Thursday, April 17, 2008

Some structured credit products still AAA

(FT) German bank LBBW - relatively speaking one of the hardest hit institutions by structured finance - has €68.3bn of covered bonds outstanding.

While LBBW has an institutional rating of A+, all of its covered bonds were affirmed AAA on Wednesday by Standard & Poor’s:

Standard & Poor’s considers that the ratings are sufficiently supported by:

- The credit quality and cash flow adequacy of the collateral;
- The adequacy of available, currently high overcollateralization that mitigates the only moderate market and liquidity risks; and
- The protection provided by the German Covered Bond Act (”Pfandbriefgesetz”).

In the US - where covered bonds have only been around since 2006 - WaMu has a $9.5bn covered bond programme, downgraded one notch last week by Moody’s to Aa1 from Aaa. In itself, that downgrade is highly unusual - covered bonds aren’t supposed to be downgraded. Put it down, perhaps, to litigation risk in a country where the structures’ legal security is so far, in practice, untested.

Consider, though, that the WaMu covered bond is backed by mortgage securities. Regular MBS issued by WaMu have in recent months gone from triple-A to BBB in one fell swoop. Covered bonds are safe things. They’re probably the only structured, mortgage-backed instruments whose ratings still mean anything.

Here’s another facet to covered bonds which will make them more saleable in the current climate: under the European statutory model for them (e.g. the “Pfandbriefgesetz” in Germany mentioned by S&P), there’s no off-balance sheet SPV shenanigans to worry about. Collateral for covered bonds is taken from a secured, dynamic pool of assets on the issuer’s balance sheet. And if the pool proves to be insufficient, noteholders have full recourse to other assets beyond it.

Finally, there’s the price. Covered bonds are cheaper to structure, but crucially, cheaper full stop. Last summer they were being issued at rates 30bp tighter than comparable bonds issued by A-rated institutions.

European banks are moving quickly with the covered bond theme. Swedbank is converting all of its outstanding long-term funding into a massive covered bond issue. Put, by some, at €67bn. SocGen reportedly has a €25bn obligations foncières (covered bond) issue in the pipeline.

In the UK (where in the absence of a specific law, SPVs come into play) Alliance & Leicester has just got away an inaugural €10bn AAA-rated issue.

A big impediment before now to covered bonds taking off in the US was Fannie and Freddie. Jumbo to GSE MBS spreadWith a deep market in “gilt” MBS already established, there wasn’t much call for a new, legally challenging instrument to come to market. Now, of course, rates in the market of MBS securities unsuitable for GSE transmutation are ridiculously high. The graph opposite is the spread between jumbo loans (ineligible for GSE use) and regular 30-year mortgages (eligible). Up to a level of 140bp from 28bp in the first half of 2007, according to Bloomberg.

If banks need a little push in the right direction, then at least it seems policymakers are aware of it. Because as disclosed on Tuesday…

The Policy Statement provides that the consent of the FDIC, as conservator or receiver, is given to covered bond obligees to exercise their contractual rights over collateral for covered bond transactions conforming to the Policy Statement no sooner than ten (10) business days after a monetary default on an IDI’s obligation to the covered bond obligee, as defined below, or ten (10) business days after the effective date of repudiation as provided in a written notice by the conservator or receiver.

Effective immediately.

Alas, the FDIC is still playing softball since the guarantee is only good on bond issues up to 4 per cent of the issuer’s total liabilities. But it’s the thought that counts. And a 10 day get-your-money-back guarantee on the bonds that do get issued is very attractive in the current market. Just the kind of good PR covered bonds might need to start being taken seriously.

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