banking regulation.46 If bank regulators imposed a
maximum leverage ratio, then it is possible that an exemption could be
created for covered bonds to level the competitive playing field. However,
any exemptions would likely require banks to satisfy additional regula-
tory standards to address firm-specific and systemic risk concerns.
Whether or not new limits on bank leverage are introduced, the
FDIC Covered Bond Policy Statement already limits covered bond
issuance to 4% of total liabilities,47 so under this regime, covered bond
issuance can only have a modest effect on leverage.
[B] Prepayment, Default, and Interest Rate Risk
The issuer of a covered bond retains the prepayment and default
risks of the mortgage loans that remain on its balance sheet. Loans in
the cover pool that are prepaid or fall into default must be replaced
with performing assets. The same is true for FHLB Advances, but
generally not MBS issuances. The prepayment risk associated with
individual loans is transferred to the investors in MBS, and this largely
explains the much wider spread on MBS, depicted in Figure 7-3,
compared with covered bonds and other benchmarks, depicted in
Figure 7-1. In the case of Agency MBS, the default risk of individual
loans is absorbed by the Agency and this guarantee is charged back to
investors via a so-called “g-fee.”48
In the United Kingdom, where most residential mortgages are float-
ing rate, prepayment rates are low, and consequently, the yield on MBS
are much lower. Compared to the 60 to 80 basis points average yield over
swaps of U.S. MBS in Figure 7-3, U.K. MBS average yields were only
45. The cover pool contributes to assets while the covered bonds (or mortgage
bonds) add to liabilities. Thus, to prevent an increase in leverage, bank
equity plus other tier one capital would have to be increased in proportion
to the size of the cover pool.
46. See, e.g., Brooke Masters & Megan Murphy, Leverage Rules Could Force
Big Banks to Cut Balance Sheets, FIN. TIMES, Dec. 7, 2009.
47. This limit was imposed to reduce the risk of the FDIC to losses on
unsecured liabilities and deposits. “The larger the balance of secured
liabilities on the balance sheet, the smaller the value of assets that are
available to satisfy depositors and general creditors.” FDIC Policy State-
ment, supra note 36.
48. The g-fee is recovered along with servicing fees via the spread between the
average mortgage pool note-rate and the coupon paid to investors. For a
general description of prepayment risk of MBS, see, for example, Mark
Adelson, MBS Basics, in NOMURA FIXED INCOME RESEARCH (Mar. 31,
2006) [hereinafter Adelson, MBS Basics].
7–12
Alternative Funding Sources § 7:1.3
about 8 to 12 basis points above swaps during the same period.49 On
average, this was 8.5 basis points above the yields on comparable U.K.
covered bonds.50 This remaining difference is largely a measure on the
risk of underperformance of the fixed pool of mortgage collateral not
faced by covered bond investors. This small premium illustrates how
closely comparable yields were on U.K. MBS and covered bonds in the
period prior to August 2007. The volume of U.K. Jumbo covered bonds,
which reached €200 billion in 2009,51 is close to the £200 billion of
outstanding RMBS (about 20% of U.K. mortgage debt),52 demonstrating
balanced use of these competitive sources of mortgage finance.
Figure 7-3
Mortgage Finance and Benchmark Yields53
49. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 39–40.
50. Id.
51. BERND VOLK, DEUTSCHE BANK, LIMITED SUPPLY OF COVERED BONDS IN
2010 6 (Nov. 27, 2009).
52. Louise Bowman, Securitization: Return of the Living Dead, EUROMONEY,
Nov. 1, 2009 [hereinafter Bowman, Securitization].
53. Deutsche Pfandbriefbank AG is the issuer of one of the ten largest covered
bond transactions (listed by Bloomberg Finance L.P. as the issuer of the
January 2004 Hypo Real Estate Holding AG issue) during the five years
ending August 2008. Dealogic Press Release, supra note 23.
7–13
§ 7:1.3 COVERED BONDS HANDBOOK
Fixed rate U.S. structured covered bonds are funded by floating rate
Mortgage Bonds. The interest rate risk this structure introduces is
hedged with swaps. The interest rate risk retained by issuers arises
from the difference between the floating rate Mortgage Bonds, which
provide the cashflows to the covered bond issuing trust, and the
underlying predominantly fixed rate U.S. mortgages in the cover pool.
[C] Consequences of Default
Since mortgage assets in the cover pool remain on the issuer ’s
balance sheet, deterioration in the issuer ’s credit quality has operational
consequences under covered bond covenants. In the U.S. covered bond
structure, if the Mortgage Bond issuer defaults, FDIC policy allows the
Mortgage Bond trustee to take possession of the pledged mortgages in
the cover pool and continue to make payments to the trust to service the
Covered Bonds.54 However, prior to default, asset segregation require-
ments are triggered if the bank’s credit rating drops below a defined
threshold.55 The segregation procedure involves placing all collections
received from eligible mortgage loans, within twenty-eight days of a
downgrade, into a segregated account maintained by the bank.56 Within
sixty days, all mortgage loan files are transferred to the Mortgage Bond
Indenture Trustee. Although the procedure is more clearly delineated for
covered bonds, the FHLB may also take possession of collateral in the
event of a serious decline in the financial condition of the bank borrower.
FDIC policy has the effect of giving covered bond holders the same
“super lien” on bank assets in the cover pool as enjoyed by the FHLB
with respect to pledged assets.57 Thus, as is the case with FHLB
Advances, covered bonds effectively remove the pledged collateral from
the reach of unsecured creditors in the event of default (to the extent
necessary to satisfy the secured obligation).
The default risk of covered bonds is reflected in their yields. As
illustrated in Figure 7-4 below, the deterioration of WaMu’s credit
54. FDIC Policy Statement, supra note 36.
55. This procedure was tested in response to the downgrade of WaMu’s long-
term credit rating from A3 to Baa2 on December 10, 2007. Moody ’s
Investors Service Press Release, “Moody’s cuts WaMu’s ratings (snr to
Baa2),” December 10, 2007. According to the WaMu Covered Bond
Program “Base Prospectus” September 22, 2006, at 76, a trigger for a
segregation downgrade is a reduction in the long-term credit rating to or
below “Baal” by Moody’s.
56. See, e.g., BOA PROSPECTUS, supra note 5, at 93.
57. In its Policy Statement, the FDIC identified the conditions and circum-
stances under which the FDIC will grant “automatic consent to access
pledged covered bond collateral.” In the language of the policy statement,
“the FDIC hereby consents to the covered bond obligee’s exercise of any such
contractual rights, including liquidation of properly pledged collateral [. . .].”
FDIC Policy Statement, supra note 36.
7–14
Alternative Funding Sources § 7:1.3
quality from August 2007 to December 2008 not only raised the spread
on the bank’s unsecured debt, but also, to a lesser extent, on its covered
bonds.58 The dual recourse structure of covered bonds makes them less
at risk from issuer default and, hence, less sensitive to issuer credit
quality than unsecured debt.59 Following the September 25, 2008
acquisition of WaMu by JPMorgan Chase Bank, N.A. (“JPMorgan
Chase”), the covered bond spread dropped to around the same level as
JPMorgan Chase unsecured debt, and more recently fell below it.
The time series performance of the BOA covered bond yields also
illustrates how the dual recourse feature of covered bonds lowers their
default risk compared to unsecured debt. It illustrates the lack of
correlation between unsecured debt and covered bond yields. Credit
risks that affect unsecured debt do not necessarily affect covered bonds,
which are separately secured by pools of mortgage assets. Conversely,
changes in the assessment of the quality of mortgage assets affect
covered bonds, but do not necessarily affect unsecured debt.
Figure 7-4
Covered Bond Response to Declining Issuer Credit Quality
58. Note that while the unsecured debt is denominated in dollars, the covered
bonds are denominated in Euros.
59. Note that the issuing bank referred to in this section is the issuer of Mortgage
Bonds held by the Trust, which in turn issues the Covered Bonds.
7–15
§ 7:1.3 COVERED BONDS HANDBOOK
[D] Regulatory Risk
The lack of a legislative foundation for U.S. covered bonds means
that the dual recourse feature of covered bonds is dependent on
favorable regulatory treatment. Thus, even though the current FDIC
policy grants covered bond holders super senior claims over the cover
pool assets, guidelines can change. The financial crisis increased the
chances of significant changes to the role of government sponsorship
and regulation of mortgage finance and banking institutions.
A particular focus of regulatory reform efforts is to address systema-
tic risk in the financial system and the problem of institutions that
become “too big to fail.” The implicit subsidies provided to GSEs have
contributed to their dominant roles and are likely to be subject to
review. There is also a subsidy implicit in granting a super-lien over
cover pool assets. It lowers yields on covered bonds by transferring risk
to the FDIC: being left with a higher concentration of lower quality
assets in the event of bank failure. In February 2009, the FDIC
introduced risk-adjusted assessment rates that raise the cost of
FDIC insurance for banks reliant on FHLB Advances or covered bonds
(if secured liabilities exceed 15% of domestic deposits).60 This policy at
least partially accounts for the higher risk posed to the Deposit
Insurance Fund by FHLB Advances and covered bonds. While these
risk-adjusted rates favor MBS issuance over on-balance-sheet mortgage
funding, they address a concern of regulators that could otherwise
undermine support for covered bonds. Faced with the challenge of
phasing out financial crisis supports for mortgage finance, the devel-
opment of a domestic covered bond market could allow the govern-
ment to reduce its systematic risk exposure from continuing GSE MBS
issuance without inducing a liquidity crisis in mortgage finance. 61
Were increased support to result in enabling legislation, not only
would regulatory risks be reduced, but the costs imposed by using
structured finance to engineer dual recourse covered bonds (including
establishing a statutory trust, issuing special mortgage bonds held by
the trust, entering swaps, and setting up guaranteed investment
contracts) could be eliminated.
[E] Counterparty Risk on Swaps
U.S. covered bond structures use swaps to hedge foreign currency and
interest rate risk exposures between the U.S. dollar denominated float-
ing rate Mortgage Bonds, which deliver the cashflows to the Trust
issuing the Covered Bond, and the Euro denominated fixed rate Covered
Bonds. In the event of counterparty default, a fall in U.S. interest rates or
60. FDIC, FINAL RULE ON ASSESSMENTS (Feb. 27, 2009).
61. Jerry Marlatt, Prospects For a Future Covered Bond Market to Finance Home
Mortgages in the United States, COVERED BOND INVESTOR, May 20, 2009.
7–16
Alternative Funding Sources § 7:1.3
an appreciation of the Euro relative to the dollar could raise liquidity
problems for the covered bond issuing Trust.62 However, ultimately, if
the cashflows from the Mortgage Bonds proved insufficient to meet
Covered Bond payment obligations, and a replacement swap provider
could not be found, the Covered Bonds would be accelerated.63
[F] Issuance Limit
There are no statutory or regulatory prohibitions on the issuance of
covered bonds by U.S. banks.64 However, in its policy statement on
covered bonds, the FDIC set a 4% limit on the volume of any bank’s
issuance of covered bonds as a percent of bank liabilities. This limit is
one of the criteria defining covered bond programs that qualify for
preferential FDIC treatment guaranteeing bond holder access to
pledged collateral in the event of a bank default.65 In theory, issuers
could choose to exceed this limit, but this would cast doubt regarding
the integrity of the security interest in the cover pool assets raising
yields demanded by investors, making covered bonds less competitive
as an alternative source of financing. The ultimate scope for develop-
ment of the covered bond market in the United States is not necessa-
rily limited by this 4% figure, since the FDIC has stated that it expects
to review its policies as the market develops. However, this limit was
introduced to limit FDIC exposure to the risk of losses on deposits and
unsecured liabilities, which is increased by granting a super-lien on
cover pool assets. The FDIC would be unlikely to raise this limit
without additional protection against systematic risk.66
62. BOA PROSPECTUS, supra note 5, at 20.
63. The GIC does not provide liquidity in this instance, but is only triggered by
acceleration of the Mortgage Bonds. The GIC is designed to preserve
payments that would have been made by the Mortgage Bonds to the swap
provider. However, in the so-called “soft-bullet” structure, the repayment
of the Covered Bond following insolvency can be delayed (by up to
sixty days in the U.S. Structure) if there is not enough liquidity in the cover
pool. DEUTSCHE BANK 2008, supra note 3, at 45.
64. FDIC Policy Statement, supra note 36.
65. “This policy statement only applies to covered bond issuances made with
the consent of the IDI’s [insured depository institution’s] primary federal
regulator in which the IDI’s total covered bond obligation as a result of
such issuance comprises no more than 4 percent of an IDI’s total
liabilities, and only so long as the assets securing the covered bond
obligation are eligible mortgages or AAA-rated mortgage securities on
eligible mortgages, if not exceeding 10 percent of the collateral for any
covered bond issuance. Substitution for the initial cover pool collateral
may include cash and Treasury and agency securities as necessary to
prudently manage the cover pool.” Id.
66. In Germany, traditionally specialized mortgage banks were entirely funded
with covered bonds, but were subject to separate regulation. Under the
Pfandbrief Act of 2005, a quasi-special banking principle preserves the tradi-
tional Pfandbrief business model. DEUTSCHE BANK 2009, supra note 33, at 58.
7–17
§ 7:1.3 COVERED BONDS HANDBOOK
Given the estimated $7.8 trillion in U.S. charted commercial
banking system liabilities in 2006 (before the financial crisis), 67 4%
implies a potential market for covered bonds of $311 billion (3% of the
outstanding balance of residential mortgages).68 This compares to
the actual $641 billion in outstanding FHLB Advances. 69 While the
European mortgage market is smaller and a greater proportion is
financed with deposits,70 covered bonds play a major role financing
23% of mortgages (see Figure 7-5). In 2006, Jumbo covered bonds
financed 13% or €758 billion.71 The market grew to €829 billion in
2008. In the case of WaMu’s program, the $7.8 billion outstanding is
small in comparison to its $37.1 billion outstanding balance of FHLB
Advances as of 2007, representing over 11% of liabilities.
Figure 7-5
Mortgage Markets in the United States and Europe in 2008
67. Savings institutions, consisting of savings and loan associations, mutual
savings banks, and federal savings banks, had liabilities of $1.5 trillion in
2006. BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, FLOW OF
FUNDS ACCOUNTS OF THE UNITED STATES, FEDERAL RESERVE STATISTICAL
RELEASE Z.1 (Sept. 17, 2009) [hereinafter FEDERAL RESERVE].
68. At the end of 2006, the outstanding balance of residential mortgages was
$11.194 trillion. FEDERAL RESERVE, supra note 67.
69. FHLB, COMBINED FINANCIAL REPORT 39 (2007).
70. Adrian Coles & Judith Hardt, Mortgage Markets: Why US and EU Markets
Are So Different, 15 HOUS. STUD. 775–83 (2000).
71. DEUTSCHE BANK 2008, supra note 3, at 17.
7–18
Alternative Funding Sources § 7:1.4
§ 7:1.4 Investor Advantages
[A] Generally
The dual recourse structure of covered bonds sets them apart from
other financial assets. This consists of specific assets pledged as
collateral, such as a pool of home mortgages, in addition to recourse
to the issuer itself.72 This structure gives covered bonds high credit
quality, yields that are more attractive to investors than sovereign debt,
and relative market liquidity. We explore each of these advantages in
turn.
[B] Dual Recourse Structure
The dual recourse nature of covered bonds grants investors a unique
advantage—that is, in the event of an issuer bankruptcy or another
default event, the investors retain exclusive rights to the underlying
cover pool. Assets that make up the cover pool that backs the covered
bond remain on the issuing bank’s balance sheet, but are “ring-fenced”
from the issuer ’s other assets.73 From the investor ’s point of view, a
covered bond can be considered equivalent to having credit risk
exposure to the issuing institution with the added protection of a
cover pool that covers coupon payments in the event of an issuer
default. Thus, the investor is placed in the position of a corporate
unsecured bond investor with additional rights arising from ultimate
recourse to the cover pool.
The FDIC’s support of the dual recourse structure creates an
implicit subsidy for the benefit of covered bond holders, by putting
their rights to the cover pool assets ahead of other creditors. This
leaves the FDIC to cover any shortfall in depositor claims that could
otherwise have been met from the assets in the cover pool.
Although U.S. issuers do not have the benefit of covered bond
legislation to provide a legal basis for dual recourse protection, the
FDIC’s Final Covered Bond Policy Statement has provided some legal
certainty on bankruptcy remoteness of cover pools. For qualifying
issues, it commits the FDIC to special treatment of covered bonds
in a conservatorship or receivership situation. 74 According to
72. In the U.S. covered bond structure, recourse to the Mortgage Bond issuer
provides additional security. The Covered Bond issuer is a Trust that holds
the Mortgage Bonds as collateral.
73. Note that the issuing bank referred to in this section is the issuer of the
Mortgage Bonds held by the Trust that in turn issues the Covered Bonds.
74. See FDIC Policy Statement, supra note 36. See also Press Release, FDIC,
FDIC Policy Statement (July 28, 2008), available at www.fdic.gov/news/
news/press/2008/pr08060a.html.
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§ 7:1.4 COVERED BONDS HANDBOOK
guidance, the covered bond trustee would enjoy the same priority over
the cover pool assets as the FHLBs do over collateral securing Ad-
vances. That is, claims of the covered bond holders would precede
those of the FDIC made on behalf of depositors and other secured
creditors. In the event that cover assets depreciate in value and do not
completely cover the bond cashflows, note holders would then also be
able to assert claims on the issuer ’s assets pari passu with other
unsecured creditors.75
Shortly after the FDIC issued its policy statement, the insolvency of
WaMu provided a test of the treatment of covered bonds in a receiver-
ship situation. WaMu was closed by the Office of Thrift Supervision,
and the FDIC was named receiver.76 JPMorgan Chase acquired the
banking operations and replaced WaMu as the sponsor of the covered
bond program.77 The covered bond liabilities were immediately trans-
ferred by the FDIC to the successor bank JPMorgan Chase. The
acquisition did not provide an opportunity to test the transfer of the
cover pool assets to the mortgage bond trustee, but the timely transfer
of covered bond liabilities to the new sponsor was consistent with the
published guidance.78
[C] High Credit Quality
The fact that the assets forming the covered bond pool remain on
the issuer ’s balance sheet (albeit “ring-fenced” from the issuer ’s other
assets) is an attractive feature to investors. Maintaining assets on the
balance sheet reduces the moral hazard problem that reportedly
contributed to recent losses in subprime MBS. 79 Many market
observers believe that the “originate and sell” model underlying the
75. There is a question about who has priority in the event of a need for
collateral substitution due to cover pool deterioration that occurs prior to
an FDIC takeover.
76. Investors reacted positively, with yields on covered bonds narrowing from
500 to 100–300 basis points, after U.S. regulators affirmed the assets
supporting covered bonds issued by WaMu would be assumed by JPMorgan
Chase & Co. See Washington Mutual Covered Bonds Rally, Pass Key
Investor Test, REUTERS NEWS, Sept. 26, 2008.
77. On September 25, 2008, the banking operations of Washington Mutual,
Inc., Washington Mutual Bank, Henderson, NV and Washington Mutual
Bank, FSB, Park City, UT (Washington Mutual Bank) were sold in a
transaction facilitated by the Office of Thrift Supervision (OTS) and the
FDIC.
78. MOFO, AN UPDATE ON COVERED BONDS, supra note 39, at 6.
79. See, e.g., John Plender, Originative Sin: The Future of Banking, FIN. TIMES,
Jan. 4, 2009.
7–20
Alternative Funding Sources § 7:1.4
subprime MBS market reduced the issuer ’s incentive to maintain
underwriting standards. 80 While recent proposals to “realign the
incentives of the securitization process” may well require some
amount of risk retention in the future,81 such a measure cannot
match the 100% retention by issuers of covered bonds.
An “independent Asset Monitor” is responsible for monitoring the
quality of the cover pool by implementing the Asset Coverage Test. 82
The quality of the cover pool is maintained by adding replacement
assets for prepaid loans and impaired loans, and to make up any other
shortfalls in collateralization.83 There are also services that allow
investors to monitor cover pools and ensure the continued backing
of covered bonds they own.84
The dual recourse nature of the covered bond structure usually
results in a higher rating for a covered bond than for the unsecured
debt of the issuer. Indeed, covered bond ratings have historically
closely tracked the quality of assets in the cover pool, and only
secondarily tracked the issuer ’s credit quality. As such, they present
an attractive, high quality, low risk investment vehicle for investors,
especially ones that operate under constraints with respect to the risk
type of allowable investments in their portfolio (such as pension funds
and insurance companies).
It has been noted that credit quality for covered bonds is robust to
extreme reductions in the credit quality of the issuer. For example, in
an event study reported in the Bank for International Settlements (BIS)
Quarterly Review, the downgrade of a major German covered bond
issuer (Allgemeine Hypothekenbank Rheinboden) on March 17, 2005
was used as a natural experiment to test the impact on covered bond
yields.85 Because this credit event was unrelated to the performance of
80. Id.
81. See, e.g., MOFO, FDIC EXTENDS SECURITIZATION SAFE HARBOR, supra
note 43.
82. BOA PROSPECTUS, supra note 5, at 3.
83. Either Eligible Mortgage Loans or Substitution Assets may be added to the
cover pool. Substitution Assets may not exceed 10% of the cover pool
assets, but may consist of cash, government or corporate securities of
sufficient credit quality, or U.S. dollar MBS. See, e.g., BOA PROSPECTUS,
supra note 5, at 115.
84. For example, Fitch Solutions, through its Covered Bonds Surveillance
Metrics Analytics Research Tools (SMART) subscription service, provides
investors with a fee-based tool for monitoring the composition of the cover
pool, loan-to-value ratio, and assessing the likelihood of default compared
to that of the covered bond issuer.
85. Frank Packer, Ryan Stever & Christian Upper, The Covered Bond Market,
BIS Q. REV. 43–55 (Sept. 2007) [hereinafter BIS Q. REV.].
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§ 7:1.4 COVERED BONDS HANDBOOK
the bank’s mortgage assets, the change in covered bond yields could be
attributed solely to the impact of the decline in the bank’s credit
quality. It was reported that the most the spread on its $55 billion in
outstanding covered bonds widened was 14 basis points (to about
3.1%). Another illustration is provided by the increases in yields that
occurred at the onset of the financial crisis in August 2007. “Un-
secured financial spreads in Europe widened by anywhere between 60
and 90 basis points. For RMBS issues that figure is between 20 and 40
[basis points]. Covered bonds, by contrast, have only widened by
approximately 3 [basis points].”86
Recently, both S&P and Fitch adopted changes in their ratings
methodologies that introduce “an explicit ‘soft link’ between certain
covered bond ratings and the issuing bank’s rating.”87 Because issuer
geography is a factor in the changes, such changes in rating methodol-
ogy effectively place covered bonds issued in certain jurisdictions (such
as the United States) in the lowest possible category, and they would
limit the number of credit rating levels (“notches”) that a bond can
place above its issuer ’s own credit rating.88 In addition to jurisdiction,
factors affecting the limits on rating uplift include the following:
• liquidity risk posed by maturity mismatch between assets in the
cover pool and the covered bonds;
• access to sources of third-party liquidity (for example, central
bank re-purchase facilities);
• a committed liquidity facility; and
• ability to sell assets.89
[D] Lack of Prepayment Risk
Unlike MBS, covered bonds have a fixed maturity with no risk of
acceleration due to prepayment of the underlying mortgage assets. In
86. Alex Chambers, Covered Bonds Catch Credit Crunch Cold, EUROMONEY,
Sept. 1, 2007 [hereinafter Chambers, Covered Bonds Catch Credit Crunch
Cold].
87. See STANDARD & POOR’S, CRITERIA, STRUCTURED FINANCE, REQUEST FOR
COMMENT: COVERED BONDS RATINGS METHODOLOGY (Feb. 4, 2009),
available at www2.standardandpoors.com/spf/pdf/japanArticles/
20090204CoveredBond.RFC.pdf.
88. While changes in rating methodologies may make it harder for U.S. issuers
with lower credit ratings to structure AAA-rated covered bond issues, these
changes alone do not alter the underlying economics—a change in rating
methodology cannot make a bond riskier.
89. MOFO, AN UPDATE ON COVERED BONDS, supra note 39.
7–22
Alternative Funding Sources § 7:1.4
the event of prepayment, eligible assets must be added to the cover
pool to maintain compliance with the Asset Coverage Test. This is an
attractive feature to many investors because it allows them to plan on
future cashflows, and avoid the return of capital under adverse interest
rate conditions. While covered bonds provide exposure to the issuer ’s
credit risk, this is mitigated by the extra protection afforded by the
cover pool.
[E] Attractive Yield
Generally, covered bonds offer attractive yields to investors above
the rate on sovereign or GSE debt,90 while providing the high default
protection afforded by their dual recourse structure. From an issuer ’s
perspective,91 these secured investments have historically on average
carried yields from 14 to 91 basis points lower than senior unsecured
bank debt of comparable quality.92
Covered bond yield spreads are also less sensitive to credit risk
events than unsecured bonds due to their dual recourse structure.
Figure 7-7 below provides a comparison of the yield spread over the
swap rate of senior unsecured debt and U.S. covered bonds. In the year
following the onset of the financial crisis in August 2007, BOA covered
bond spreads rose by between 60 and 70 basis points, while senior
unsecured debt rose over 140 basis points. Over the same period,
FHLB Advance yield spreads rose only about 20 basis points. BOA
covered bonds, which had enjoyed lower spreads 5 to 10 basis points
lower than FHLB Advance rates in the year before the onset of the
financial crisis, a year after exhibited spreads higher than FHLB
Advance rates.93 However, the further escalation of the financial crisis
beginning in September 2008 with the Lehman Brothers Bankruptcy, 94
led to a further sharp rise in yields, which closed the gap in spreads
between FHLB Advances and covered bonds.
90. For example, in the six months prior to the onset of the financial crisis in
August 2007, the average yield on a U.S. covered bond issue ranged from
about 25 to 45 basis points above the yield on Fannie Mae debt.
91. See supra section 7:1.2.
92. “[Y]ields on covered bonds are lower by an average of 14, 42 and 91 basis
points for issuers in the broad rating categories of AA (Aa), A and BBB
(Baa), respectively.” BIS Q. REV., supra note 85, at 51.
93. The BOA U.S. dollar denominated covered bond issued on June 14, 2007 is
not included in Figure 7-6.
94. See, e.g., Faten Sabry & Chudozie Okongwu, How Did We Get Here? The
Story of the Credit Crisis 2009, J. STRUCTURED FIN. (Apr. 30, 2009)
[hereinafter Sabry & Okongwu].
7–23
§ 7:1.4 COVERED BONDS HANDBOOK
Figure 7-6
BOA Covered Bond Financial Crisis Performance
More generally, the financial crisis precipitated a divergence and
differentiation in performance of covered bonds issued in different
countries and by different issuers.95 Jumbo Pfandbriefe showed the
most resilience, with yields barely rising compared with the first seven
months of 2007. Pfandbriefe continued to trade 10 basis points below
the Euro Interbank Offered Rate (“Euribor”), whereas securitizations
and covered bonds issued in other jurisdictions saw spreads widen by
between 40 and 80 basis points.96
WaMu’s liquidity problems led it into an FDIC facilitated acquisi-
tion by JPMorgan Chase on September 25, 2008.97 This acquisition
included the assumption of the WaMu covered bond liabilities
(henceforth the JPMorgan Chase/WaMu covered bonds). As seen in
95. DEUTSCHE BANK 2009, supra note 33, at 6.
96. See Association of German Pfandbrief Banks Association of German
Pfandbrief Banks (“Verband Deutscher Pfandbriefbanken” or “vdp”)
Home Page, available at www.pfandbrief.de/cms/_internet.nsf/tindex/en.
htm.
97. Press Release, FDIC, JPMorgan Chase Acquires Banking Operations of
Washington Mutual; FDIC Facilitates Transaction that Protects All De-
positors and Comes at No Cost to the Deposit Insurance Fund (Sept. 25,
2008).
7–24
Alternative Funding Sources § 7:1.4
Figure 7-7 below, even through this period of financial distress, the
covered bond yields rose by less than the increase in yields on senior
unsecured debt. Following the JPMorgan Chase acquisition, the
covered bond spreads dropped closer to the spreads on JPMorgan
Chase senior unsecured debt, and below them by October 2009, as
seen previously in Figure 7-4.98
Figure 7-7
WaMu/JPMorgan Chase Covered Bond
Financial Crisis Performance
[F] Liquidity
Liquidity is an important factor to an investor who is concerned
about being able to value holdings of covered bonds and sell positions
at will without materially affecting prevailing prices. A useful measure
of liquidity is the bid-ask spread, which is the difference between the
lowest offer to sell a security (the “ask”) and the highest offer to buy
(the “bid”) that security. The bid-ask spread of traded securities is a
measure that allows one to determine the cost of trading and to make
inferences about the liquidity in a market. The narrower the bid-ask
98. By October 2009, the covered bond yield spread over swaps in Figure 7-4
fell below the ten-year JPMorgan corporate bond yield spread.
7–25
§ 7:1.4 COVERED BONDS HANDBOOK
spread, the more liquid the market. A wide bid-ask spread indicates
reduced certainty about the true value of a security and imposes higher
transaction costs, which inhibit arbitrageurs who might otherwise be
willing to purchase or sell the security in order to gain from (and in the
process, arbitrage away) temporary mispricings and increase market
efficiency.
In Europe, Jumbo covered bond market making has been mandated
since the market’s inception in 1995.99 Market making commitments
are required from at least five investment banks for each issue. Quoted
bid-ask spreads must not exceed certain limits for the life of each
bond, from 5 cents during the first four years after issue rising
progressively to 20 cents after twenty years.100 More recently, the
three banks issuing French covered bonds (“Obligations Foncières”)
established a market making agreement together with twenty-three
other banks.101 Each institution undertook to quote eligible covered
bonds on electronic trading platforms, including Bloomberg and
Finninfo. Since then, electronic trading platforms such as EuroCredit
MTS have established additional B2B liquidity mechanisms using self-
defined standards.102
Prior to the financial crisis, the liquidity of the secondary market
for covered bonds was generally good.103 For example, in July and
August 2007, prior to the financial crisis, there was turnover of over
€10 billion on the EuroCredit MTS trading platform.104 This com-
pares to aggregate European Jumbo volume outstanding at year end of
about €827 billion.105 However, secondary market trading volumes
collapsed to almost zero in the following months, and traders quickly
reverted to traditional “head-to-head” phone-based interbank quoting
once the market turbulence started.106 “During the week of August 13,
2007, market makers were forced to triple bid-ask spreads from 10 to
30 cents in order to keep the covered bond market functioning as
99. Beginning in 1999, issuers from other European countries started issuing
Jumbo covered bonds. See Association of German Pfandbrief Banks (“Ver-
band Deutscher Pfandbriefbanken” or “vdp”) Home Page, available at www.
pfandbrief.de/cms/_internet.nsf/tindex/en.htm.
100. DEUTSCHE BANK 2008, supra note 3, at 46.
101. Id.
102. Id.
103. In October 2005, the credit problems of a particular covered bond issuer,
Allgemeine Hypothekenbank Rheinboden (AHBR), resulted in the aban-
donment of market making for AHBR Jumbo Pfandbriefe. As a result of
this breakdown, the market making rules for the Jumbo Pfandbrief market
were amended in August 2006. DEUTSCHE BANK 2008, supra note 3.
104. DEUTSCHE BANK 2008, supra note 3, at 48.
105. Id. at 17.
106. DEUTSCHE BANK 2008, supra note 3.
7–26
Alternative Funding Sources § 7:1.4
money market liquidity evaporated.”107 The ACI financial markets
association (responsible for defining best practices) held a conference
call on which Jumbo covered bond maximum spread commitments
were tripled to support a resumption of trading.108
We examined the bid-ask spreads of the six Euro denominated
covered bonds issued by BOA and WaMu, and compared them to the
bid-ask spreads of the issuers’ own senior unsecured debt during this
period. As shown in Figure 7-8 below, average bid-ask spreads of the
covered bonds range from 5 cents to 12 cents, while those for
unsecured debt range from 45 cents to 118 cents prior to the onset
of the financial crisis in August 2007. In the following four months,
bid-ask spreads of the covered bonds increased by between 2 cents and
8 cents, while bid-ask spreads for senior unsecured debt rose by
between 77 cents and 472 cents. This relative stability of U.S. covered
bond bid-ask spreads was also comparable to the stability of bid-ask
spreads of a representative Pfandbrief.109
Figure 7-8
Average Bid-Ask Spread of WaMu and BOA Bonds
107. Louise Bowman, It Depends What You Mean By Covered Bond, EURO-
MONEY, Sept. 1, 2007.
108. Chambers, Covered Bonds Catch Credit Crunch Cold, supra note 86.
109. Deutsche PfandbriefBank AG is the issuer of one of the ten largest covered
bond transactions (listed by Bloomberg Finance L.P. as the issuer of the
January 2004 Hypo Real Estate Holding AG issue) during the five years
ending August 2008. Dealogic Press Release, supra note 23.
7–27
§ 7:1.5 COVERED BONDS HANDBOOK
§ 7:1.5 Investor Disadvantages
[A] Generally
U.S. covered bonds present some disadvantages to investors. First,
U.S. investors are not familiar with covered bonds as a class of
investments, and U.S. covered bonds have only a short track record
with European investors. As with covered bonds issued in some other
jurisdictions, the bankruptcy remoteness of the cover pool backing
U.S. covered bonds is not established through legislation, but only
through structured finance, and depends on favorable regulatory
treatment. U.S. financial market turmoil may also have reduced
investor appetite for covered bonds issued by U.S. banks.
The segregation downgrade of WaMu covered bonds in October
2007 and subsequent assumption by JPMorgan Chase of WaMu’s
covered bond program provided a limited opportunity to test the
FDIC’s treatment of covered bond holders.110 However, this limited
experience may be insufficient to satisfy investors who seek assurance
as to how their claims to the assets in a covered bond pool would be
assured in the event of default.
[B] Lack of Legislative Framework
In theory, the absence of a legislative framework has been cited as
an explanation for differences in covered bond spreads, and is a factor
considered by the rating agencies in rating covered bond issues. Absent
legislative support, investors incur higher costs to evaluate the risks
underlying the particular structure of covered bonds—particularly in
the absence of international standardization.
In practice, market participants have shown an acceptance of
structured covered bonds demanding only moderately higher yields.
Prior to the onset of the financial crisis in August 2007, cross-country
effects appeared to explain more of the variation in covered bond
spreads (about plus or minus 8 basis points relative to German issues)
than the existence of covered bond legislation, which tended to
decrease yields by 4 basis points.111 This suggests that the lack of a
legislative framework is not a significant barrier to the success of
potential future U.S. covered bond programs.
Basel II establishes risk weightings of as low as 10% for covered
bonds based on issuer credit risk. By contrast, the risk weighting for
triple A MBS is 7%. From the perspective of an investor in MBS or
110. See supra section 7:1.4[B].
111. See BIS Q. REV., supra note 85, at 43–55. Covered bonds from the
Netherlands, the United Kingdom, and BNP Paribas are included in their
sample of jurisdictions without legislative framework.
7–28
Alternative Funding Sources § 7:1.5
covered bonds, higher regulatory capital costs make covered bonds less
competitive. A 5% lower risk weight is estimated to be worth 3.1 basis
points in terms of yield.112 However, since banks buy about half the
Jumbo covered bond issues in Europe,113 the estimated effect on yields
in the market would be half this amount. Of course, to avoid the effect
of this potential regulatory capital disadvantage, an issuer could
market its covered bonds to non-bank investors who face no regulatory
capital cost.
Since the onset of the financial crisis, covered bond performance
has exhibited a divergence in yield spreads depending on differences
between issuer credit risk profiles, collateral quality, and covered bond
structures (jurisdiction).114 For example, whereas the average spreads
for covered bonds from each jurisdiction varied by not more than
16 basis points during the two and a half years ending June 2006, 115 by
January 2009, the average spread premium for Irish and U.K. issues
relative to Jumbo Pfandbriefe was about 100 basis points.116 Since
both these two jurisdictions already have legislative frameworks in
place, this divergence shows that other factors can be more important
in influencing the credit risk associated with covered bonds issued in
different jurisdictions.
[C] Decline in Appetite for U.S. Financial Sector
Exposure
Recent events relating to both U.S. and global credit markets have
increased uncertainty in the value of mortgage assets and U.S. bank
credit risk. Problems with mortgage underwriting standards and rating
agency failures, which have been reported to have contributed to the
financial crisis,117 raise the perceived risk of structured products
backed by mortgage assets. This uncertainty, coupled with investors’
wariness of increased exposure to the financial sector, may reduce
investor demand for credit products backed by U.S. mortgage-based
financial assets, including covered bonds, for some time to come.
However, regulatory restructuring that affected the rate of the GSEs
could make covered bonds relatively more competitive in the near
future.
112. For an A+ rated bank with a target capital ratio of 11.2%, a 5% change in
risk weighting would result in a capital release of 0.6%. At a cost of capital
of 5.9%, this amount to an opportunity cost of 3.3 basis points. Id. at 36.
113. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 76.
114. DEUTSCHE BANK 2008, supra note 3.
115. BIS Q. REV., supra note 85, at 52.
116. DEUTSCHE BANK 2008, supra note 3, at 6.
117. See, e.g., Edward Pinto, Acorn and the Housing Bubble, WALL ST. J., Nov.
13, 2009; Aline van Duyn & Joanna Chung, Rating Agency Model Survives
Largely Intact, FIN. TIMES, July 23, 2009.
7–29
§ 7:2 COVERED BONDS HANDBOOK
§ 7:2 Historic Funding Model for U.S. Mortgage Loans
(Housing Finance)
§ 7:2.1 Development of GSEs
The traditional model for mortgage lending involves a direct
arrangement between a borrower and a lender in which the lender
takes on all the credit risk associated with the borrower, as well as the
burden of servicing the loan. Historically, at least until the 1980s,
depository institutions like Savings and Loans (S&Ls) or thrifts played
the leading role in originating residential mortgages in the United
States.
The Great Depression caused a rise in mortgage foreclosures and
created a liquidity crisis in the banking system. As part of President
Franklin Delano Roosevelt’s New Deal, several new government and
government sponsored institutions were established in order to increase
liquidity and reduce the cost of credit in the mortgage market. The first
was the FHLB System, created in 1932 to provide cash advances to
participating banks secured by their illiquid mortgage assets.118
Fannie Mae was established in 1938, initially as a government
agency authorized to buy only loans insured by the Federal Housing
Administration (FHA). This charter was later expanded to include the
purchase of loans guaranteed by the U.S. Department of Veterans
Affairs (VA).119 The idea was to replenish the supply of funds available
to originate these government-backed loans, and thereby create a
secondary market. Prior to the existence of a secondary market, there
were often regional imbalances in the supply and demand for mortgage
financing that served to raise borrowers’ mortgage costs.
The 1968 Charter Act changed Fannie Mae into a privately owned
company operating with private capital on a self-sustaining basis. 120
Its role of supporting special assistance programs (in the form of
purchasing FHA-insured and VA-guaranteed mortgages) was transferred
to the new Government National Mortgage Association (Ginnie Mae),
118. See also infra section 7:2.2.
119. Congress created the Federal Housing Administration (FHA) in 1934 in
order to provide mortgage insurance on single family home loans and
multifamily home loans, including manufactured homes and hospital
loans made by FHA-approved lenders. U.S. Government Accountability
Office, Fannie Mae and Freddie Mac: Analysis of Options for Revising the
Housing Enterprises’ Long-term Structures, Publication No. GAO-09-782,
12 (Sept. 2009) [hereinafter GAO-09-782].
120. Id. at 13.
7–30
Alternative Funding Sources § 7:2.1
while Fannie Mae’s overall mandate was expanded to buy mortgages
beyond those insured by the FHA or guaranteed by the VA.121 The 1968
Act also provided the authority to issue MBS leading to a dramatic
expansion of the investor base for mortgages. In 1970, Ginnie Mae
pioneered the issuance of MBS backed by pools of qualifying
mortgages.122
The 1970 Emergency Home Finance Act123 created a new second-
ary mortgage market participant, the Federal Home Loan Mortgage
Corporation (Freddie Mac) to support conventional mortgages origi-
nated by thrift institutions and to increase efficiency of the secondary
market through competition with Fannie Mae.124
Throughout the 1980s, a variety of factors, including interest rate
deregulation and the “thrift crisis,” drastically reduced the market
share of S&Ls involved in the mortgage origination process. As a result
of the high level of interest rates at that time, a large number of banks
and thrift institutions found themselves holding residential mortgages
that were earning less than what the institutions were paying for
deposits. Securitization provided a means for non-traditional mortgage
lenders, such as insurance companies and pension funds, to replace
some of the mortgage financing that had previously been provided by
depository institutions. This, in turn, supported the growth in origi-
nation by specialized mortgage companies and commercial banks,
which became the dominant sources of mortgage origination.
Fannie Mae, which began issuing mortgage-backed securities in
1981,125 has been the largest Agency issuer of MBS since 1990 and
currently has the largest amount of outstanding Agency MBS.126
Fannie Mae issues a variety of MBS products reflecting the range of
mortgage choices available to homeowners in the primary market.127
By the early 1990s, the number of mortgages originated by banks
and S&Ls had dropped to about one quarter of the overall market
share. Significant portions of loans were being sold into the increas-
ingly active “secondary” mortgage market even by these traditional
121. Today, lenders pool packages of qualifying FHA, VA, Rural Housing Service
(RHS), or Public and Indian Housing (PIH) mortgages and convert them
into securities. Ginnie Mae guarantees investors the timely payment of
principal and interest on these securities.
122. GAO-09-782, supra note 119, at 11.
123. Emergency Home Finance Act of 1970, Pub. L. No. 91-351 (July 24, 1970).
124. GAO-09-782, supra note 119, at 14.
125. Id. at 11.
126. Inside Mortgage Finance, The 2009 Market Statistical Annual—Volume II,
9–10.
127. GAO-09-782, supra note 119, at 12.
7–31
§ 7:2.2 COVERED BONDS HANDBOOK
mortgage finance institutions.128 By 2008, over half of the outstanding
$15 trillion in U.S. mortgage debt was securitized. 129
Under the securitization model, a mortgage originator sells its
mortgage pools into a trust. The trust enlists an underwriter to issue
rated bonds backed by the future cashflows of these mortgage loans.
The bank (or other originator) has the option to either retain or sell the
rights to service the mortgages. This involves collecting payments and
forwarding them to the trust, as well as dealing with any delinquencies
or defaults. The cashflows from the mortgages are passed through to
the investors, which may include pension funds, insurance compa-
nies, mutual funds, hedge funds, or themselves used as collateral in
collateralized debt obligations (CDOs).
§ 7:2.2 FHLB
[A] Generally
The core function of the FHLB System is to provide liquidity to its
member financial institutions in support of residential and community-
based mortgage lending.130 It provides liquidity to member institutions
that hold mortgages in their portfolios and facilitates the financing of
home mortgages by making low-cost loans,131 called Advances, to those
members.132
[B] History
The FHLB System was chartered by Congress in 1932 to provide
liquidity to the banking system in response to mounting bank failures
during the Great Depression.133 It was the first GSE, which gives it the
benefit of an implicit government guarantee, lowering its cost of
financing.134
128. See FDIC Advisory Committee on Banking Policy, Federal Home Loan
Bank System (last updated Apr. 25, 2003), available at www.fdic.gov/about/
learn/advisorycommittee/fhlb_advances.html [hereinafter FDIC, Federal
Home Loan Bank System].
129. FEDERAL RESERVE BULLETIN STATISTICAL SUPPLEMENT, MORTGAGE DEBT
OUTSTANDING (Aug. 2008), available at www.federalreserve.gov/pubs/
supplement/2008/08/table1_54.htm.
130. AMERICAN BANKERS ASS’N, FEDERAL HOME LOAN BANK (FHLBANK) SYSTEM
[hereinafter FHLB ANK S YSTEM ], available at www.aba.com/Issues/
Issues_FHLBSystem.htm.
131. Federal Home Loan Banks (FHLBs) also provides liquidity to members by
purchasing AAA-rated mortgage-backed securities (MBS) and maintaining
a limited portfolio of residential mortgage loans purchased from members.
132. FDIC, Federal Home Loan Bank System, supra note 128.
133. GAO-09-782, supra note 119, at 12.
134. Id.
7–32
Alternative Funding Sources § 7:2.2
In 1989, the mission of the FHLBs was expanded by Congress to
include community and economic development. This mandate ex-
pands access to funding for projects and authorities, and provides
more attractive rates than may be available from other sources. The
FHLBs are statutorily mandated to fund affordable housing programs,
and are also responsible for paying off the RefCorp bonds that were
used to help resolve the 1980s S&Ls deposit insurance agency losses.
The FHLB System consists of twelve regional banks (the
“Banks”), 135 as well as the FHLB Office of Finance, which has
responsibility for the preparation of the combined financial reports,
and issuance of bonds and notes on behalf of members. 136 Eligibility
for membership in the System is governed by statute and includes
community banks, thrifts, commercial banks, credit unions, commu-
nity development financial institutions and insurance companies, and
state housing finance agencies.
Each regional FHLB is a separately chartered entity with its own
board of directors and management. There is no system-wide central
management of the Banks. Instead, each member bank is subject to
regulations issued by the Finance Board, which periodically examines
the Bank operations.137
The Banks raise funds for making advances to members primarily
by issuing consolidated obligations (bonds) in the capital markets.
Although the U.S. government does not formally guarantee the Banks’
debt securities, as a consequence of its federal charter, the FHLBs enjoy
borrowing costs close to those of the federal government itself.
[C] Ownership Structure
[C][1] Generally
Each Bank is a mutual organization owned by its financial institu-
tion members. Prior to the Financial Services Modernization Act of
1999,138 federally insured thrift institutions were required to become
FHLB members. Today, however, FHLB membership is voluntary.139
135. GAO-09-782, supra note 119, at 6.
136. The Office of Finance can issue consolidated obligations only when an
FHL Bank provides a request for, and agrees to accept, funds. FHLB
CONSOLIDATED FIN. STATEMENT, supra note 26, at 11.
137. Id.
138. Financial Services Modernization Act of 1999, Pub. L. No. 106-102, 113
Stat. 1338 (Nov. 12, 1999), also known as the Gramm-Leach-Bliley Act
(GLBA).
139. Federal Reserve Bank of Atlanta, The Federal Home Loan Bank System:
The “Other” Housing GSE, ECON. REV. 43 (Third Quarter 2006).
7–33
§ 7:2.2 COVERED BONDS HANDBOOK
A non-transferable stock purchase is required for membership. 140
For most regional Banks, stock purchase requirements include an
activity component based on the value of Advances and other
borrowings.
Membership of a particular regional FHLB is restricted by statute to
institutions operating in that FHLB’s region. Institutions operating in
multiple regions are supposed to be restricted to membership in a
single regional FHLB. However, some acquisitive financial institutions
have retained charters in multiple FHLB districts—a practice that
permits them to borrow from the Bank offering the cheapest ad-
vances.141 As of 2003, about 100 such cases existed, in effect creating
a degree of inter-FHLB competition. This practice has also spurred
policy debate on so-called multidistrict membership (that is, whether
FHLB membership should be opened further to allow any eligible
financial institutions to access the FHLB System through multiple
channels).142
[C][2] Dividends
The Banks balance the trade-off between credit prices (the rates
offered on Advances) and dividends paid on the stock exclusively held
by the members in similar ways. For example, the FHLB of San
Francisco states that it follows a policy of paying a market rate return
on members’ investment in the Bank’s capital and keeping Advances
competitive with the cost of most wholesale borrowing alternatives
available to their largest members. 143 The market rate of return
dividend policy is maintained with reference to a benchmark calcu-
lated as the combined average of (i) the daily average of the overnight
federal funds effective rate, and (ii) the four-year moving average of the
Treasury note yield (calculated as the average of the three-year and five-
year Treasury note yields).144
[D] Financing
The FHLB System is one of the largest debt issuers in the world and
is the second largest GSE borrower. Its debt consists of bonds and
discount notes, known as FHLB consolidated obligations, and is the
140. Members resigning their membership are subject to a five-year lockout
from the FHLB System. Mark J. Flannery & W. Scott Frame, The Federal
Home Loan Bank System: The “Other” Housing GSE, 91 ECON. REV. 42
(2006) [hereinafter Flannery & Frame].
141. For example, WaMu maintained membership in four FHLB regions: San
Francisco, Seattle, Dallas, and New York.
142. Flannery & Frame, supra note 140, at 43.
143. Federal Home Loan Bank of San Francisco, Annual Report on Form 10-K 2
(2007).
144. Id.
7–34
Alternative Funding Sources § 7:2.3
joint and several obligations of all twelve FHLBs. As of December 31,
2007, consolidated obligations represented an amount equal to 92.5%
of the FHLBs’ combined total assets.145 At year-end 2002, the FHLB
had about $668 billion in outstanding debt compared to Fannie Mae’s
$844 billion and Freddie Mac’s $644 billion. The FHLB is the largest
GSE issuer of long-term debt, with $435 billion outstanding compared
to $295 billion by Freddie Mac and $239 billion by Fannie Mae. 146
[E] Advances
FHLB Advances facilitate asset liability management of depository
institutions by providing medium- and long-term collateralized loans.
Although Advances compete with alternative sources of funding
available to its members, FHLB Advances are (after deposits) the
largest source of funding for many member institutions.147
The individual regional Banks independently set their own Advance
rates. Over the period from 2006 to 2007, five-year Advance rates were
priced on average at approximately 10 basis points above the swap rate.
FHLB Advances are available to members with a wide variety of
terms to maturity, from overnight to long-term, and with different
interest rate features.148 Qualifying collateral for Advances includes
residential mortgages, commercial mortgages, and (for small institu-
tions) small business and agricultural loans.
§ 7:2.3 GSE and Private Securitization
[A] Early Days of MBS
Structured finance arose in 1970 when mortgage bankers started
creating bonds from the cashflows of newly originated FHA and VA
mortgages.149 The resulting MBS were guaranteed by Ginnie Mae and
referred to as “Ginnie Maes.”
The process of securitization involves packaging debt instruments
backed by assets (such as mortgages or loans financing houses, cars, or
credit card receivables) in order to create securities for sale to third-
party investors. Such instruments serve to transform illiquid pools of
loans into tradable and marketable products. Because their cashflow
145. Id.
146. FDIC, Federal Home Loan Bank System, supra note 128.
147. See, e.g., WaMu, Form 10-K/A (Dec. 31, 2007) (interest bearing deposits of
$168 billion and FHLB Advances of $37 billion).
148. See, e.g., FHLB Boston, Credit Products, Overview Page, available at www.
fhlbboston.com/productsandservices/creditproducts/index.jsp.
149. FHA mortgages are insured by the Federal Housing Administration; VA
mortgages are guaranteed by the Department of Veterans Affairs. J OSEPH
HU, BASICS OF MORTGAGE-BACKED SECURITIES 15 (1st ed. 1997) [herein-
after BASICS OF MORTGAGE-BACKED SECURITIES].
7–35
§ 7:2.3 COVERED BONDS HANDBOOK
derives from a diverse pool of borrowers, the credit and cashflow
timing properties of securitized products differ from those of govern-
ment or corporate debt.
The same securitization techniques pioneered by Ginnie Mae for
FHA and VA loans were later employed by Fannie Mae and Freddie
Mac to create broader classes of Agency MBS. As with Ginnie Maes,
the principal repayment for Fannie Mae and Freddie Mac MBS is also
guaranteed by their respective issuing Agency.
The Agencies are restricted as to the types of mortgages they can
buy and the types of securities they can issue. Consequently, the
Agency MBS market is standardized and well-understood by market
participants. Three important features that define the collateral of
Fannie Mae and Freddie Mac MBS are the following:
• average loan size,
• average borrower credit rating (almost always determined by the
FICO score), and
• average loan-to-value ratio (LTV).
Because specific guidelines for eligibility are required to be met, loans
that the Agencies will securitize are said to be “conforming.”
Originally, the Agencies issued only the simplest form of MBS,
called a “pass-through” security. Structurally, this bond is just a single,
securitized pool of mortgages whose payments are combined and
transferred directly to investors on a pro rata basis.150 Because Fannie
Mae and Freddie Mac continuously offer bids for mortgages at compe-
titive rates, the Agencies serve to increase the liquidity of funds
required for mortgage origination. In 2007, the Agencies securitized
$1.3 trillion worth of mortgage loans.151
[B] CMOs
Unlike most other types of bonds, the cashflows in an MBS pass-
through structure are uncertain in their timing, because the borrowers
of the collateral mortgages may prepay or refinance their mortgages at
any time and return that principal to the MBS bond holders. This
profile of cashflows does not necessarily meet the investment needs of
all investors. Collateralized Mortgage Obligations (CMOs) were devel-
oped to address this limitation. A CMO is an example of a structured
product that is derived from simpler MBS. The basic idea behind a
structured product (and structured finance in general) is to create
150. FRANK J. FABOZZI & STEVEN V. MANN, HANDBOOK OF FIXED INCOME
SECURITIES 501 (7th ed. 2005).
151. SIFMA, STATISTICAL TABLE ON U.S. MORTGAGE RELATED ISSUANCE (2009),
available at www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_
US-MortgageRelatedIssuance.pdf.
7–36
Alternative Funding Sources § 7:2.3
bonds with expected cashflows that conform to specific investor needs.
Structuring a CMO involves taking cashflows from a collateral pool
(usually of Agency pass-through MBS), allocating it to different classes
of securities, and then issuing different classes of bonds, where each
class has its own timing characteristics and risk/reward profiles. The
first CMO was issued by Freddie Mac in 1983.152
[C] Structuring Non-Agency MBS
Securitization and the issuance of structured products using non-
conforming mortgage assets as collateral occur in the non-Agency or
“private label” market.
One important feature that distinguishes non-Agency MBS from
Agency MBS is the lack of an Agency collateral guarantee. While
Agency MBS are insured against defaults, non-Agency bonds must
acquire credit protection, or enhancement, via various mechanisms to
attain an equivalent credit profile. Common ways to provide this
credit enhancement are credit-tranching, overcollateralization, and
excess spread.
[D] Credit Enhancement
Since the late 1980s, credit-tranching has been a very popular way
to provide credit enhancement for non-Agency MBS.153 This involves
creating two or more classes of bonds (referred to as tranches) with
different payment priorities over the cashflows from the same pool of
mortgages. That is, junior (subordinated) classes do not receive any
principal or interest until the senior classes have been paid in full. The
junior-most piece of a deal is often retained by the issuer and is called
the residual, or equity tranche.
When the pool balance that backs an MBS deal exceeds the total face
value of the issued bonds, the deal is said to be “overcollateralized.” The
surplus funds serve as a resource to cover losses in the pool should they
occur. Often the overcollateralized portion of a deal is allocated to
the residual, or equity, tranche.
An excess spread between the average rate paid by the mortgagors
and the average bond coupon rate can be used to provide credit
enhancement. The associated cashflow is either set aside in an excess
spread account, or is immediately put to use in paying down the
principal of the MBS. Excess spread can also be used to pay insurance
premiums on policies to protect bond principal.
152. BASICS OF MORTGAGE-BACKED SECURITIES, supra note 149, at 66.
153. Eric Bruskin, Anthony B. Sanders & David Sykes, The Nonagency Mort-
gage Market: Background and Overview, in THE HANDBOOK OF NON-
AGENCY MORTGAGE-BACKED SECURITIES (Mar. 1999).
7–37
§ 7:2.4 COVERED BONDS HANDBOOK
[E] Subprime Market
Subprime mortgages are loans to borrowers with high debt-to-
income ratios, impaired or minimal credit histories, or incomplete
documentation. These borrower features make subprime loans riskier
to the lender; hence, they are originated at a significant premium over
the prime mortgage rate. Subprime mortgages are non-conforming and
so are only securitized in non-Agency MBS.154
The main distinction between loans eligible for prime and sub-
prime securitization lies in the borrowers’ FICO scores, LTVs, and
documentation. A typical subprime loan has a FICO score around 620
and a LTV above 80. Information about employment and earnings is
requested at origination; however, documented support is not required
by all originators and, in turn, some private label MBS issuers
securitize these “no-doc” loans at a significant premium above the
rate for prime loans. Not only do subprime borrowers pay up to several
hundred basis points above the prevailing prime mortgage rate, the
MBS investors in such securities receive a correspondingly high
coupon on their bond.
In order to provide investors with protection against defaults and
subsequent principal losses, subprime deals are almost always set up
with a senior-subordinate structure. This credit protection comes
about through several mechanisms. As discussed above, senior bonds
get paid their interest and principal before the subordinate bonds.
Consequently, the junior tranches take losses before the senior ones.
§ 7:2.4 Growth of the Securitization Market
[A] Growth of the Agency and Non-Agency Markets
The idea of securitizing mortgage pools has been around for nearly
forty years, and has been a very successful way to expand available
sources of mortgage funding for homeowners. General acceptance of
MBS as viable and well-understood financial instruments led to the
birth of asset-backed securities (ABS), which involve the securitization
of a much wider range of assets, including credit card receivables, auto
loans, and student loans.155
The U.S. residential mortgage market as a whole is very large. As
seen in Figure 7-9 below, total mortgage originations in the period
from 2004 to 2007 were approximately $8 trillion, and subprime
originations in the same period were almost $1.5 trillion. The
154. Although prior to the onset of the financial crisis in 2007, there was some
Agency subprime activity. See, e.g., Carol D. Leonnig, How HUD Mortgage
Policy Fed the Crisis, WASH. POST, June 10, 2008.
155. ANAND K. BHATTACHARYA & FRANK J. FABOZZI, ASSET-BACKED SECURITIES
501 (2005) [hereinafter BHATTACHARYA & FABOZZI].
7–38
Alternative Funding Sources § 7:2.4
subprime sector grew rapidly in recent years, from a little over 7% of
originations in 2003 to 21.9% in 2006. Subprime and Alt-A mort-
gages, a class lying between subprime and prime loans in credit
quality, accounted for over 30% of the total in 2006.156
Figure 7-9
Growth of Subprime Mortgage-Backed Securities (billions)
Although significantly smaller in size than the Agency market, the
non-Agency market grew tremendously over the decade to 2007.157 In
2007, non-Agency MBS issuance in the United States was $774 billion,
up 303% from $192 billion in 1998. However, non-Agency new issuance
for 2008 was down nearly 95% to $40.5 billion, with 96% of the year ’s
issuance taking place in the first half of 2008.158 Starting in late 2007,
liquidity dried up in the market for mortgage-backed and asset-backed
securities, forcing down prices and leading to large and repeated write-
downs at many financial institutions. Since 2007, mortgage securitiza-
tion has continued almost entirely because of government support of
Fannie Mae and the purchase by the Federal Reserve of an estimated
80% to 85% of all Agency mortgage-backed securities.159
156. MORTGAGE MARKET STATISTICAL ANNUAL 2009 (Inside Mort. Fin. Pubs.
2009).
157. FDIC, In Focus This Quarter: Accessing Capital Markets and Managing
Market Risk, FDIC OUTLOOK (Fall 2006), available at www.fdic.gov/bank/
analytical/regional/ro20063q/na/t3q2006.pdf.
158. For more information, see the SIFMA website, available at www.sifma.org.
159. Jenny Anderson, Debt-Market Paralysis Deepens Credit Drought, N.Y.
TIMES, Oct. 7, 2009.
7–39
§ 7:3 COVERED BONDS HANDBOOK
[B] Factors Driving the Growth of Mortgage
Securitization
MBS have come to play a vital role in modern housing finance
markets by virtue of their many advantages. For borrowers, securitiza-
tion attracts private capital to residential housing markets, thus
increasing liquidity. For investors, securitization provides rated bonds
of both investment and below investment grade, as well as a liquid
secondary market in which to trade these securities. Finally, securiti-
zation allows an issuer to tap investors seeking investment grade debt
even if the issuer itself has a non-investment grade debt rating.
Securitization helps to diversify sources of capital, and frees up capital
that would otherwise be tied up in the underlying, long-term, illiquid
mortgage assets that impose relatively high regulatory capital charges.
Securitization also provides opportunities for specialization through
outsourcing of loan servicing, for example. By securitizing mortgage
loans for sale into the secondary market and retaining the servicing
rights, the issuer effectively converts a capital-intensive pool of assets
into a less capital-intensive source of income.
A bank that chooses to securitize a portfolio of mortgage loans and
sell the resulting MBS removes risky assets from its balance sheet and
replaces them with the proceeds of the sale of the MBS. Since only
risky assets impose a regulatory capital charge, this reduces the
institution’s regulatory capital burden. Under Basel I, mortgage loans
carried a 50% risk weight that created an incentive for securitiza-
tion.160 Even if an institution retains some of the MBS it issued on its
balance sheet rather than selling them, it may still lower its regulatory
capital burden. Under Basel II, MBS have risk weights as low as 7%, 161
compared to 35% for the underlying mortgage loans.162
§ 7:3 Securitization Compared to Covered Bonds
Securitization is the dominant means of financing mortgage lend-
ing in the United States, while covered bonds play a dominant role in
Europe. The features of MBS and how they compare to covered bonds
are described in this section.
§ 7:3.1 Recourse and Credit Enhancement
One of the attractive features of covered bonds is their dual recourse
structure. That is, even if the cover pool assets are insufficient to pay
160. Capital arbitrage possibilities were “often an important driver of the use of
RMBS under Basel I.” DEUTSCHE BANK 2008, supra note 3, at 8–9.
161. EUROPEAN COVERED BOND FACT BOOK, supra note 2, at 38–39.
162. Risk pooling and credit enhancement are two features of MBS that make
them less risky than whole loans.
7–40
Alternative Funding Sources § 7:3.1
off bond holders in the event of default, the bank is still on the hook.
By contrast, for MBS there is only recourse to the mortgage pool. The
issuing Trust owns the mortgages backing the securities, and is
decoupled from the bank that originally owned the mortgages, so the
pool assets provide the only security. Payments on the MBS are made
with cashflows from the mortgage pool, and from any credit enhance-
ment features of the issuing trust. If the cashflows fall short, the
securities realize losses, starting with those in the lowest seniority
tranche, or else on a pro rata basis for pass-through MBS.163
In the U.S. covered bond structure, the Institution setting up the
covered bond program funds a statutory trust as a vehicle for issuing
the covered bonds. As previously shown in Figure 6-6, the trust is
funded by floating rate U.S. dollar denominated Mortgage Bonds that
are the unconditional general obligations of the Institution and are
secured by the cover pool. The Covered Bonds are the limited recourse
obligations of the statutory trust and are secured by the Mortgage
Bonds; the covered bond swaps that exchange floating U.S. dollar
payments for fixed Euro denominated coupons; and guaranteed in-
vestment contracts (or alternative, equivalent instruments) that pro-
vide standby liquidity in the event of Mortgage Bond default.
In addition to its dual recourse structure, Covered Bond investors
enjoy credit enhancement from cover pool overcollateralization. MBS
also use overcollateralization for credit enhancement, but unlike
covered bonds, MBS commonly employ subordination, excess spread,
and insurance/guarantees.164 Subordination is created through tranch-
ing the cashflows from the collateral pool to create separate classes of
securities with different seniority. Excess spread is the difference be-
tween the net interest rate on the underlying mortgages and the
weighted average coupon on the MBS. Cashflows in excess of MBS
coupon payments can be used, after covering any losses, to prepay the
principal, typically of senior tranches, or to build up a reserve fund to
provide protection against future losses.165 Such losses from the mort-
gage pool can be offset through bond insurance, guarantees such as
stand-by letters of credit from a bank, or in the case of agency MBS or
CMOs derived from pools of agency MBS, by the issuing GSE.166
Collateral default protection is a built-in feature of covered bonds.
Unlike the static mortgage pools that collateralize MBS, cover pools
are dynamic. Non-performing assets must be immediately substituted
for performing assets to comply with the Asset Coverage Test.167
163. Adelson, MBS Basics, supra note 48.
164. Id. at 22–24.
165. Id.
166. Id. at 24.
167. See, e.g., BOA PROSPECTUS, supra note 5, at 2.
7–41
§ 7:3.2 COVERED BONDS HANDBOOK
§ 7:3.2 Prepayment Risk
The dynamic feature of covered bond collateral pools eliminates
prepayment risk.168 Eligible assets must be added to the cover pool in
the event of mortgage prepayment, so prepayments do not affect the
security provided by the cover pool.169 This lack of prepayment risk
means that covered bonds perform more like other fixed income
securities than U.S. MBS, for which prepayment risk is significant.
An institution issuing a covered bond commits to adding eligible
collateral to the cover pool as needed over the life of the bonds. This
means that issuing covered bonds would involve a greater commit-
ment of collateral than issuing MBS collateralized with the same
initial pool of mortgages. This greater commitment of collateral
provides credit enhancement and is a major reason for the lower
yields for covered bonds, compared with MBS collateralized with
similar assets. The issuer enjoys lower yields, but retains the risks of
maintaining the collateral pool—that is, prepayment risk, mortgage
loan default risk, and any interest rate risk between the fixed rate
mortgage loans and the floating rate Mortgage Bond obligations
secured by the pool.
Prepayment of mortgages in an MBS collateral pool results in the
repayment of principal—reducing the principal amount of MBS out-
standing. By tranching mortgage loan cashflows, prepayments can be
allocated to specific classes of securities.170 Typically, the most senior
tranches are repaid first, thus preserving the size of the subordinate
classes, or up until the end of a predefined “lockout” period. This is the
case in the so-called “six-pack” structure used in most private label
issues backed by Jumbo mortgage loans, and refers to its six layers of
subordination.171
§ 7:3.3 Accounting
Whereas mortgage assets used to collateralize U.S. covered bonds
remain on a bank’s balance sheet and consequently impose a capital
charge, securitization removes them from the books in one of two
ways. If the mortgages conform to Agency guidelines in terms of credit
quality, loan size, and other characteristics, then they can be sold to the
Agencies directly in exchange for either cash or securities (Agency pass-
throughs). If, on the other hand, the mortgage pool is non-conforming
168. Adelson, MBS Basics, supra note 48.
169. See, e.g., BOA PROSPECTUS, supra note 5, at 3.
170. Adelson, MBS Basics, supra note 48, at 16.
171. In some CMO structures, known as “planned amortization classes,” the
repayment of principal is scheduled to occur during a particular time
period as long as actual prepayments are not outside preset bounds. Id.
at 18–23.
7–42
Alternative Funding Sources § 7:3.4
(typically because the loans are too large, they lack documentation, or
the average credit quality is substandard), then they can be used to
collateralize private label (that is, non-Agency) MBS or sold to a non-
Agency MBS issuer. In private label issuance, a bankruptcy remote trust
is established to hold the mortgage assets and, while it is typical that a
private label issuer retains the riskiest securities of the deal, the mort-
gages themselves remain decoupled from the bank’s balance sheet.
Whether mortgages are securitized or used as security for a covered
bond program, bankruptcy remoteness is assured by FDIC rules that
legally isolate the mortgage assets in the event of FDIC conservator-
ship or receivership. However, recent changes to accounting rules
created uncertainty regarding the status of the FDIC Securitization
Rule, which provided the assurance of bankruptcy remoteness for private
label securitization by insured depository institutions. The Financial
Accounting Standards Board (FASB) Statements, issued on June 12,
2009, tightened the accounting for financial assets transferred for
securitization for fiscal years beginning after November 15, 2009.172
Rather than being treated as sales, transfers for securitization will be
treated as secured borrowings—that is, as if the assets remained on the
balance sheet. In response, the FDIC extended an Interim Rule preserv-
ing the pre-existing safe harbor for securitizations. 173 Additional
changes to the Securitization Rule are expected in the Final Rule to
add additional conditions on banks engaged in private securitization to
“realign the incentives of the securitization process.”174 Such measures
could include additional disclosure and risk retention requirements.175
§ 7:3.4 Liquidity
Prior to the financial crisis, the market for MBS with a triple-A credit
rating was broad. Broad-based demand for MBS and standardization of
the securities issued by different underwriters contributed to liquidity.176
172. FASB, Accounting for Transfers of Financial Assets, an Amendment for
FASB Statement No. 140, Statement of Financial Accounting Standards
No. 166 (June 12, 2009), and FASB, Amendments to FASB Interpretation
No. 46(R), Statement of Financial Accounting Standards No. 167 (June 12,
2009).
173. FDIC, Interim Final Rule amending 12 C.F.R. § 360.6 Regarding the
FDIC’s Treatment, As Conservator or Receiver, of Financial Assets Trans-
ferred in Connection With a Securitization or Participation (Nov. 12,
2009).
174. MORRISON & FOERSTER, FDIC EXTENDS SECURITIZATION SAFE HARBOR
AND PORTENDS FURTHER SECURITIZATION REFORMS (Nov. 18, 2009).
175. Id.
176. Agency MBS traded relatively close to the mark-to-market prices at which
they were recorded on the books, which is a good indicator of liquidity.
This is an observation made with the benefit of confidential data produced
by parties in connection with financial crisis-related litigation.
7–43
§ 7:3.4 COVERED BONDS HANDBOOK
Covered bonds also have a broad investor base, mainly in Europe, and
benefit from market making requirements. In the case of Jumbo issues,
industry practice mandates narrow bid-ask spreads in the secondary
market (see supra section 7:1.3[F]).
Another measure of the liquidity of the MBS and covered bond
markets is issuance volumes. Figure 7-10 compares the quarterly
issuance of non-Agency prime MBS with European Jumbo covered
bonds. The size of the U.S. non-Agency prime MBS market is
comparable in size to the European Jumbo covered bond market. In
the first quarter of 2007 there was about $60 billion in non-Agency
prime MBS issuance compared with about €50 billion in Jumbo
covered bonds. However, during the financial crisis the impact on
U.S. non-Agency prime MBS issuance was more immediate than the
effect on the Jumbo covered bond market.
Figure 7-10
Issuance of Non-Agency Prime MBS Versus
Jumbo Covered Bonds
Subprime MBS issuance began to decline in the third quarter of
2006. Non-Agency prime MBS issuance did not begin to decline until
the third quarter of 2007, however, within a year the market was
7–44
Alternative Funding Sources § 7:3.4
effectively closed down. European Jumbo covered bond issuance also
dropped in the third quarter of 2007 and was also effectively closed
down in the fourth quarter of 2008, but has since recovered. U.S. non-
Agency prime MBS issuance has not yet recovered. The recovery of
U.S. Agency MBS issuance was made possible by the U.S. government
bailout of Fannie Mae and the purchase by the U.S. Federal Reserve of
an estimated 80 to 85% of the securities Fannie Mae issued in the first
three quarters of 2009.177
The resumption of European Jumbo covered bond issuance oc-
curred at higher yields of between 48 and 123 basis points above
swaps.178 Then, in May, the ECB announced its intention to buy back
€60 billion of Euro denominated covered bonds. 179 The program
became effective in July, but contributed to a burst of new issues in
May that almost doubled the year-to-date volume. 180 By September,
the European covered bond market had completely recovered, record-
ing its second busiest month ever of new issues (the previous high was
January 2006).181 Spreads narrowed, in the case of Eurohypo, to
within 7 basis points of its pre-crisis yield to swap rate and 86 basis
points lower that the yield it achieved on its March issue. 182
By contrast, European MBS market issuance has not yet returned to
pre-crisis levels of liquidity or pricing. The first deals since the onset of
the financial crisis occurred in April by Lloyds (£3.9 billion) and
Nationwide priced at 170 basis points and 145 basis points over
swaps. These were underwritten with the help of pre-placement via
JPMorgan Chase. The Lloyds deal included a five-year put-back to the
issuer to mitigate extension risk, a concession that “would not have
been necessary pre-2007.”183
Covered bonds can be structured with more collateral or stricter
eligibility standards, to secure a top credit rating. However, the credit
enhancement features of MBS, in particular the use of tranching, are
more complicated to model and hence to rate. MBS rating failures
have been blamed for contributing to the over-expansion and collapse
of the subprime MBS market,184 which triggered the financial crisis.185
177. Jenny Anderson, Debt-Market Paralysis Deepens Through Credit Drought,
N.Y. TIMES, Oct. 7, 2009.
178. BERND VOLK, DEUTSCHE BANK, EUR 6.5 BN OF NEW EUR JUMBO COVERED
BOND ISSUES (May 15, 2009) [hereinafter DEUTSCHE BANK, May 15, 2009].
179. Philip Moore, Covered Bonds: Picking Up Tacks In Front of the Steamroller,
EUROMONEY, Nov. 1, 2009 [hereinafter Moore].
180. DEUTSCHE BANK, May 15, 2009, supra note 178.
181. Moore, supra note 179.
182. Id.
183. Bowman, Securitization, supra note 52.
184. See, e.g., Jennifer Hoyt, Moody’s Profit Drops 48%, Reflecting State of
Market, WALL ST. J., July 31, 2008.
185. See, e.g., Sabry & Okongwu, supra note 94.
7–45
§ 7:3.5 COVERED BONDS HANDBOOK
In this context, the less complicated features of covered bonds are an
advantage, being potentially less vulnerable to the risk of rating failure.
§ 7:3.5 Ratings
MBS credit enhancement typically takes the form of overcollater-
alization, private insurance, excess spread, and subordination, the
effect of which differs in each tranche, helping to create different risk
profiles.186 The ratings agencies model possible cashflows and use
their own customized loss criteria to determine a bond’s credit rating.
Each tranche must be able to withstand a pre-determined level of
collateral pool losses in order to qualify for triple A-rated status.
Agency MBS do not carry ratings because the Agencies assume the
default risk on the underlying loans, for which they charge a fee.
The counterparty risk on this guarantee is effectively nil because the
Agencies are backed by the U.S. government.
§ 7:3.6 Assets
Covered bond cover pools are typically restricted to prime mort-
gages, but can also include other assets and debt, such as public debt.
Securitization techniques with credit enhancement are used to issue
securities backed by a wide range of non-mortgage assets (for example,
ABS). Auto loan and credit card receivables comprise the majority of
the non-mortgage asset classes that are securitized; there is also a
market for other types of assets and receivables, including healthcare
receivables, heavy equipment loans, and aircraft leases. 187
Whereas a trust is used to hold collateral to secure a single cohort of
MBS, a cover pool may provide a common security interest for several
covered bond issues that are part of the same program. Thus, there is
not a separate cover pool for each covered bond issue.
§ 7:3.7 Investors
The U.S. covered bond market is immature, with only a few
issuances to date. However, the depth of the European market in-
dicates that the potential for broad-based participation is real. The
domestic investor demand for covered bonds in the United States has
no doubt been dampened by the availability of implicitly subsidized
Advances via the government chartered FHLB System and securitiza-
tion by Freddie Mac and Fannie Mae. Were the level of government
support for these institutions to decline, the relative demand for
covered bonds would likely increase.
186. See, e.g., Adelson, MBS Basics, supra note 48.
187. BHATTACHARYA & FABOZZI, supra note 155.
7–46
Alternative Funding Sources § 7:4.1
In the United States, institutional investors such as banks, insur-
ance companies, and pension funds have historically had strong
appetites for MBS and ABS. This is driven by a variety of MBS features,
including the following:
• high returns compared to fixed income instruments of compar-
able quality and maturity;
• high credit quality in the case of Agencies;
• wide range of cashflow profiles accommodated through the
structuring process;
• good liquidity; and
• excellent analytic tools that have been developed for the pur-
poses of modeling and pricing.188
These are features with enduring appeal that underpin the con-
tinuing major role of securitization in U.S. financial markets.
§ 7:4 FHLB Advances Compared to Covered Bonds
FHLB Advances provide banks that are members of the FHLB
System with the opportunity to finance pools of mortgages held on
their balance sheet in a similar fashion as they would issuing covered
bonds to private investors. The features of FHLB Advances and how
they compare with covered bonds are described in this section.
§ 7:4.1 Assets/Collateral
Collateral eligible to secure FHLB advances includes the following:
• mortgage loans,
• Agency MBS,
• certain other securities including government securities, and
• cash deposits with the FHLB.189
The FHLBs require substantial levels of overcollateralization based on
the quality of assets, and can usually demand additional collateral or
substitute collateral at will during the life of an Advance. Collateral
arrangements vary depending upon borrower credit quality, financial
condition and performance, borrowing capacity, collateral availability,
and overall credit exposure to the borrower. Covered bonds are
typically overcollateralized by 10%, compared with 30% for FHLB
188. SALOMON SMITH BARNEY GUIDE TO MORTGAGE-BACKED AND ASSET-
BACKED SECURITIES 11–13 (Lakhbir Hayre, ed. 2001).
189. FHLB CONSOLIDATED FIN. STATEMENT, supra note 26, at 99.
7–47
§ 7:4.2 COVERED BONDS HANDBOOK
Advances.190 Perhaps more significantly, covered bond collateral rules
are set in advance and are not subject to change.
Figure 7-11 below shows the collateral “lending values” reported for
different asset classes by the FHLB System as of December 31,
2007. 191 This measure is the reciprocal of the rate of
overcollateralization.
Figure 7-11
Collateral “Lending Values” by Asset Class
In addition to collateral demanded by FHLBs to secure Advances,
member banks must purchase capital stock in the FHLB equal to about
5% of the outstanding amount of their Advances.192
§ 7:4.2 Recourse
A FHLB would typically take physical possession of collateral in the
event of deteriorating financial condition of a member. Historically,
when an insured depository institution member has failed, the value of
collateral, including any FHLB stock owned by the member, has
almost always far exceeded the outstanding Advances and other credit
obligations to the FHLB.193
190. MOFO, AN UPDATE ON COVERED BONDS, supra note 39.
191. These values are expressed by FHLB as collateral lending values. FHLB
CONSOLIDATED FIN. STATEMENT, supra note 26, at 100.
192. Id.
193. Federal Home Loan Bank System, Lending and Collateral Q&A (Dec. 4,
2008) [hereinafter FHLBS, Lending and Collateral Q&A], at 10.
7–48
Alternative Funding Sources § 7:4.4
In addition to the security provided by overcollateralization, the
FHLBs have a statutory super-lien on collateral in the event of bank-
ruptcy of a member ahead of the FDIC. This enables the FHLBs to
demand priority repayment of Advances when a member institution
fails,194 putting the security interest of the FHLB ahead of the other
secured creditors and uninsured depositors. This is similar standing as
provided to covered bond holders over the cover pool. As a conse-
quence of its collateral policies and its super-lien, no FHLB has ever
experienced a credit loss on an Advance.195 The dual recourse feature
of covered bonds provides even more security allowing investors to
claim against the general assets of the issuer.
§ 7:4.3 Member Credit Limits
Member credit limits are designed to mitigate the FHLBs’ credit
exposure to individual borrowers and also have the effect of encoura-
ging borrowers to diversify their funding sources. 196 Each FHLB
determines the credit limit of a member by evaluating a wide variety
of factors, including, but not limited to, the borrower ’s overall cred-
itworthiness, collateral management practices, and the quality of
pledged collateral.197 The aggregate limit is set based on the amount
it will lend against each collateral type. Each regional FHLB also
manages its credit exposure to Advances by conducting ongoing
reviews of the financial condition of its borrowers.
Typical FHLB borrowing limits are in the range of 35% to 55% of a
member ’s total assets. By contrast, the FDIC has established a 4%
ceiling on covered bond issuance as a percent of bank liabilities. 198
§ 7:4.4 Term Structure
While the FHLBs do offer some long-term Advances, most Advances
have terms of two years or less. Figure 7-12 presents the maturity
profile of outstanding Advances at year-end 2006 and 2007. The terms
194. If there are FHLB advances in the institution at failure, the FDIC as
receiver promptly pays off the principal and interest to date. The FHLB
then demands a prepayment fee under regulation. The regulation allows
prepayment fees not to “exceed the present value of the loss attributable to
the difference between the contract rate . . . and the reinvestment rate. . . .”
See FDIC, Federal Home Loan Bank System, supra note 128.
195. FHLBS, Lending and Collateral Q&A, supra note 193, at 10.
196. A borrower ’s total credit limit with an FHL Bank includes the face amount
of outstanding letters of credit, the principal amount of outstanding
advances, the total exposure of the FHL Bank to the borrower under any
derivative contract, and credit enhancement obligation of the member on
mortgage loans sold to the FHL Bank (if any).
197. FHLBS, Lending and Collateral Q&A, supra note 193, at 5.
198. FDIC Policy Statement, supra note 36.
7–49
§ 7:4.5 COVERED BONDS HANDBOOK
on which long-term Advances are made available to members may
also depend on an evaluation of a creditworthiness and financial
condition. By comparison, covered bonds are typically issued with
maturities of between five and ten years. These longer maturities lower
refinancing costs and more closely match the maturity of underlying
collateral.
Figure 7-12
Outstanding FHLB Advances
Many of the FHLBs’ Advances are callable at the option of a
member. However, the FHLBs charge a prepayment fee when members
terminate certain Advances. Members may repay other advances on
specified dates (call dates) without incurring prepayment fees (callable
Advances).
§ 7:4.5 Potential for Regulatory Reform
The housing finance crisis, which escalated through 2008, resulted
in Fannie Mae and Freddie Mac being taken into conservatorship by
the federal government.199 Although the FHLB System has performed
better through the crisis, the turmoil in housing finance markets has
led to large unilateral increases in FHLB debt issuance to fund a large
increase in Advances, greatly increasing the system’s exposure to
systematic risks. Aggregate outstanding FHLB Advances increased
199. Press Release, Federal Housing Finance Agency, Statement of FHFA
Director James B. Lockhart (Sept. 7, 2008), available at www.treas.gov/
press/releases/reports/fhfa_statement_090708hp1128.pdf.
7–50
Alternative Funding Sources § 7:4.5
35% from $641 billion in 2006 to $875 billion in 2007. 200 These
events have fueled calls for an overhaul of the housing GSEs, with the
aim of reevaluating the role that they should play in housing finance.
The Administration has also recommended that Congress establish a
new agency that would regulate all of the housing GSEs, including the
FHLB System.201 Features of the FHLB that have raised concern and
could be the subject of reevaluation include:
• The moral hazard arising from its mutual ownership structure
and the perceived federal guarantee. As was illustrated by the
IndyMac bank failure (which was preceded by large increases in
FHLB Advances), the FHLBs have incentives to provide loans to
failing member banks without bearing the costs of bank
failure.202
• The cross-guarantee provision in the FHLB System’s consoli-
dated debt obligations, which reinforce the moral hazard pro-
blem.203 Funding costs for the individual member banks reflect
the average risk of the FHLB System rather than the exposure of
any one institution. Hence, any FHLB System-wide incentive to
increase risk because of the implied federal guarantee is further
accompanied by an incentive at the individual FHLB level to
increase risk relative to its sister institutions.204
• The current resolution process involving Advances gives FHLBs
a preferred status over other secured creditors, including the
Federal Reserve Banks.205
Reliance on FHLB Advances for future financing needs involves the
assumption of regulatory risk. Specifically, the risk of material changes
in the terms on which FHLB funding will be available in the future.
The competitiveness of covered bond financing is influenced by the
regulatory support for ensuring bankruptcy remoteness of assets in the
absence of covered bond legislation. However, in the current climate,
the regulatory risks of a change in government support for GSE
mandates may be greater than any regulatory risk to the development
of the U.S. covered bond market.
200. FHLB CONSOLIDATED FIN. STATEMENT, supra note 26, at 39.
201. FHLBANK SYSTEM, supra note 130.
202. Ronnie J. Phillips, Will “Flub” Follow Fannie and Freddie?, FORBES.COM,
Feb. 11, 2009.
203. One counterargument to this assumption is that joint and several liability
may induce the FHLBs to monitor one another. However, the Banks may
lack the willingness to do so because of the standard “free-rider” problems,
the presence of the implicit federal guarantee, and the fact that they have
no authority to directly discipline each other.
204. Flannery & Frame, supra note 140, at 48.
205. FHLBANK SYSTEM, supra note 130.
7–51
§ 7:4.6 COVERED BONDS HANDBOOK
§ 7:4.6 Funding Cost
The FHLB’s implicit government guarantee lowers its cost of
borrowing and in turn enables the FHLBs to offer Advances at lower
rates to member banks. The implication of the government guarantee
is that if the FHLB System were to suffer financial distress, the
government would step in and bail it out—along with the holders of
bonds issued by the FHLB System. However, the risk of such distress is
low because the priority granted to FHLB Advances by the FDIC in
conservatorship and receivership has meant that the FHLB has never
failed to recover Advances. Covered bonds enjoy a similar priority.
Covered bonds compete with FHLB Advances as alternative sources
of bank funding. The WaMu and BOA issues, priced at a few basis
points above the swap rate, proved that, at least for large institutions,
U.S. covered bonds can provide a less expensive source of funds. 206
§ 7:5 Prospects for Covered Bonds in the Post Financial
Crisis Economy
The GSEs, Freddie Mac, Fannie Mae, and Ginnie Mae, as well as
the FHLB System, have been an integral source of funding for the U.S.
housing market over the last three decades. Whether through explicit
loan programs or via securitization and secondary market sales, both
lenders and borrowers have benefited greatly from these programs. For
lenders, GSEs have enabled lenders to better match liabilities and
remove assets from their books; for borrowers, efficient financing has
led to a competitive primary market and lower interest rates. However,
the future of the GSEs remains unclear.
Currently, the Agencies function as government-owned entities
surviving only through extensive taxpayer support. As the financial
crisis resolves and the economy begins to stabilize, the government
programs introduced to provide transitional support to the financial
sector are expected to be wound down. This may trigger a wider review
of existing GSE charters and government support. Any changes to GSE
charters would likely have implications for the future of U.S. covered
bonds.
The FHLB System, like the Agencies, was designed to address the
housing crisis of the Great Depression. While it has not required a direct
government bailout, the FHLB System enjoys preferential status from
the government through implicit support and borrowing rights. Like
the Agencies, the FHLB System may have crowded out development of a
206. See supra section 7:1.2[A].
7–52
Alternative Funding Sources § 7:5
U.S. covered bond market.207 A scaling back of government support for
the FHLB System could increase interest in covered bonds.
After the rapid deterioration of the U.S. financial system starting in
2007, and gaining momentum following the collapse of Bear Stearns
and Lehman Brothers in 2008, the government brought about a host of
emergency financing programs, including the Temporary Liquidity
Guaranty Program (TLGP), Term Asset-Backed Securities Lending
Facility (TALF), and Public-Private Investment Program (PPIP). 208
Some of these initiatives could also crowd out the development of a
domestic market for covered bonds. For example, TLGP is designed to
insure senior bank debt through 2012—in essence, replicating the dual
recourse feature of covered bonds. The TLGP program was extended
on October 20, 2009 for six months with increased fees as part of an
orderly phase-out.209 When the phase-out of federal supports will
actually be completed is uncertain.
Proposals being discussed for changes in banking regulation in
general could also influence the attractiveness of covered bonds.
According to Kevin Bailey, Deputy Comptroller of the Currency that
regulates national banks, one proposal would require banks to operate
under new measures to control their dependence on short-term
funding.210 To the extent that covered bonds could provide a substitute
source of funding that would increase the maturity profile and lower
dependence on short-term funding, such a policy could promote the
development of a domestic covered bond market.211
Eventually, the stabilization of U.S. housing prices will be the key to
attracting private investors back into the mortgage finance market.
Stable house prices will alleviate some of the need for government
207. Jerry Marlatt, Prospects for a Future Covered Bond Market to Finance
Home Mortgages in the United States, COVERED BOND INVESTOR, May 20,
2009.
208. TLGP is designed to insure senior bank debt; TALF provides financing for
investors to buy asset-backed securities; PPIP is a vehicle for the federal
government to purchase assets and equity from financial institutions to
strengthen its financial sector.
209. FDIC, Final Rule Regarding Limited Amendment of the Temporary
Liquidity Guarantee Program to Extend the Transaction Account Guaran-
tee Program with Modified Fee Structure, 12 C.F.R. pt. 370 (Aug. 26,
2009).
210. Henny Sender, Move to Halt Bank Over-Reliance on Short-Term Funds,
FIN. TIMES, Sept. 28, 2009.
211. While covered bonds involve taxpayer support provided via the priority
granted in bankruptcy, the FHLB has equivalent priority. Unless covered
bond underwriting practices were sufficiently weaker than FHLB practices
to raise bankruptcy risk, replacing government support for the FHLB
System with equivalent support for covered bonds would have no net
cost to the taxpayer.
7–53
§ 7:5 COVERED BONDS HANDBOOK
guarantees and allow a rethink of government supports for housing
finance. Any transition away from government-supported housing
finance could be a natural segue into the development of a U.S.
covered bond market.
7–54
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