The next “next thing” in finance is said to be covered bonds. These securities have a long and distinguished pedigree, originating under the rule of King Frederick the Great in order to generate mortgage financing for Prussia’s landed gentry, who had been battered by the Seven Years War. Historically used in European finance, covered bonds are now becoming used in the U.S., Canada, and Asia.
Covered bonds are long-term debt securities that are secured by specific assets of the issuer of the bonds. The assets so constituting collateral are called “cover-pool” assets. To the extent the cover-pool assets are insufficient to repay principal and interest on the covered bonds, investors in the bonds have an unsecured claim against the issuer for the insufficiency. As with any granting of collateral, the cover-pool assets are deemed to remain on the issuer’s balance sheet (i.e., they remain owned by the issuer) for accounting purposes. Unlike normal collateral, however, these assets are “ring-fenced” to give covered bondholders greater protection in the event of the issuer’s bankruptcy. Additionally, weak cover-pool assets are required to be replaced by good-quality assets throughout the life of the covered bonds, thereby maintaining a requisite level of “overcollateralization”—a surplus of collateral value over indebtedness.
To ensure this is all enforceable by covered bondholders against other creditors of the issuer, some countries have promulgated specific covered bond legislation (a “legislative” covered bond regime). Absent such legislation, covered bondholders must rely on contractual protections and related commercial law (a “structured” covered bond regime).
Market observers and government officials perceive the safety of covered bonds as an antidote for some of the problems that led to the recent financial crisis. At least two U.S. banks have issued structured covered bonds, and the House of Representatives is currently considering a bill, H.R. 5823 (the United States Covered Bond Act of 2010), that would create a legislative covered bond regime.
Covered bonds can offer real benefits. Like securitization, they can provide access to low-cost capital market funding at low risk to investors, and they can also be used to regenerate lending markets.
Covered bonds are more likely than securitization, however, to impact unsecured creditors. In a forthcoming article, I explain why covered bonds are, to some extent, like securitization on steroids. Although both forms of financing pay their investors from segregated asset pools, securitization effectively fixes the segregated asset pool, thereby allocating risk to all parties. In contrast, as discussed above, weak cover-pool assets in covered bond transactions are required to be replaced by good-quality assets throughout the life of the bonds, in priority to paying unsecured claims. Furthermore, if those assets are ultimately insufficient to repay the covered bonds, covered bondholders have an unsecured claim against the issuer for the insufficiency—a claim that will further dilute repayment of the unsecured creditors.
The extent to which risk should be allocated so asymmetrically to unsecured creditors is a policy question for the U.S. Congress and for any other lawmaking body considering a legislative covered bond regime.
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