Coming to America: Covered Bonds?
Ultimately, covered bonds and ABS are complements, not substitutes.
On May 18, 2012, the Securities and Exchange Commission effectively announced
that it would allow the Royal Bank of Canada to register and publicly sell
covered bonds in the U.S. market.1 The offering marks the first time covered bonds will be sold to retail
investors in the United States. Previously, only “qualified institutional investors” were permitted to purchase covered bonds. Meanwhile, separate bills now in the
House of Representatives and Senate seek to establish a legal framework for
covered bond issuance by U.S. banks.2 This essay explains covered bonds, the motives for legislating a market for
them, and the advantages and disadvantages of covered bonds versus asset-backed
Covered bonds are a type of collateralized debt. The bond seller, typically a
bank or other type of financial institution, maintains a “cover” pool of high-quality assets on its balance sheet to which the bond buyer has
priority claim (ahead of any other creditors) should the seller default. Hence,
the bond buyer has dual recourse to both the bond seller and the specific pool of assets backing the bond should
the seller become delinquent on its payments.
While covered bonds are new to the United States, Europeans have used them for
centuries. A 1769 executive order by Frederick II of Prussia established the
first covered bonds (called Pfandbriefe in German, or literally “letter of pledge”), though they did not assume their current form until the German Mortgage Bank
Law of 1899.
So why is there now a legislative effort to establish a covered bond market in
the United States? Covered bonds have attracted the attention of U.S. lawmakers
in the aftermath of the financial crisis primarily as an alternative to ABS,
which have been widely blamed for providing perverse incentives to loan
originators and fueling the recent housing bubble. Securitization, or the
process of creating ABS by packaging assets together (such as loans) and
selling their payment streams, potentially engenders a principal-agent problem.
The principal-agent problem occurs when one party (the agent) is charged with
making decisions on behalf of a second party (the principal), but the agent is
not fully incentivized to act in the principal’s best interest. In the securitization process, for example, the security buyer
assumes all risks associated with the actual repayment of the loan. The bank
that originated the loan faces no financial losses should the loan sour. As a
result, the bank may have little incentive to make high-quality loans.
Providing the framework for U.S. banks to issue covered bonds has been proposed
as one solution to the principal-agent problem associated with securitization.
Covered bonds require the bond seller to hold the assets underlying the bond on
its own books; thus the seller retains all exposure to the credit risk of the
loans. Moreover, a covered bond seller must actively manage the cover pool to
ensure the pool’s value. All else equal, this should incentivize only high-quality loan
origination. Another solution would be to force the banks that originate loans
that become securitized to hold the “equity” tranche of the ABS issuance, as, for example, German law requires. The
securities in the equity tranche are the first and hardest hit by any losses to
the value of the underlying assets, so requiring banks to hold this tranche
would force them to have “skin in the game,” thereby alleviating the principal-agent problem.
Ultimately, covered bonds and ABS are complements, not substitutes. ABS are a
vehicle for packaging and selling exposure to private credit risk, with the
promise of the higher returns that holding such risk entails. Covered bonds are
a means for banks to raise long-term funding at a lower cost than if they
issued unsecured debt. The assets underlying a covered bond simply enhance the
issuer’s promise to pay back the loan and are not intended to offer exposure to the
underlying pool of assets. These differences between the two instruments are
reflected in their payment structure: ABS typically pay floating interest rates
and pass through any early payments; covered bonds typically pay a fixed
interest rate and mature on a fixed date, like any other type of bond.
Although there may be disadvantages to banks selling the loans that they
originate, there are also advantages. Securitization increases the financial
system’s capacity to lend in a way that covered bonds do not. By moving loans off the
originating bank’s balance sheet, securitization reduces the amount of capital (reserves) that
the bank must hold to back its loans. As a result, banks can make more loans
with the same amount of capital. Covered bonds, which keep the loans on the
banks’ balance sheets, do not offer this benefit.
2 The House and Senate bills, respectively, are H.R. 940: United States Covered
Bond Act of 2011 and S. 1835: United States Covered Bond Act.