Covered bonds are not the answer

As Hank Paulson looks to push through his Economic Patriot Act, it bears remembering that just a few months ago he saw Covered Bonds as a potential solution to U.S. problems with declining home prices.

They are not the solution. This market is now cratering and is having it’s worst month since 1999. Covered Bonds are just another instrument in the arsenal of products that the mortgage market can use to increase market confidence and liquidity.

Market instruments are not a solution. Avoiding easy money is.

Covered bonds, securities which Treasury Secretary Henry Paulson has advocated to boost U.S. mortgage lending, are poised for their worst month this decade as credit market turmoil erodes investor confidence in the top-rated debt.The bonds have handed investors a 1.12 percent loss this month, the biggest decline since they tumbled 1.41 percent in June 1999, according to Merrill Lynch & Co.’s European Covered Bond Index. Investors are demanding the highest yields, or spreads, to buy the securities relative to government debt in almost eight years.

“Investors are definitely on strike,” Timo Boehm, a Munich-based portfolio manager at Allianz Global Investors, said at the Euromoney European Covered Bond Conference in Paris today, where investors, bankers, traders and issuers are meeting to discuss the future of the market.

Covered bonds, which are largely issued by borrowers in Europe, have been promoted by Paulson as a new source of funding for U.S. home loans. While the debentures are backed by mortgages and bank assets to get AAA ratings, Seattle-based Washington Mutual Inc. and Bradford & Bingley Plc in the U.K. both had their covered bonds downgraded by Moody’s Investors Service in the past week as the mortgage lenders’ main debt ratings were cut.

Yield spreads widened to 120 basis points on average last week, the biggest gap since 2000, from 46 basis points at the start of the year, according to the Merrill Lynch index, which contains 704 bonds with a face value of $863 billion. The spread ended yesterday at 107 basis points. A basis point is 0.01 percentage point.

`Into Question’

The perceived “quality” of covered bonds has come “into question,” said Leef Dierks, an analyst at Barclays Capital in Frankfurt who tracks the securities.

Covered bonds are secured by loans to public sector institutions or mortgages and differ from mortgage-backed securities in that they are supported by assets as well as a borrower’s pledge to pay. The extra security means the notes typically get the highest ratings, allowing lenders to pay less interest.

Paulson backed guidelines in July to replicate Europe’s market for covered bonds, which dates back to the 18th century and totals $3.3 trillion. His plan for an alternative to selling mortgages to government agencies Fannie Mae in Washington and McLean, Virginia-based Freddie Mac hasn’t encouraged any new sales in the U.S. as the seizure in credit markets spread from the collapse of the housing market to last week’s bankruptcy of investment bank Lehman Brothers Holdings Inc.

Paulson said in July that a covered bond market will bring new sources of financing to the world’s largest economy, cutting costs for homebuyers. His plan is one of a series of government measures designed to shore up confidence in the financial system and encourage banks to lend.

Battered Confidence

“The housing market collapse has battered investor confidence regarding any mortgage product,” said Stig Tornes- Hansen, a Copenhagen-based covered bond analyst at Danske Bank A/S, who is attending the meeting in Paris today. “We had quite a liquid covered bond market and everyone agreed it was an AAA product. Quite soon the liquidity dried up completely because there were only sellers.”

Bank of America Corp. was the last U.S. bank to issue the bonds, selling $1.5 billion of the securities in June 2007. The spread on the Charlotte, North Carolina-based lender’s three-year notes has widened almost eight-fold to 184 basis points, according to Citigroup Inc. prices on Bloomberg.

Fewer Losses

The only other U.S. issuer is Washington Mutual, which put itself up for sale last week. Its 6 billion euros ($8.8 billion) of covered bonds were downgraded one level to Baa1, the third- lowest investment-grade ranking, by Moody’s.

The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Even with the decline, investors are doing better than those holding European corporate securities. Investment-grade company debt in euros has lost 3.9 percent this month, the biggest decline since Merrill began compiling the daily data in 1999, while bonds of financial companies have lost 5.1 percent.

Sales of the securities are on course to decline for a fifth month. New issues totaled 11.2 billion euros in September, a decline of 45 percent from a year ago and half the monthly average of 23.2 billion euros for the past year, Bloomberg data show. The last time sales in September were this low was in 2000.

“I don’t think that covered bonds are going to be the way to rescue the U.S. housing market,” Tornes-Hansen said. “As long there is no confidence among banks and within the investor community that they are going to get their money back, then not even covered bonds can add liquidity.”


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