Perspective: The Covered Bonds Option

Are European-style covered bonds a solution to the liquidity gap in the apartment sector?  In Europe they are a $3 trillion marketplace, and some have gone as far as to suggest that they could potentially replace the GSEs, Fannie Mae and Freddie Mac.

While they may be able to provide some additional liquidity to U.S. multifamily finance, they are not a panacea and are unlikely to provide the capacity, flexibility and pricing superiority necessary to adequately replace traditional sources of multifamily mortgage credit.

What are covered bonds? They’re similar to asset‐backed securities, but with differences that improve the bond buyer’s security. The underlying security interests remain on the balance sheet of the issuing bank, and bondholders retain security interests, even if the issuer becomes insolvent.

Covered bonds offer some advantages to issuers and investors. They give issuers access to lower-cost funding for mortgage and other asset-backed credit with more favorable risk-based capital requirements than whole loans held in their portfolio.

For investors, covered bonds offer high credit quality, solid yield, low risk and diversified investments. They also offer both issuer and investor the ability to substitute bond assets in the collateral pools if there is a problem with an individual loan or mortgage, thus reducing overall risk.

A supplement, but not a replacement

Historically, the apartment industry has received credit from a variety of sources.  In addition to FHA and the GSEs, banks and thrifts, life insurance companies, pension funds and the commercial mortgage-backed securities market have all provided significant amounts of mortgage capital to the apartment industry. These sources have proven to be reliable and durable.

Covered bonds would be a welcome addition to our existing capital sources, but it is unclear whether they would actually increase the amount of credit banks would make available to apartment firms. The covered bond structure limits issuer lending volumes by requiring issuers to hold loans on their balance sheet and retain capital reserves in case of losses.  It’s also possible that banks could simply replace some of their whole loans activities with covered bonds, which would not increase lending capacity.

Even then, larger banks—which are anticipated to be major covered bond issuers—may choose not to issue covered bonds for multifamily mortgages because they already originate such mortgages for the GSEs or CMBS market and by doing so, in part, avoid any balance sheet liability.

Additionally, because so many asset classes qualify for covered bonds—including single-family mortgages, auto loans and student loans, among others—it is unclear what allocation, if any, banks would direct to multifamily lending.

Furthermore, the European experience with covered bonds for multifamily properties may not translate in the U.S. European rental markets operate on a condominium model comprised of small investors buying individual units and renting them out.  For instance, in the United Kingdom, 73 percent of the rental stock is owned by “mom-and-pop” operators, and there is no institutional investment. There is little existing analysis determining to what degree European covered bonds actually finance commercially developed rental housing.

Finally, questions remain about whether a purely private American covered bond market could become a critical “back-stop” capital source during periods of financial instability. Europe’s covered bond market came to something of a standstill during the global financial crisis, going dormant for several months after the Lehman Brothers collapse in September 2008.

In contrast, in the U.S., Fannie Mae and Freddie Mac continued to provide liquidity to the multifamily sector. They have also been critical in this current crisis.  Fully 80 percent of apartment loans issued in the first six months of 2010 had some form of government credit behind them, namely the GSEs and FHA.

For all these reasons, covered bonds should not be considered an alternative to, or a replacement for, the current secondary multifamily mortgage system—especially Fannie Mae and Freddie Mac—but rather a supplement to them.

Framework needed

Despite their limitations, covered bonds could be a liquidity supplement for apartment firms. To do so, however, Congress needs to create the legal and regulatory oversight necessary for them to become a practical reality in the U.S.

Fortunately, work on that front has begun. Legislation (H.R. 5823) has been introduced in the House of Representatives and has been marked up by a key subcommittee. In September, the Senate Banking Committee held a hearing on the topic, and NMHC testified in support of covered bonds, with the caveat that we not let our enthusiasm for them mask the reality of their likely impact. The best solution to the industry’s credit crisis rests not on covered bonds, but on a return of private capital to the market via our traditional mortgage sources.

David Cardwell is vice president of Capital Markets and Technology for the National Multi Housing Council in Washington, D.C.

The views expressed in this Perspective are the opinion of the contributor.