Are covered bonds really the solution?
Last month, Hank Paulson, the U.S. Treasury Secretary, was waxing prosaically about covered bonds and their benefits to mortgage markets. From his comments, one gets the impression he sees this a potential solution to preventing a future crisis in residential property in the US.
But covered bonds are not the silver bullet they have been touted as. They are simply an additional product in the arsenal of the giant mortgage market. See my post ‘Covered bonds: German Pfandbriefs are the new U.S. solution’ for an explanation of just what covered bonds are and how they work.
The truth is that the covered bond market itself is going through some convulsions in Europe in the wake of the credit crisis, suggesting all is not well, even in this market. Here’s what Handelsblatt, the German daily has to say about this issue.
Pfandbriefs are bank loans backed by mortgages or government bonds, internationally known under the name of Covered Bonds. The market for large jumbo-covered bonds alone has a volume of around 850 billion Euros. Germany has a market share of just over a third of that.
Previously, investors often purchased 50 million or 100 million Euros from a single issue, according to [Christian] Haller, but today it is often only ten million to 20 million Euros. Moreover, it must be noted that foreign investors have been holding back. Accordingly, banks with Jumbos can no longer take up quite so much money. This year, the average jumbo size, according to Haller, has been reduced to 1.25 billion Euros compared to two billion Euros previously. Most Jumbos also have only had a two to three year maturity.
German issuers in particular have nevertheless still been able to refinance themselves because there has been a solid foundation of domestic investors, says Haller. Meanwhile, according to calculations by Dresdner Kleinwort, on average about 70 percent of a German Jumbo goes to German investors. Before the crisis, the share was below 50 percent. “German investors, long familiar with covered bonds, are now the most important support for the market,” says Caren Arp-Wiese, who serves German covered bond issuers at Commerzbank. A larger percentage of German issues than in the past also now goes to banks. This is primarily due to the fact that banks still have the most money to invest.
If the core market in Germany is being negatively affected by the financial crisis, why should we expect covered bonds to be a lasting solution to all that ails America’s mortgage markets? In Germany, foreign investors have reduced their appetite for covered bond paper and they are buying issues in smaller size. As a result, the credit available to the German mortgage market, which had not seen an uptick during the housing bubble, is being reduced. That’s not a solution to a credit crunch.
If Hank Paulson wants a real solution to the present crisis and to future crises, he’s going to have to look not just at new mortgage products like covered bonds, he is going to have to examine why lax regulation and easy monetary policy were permitted. Maybe then, we can get to the bottom of this.