During the euphoria of booms, the financial world may have completely forgotten the old adage that our deeds, good or bad, ultimately catch up with us. You reap what you sow, but innovative mortgage-backed securities made big financiers in the West actually believe that you can reap fistfuls of dollars without sowing a single dime. After eventually seeing the outcome, now is the time to rediscover alternatives. But do we actually have any alternative?
Johnny: That’s precisely the problem, Jinny. I don’t see any alternative for mortgage-backed securities.
Jinny: Well, one alternative has already been popular in Europe for some time. But now, I think, the time has come for the rest of the world to appreciate its true potential. That alternative goes by the name of “covered bonds”.
Johnny: Covered bonds? What are they?
Jinny: A covered bond is a kind of debt instrument. It has, like any other bond, a face value on which the issuer undertakes to pay interest. The principal or the face value is repayable on maturity.
But that’s not all. To make debts more green, covered bonds use the backing of a pool of assets that are mainly high-quality mortgage loans or, in some instances, loans to public sector enterprises.
Illustration: Jayachandran / Mint
So what, you may ask. Don’t all mortgage-backed securities or asset-backed securities have a similar structure? What looked so green in the case of mortgage-backed securities before the subprime crisis actually turned out to be a rotten cabbage. Then, you may ask, what’s so special about covered bonds?
Johnny: Exactly. I was just wondering, Jinny, whether covered bonds is just a Victorian name for mortgage-backed securities.
Jinny: Not just in name, covered bonds do in fact reflect the financial spirit of the Victorian era. They were first put to use in 1770 by Germany to finance public work projects. At present, some 24 European countries have adopted a formal law that determines the terms and conditions of their use.
So, like a true gentleman, covered bonds follow the old rules strictly. The first rule is that covered bonds can only be issued by banks; however, certain European countries do permit other credit institutions that meet a particular standard of certain credit quality to issue covered bonds.
The second rule is that the mortgage loans backing covered loans remain on the balance sheet of the issuing bank. This makes a lot of difference.
The issuers of mortgage-backed securities remove the mortgage loans from their own balance sheets. They transfer mortgage loans to a special purpose vehicle (SPV), which subsequently issues securities to investors.
Once the transactions are complete, the issuers of mortgage-backed securities completely wash their hands off any future liability.
Investors in mortgage-backed securities are totally at the mercy of the income generated by the assets held by the SPV.
In case the assets fail to generate any income or if they fall in value, the investors can’t turn to issuers and ask for their money back.
Johnny: Are you saying that investors in covered bonds can actually ask for their money back?
Jinny: You guessed it right. The issuers of covered bonds have to meet their repayment obligation even if the mortgage loans backing the bonds fail to generate income or fall in value. In fact, the rules mandate that the issuers have to ensure that the value of collateral remains sufficient all the time to meet the outstanding obligations.
In case the value of the existing mortgage loans declines, the issuers have to bring in new mortgage loans. Here, rules leave no room for discretion.
In fact, what kind of mortgage loans would be eligible to back covered bonds are also fixed by the rules. Only loans meeting certain minimum quality standards are treated as eligible; this ensures that the value of the collateral frequently does not go down.
Due to such rules, the value of the collateral generally exceeds the outstanding obligations of covered bonds.
Johnny: That sounds very comforting, Jinny. But tell me, what happens if the issuing bank actually goes bankrupt? After all, we have seen even good banks going down the drain.
Jinny: Well, covered bonds carry no guarantee of protection against bankruptcy but still, there is room for some comfort.
If the issuer defaults or goes bankrupt, investors in covered bonds have the first claim over the pools of assets backing those bonds.
No other claimant can actually touch those assets unless and until the obligations of covered bonds have beenmet fully.
In case the mortgage loans backing covered bonds are not sufficient to meet the claim of bondholders, the bondholders become general claimants against the issuing bank for the outstanding amount.
In such an eventuality, the holders of covered bonds may have to stand in queue with other claimants. But since the issuers have to keep the value of collateral backing covered bonds sufficient all the time, it is very unlikely that the bondholders will not be able to get back their money.
Johnny: Looks like nobility from a different age, Jinny, where everybody is willing to pay what they owe.
What: Covered bonds can emerge as a good alternative to the “originate to distribute” model followed by mortgage-backed securities.
Where: Covered bonds are presently more popular in some European countries.
How much: At the end of 2007, at least €2 trillion in covered bonds was outstanding.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas fortheir weekly chat. You can write to both of them at email@example.com