Four US Banks To Launch Covered-Bond Mkt Programs

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Last Update: 7/29/2008 7:35:00 AM

(This article was originally published Monday)

By Meena Thiruvengadam

Of DOW JONES NEWSWIRES

WASHINGTON (Dow Jones)–Four of the U.S.’s leading banks are joining a government
effort to promote the development of a covered-bond market.

Bank of America Corp. (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM) and
Wells Fargo & Co. (WFC) on Monday unveiled plans to launch covered-bond programs
and become leading issuers of the financial instruments, which date back to
18th-century Europe.

The bonds, secured by residential mortgage assets that would remain on the
issuer’s balance sheet, are seen as a new liquidity tool for banks. Covered
bonds, although unfamiliar to many U.S. investors, are a $3 trillion market used
heavily in Europe.

“We believe a robust U.S. covered-bond market would provide an additional stable
and cost effective funding source for banks to originate and hold mortgages on
their balance sheet,” the four banks said in a joint statement.

U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke
have in recent months been touting the bonds as a way to help revive the nation’s
struggling housing market. “Covered bonds have the potential to increase mortgage
financing, improve underwriting standards, and strengthen U.S. financial
institutions by providing a new funding source that will diversify their overall
portfolio,” Paulson said Monday.

The Treasury Department on Monday released guidelines that would direct the
development of a U.S. covered bond market. The guidelines require issuers to
maintain overcollateralization value of at least 5% of the outstanding principal
balance of the bonds, to have a specified investment, to disclose specific
information about mortgage pools by which the bonds would be backed and to test
assets on a monthly basis to ensure the quality of collateral.

Non-performing mortgages would have to be removed from the pool, insuring the
quality of underlying mortgages.

“What they’re trying to come up with here is a product investors should have
confidence in,” said John Arnholz, co-head of the covered bonds practice team at
the law firm McKee Nelson.

The guidelines are thought to provide the necessary legal, regulatory and market
framework necessary to develop a covered-bond market in the U.S.

“A new source of liquidity provided by the capital markets is certainly welcomed
and should help provide stability to the mortgage market as a whole,” said Jeff
Brown, Bank of America’s corporate treasurer.

“Covered bonds will allow the investing community to diversify portfolio holdings
and will provide banks with greater lending capacity,” he said.

Federal Reserve Governor Kevin Warsh commended the guidelines for covered bond
issuers and said the Fed would accept the bonds as collateral. With financial
markets continuing to show signs of stress triggered by mortgage losses, he
stressed the importance of financial market innovation. That innovation need not
be equated with complex products, he said.

Still, it isn’t clear if or when covered bonds will become a meaningful source of
funding for the housing market, Paulson said. “There’s not 100% certainty that it
ever will become very significant,” he said.

While there isn’t a lot of evidence there will be sufficient demand for the
bonds, Paulson said they appear attractive to major banks.

Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., called
Monday’s guidelines “a tiny patch for a big hole, but one of many solutions to
the enormous problem.”

“Investors will be drawn by the fact that banks will underwrite their mortgages
in ways that reflect the fact that loans backing covered bonds will be kept on
the books of banks selling covered bonds,” he wrote in a client note. “This will
force discipline on banks, which are likely to keep loan-to-value ratios at 80%
or better, in keeping with the Treasury’s guidelines.”

He cautioned that a U.S. covered-bond market could take years to develop and may
never equal the size and scope of the European market.

Only two U.S. financial institutions - Bank of America and Washington Mutual (WM)
- have issued covered bonds in the past and investors have been reluctant to
embrace them.

A recent policy statement from the Federal Deposit Insurance Corp. has alleviated
some concerns about regulatory uncertainty that have kept financial institutions
from embracing the bonds, according to a client note co-authored by former FDIC
general counsel John Douglas, now at the law firm Paul Hastings.

Still, “it remains to be seen whether the current restrictions and inherent
execution costs on covered bonds will allow the vehicle to become a viable
substitute for alternatives,” Paul Hastings said in a note to clients Monday.

Restrictions of acceptable collateral and the size of issuance make the bonds
less attractive to issuers. Under FDIC guidelines, covered bonds can account for
no more than 4% of an issuer’s liabilities.

FDIC Chairman Sheila Bair said that that limitation could eventually be lifted
and that initial guidelines on covered bonds needed to be conservative enough as
to not require legislation.

At this point the cap is “more than ample to accommodate the demand that we were
aware of,” she said.

Paul Hastings also said it was concerned the bonds could increase deposit
insurance assessments and would remain on a bank’s books, thereby providing no
capital relief.

The first U.S. covered bonds were issued by Washington Mutual in 2006 and had
been expected to bring a flurry of activity in the sector that never
materialized.

“There hasn’t been overwhelming enthusiasm in the market for these things,” McKee
Nelson’s Arnholz said.

The covered-bond market hasn’t yet flourished in the U.S. because of a lack of
legal and regulatory clarity surrounding them and because of the existence and
roles of government-sponsored mortgage giants Fannie Mae (FNM) and Freddie Mac
(FRE), a Treasury official said.

Bank of America in 2007 issued four covered bonds valued at about $9 billion, the
last late that year.

“With the market disruptions, we’ve kind of sat back,” said Paul Baalman, a Bank
of America structured-finance executive.

Baalman was optimistic about the potential for a U.S. covered-bond markets,
saying there is no reason it couldn’t eventually grow to $1 trillion should
issuers and investors express sufficient interest.

“We knew that this initiative would be successful only if the largest banks paved
the way,” Paulson said.

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