Covered Bonds

Commercial Mortgage Backed Securities (CMBS) are now at an all time record high default rate of 10.6%. Compare this to the 2011 projected default rate of 5.5% for commercial loans still held by US banks on their balance sheets. This provides damning evidence for the reckless underwriting employed by the CMBS issuers. The days of easy CMBS lending terms are surely past, but what will take its place?

CMBS loans have begun to be issued again albeit at a much reduced pace and at a fraction of the volumes seen up to 2007. Investors will demand higher standards of underwriting before the CMBS market can return to any semblance of its former self. Perhaps Covered Bonds are the answer.

Commercial Mortgage Backed Securities (CMBS) are securities issued to investors in the bond market. They are collateralized, or secured, against pools of commercial real estate. Banks would provide loans to owners of commercial real estate and then bundle the loans into pools where the loans shared similar characteristics such as loan terms and property types. When the loan pools became a significant size they would be placed within a CMBS issue to be sold to investors as bonds. Each bond representing a small share in the pool of loans.

This practice had the advantage of giving banks tremendous liquidity and allowed them to provide even more loans. The lending bank would provide loan funding to its customers, earn an origination fee, and then sell the loan to an Investment Bank for another fee. The lending bank would then be able to write a new loan from the proceeds of the loan they sold. The Investment Bank would then create the CMBS and sell the bonds to investors. For investors it provided them with what appeared to be a relatively safe return secured against a diversified pool of multiple commercial properties.

The inherent problem with this funding cycle is that the lending bank, and the Investment Bank creating the CMBS and selling the bonds, were only liable for the loan performance for a short period of time while they held the loans on their own balance sheets. By not having any long term responsibility for the loans' performance and not holding any risk in it, this fostered poor underwriting standards on the part of the lending bank. They became more of a transaction machine earning fees and less of a relationship bank that tied its' interests with the long term interests of its customers.

It must be pointed out that the lending banks taking advantage of this CMBS funding cycle were typically the big players that would later be the recipients of federal bail outs. Smaller community & regional banks have tended to continue to be portfolio lenders, where they hold each loan on their balance sheet, and therefore they would underwrite to conservative traditional standards unless they felt compelled to compete with the CMBS loans on offer.

Covered Bonds could provide US banks with an alternative to CMBS. They offer banks the same liquidity that CMBS does, in that they can sell pools of loans through bonds as before, but the lending bank is kept on the hook for the performance of the loans. Having the lending banks maintain an interest in the risk of each loan will ensure that they keep their underwriting standards high.

Covered Bonds are very similar to CMBS. They are debt securities that are collateralized, or secured, against mortgages on real estate. When a bank sells Covered Bonds it must maintain the underlying loans on its own balance sheet. This means the lender maintains borrower default risk. The investor in the Covered Bond has recourse to the underlying real estate that the loan was made against, and recourse to the lender who issued the Covered Bond.

Covered Bonds have been in existence for over 250 years and they have an excellent performance track record. There is currently a $3 trillion market for Covered Bonds in Europe. In 2008 Treasury Secretary Paulson announced plans to launch a Covered Bond market. This got sidelined when the financial markets went into meltdown following the collapse of Lehman Brothers. Covered Bond legislation was passed this year in the House of Representatives but was not taken up by the Senate. There are plans to have it reintroduced early next year.