Covered bond

Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet.

Detailed explanation

Essentially, a covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. This enhancement typically (although not always) results in the bonds' being assigned AAA credit ratings.

For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.

Another advantage is that the interest is paid from an identifiable source of projected cash flow versus out of other financing operations. Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.

History

Covered bonds were created in Prussia in 1769 by Frederick The Great. These Pfandbriefe were sold by the so-called countrysides, unions of aristocratic owners of large estate, and regulated under public law. They were secured by real estate, and subsidiary by the countryside. About 1850 the first mortgage banks were allowed to sell Pfandbriefe as a means to refinance mortgage loans. With the mortgage banks law of 1900 the whole German Empire was given a standardized legal foundation for the emission of Pfandbriefe. Pfandbriefe are quite common in Germany and Europe and are utilized as a financial instrument with great success.

U.S.

On July 28, 2008, US Treasury Secretary Henry Paulson announced that, along with four large US banks, the Treasury would attempt to kick-start a market for these securities in the U.S., primarily to provide an alternative form of mortgage-backed securities. The guidelines issued specifically address covered bonds backed by pools of eligible mortgages.

The Federal Reserve also announced that it would potentially consider highly rated covered bonds as acceptable collateral for emergency fund requests. Because the United States has already shown a robust market for other securitized debt products, regulators have been promoting the covered bond market strategy.