US banks can find shelter in the covered bonds market - FT

--Covered bonds is championed among US to diversify funding sources, which consists of issuing unsecured debt, selling MBS, raising deposits, and advances from FHLB. --It offered double barrelled protection: access to issuers' general obligations and collateral pool of mortgages --It offered tigher spreads than other funding vehicles, 25 bps + LIBOR --Yet, it can not replace agency MBS in terms of funding sources. 4.5 tril out of 7 tril market goes to Agency MBS. Its large size and unfunded nature, dollar rolls, appeals to investors. By Ajay Rajadhyaksha Hank Paulson, US Treasury Secretary, has started promoting covered bonds as an alternate source of financing for US banks. Indeed, covered bonds are a $3,000bn asset class in Europe, but are still missing in the US. On the face of it, a US covered bond market seems a slam dunk, to use an Americanism. But, in practice, the US experience will be quite different, with its own challenges and opportunities. Consider the prospective investor base. Covered bonds offer double-barreled protection - investors have access to the issuer's general obligation, or unsecured debt, and to a discrete pool of mortgage assets. So the bonds should be highly rated. Central banks, sovereign funds and other fixed income managers with conservative mandates should have strong interest. Investors might also receive favourable capital treatment vis-à-vis other assets, given the two layers of protection. Levered players like hedge funds might be more difficult to attract, given their lack of clarity on financing conditions and lower liquidity. But done the right way, covered bonds can be a highly rated alternative to Treasury/agency debt, with better yield. However, covered bonds are unlikely to compete with US mortgage- backed securities. Even in their current weakened state, US MBS are one of the largest fixed income asset classes at nearly $7,000bn outstanding, and $4,500bn of agency MBS. While there is little securitisation of non-agency mortgages, agency MBS gross issuance was $620bn by June 2008. Moreover, Treasury's guidelines suggest using prime, performing mortgages as collateral for covered bonds. But most such mortgages can be securitised as agency MBS, providing instant capital relief since the loans move off balance sheet, unlike with covered bonds. And only 4 per cent of a US bank's total liabilities can be funded using covered bonds. Agency MBS are also very liquid (often more than US Treasuries) and have funding via "dollar rolls", a market of forward contracts that allows investors to buy MBS without putting money down. With such advantages, MBS are unlikely to face serious competition, even though they have pre-pay risk that covered bonds do not. Now consider a US issuer's point of view. US banks can fund mortgages by raising deposits, issuing unsecured debt, selling in the MBS market, or through Federal Home Loan Bank (FHLB) advances. The last alternative - FHLB advances - could pose the biggest challenge to US covered bonds. The FHLBs typically fund themselves sub-Libor and lend to banks at Libor plus 10-15 basis points. In the current credit environment, this is a huge funding advantage versus unsecured bank debt and should be compelling against covered bonds. There is no such FHLB mechanism in Europe, which has probably helped the growth of European covered bonds. Admittedly, there are some counter-arguments. FHLB often asks for 120-130 per cent over-collateralisation while Treasury recommends 105 per cent for covered bonds. Banks might want to use covered bonds to diversify sources of funding. US banks also have to buy equity in FHLB equal to 5 per cent of their borrowings. Nevertheless, tighter bank spreads are a critical element for covered bond success in the US. If spreads go back to the levels of a year ago, when they were 50-100bp tighter for the major banks, US covered bonds could be issued at, say, 25bp above Libor, making the product far more competitive for issuers. Meanwhile, there are definitely areas where covered bonds would be useful right away. For example, covered bonds in Germany fund public sector projects as well and the US might emulate that. Also, higher credit non-agency mortgage loans, which cannot be currently securitised and which might not qualify for FHLB advances, might be another area for covered bond issuance. In summary, US covered bonds face both opportunities and challenges. How the various stakeholders - regulators, investors and issuers - respond to these will determine the fate of the US covered bond market in the months and years to come.