US Covered Bonds Get a Boost from SEC

Today’s Financial Times details a “no action” letter released by the Securities and Exchange Commission last Friday which will allow issuers of Covered Bonds to move beyond the restriction of selling these securities ONLY to qualified institutional investors under a Rule 144A offering and will now allow issuers to sell these securities directly to retail investors under a regular public offering.

As followers of the structured markets know very well, some have suggested that the growth of a US Covered Bond market could go a long way towards filling the gap left by the many Dodd-Frank related restrictions that have been placed on the traditional MBS markets.

Covered Bonds are not likely to become a complete solution for the securitization markets.  In fact, many would argue that a Covered Bond structure is not really a securitization (i.e. off balance sheet treatment) and it would be hard to argue with that view.  While Covered Bonds do act in a similar way to structured mortgage-backed bonds in passing cash flows associated with the underlying mortgages onto investors in the form of principal and interest payments, the mortgages never leave the balance sheet of the issuer.  So, essentially, while the investor can pinpoint where there cash flows are coming from, they must accept the fact that they are lumped in with other creditors of the issuer, when and if things go south.

On the issuer side, the benefits of a Covered Bond program include their ability to continue to fund their mortgage business by “freeing up” additional capital to fund their activities through the issuance of the bonds.  However, the fact that the underlying mortgages remain on the balance sheet, precludes an issuer from taking advantage of the attractive balance sheet management features that a traditional securitization structure provides.

Given these shortcomings, we continue to have reservations as to the extent to which Covered Bonds can “save” the US MBS market.  While these structures have been successfully sold in the European market for many years, they cannot replace the flexibility and efficiency that traditional MBS structures have provided US issuers for many years.  Nevertheless, opening up the investor base to the general public cannot but help to broaden issuance and, at this point, any positive development is worth noting.  Good decision by the SEC.

About markferraris
Managing Principal Orchard Street Partners LLC

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