Wednesday, July 9, 2008

On covered bonds and subprime mortgages

(FT Alphaville) Hank Paulson has been singing their praises for some time now: covered bonds. But it was only in a speech yesterday when he outlined their potential for the US mortgage securitisation market that they’ve got much shrift. The WSJ covers some of the Paulson speech:

Speaking at a mortgage lending forum in Virginia, Mr. Paulson said he is working with the Federal Deposit Insurance Corp., the Federal Reserve and other federal offices “to explore the potential of covered bonds,” which he described as a “promising vehicle” to speed up the availability of mortgage financing.

Paulson - notably - also touted the benefits of subprime and the need specifically, for the subprime mortgage market in the US to start rolling once more. From Dealbreaker:

Hank Paulson lamented the disappearance of the subprime markets in a speech today…

The interesting part was his plea that the US “not lose the benefits of the subprime market as we eliminate its flaws.” Paulson said that his boys were working on the possibility of covered bonds playing a major part in the mortgage market as a means to increase the availability of mortgage financing. The loss of financing for subprime mortgages has made the correction “more challenging.”

Felix Salmon at Market Movers is also on the case:

Could covered bonds be part of the solution to the current credit crisis? Paulson thinks so, and so do I. They’re not a panacea, by any means. But they certainly can’t do any harm, and they might be able to do some good.

But how much are covered bonds the answer? In the past, we’ve touted their benefits - and there are quite a few. But in terms of getting the subprime market moving again - securitising non-prime loans - the structures are inherently unsuitable.

Subprime securitisation works because you overcollateralise to accommodate statistically modelled losses: in a subprime RMBS or CDO, you expect losses to occur, and the tranching - the structuring - is what compensates for this and allows for ratings all the way to triple A.

The tranches are ‘attached’ to the collateral in such away so as to reflect the statistical unlikelihood of - say - 50% collateral default with only 50% recovery. In that very bearish scenario, 25% of the collateral’s value is lost. If the AAA attachment point was 70% - it would still not see those losses. Thus it’s AAA.

In a covered bond though the security - the AAA rating - is achieved differently and not through tranching. The triple A (at least going by form) comes from the quality of the collateral on offer and the fact that it is secured in an on-balance sheet pool, immediate recourse to which is protected by specific statute.

Further, the market value of that pool is set and the issuing bank has to make substitutions in the event of collateral deterioration. And Further in many cases the bondholder has full recourse to the issuers balance sheet in the event of a shortfall.

Thus the backing for covered bonds in Europe is unexciting: prime mortgages, public sector debt and ship loans. For the full lowdown, pay a visit to the ECBC website - the European Covered Bond Council.

Maybe this is just splitting hairs, however. Covered bonds could be used effectively for prime mortgage debt. The important thing, though, will be in ensuring that a law is passed by the US government to allow for their swift takeup. European countries all have covered bond laws.
Without a law, covered bonds for investors are just another confusion of Delaware companies and complex trusts. In other words, not particularly saleable in the current market.

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