This content is from: Portfolio

Cover your Bonds

After a blockbuster issue from Washington Mutual, more U.S. borrowers are seeking to tap the giant European covered bond market.

On September 27, Washington Mutual became the first U.S. company to tap the thriving European market for covered bonds, a variation on asset-backed securities. WaMu’s offering was so popular that underwriters at Barclays Capital were able to raise its size from E3 billion to E4 billion ($3.8 billion to $5.1 billion) in little more than one hour.

The Seattle-based savings and loan’s pioneering deal comes as the 237-year-old covered bond market — historically an obscure niche confined mostly to German issuers — undergoes a growth spurt. Issuance is expected to jump more than 20 percent this year, to E165 billion, from E135 billion in 2005, bankers say. And several other U.S. lenders, including Wachovia Corp. and Countrywide Financial Corp., are contemplating similar transactions.

Unlike asset-backed securities, covered bonds are secured by loans that remain on the issuer’s balance sheet. That gives lenders flexibility when dealing with retail borrowers and, most important, cheaper financing costs. Investors, meanwhile, have recourse to the underlying assets in the event of default, making covered bonds an extremely safe investment.

“You’re taking a non-triple-A issuer and using collateral to create a triple-A credit,” says Dominic Swan, head of structured investment vehicles at HSBC. That allows investors who limit their portfolios to only the highest-rated debt, such as central banks and insurers, to buy the securities.

For investors, the arrival of a U.S. issuer provides welcome diversification to a supply of covered bonds that now comes mostly from Germany and Spain, which account for roughly one third each of the overall market.

Covered bonds date back to 1769, when Frederick the Great of Prussia authorized their issuance to help rebuild the country after the Seven Years War. Until recently, the market was small and dominated by government-sponsored issuers. It took off in 1995 when German banks began offering jumbo covered bonds. The size of these issues, at least Dm1 billion ($720 million), fostered a more liquid secondary market and attracted a wider range of investors. Banks elsewhere in Europe soon followed suit.

WaMu created a special-purpose entity, the WM Covered Bond Program, to issue euro-denominated fixed-rate bonds and use the proceeds to buy dollar-denominated floating-rate mortgage bonds from WaMu that are backed by a specified pool of mortgages on the bank’s balance sheet. Those loans ultimately support, or “cover,” the bonds. The company received attractive terms on two tranches of securities: a five-year, 3.875 percent portion priced at 3 basis points over midswaps, the European benchmark for corporate issuers; and a ten-year, 4 percent tranche at 9 basis points over midswaps.

The deal garnered an Aaa rating from Moody’s Investors Service, several notches higher than the A3 rating on WaMu corporate bonds. The bank would probably pay a spread of about 15 basis points over midswaps to issue five-year mortgage-backed securities and 23 basis points for ten-year MBSs, estimates Timothy Skeet, London-based head of covered bonds at Merrill Lynch & Co.

WaMu tapped the European covered bond market to expand its investor base and as an alternative to borrowing from U.S. Federal Home Loan Banks. The S&L currently gets about 20 percent of its funding from FHLBs, but a proposal by the Federal Housing Finance Board to bolster the capital of those banks could increase WaMu’s cost of funds.

Experts predict that WaMu’s competitors will follow it into the covered bond market, to ensure that they too can secure lower-cost funds with which to make more-profitable mortgage loans. Indeed, ABN Amro estimates that U.S. banks could issue as much as E20 billion a year in covered bonds by 2008. Barclays Capital analyst Fritz Engelhard is even more bullish, predicting U.S. issuance of $100 billion by 2010. U.S. banks sold $663 billion in MBS in the first nine months of 2006, according to Dealogic.

“We’re looking at it with interest,” says Vincent Breitenbach, managing director of treasury finance at Countrywide, the biggest U.S. mortgage provider, referring to a potential covered bond issue. “We’ll watch what other people do and learn from their experiences.”

Related Content