Covered bond
Encyclopedia
Covered bonds are debt
securities backed by cash flow
s from mortgages
or public sector
loan
s. They are similar in many ways to asset-backed securities
created in securitization
, but covered bond assets remain on the issuer’s consolidated balance sheet.
with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. Before the outbreak of the Financial Crisis in 2008, this enhancement typically (although not always) resulted in the bonds being assigned AAA credit rating
s. Due to the realisation that many of the loans backing these bonds were of a low quality, credit ratings declined sharply. This diminished the demand for all the types of asset backed or covered bonds, contributing to The Financial Crisis.
For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.
Another advantage is that the interest is paid from an identifiable source of projected cash flow versus out of other financing operations. Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.
in 1769 by Frederick The Great and in Denmark in 1795. Danish covered bond lending emerged after the Great Fire of Copenhagen in 1795, when a quarter of the city burnt to the ground. After the fire, a great need arose for an organised credit market as a large number of new buildings were needed over a short period of time. Today nearly all real estate is financed with covered bonds in Denmark, and Denmark is the 3rd largest issuer in Europe.
In Prussia these Pfandbriefe
were sold by estates of the country and regulated under public law. They were secured by real estate and subsidiary by the issuing estate. In about 1850, the first mortgage banks were allowed to sell Pfandbriefe as a means to refinance mortgage loans.With the mortgage banks law of 1900, the whole German Empire was given a standardized legal foundation for the issuance of Pfandbriefe.
Pfandbriefe are quite common in Germany
and Europe
and are utilized as a financial instrument with great success. In its more than 200 years of history, there was not even a single case of a defaulted Pfandbrief.
For this reason and due to the security provided by the cover pool, covered bonds were one of the first markets to recover following the global financial crisis of late 2008.
The Federal Reserve also announced that it would potentially consider highly rated covered bonds as acceptable collateral for emergency fund requests. Because the United States has already shown a robust market for other securitized debt products, regulators have been promoting the covered bond market strategy.
announced that it had launched the first covered bond programme in Australasia. Covered bonds issued by Bank of New Zealand
will be rated 'Aaa' by Moody's Investor Service and 'AAA' by Fitch Ratings. No issuers in New Zealand, Australia or surrounding countries have issued covered bonds previously.
, Wayne Swan
, announced that Australia would change its financial regulations to allow covered bonds. The Australian Securitisation Forum has attempted to get APRA to allow ADI's to issue these bonds for several years - without success. More recently the major Banks have been lobbying for this, stating that Australian Banks would be at a disadvantage to their international counterparts.
Legislation authorizing issuance of covered bonds by Australian financial institutions won support from the minority Labor government and the opposition in the house of representatives on the 12th of October 2011. The bill then passed to the senate where it was passed the next day, 13th of October.
In November 2011 ANZ Banking Group released Australia's first Covered Bond issue.
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
securities backed by cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s from mortgages
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
or public sector
Public sector
The public sector, sometimes referred to as the state sector, is a part of the state that deals with either the production, delivery and allocation of goods and services by and for the government or its citizens, whether national, regional or local/municipal.Examples of public sector activity range...
loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
s. They are similar in many ways to asset-backed securities
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
created in securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
, but covered bond assets remain on the issuer’s consolidated balance sheet.
Detailed explanation
A covered bond is a corporate bondCorporate bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. Before the outbreak of the Financial Crisis in 2008, this enhancement typically (although not always) resulted in the bonds being assigned AAA credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
s. Due to the realisation that many of the loans backing these bonds were of a low quality, credit ratings declined sharply. This diminished the demand for all the types of asset backed or covered bonds, contributing to The Financial Crisis.
For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.
Another advantage is that the interest is paid from an identifiable source of projected cash flow versus out of other financing operations. Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.
History
Covered bonds were created in PrussiaPrussia
Prussia was a German kingdom and historic state originating out of the Duchy of Prussia and the Margraviate of Brandenburg. For centuries, the House of Hohenzollern ruled Prussia, successfully expanding its size by way of an unusually well-organized and effective army. Prussia shaped the history...
in 1769 by Frederick The Great and in Denmark in 1795. Danish covered bond lending emerged after the Great Fire of Copenhagen in 1795, when a quarter of the city burnt to the ground. After the fire, a great need arose for an organised credit market as a large number of new buildings were needed over a short period of time. Today nearly all real estate is financed with covered bonds in Denmark, and Denmark is the 3rd largest issuer in Europe.
In Prussia these Pfandbriefe
Pfandbrief
The Pfandbrief , a mostly triple-A rated German bank debenture, has become the blueprint of many covered bond models in Europe and beyond. The Pfandbrief is collateralized by long-term assets such as property mortgages or public sector loans as stipulated in the Pfandbrief Act. Total volume...
were sold by estates of the country and regulated under public law. They were secured by real estate and subsidiary by the issuing estate. In about 1850, the first mortgage banks were allowed to sell Pfandbriefe as a means to refinance mortgage loans.With the mortgage banks law of 1900, the whole German Empire was given a standardized legal foundation for the issuance of Pfandbriefe.
Pfandbriefe are quite common in Germany
Germany
Germany , officially the Federal Republic of Germany , is a federal parliamentary republic in Europe. The country consists of 16 states while the capital and largest city is Berlin. Germany covers an area of 357,021 km2 and has a largely temperate seasonal climate...
and Europe
Europe
Europe is, by convention, one of the world's seven continents. Comprising the westernmost peninsula of Eurasia, Europe is generally 'divided' from Asia to its east by the watershed divides of the Ural and Caucasus Mountains, the Ural River, the Caspian and Black Seas, and the waterways connecting...
and are utilized as a financial instrument with great success. In its more than 200 years of history, there was not even a single case of a defaulted Pfandbrief.
For this reason and due to the security provided by the cover pool, covered bonds were one of the first markets to recover following the global financial crisis of late 2008.
USA
On 28 July 2008, US Treasury Secretary Henry Paulson announced that, along with four large US banks, the Treasury would attempt to kick-start a market for these securities in the USA, primarily to provide an alternative form of mortgage-backed securities. The guidelines issued specifically address covered bonds backed by pools of eligible mortgages.The Federal Reserve also announced that it would potentially consider highly rated covered bonds as acceptable collateral for emergency fund requests. Because the United States has already shown a robust market for other securitized debt products, regulators have been promoting the covered bond market strategy.
New Zealand
On 3 June 2010, Bank of New ZealandBank of New Zealand
Bank of New Zealand is one of New Zealand’s largest banks and has been operating continuously in the country since the first office was opened in Auckland in October 1861 followed shortly after by the first branch in Dunedin in December 1861...
announced that it had launched the first covered bond programme in Australasia. Covered bonds issued by Bank of New Zealand
Bank of New Zealand
Bank of New Zealand is one of New Zealand’s largest banks and has been operating continuously in the country since the first office was opened in Auckland in October 1861 followed shortly after by the first branch in Dunedin in December 1861...
will be rated 'Aaa' by Moody's Investor Service and 'AAA' by Fitch Ratings. No issuers in New Zealand, Australia or surrounding countries have issued covered bonds previously.
Australia
On 12 December 2010, the Treasurer of AustraliaTreasurer of Australia
The Treasurer of Australia is the minister in the Government of Australia responsible for government expenditure and revenue raising. He is the head of the Department of the Treasury. The Treasurer plays a key role in the economic policy of the government...
, Wayne Swan
Wayne Swan
Wayne Maxwell Swan is the Deputy Prime Minister of Australia and an Australian politician. He has been an Australian Labor Party member of the Australian House of Representatives from 1993 to 1996, and then re elected in 1998 till today , representing the Division of Lilley, QLD...
, announced that Australia would change its financial regulations to allow covered bonds. The Australian Securitisation Forum has attempted to get APRA to allow ADI's to issue these bonds for several years - without success. More recently the major Banks have been lobbying for this, stating that Australian Banks would be at a disadvantage to their international counterparts.
Legislation authorizing issuance of covered bonds by Australian financial institutions won support from the minority Labor government and the opposition in the house of representatives on the 12th of October 2011. The bill then passed to the senate where it was passed the next day, 13th of October.
In November 2011 ANZ Banking Group released Australia's first Covered Bond issue.
See also
- Financial instrumentsFinancial instrumentsA financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
- European Covered Bond CouncilEuropean Covered Bond CouncilThe European Covered Bond Council is the platform that brings together covered bond market participants including issuers, analysts, investment bankers, rating agencies and a wide range of interested stakeholders.-History:...
- SecuritizationSecuritizationSecuritization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
- Bank of New ZealandBank of New ZealandBank of New Zealand is one of New Zealand’s largest banks and has been operating continuously in the country since the first office was opened in Auckland in October 1861 followed shortly after by the first branch in Dunedin in December 1861...
- The Cover
External links
- The Covered Bond Report (covered bond news and data available free to investors)
- The Cover (daily news on the covered bond market)
- Covered Bond InvestorTM (free news, analysis & resources)
- US Treasury Best Practices for Residential Covered Bonds
- FDIC Policy Statement on Covered Bonds
- ECBC Technical Issues Covered Bond Comparative Framework Database
- ICMA Covered Bond Investor Council (CBIC)