Towards the Recovery of Financial Intermediary Functions in the Global Financial Markets
February 13, 2009
In the wake of the subprime crisis of the summer of 2007 and the collapse of Lehman Brothers in September 2008, financial intermediary functions on the international financial markets have remained in a severely depressed state.
Against this backdrop, covered bonds, which are widespread in Europe and account for a significant portion of the European bond markets, have the potential to overcome the weaknesses of the off-balance-sheet securitization markets (MBS, CDO, etc.) exposed by the current crisis. This character has been held in high esteem by market participants and, even during the current crisis, when they have been subjected to extreme stress, their performance has remained steady overall, unlike that of other securitization products.
There is great scope for the utilization of covered bonds to promote the recovery of financial intermediary functions in the international financial markets. Japan, too, should consider their use and the establishment of a legislative framework to support it.
The Growth of the covered bond markets
— Covered bonds have become the next most important sector of the European bond markets after government bonds
1. What are covered bonds?
"Covered bonds" are bonds that offer dual recourse, to (i) a cover pool made up of high-quality collateral (real estate, public sector loans, etc.) and (ii) the issuing bank (Chart 1).
— For investors, they represent the next most secure investment after government bonds and can be expected to give a somewhat higher yield than government bonds.
— For financial institutions, they allow fund procurement at a rate below the base swap rate.
Most covered bonds are secured by (i) real estate (housing, commercial) loans or (ii) public sector (local government authorities, etc.) loans. Provided their price of the collaterals is correctly valued, they are highly secured claim.
2. Market growth
The prototype for covered bonds was the German "Pfandbrief", which has a tradition of more than 200 years. The introduction of jumbo pfandbrief (large issue lots, standardized) in 1995 lent momentum to market growth and, from around the year 2000, innovations in financial technology made it possible, even in the countries without specific legislation, to issue structured covered bonds with the properties of traditional covered bonds. As a result, covered bonds showed rapid growth, especially in European countries.
At the end of 2007, the outstanding volume reached 2.1 trillion euros (Figure 1). A breakdown by country reveals that Germany, as originator, accounts for more than 40% of this total (Chart 2). Issues from Eurozone countries account for more than 70% (Figure 2) and, in recent years, covered bonds have been issued in the United States and Canada. Pfandbrief accounts for just under 20% of Germany's bond market (Chart 3). The share of the overall Eurozone bond market commanded by covered bond as a whole has risen to just over 10%. For financial institutions (monetary financial institutions
What are covered bonds?
— How do they differ from off-balance-sheet securitization?
3. The weaknesses of off-balance-sheet securitization
The present international financial crisis has exposed the following weaknesses in CDOs (collateralized debt obligations), MBS (mortgage-backed securities) and other off-balance-sheet securitized products as a means of market-based indirect financing.
(i) In the process of unbundling and transferring the risk of the original loan asset through securitization, there is no system designed to disclose the risk, and maintain the quality (creditworthiness) of, individual loan assets.
(ii) Once the issuing institution takes an asset of its balance sheet and issues it in the form of an off-balance-sheet securitized product, there is neither system nor legislative framework to ensure that it takes responsibility for the creditworthiness of the secured claim.
4. Systemic design of covered bonds
Covered bonds, by contrast, are an on-balance-sheet means of market-based indirect financing (Chart 5). In view of the high probability that any error in the systemic design of market-based indirect financing may lead to problems on the lines of (i) and (ii) above, their systemic design has remained based on the following, extremely simple, concept for more than 200 years.
(i) To maintain the high quality of cover assets until the maturity date,
(a) issuing banks are obliged to disclose information on the cover assets on an ongoing basis,
(b) the financial authorities or a third party monitor the cover assets, and
(c) issuing banks are required to replace cover assets as and when necessary.
(ii) Because the cover assets remain on their balance sheets, the issuing banks must continue to manage risk even after issuing the covered bond.
5. Comparison of creditworthiness (interest rate level)
Given these differences in systemic design, the general opinion in the market is that covered bonds have higher creditworthiness than asset-backed securities.
For instance, if you compare the level of interest paid on the two similar securities secured by residential mortgage loans in "ordinary times" i.e. before the present crisis (Chart 6), you may find that the interest rate on covered bonds is generally 15-20bp lower than interest on asset-backed securities and trends to be even lower than the swap rate which is the base rate for fund procurement by private-sector banks.
Covered bonds and the turmoil in the international financial markets
—Unlike that of other securitization products, the performance of covered bonds has remained steady overall
6. Covered bonds during the present international financial crisis
The market's high evaluation towards "prudent" systemic design and operation of covered bonds has become all the more apparent during the period of extreme stress represented by the present international financial crisis. A comparison of the level of interest rate(the asset swap spread), following the emergence of the subprime crisis in the summer of 2007, on covered bonds backed by residential mortgages with that on off-balance-sheet securitization products (RMBS) of similar types (Chart 7) reveals that the spread on RMBS has widened considerably, while the widening of the spread on covered bonds has been relatively small. This is more evident among traditional covered bonds, which are based on a robust legislative system, than among structured covered bonds,which are not based on any specific legislative system. In particular, the interest rate on German Pfandbrief bonds and French obligations foncières (OF) remained lower than the swap rate for a number of months in the early part of 2008 (Chart 8). During this time, although new issuance by public offering was sluggish, new issuance of covered bonds saw steady growth, especially issuance by private offering and issuance of mortgage-covered bonds (real estate).
— The volume of new issuance of Pfandbrief in German between January and October 2008 was as follows:
Overall: 133.4 billion euros (+18% on same term in previous year)
Mortgage (real estate), Ship Pfandbrief : 49.6 billion euros (+174%)
Public sector Pfandbrief : 83.8 billion euros (12%)
7. The evaluation of the European and US financial authorities
This strong performance has already attracted the attention of the financial authorities in Europe and the United States.
— The ECB has described its evaluation as follows; in the context of the ongoing financial market turmoil, it is important to stress that, on the whole, covered bonds have proven themselves relatively resilient, in particular in comparison with securitization (Covered Bonds in the EU Financial System, December 2008).
— In the United States, where the off-balance-sheet securitization market, has been dealt a severe blow by the subprime crisis, the FDIC set out standards for covered bonds (policy statement) in July 2008 and the Department of the Treasury published a best practice document. With a view to rebuilding its $11 trillion residential mortgage market, covered bonds have been positioned as an additional/complementary means of fund procurement.
Scope for further utilization of covered bonds
— a promising means to promote recovery of financial intermediary functions
8. Towards the restoration of "prudent" financial intermediary functions in the international financial markets
Even today, it cannot be said yet that the lack of confidence between players on the international financial markets has been resolved. It is likely that the markets will remain dependent on government intervention in the form of emergency measures for some time to come. Bringing the markets back from this "state of emergency" mode to an "ordinary times" mode is the role of government and the financial authorities. However, the government cannot be responsible for restoring proper financial intermediary functions in the markets by nature; only private-sector financial institutions can undertake this task. In this sense, covered bonds may be an effective means of promoting the recovery of financial intermediary functions in the international financial markets.
— Market-based indirect financing itself is a means of diversifying the distribution of risk and achieving greater smoothness and efficiency of financial intermediary functions. Its importance has remained unchanged even after the present crisis. Where the mistakes were made was in the "operation" of market-based indirect financing. The use of market-based indirect financing was not a mistake in itself.
— Covered bonds have properties that overcome the weaknesses of off-balance-sheet securitization.
— The high esteem of the markets for their "prudent" systemic design and rigorous operation have been validated by their performance during the present crisis.
9. Implications for Japan
Real estate loans and public sector loans (loans to local government authorities, etc.) which are the target of covered bonds are areas where, in Japan, public finance, such as fiscal investment & loans programs, has traditionally played the key role. The fact that Japan has such a large outstanding volume of public debts means that there are limits to the future capacity of public finance to provide the necessary funding. In particular, if the object were to ensure the recovery of medium-to-long term financial intermediary functions, it would surely be worthwhile for private banks to consider utilizing a covered bond framework.
— However, since the bankruptcy of Lehman Brothers in September 2008, the governments of the major European countries have provided guarantees of bank debts and for this reason, investor demand has focused on government-guaranteed bank bonds, causing major distortion or dislocation of the credit markets (Chart 7 and 8). The situation will have to be remedied if covered bonds are once more to function in the markets as an asset class with high creditworthiness.
Japan, too, should consider the utilization of covered bonds and the establishment of a legislative framework to support it.
— A survey of the performance of covered bonds in different countries reveals that in countries with special legislative systems, especially countries where they are issued under a rigorous legislative system (Reference Chart 4 and Figure 2), they have performed relatively well (Chart 9).
— Specifically, there is a need for special legislation that will exclude the effects of the provisions of the Bankruptcy Law as a general civil law (Reference Charts 1 and 2).
For more information on the content of this report, please contact Sayuri Kawamura, the Japan Research Institute, Limited.