Thursday, November 4, 2010

Don't Make Covered Bonds the New Toxic Securities

Covered bonds are the original structured finance security and are frequently mentioned as a potential replacement for the multi-tranche structured finance securities used to fund mortgages, credit cards and auto loans.  

Covered bonds were developed decades ago in Europe and share several features with all asset-backed securities, including the toxic asset-backed securities:  

  1. They use the cash-flow from a pool of assets to make the bond’s principal and interest payments;
  2. They give the investors in the bond a perfected security interest in the pool of assets that isolates the assets and insulates the pool should the issuer becoming insolvent;
  3. They use over-collateralization in the asset pool as a credit enhancement;
  4. They provide very little in the way of disclosure on the underlying assets on a once-per-month or less frequent basis.  
This where the major similarities to the multi-tranche asset-backed securities ends.  

There is one feature in particular which is unique and has drawn attention to covered bonds.  During the life of the bond, the issuer remains on the hook for the performance of the underlying collateral.  If the collateral does not perform as expected whether from prepayments or defaults, the issuer must replace all “non-performing” assets in the collateral pool with performing assets or other acceptable collateral.

This is a one hundred percent (100%) skin in the game retention requirement.

Is there any reason that investors should take comfort from this retention requirement and skip doing their homework on the individual assets backing the covered bond?

Supporters of covered bonds would say yes.  They have to be saying yes because the legislation proposed to start the US covered bond market requires once-per-month reporting with little to no information on the actual performance of the individual assets.

The supporters assume that because this retention requirement gives issuers an incentive to underwrite and place in the covered bond pool only good loans or receivables, that they will do so.  Therefore, investors can 'trust' the quality of the underlying collateral because of the retention requirement.

Is this basic assumption true?  NO!

Over the last 40 years, there have been numerous examples of credit originators misjudging the riskiness of the loans they underwrote to their own detriment.  The list includes commercial banks that made loans to less developed countries (spurred on by the idea that countries never go bankrupt, but people do), Savings and Loans that made loans to commercial real estate (spurred on by trying to recover from its losses on fixed rate residential mortgages in a rising rate environment) and, most recently, the entire housing finance industry that made loans on residential real estate (spurred on by the idea that house prices in the US never decline).

Investors know this track record of credit institutions misjudging risk in the midst of a credit bubble.  They realize the high likelihood that at the same time the underlying assets are losing value, the issuer will also be failing and no longer able to replace the prepaying or dodgy assets in the covered pool.

In light of this history with credit bubbles, the question facing all covered bond investors is how to value these securities.

Since existing covered bonds offer an almost total lack of information on the performance of the underlying assets, investors are valuing and trading these covered bonds based on the perceived solvency of the issuer.  In particular, just like with the toxic asset backed securities for which no current information is available, investors rely on credit ratings.  In the case of covered bonds, investors look at how the issuer is rated.

One result of this reliance on ratings as a substitute for performance information is that covered bonds perform in a highly pro-cyclical fashion.  When the issuer is highly rated, the issuer has access to the covered bond market on attractive terms.  As shown from late 2007 through early 2009, when there were doubts about the solvency of the issuers in Europe, access to the covered bond market on any terms disappeared as the market froze except for purchases by the European Central Bank.

Another result of reliance on ratings as a substitute for performance information is that the covered bonds of issuers that fail become just like the toxic mortgage-backed securities.  Impossible to value.  

Fortunately, there is a solution that reduces the pro-cyclicality of covered bonds and allows investors to value and trade the covered bonds in a deep, liquid secondary market even if the issuer fails.

The solution is to disclose loan-level performance data on the assets supporting the covered bonds on the day an observable event occurs.  Observable events include payments and delinquencies on the underlying loans.  Investors will therefore always have current information about the status of the underlying collateral.

With performance data, investors in both the primary and secondary markets can do their own homework and analyze and value the covered bonds.  With performance data, investors can assess how dependent the covered bond's interest and principal payments are to replacement of the non-performing assets.  The less dependent, the more the covered bond is priced off the asset quality and not the issuer’s credit rating.  The more the covered bond is priced off asset quality, the more attractive this product becomes as a source of funding for issuers whether they have a credit rating or not.  The more the covered bond is priced off asset quality, the more robust the primary and secondary markets are and the less likely they are to freeze.

No comments: