Wall Street's bond invasion

A loosening of SEC regulations which has allowed US retail investors to buy covered bonds for the first time has triggered calls of a Wall Street invasion, but there's a key sticking point.


Frederick the Great, the 18th century king of Prussia and famed general, never set foot on US soil. But now, more than 200 years after his rule, one of the former European sovereign’s most pervasive inventions could be on the brink of a new invasion into the US.

The humble covered bond, a centuries-old mainstay of European debt markets, made major inroads into the US market this week after the Securities and Exchange Commission gave the green light for a $12 billion covered bond program to be sold by Royal Bank of Canada as "registered securities”.

Banks have already sold billions worth of dollar-denominated covered bonds into the US market but only under the umbrella of private placements that are restricted to institutional investors like pension or mutual funds.

Allowing covered bonds from Canada’s biggest bank to be sold as registered securities means the products can be bought by retail investors for the first time.

While covered bonds suffer from a decidedly stodgy image, they are big business.

Last year, a record $335 billion were sold in Europe, the bonds’ oldest and deepest market. That is despite the general market aversion to buying bank-issued bonds.

To understand the continued appeal of covered bonds, you have to know what makes them different to so-called "unsecured” bank bonds, the bread and butter of bank funding.

Not only are covered bonds backed by relatively high-quality loans, they are also overstuffed with the assets in case any of them deteriorate.

Perhaps most importantly, investors have recourse to this pool of high-quality mortgages if the issuing bank cannot make good on its guarantee of the debt.

This "dual recourse” structure and "over-collateralisation” has helped European banks continue to sell the debt even in the midst of a severe debt crisis.

But the bonds are not without their issues.

For investors in unsecured bank debt, they can be decidedly problematic.

Every covered bond issued hives off good-quality assets and effectively subordinates unsecured creditors, including depositors, leaving fewer assets available to settle their claims in the event of a bank failure.

This "encumbrance” issue is growing in Europe as banks’ reliance on covered bonds – and other types of secured funding including liquidity sourced from central banks – intensifies.

In the US, Frederick the Great’s invention is relatively unknown outside of Wall Street. In fact, the US market has long been seen as an El Dorado for capital market participants keen to introduce the covered debt to new markets. Some banks have already positioned teams of covered bond specialists in anticipation of a boom in the market and George Soros has started a related project.

The pro-covered bond camp duly went into overdrive this week, predicting a boom in demand for the bonds after the SEC loosened its rules for RBC’s issue. But a key sticking point remains.

Frederick’s capital markets magnum opus was nothing without the 1769 legal decree that established rules for covered bonds. Unlike many other countries, the US does not have a special legal framework to govern what happens to covered bonds in the event that the issuing bank goes bust. That remains the holy grail of a very large lobbying force.

"The growing acceptance of covered bonds among US regulators is a positive development,” said Kay Hagan, a US senator, this week. "Unfortunately, until a legislative framework for covered bonds is in place in the US, our economy, US lenders and their customers will be unable to benefit from the low-cost funding that covered bonds provide.”

A bill to set up such a framework is slowly winding its way through Congress but a key sticking point is the encumbrance issue.

Perhaps unsurprisingly, the US government body charged with safeguarding bank deposits isn’t keen on the idea of banks tying up more of their assets away from unsecured creditors.

Covered bond optimists say there are ways of easing the Federal Deposit Insurance Corporation's concerns. And, if not, some seem prepared to override its objections with an almost militaristic determination.

The invasion may already be under way.

Copyright The Financial Times Limited 2012.

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