Covered bonds work

19 Oct 2016 | Richard Kemmish

In a recent article in GlobalCapital Bill Thornhill pointed out that the recent maturities of covered bonds issued by Washington Mutual and the National Bank of Greece (to the last cent on the due date) demonstrate that covered bonds work even in some fairly extreme stress scenarios. He is of course correct. I have often commented that the credit performance of covered bonds over the last ten years is far more important than anything which may or may not have happened in the 18th century in Prussia.

What lessons can be drawn from these two? Bill quite rightly points out in the case of the National Bank of Greece, the rating agencies overstate the risk of capital controls. I would go further and say that it is not just the rating agencies – if anything the spreads of covered bonds (as determined by the market) are more correlated to sovereign spreads than their ratings are to their host country’s rating. Ratings lag spreads. So far this is just a theory, if anyone can find a good way to quantify this please let me know.

Furthermore, NBG shows that it isn’t just about capital controls. The other forms of credit contagion from sovereign to covered bond are hugely overstated. Of course NBG’s standalone credit rating has deteriorated but the rating agency models increasingly differentiate between those parts of the standalone credit rating that are truly standalone (each agency uses different terminology but most have a concept approximating to ‘what the rating would be if they were based in Germany instead’) and those that are used for senior unsecured debt (with the risk of a forced default).

More significantly though, look at the quality of the cover pool backing the bonds and you’ll see that the sovereign-covered bond credit link that goes via the macro-economy is less significant than you think. This is a point that has been made many times, for example in Ireland. No matter how bad the housing market, the cover pools have been fine. 
Looking further west, it’s clear that covered bonds are not even vaguely systemically important to the US financial system (maybe they never will be. Sigh). Yet that didn’t stop the government, in the form of the FDIC, overseeing the smooth transition of the covered bond parts of WaMu’s business into the safe hands of JP Morgan.

The FDIC’s action was nothing to do with the risks of systemic contagion being greater than the downside of allowing the transfer of the assets.

Nor was it to do with the compassionate attitude towards bondholders for which the FDIC is not famed.
It was the pure, naked self-interest of the guarantor of the other creditors that via a segregation of the covered bond assets and their liabilities they have avoided the acceleration of the covered bond’s claims against the issuer. That was a greater potential loss than the potential gain of some excess collateral becoming available at some stage in the (then) distant future of 2016.

As Bill correctly says, covered bonds work. Not always in the most obvious ways.

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