Jefferies LLC. USD Covered Bonds, A Future? Presented by: Daniel Kim. April 18, Jefferies LLC. Member SIPC

Transcription

1 Jefferies LLC USD Covered Bonds, A Future? Presented by: Daniel Kim April 18, 2013 Jefferies LLC Member SIPC

2 Table of Contents Market Overview 1 What Are Covered Bonds? 5 Market Growth 11 US Dollar-Denominated Covered Bonds 19 Valuation of Covered Bonds 24 Outlook/Forecast Summary 33 i

3 Market Overview 1

4 Market Overview Total Covered Bonds Outstanding & Gross Issuance TOTAL COVERED BONDS OUTSTANDING & GROSS ISSUANCE Outstanding (in mm) Covered Bonds Outstanding 1,498,479 1,553,224 1,676,006 1,880,598 2,021,540 2,279,092 2,394,450 2,502,945 2,675,962 3,208,260 Number of Issuers Gross Issuance (in mm) Covered Bonds Issuance 399, , , , , , , , , ,765 Number of New Issuers mm 3,500,000 Covered Bonds Outstanding & Number of Issuers 350 3,000, ,500, ,000, ,500, ,000, , mm 700, , , , , , , Covered Bonds Outstanding (lhs) Number of Covered Bond Issuers (rhs) Covered Bonds Gross Issuance & Number of New Issuers Covered Bonds Issuance (lhs) Number of New Covered Bond Issuers (rhs) Source: European Covered Bond Council (ECBC); Bloomberg 2 0

5 Market Overview US$ Covered Bonds vs. US Agency Debt Outstanding & Net Issuance US$ COVERED BONDS & US AGENCY LONG-TERM DEBT 1 ISSUANCE & OUTSTANDING Outstanding (in $bn) US$ Covered Bonds US Agency Long-Term Debt 1 2,074 2,085 2,074 1,971 1,808 1,634 Net Issuance (in $bn) US$ Covered Bonds US Agency Long-Term Debt 1 (40) 11 (10) (103) (163) (174) 125 US$ Covered Bonds vs. US Agency Long-Term Debt 1 Outstanding ($bn) 2, , , , US$ Covered Bonds (LHS) US Agency Long-Term Debt (RHS) US$ Covered Bonds vs. US Agency Long-Term Debt 1 Net Issuance ($bn) 0 0 (50) (100) (150) (200) US$ Covered Bonds US Agency Long-Term Debt 1 One-year debt or longer; issued by FNMA, FHLMC, FHLB, FFCB, Farmer Mac, and TVA Source: European Covered Bond Council (ECBC); SIFMA 3

6 Market Overview US$ Covered Bond Relative Performance Since July 1, 2010 US$ Covered Bonds Yield (%) July 1, 2010 April 11, 2013 Change ASW Spread (bps) Yield (%) ASW Spread (bps) Yield (bps) ASW Spread (bps) RY /14/ % % 13 (198) (18) BMO /09/ % % 10 (201) (35) CM /02/ % % 10 (196) (31) US$ Comparable Bonds Yield (%) ASW Spread (bps) Yield (%) ASW Spread (bps) Yield (bps) ASW Spread (bps) FHLMC /09/ % (1) 0.25% (16) (167) (15) FNMA /28/ % % (4) (182) (12) ONTARIO /16/ % % 11 (198) (25) KFW /03/ % % 1 (191) (30) UST /30/ % (26) 0.26% (13) (153) 13 Source: Jefferies 4

7 What Are Covered Bonds? 5

8 What Are Covered Bonds? Overview Covered bonds are issued by regulated financial institutions, secured by a priority claim on a collateral pool of high quality, on-balance sheet assets, and are either backed by dedicated legislation or rely on contractual law. Legislation or Statutory (Special-Law) Legal Frameworks: based on a law and/or binding regulations of a public supervisory authority, specifically dedicated to regulate a covered country s bond system of a country. Currently, special-law based frameworks exist in 28 European jurisdictions. Although frameworks can vary between jurisdictions, examples of legally supported provisions include criteria for: Eligible Cover Pool Assets Maximum Asset Loan-to-Value Ratios (LTVs) Limits on Issuance Amounts Percentage Limits of Encumbered Assets Swap and Segregation Mechanics Minimum Over-Collateralization (OC) Requirements Bankruptcy Effects 6

9 What Are Covered Bonds? Overview Covered bonds are issued by regulated financial institutions, secured by a priority claim on a collateral pool of high quality, on-balance sheet assets, and are either backed by dedicated legislation or rely on contractual law. Legislation or Statutory (Special-Law) Legal Frameworks: based on a law and/or binding regulations of a public supervisory authority, specifically dedicated to regulate a covered country s bond system of a country. Currently, special-law based frameworks exist in 28 European jurisdictions. Although frameworks can vary between jurisdictions, examples of legally supported provisions include criteria for: Eligible Cover Pool Assets Maximum Asset Loan-to-Value Ratios (LTVs) Limits on Issuance Amounts Percentage Limits of Encumbered Assets Swap and Segregation Mechanics Minimum Over-Collateralization (OC) Requirements Bankruptcy Effects Contractual or Structured (General-Law) Legal Frameworks: based on general law (such as contract law) or on law and/or regulations of a country not specifically dedicated to regulate a covered bonds system. Covered bonds issued under these frameworks rely on general contractual rules and structured techniques that enhance the credit quality of the bond. These bonds are generally issued by financial institutions in jurisdictions where no covered bond statutory framework exists, such as the UK, the Netherlands, and the United States. 6

10 What Are Covered Bonds? Essential Features 1 According to the European Covered Bond Council (ECBC), covered bonds are characterized by 4 common Essential Features 1 : 1. Issued by or bondholders otherwise have full recourse to a credit institution subject to public supervision and regulation; 1 Essential Features are defined by the European Covered Bond Council (ECBC) and are understood as minimum standards for covered bonds 7

11 What Are Covered Bonds? Essential Features 1 According to the European Covered Bond Council (ECBC), covered bonds are characterized by 4 common Essential Features 1 : 1. Issued by or bondholders otherwise have full recourse to a credit institution subject to public supervision and regulation; 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; 1 Essential Features are defined by the European Covered Bond Council (ECBC) and are understood as minimum standards for covered bonds 7

12 What Are Covered Bonds? Essential Features 1 According to the European Covered Bond Council (ECBC), covered bonds are characterized by 4 common Essential Features 1 : 1. Issued by or bondholders otherwise have full recourse to a credit institution subject to public supervision and regulation; 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; 3. The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool at all times; 1 Essential Features are defined by the European Covered Bond Council (ECBC) and are understood as minimum standards for covered bonds 7

13 What Are Covered Bonds? Essential Features 1 According to the European Covered Bond Council (ECBC), covered bonds are characterized by 4 common Essential Features 1 : 1. Issued by or bondholders otherwise have full recourse to a credit institution subject to public supervision and regulation; 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; 3. The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool at all times; 4. The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies. 1 Essential Features are defined by the European Covered Bond Council (ECBC) and are understood as minimum standards for covered bonds 7

14 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution 8

15 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution Structure Typically bullet, with principal paid at maturity. Exception: soft-bullet structure, where repayment can be delayed by a specified amount of time Typically pass-through. Amortization is common in MBS structures, so investors assume prepayment risk Typically bullet 8

16 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution Structure Collateral Pool Typically bullet, with principal paid at maturity. Exception: soft-bullet structure, where repayment can be delayed by a specified amount of time Typically dynamic; issuer is legally required (special-law) or contractually committed (general-law) to maintain quality and size of the cover pool; non-performing and/or maturing collateral must be replaced Typically pass-through. Amortization is common in MBS structures, so investors assume prepayment risk Typically a static pool that amortizes via repayments; may also be dynamic, where the originator substitutes/adds new assets as the underlying pool pays down Typically bullet No direct recourse to a dedicated pool of collateral 8

17 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution Structure Collateral Pool Typically bullet, with principal paid at maturity. Exception: soft-bullet structure, where repayment can be delayed by a specified amount of time Typically dynamic; issuer is legally required (special-law) or contractually committed (general-law) to maintain quality and size of the cover pool; non-performing and/or maturing collateral must be replaced Typically pass-through. Amortization is common in MBS structures, so investors assume prepayment risk Typically a static pool that amortizes via repayments; may also be dynamic, where the originator substitutes/adds new assets as the underlying pool pays down Typically bullet No direct recourse to a dedicated pool of collateral Over- Collateralization (OC) Yes. Rating agencies usually ask for an OC that is greater than the legally required (special-law) or contractually committed (general-law) amount to achieve a particular target rating Yes, as required by rating agencies to achieve a particular target rating No 8

18 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution Structure Collateral Pool Typically bullet, with principal paid at maturity. Exception: soft-bullet structure, where repayment can be delayed by a specified amount of time Typically dynamic; issuer is legally required (special-law) or contractually committed (general-law) to maintain quality and size of the cover pool; non-performing and/or maturing collateral must be replaced Typically pass-through. Amortization is common in MBS structures, so investors assume prepayment risk Typically a static pool that amortizes via repayments; may also be dynamic, where the originator substitutes/adds new assets as the underlying pool pays down Typically bullet No direct recourse to a dedicated pool of collateral Over- Collateralization (OC) Yes. Rating agencies usually ask for an OC that is greater than the legally required (special-law) or contractually committed (general-law) amount to achieve a particular target rating Yes, as required by rating agencies to achieve a particular target rating No Tranching No Yes No 8

19 What Are Covered Bonds? Market Comparisons Issuer Covered Bonds Generally, a credit institution/originator who keeps the assets on balance sheet. Securitizations (ABS/MBS) Special Purpose Entity (SPE); securities are not on the balance sheet (i.e., bondholders have no recourse to the issuer) Senior Unsecured Bank Debt Financial Institution Structure Collateral Pool Typically bullet, with principal paid at maturity. Exception: soft-bullet structure, where repayment can be delayed by a specified amount of time Typically dynamic; issuer is legally required (special-law) or contractually committed (general-law) to maintain quality and size of the cover pool; non-performing and/or maturing collateral must be replaced Typically pass-through. Amortization is common in MBS structures, so investors assume prepayment risk Typically a static pool that amortizes via repayments; may also be dynamic, where the originator substitutes/adds new assets as the underlying pool pays down Typically bullet No direct recourse to a dedicated pool of collateral Over- Collateralization (OC) Yes. Rating agencies usually ask for an OC that is greater than the legally required (special-law) or contractually committed (general-law) amount to achieve a particular target rating Yes, as required by rating agencies to achieve a particular target rating No Tranching No Yes No Residual Risk/ Recourse to Issuer Typically, investors have "full recourse" to both the cover pool and the issuer Exception: in some jurisdictions/structures (e.g., US, Portugal, Hungary, and certain French and Italian covered bonds), investors only have recourse to the cover pool following an issuer default ( limited recourse ) No legal recourse to the issuer. Structural risk is transferred to the investor, who has a claim only on the SPE assets and its associated cash flows, depending on the tranche owned Only to an issuer's assets after all secured and other claims (e.g., tax) have been settled 8

20 What Are Covered Bonds? Rating Agency Perspective Fitch and Moody s Payment Discontinuity Risk FITCH S COVERED BONDS RATING METHODOLOGY Determines how far the covered bonds probability of default can differ from that of the financial institution acting as main debtor of recourse, expressed via the Fitch Discontinuity Factor while the institution s probability of default is evidenced through its Issuer Default Rating (IDR). 9

21 What Are Covered Bonds? Rating Agency Perspective Fitch and Moody s Payment Discontinuity Risk Cover Assets/ Projected Cash Flows FITCH S COVERED BONDS RATING METHODOLOGY Determines how far the covered bonds probability of default can differ from that of the financial institution acting as main debtor of recourse, expressed via the Fitch Discontinuity Factor while the institution s probability of default is evidenced through its Issuer Default Rating (IDR). Checks whether, post-issuer default and considering over-collateralization between the cover pool and all outstanding covered bonds, asset cash flows enable payments on the liabilities under Fitch s stress scenarios corresponding to the covered bond s maximum achievable rating on a probability-of-default basis. 9

22 What Are Covered Bonds? Rating Agency Perspective Fitch and Moody s Payment Discontinuity Risk Cover Assets/ Projected Cash Flows Recovery Given Default FITCH S COVERED BONDS RATING METHODOLOGY Determines how far the covered bonds probability of default can differ from that of the financial institution acting as main debtor of recourse, expressed via the Fitch Discontinuity Factor while the institution s probability of default is evidenced through its Issuer Default Rating (IDR). Checks whether, post-issuer default and considering over-collateralization between the cover pool and all outstanding covered bonds, asset cash flows enable payments on the liabilities under Fitch s stress scenarios corresponding to the covered bond s maximum achievable rating on a probability-of-default basis. The assigned covered bond rating can be lifted above its rating on a probability-of-default basis by a maximum of 2 or 3 notches depending on whether the rating is in the investment or non-investment grade range, provided that over-collateralization taken into consideration produces outstanding stressed recoveries on covered bonds assumed to be in default. 9

23 What Are Covered Bonds? Rating Agency Perspective Fitch and Moody s Payment Discontinuity Risk Cover Assets/ Projected Cash Flows Recovery Given Default Expected Loss (EL) Model FITCH S COVERED BONDS RATING METHODOLOGY Determines how far the covered bonds probability of default can differ from that of the financial institution acting as main debtor of recourse, expressed via the Fitch Discontinuity Factor while the institution s probability of default is evidenced through its Issuer Default Rating (IDR). Checks whether, post-issuer default and considering over-collateralization between the cover pool and all outstanding covered bonds, asset cash flows enable payments on the liabilities under Fitch s stress scenarios corresponding to the covered bond s maximum achievable rating on a probability-of-default basis. The assigned covered bond rating can be lifted above its rating on a probability-of-default basis by a maximum of 2 or 3 notches depending on whether the rating is in the investment or non-investment grade range, provided that over-collateralization taken into consideration produces outstanding stressed recoveries on covered bonds assumed to be in default. MOODY S COVERED BONDS RATING METHODOLOGY Determines a rating based on a largely quantitative calculation of expected loss, taking into account both the issuer s credit strength and the value of the cover pool following issuer default. 9

24 What Are Covered Bonds? Rating Agency Perspective Fitch and Moody s Payment Discontinuity Risk Cover Assets/ Projected Cash Flows Recovery Given Default Expected Loss (EL) Model Timely Payment Indicator (TPI) FITCH S COVERED BONDS RATING METHODOLOGY Determines how far the covered bonds probability of default can differ from that of the financial institution acting as main debtor of recourse, expressed via the Fitch Discontinuity Factor while the institution s probability of default is evidenced through its Issuer Default Rating (IDR). Checks whether, post-issuer default and considering over-collateralization between the cover pool and all outstanding covered bonds, asset cash flows enable payments on the liabilities under Fitch s stress scenarios corresponding to the covered bond s maximum achievable rating on a probability-of-default basis. The assigned covered bond rating can be lifted above its rating on a probability-of-default basis by a maximum of 2 or 3 notches depending on whether the rating is in the investment or non-investment grade range, provided that over-collateralization taken into consideration produces outstanding stressed recoveries on covered bonds assumed to be in default. MOODY S COVERED BONDS RATING METHODOLOGY Determines a rating based on a largely quantitative calculation of expected loss, taking into account both the issuer s credit strength and the value of the cover pool following issuer default. Applies a ceiling to the rating arrived at using Moody s EL Model and determines the maximum covered bond rating based on the issuer s senior unsecured rating and the TPI assigned to the program, which reflects the probability of timely payments continuing following the default of the issuer (or a rated entity on which the issuer relies for support). 9

25 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. 10

26 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) Program Categorization S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. Categorizes programs predominantly by country, based on the range of external funding options available and the likelihood of obtaining this funding, into one of 3 categories, each with a range of maximum potential ratings uplift. The broader the range of funding options and the more well-established and systemically important the covered bond product is in a particular country, the higher the potential uplift. 10

27 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) Program Categorization Maximum Potential Covered Bond Rating S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. Categorizes programs predominantly by country, based on the range of external funding options available and the likelihood of obtaining this funding, into one of 3 categories, each with a range of maximum potential ratings uplift. The broader the range of funding options and the more well-established and systemically important the covered bond product is in a particular country, the higher the potential uplift. Evaluates maximum degree to which a program s rating may potentially exceed the issuing bank s rating, combining its assessments of its ALMM exposure (Step 1) and its ability to cover its funding need (Step 2): ALMM Risk Category 1 Category 2 Category 3 Zero Unrestricted Unrestricted Unrestricted Low Moderate High

28 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) Program Categorization Maximum Potential Covered Bond Rating Cash Flow/Market Value Analysis S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. Categorizes programs predominantly by country, based on the range of external funding options available and the likelihood of obtaining this funding, into one of 3 categories, each with a range of maximum potential ratings uplift. The broader the range of funding options and the more well-established and systemically important the covered bond product is in a particular country, the higher the potential uplift. Evaluates maximum degree to which a program s rating may potentially exceed the issuing bank s rating, combining its assessments of its ALMM exposure (Step 1) and its ability to cover its funding need (Step 2): ALMM Risk Category 1 Category 2 Category 3 Zero Unrestricted Unrestricted Unrestricted Low Moderate High Targets credit enhancement level that corresponds to the maximum potential ratings uplift by analyzing the program cash flows and applying market value stress to the cash flows in the situations where ALMMs occur and there is a funding need. 10

29 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) Program Categorization Maximum Potential Covered Bond Rating Cash Flow/Market Value Analysis Covered Bond Program Rating S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. Categorizes programs predominantly by country, based on the range of external funding options available and the likelihood of obtaining this funding, into one of 3 categories, each with a range of maximum potential ratings uplift. The broader the range of funding options and the more well-established and systemically important the covered bond product is in a particular country, the higher the potential uplift. Evaluates maximum degree to which a program s rating may potentially exceed the issuing bank s rating, combining its assessments of its ALMM exposure (Step 1) and its ability to cover its funding need (Step 2): ALMM Risk Category 1 Category 2 Category 3 Zero Unrestricted Unrestricted Unrestricted Low Moderate High Targets credit enhancement level that corresponds to the maximum potential ratings uplift by analyzing the program cash flows and applying market value stress to the cash flows in the situations where ALMMs occur and there is a funding need. Determines the rating that reflects the cover pool s actual level of credit enhancement. S&P assigns the first notch of uplift if the available credit enhancement covers all credit risks related to the default of the cover pool assets. The remaining credit enhancement is compared to the additional notches of potential ratings uplift to determine the uplift achievable. 10

30 What Are Covered Bonds? Rating Agency Perspective S&P Asset-Liability Mismatch (ALMM) Program Categorization Maximum Potential Covered Bond Rating Cash Flow/Market Value Analysis Covered Bond Program Rating Other Risks S&P S COVERED BONDS RATING METHODOLOGIES Calculates its view of a program s ALMM exposure, its magnitude, and the timing, treating near-term mismatches as more significant than those occurring in the medium- or long-term. S&P classifies each program as a low, moderate, or high ALMM risk, which determines the number of maximum notches of potential rating uplift from the issuer s rating. Categorizes programs predominantly by country, based on the range of external funding options available and the likelihood of obtaining this funding, into one of 3 categories, each with a range of maximum potential ratings uplift. The broader the range of funding options and the more well-established and systemically important the covered bond product is in a particular country, the higher the potential uplift. Evaluates maximum degree to which a program s rating may potentially exceed the issuing bank s rating, combining its assessments of its ALMM exposure (Step 1) and its ability to cover its funding need (Step 2): ALMM Risk Category 1 Category 2 Category 3 Zero Unrestricted Unrestricted Unrestricted Low Moderate High Targets credit enhancement level that corresponds to the maximum potential ratings uplift by analyzing the program cash flows and applying market value stress to the cash flows in the situations where ALMMs occur and there is a funding need. Determines the rating that reflects the cover pool s actual level of credit enhancement. S&P assigns the first notch of uplift if the available credit enhancement covers all credit risks related to the default of the cover pool assets. The remaining credit enhancement is compared to the additional notches of potential ratings uplift to determine the uplift achievable. S&P also reviews any legal risks, operational and administrative risks, and any counterparty exposures to determine whether these are commensurate with the rating being assigned above. 10

31 Market Growth 11

32 Market Growth Global Momentum Growing preference for secured funding Political and regulatory support Excluding this funding alternative can represent a competitive disadvantage to a nation s financial system Several major jurisdictions have recently enacted or are in the process of adopting covered bond legislation Non-European bank covered bond issuance increased 73% in 2012, while issuance from European banks was down 22%. 1 After legislation was passed in October 2011, Australian borrowers became the biggest covered bond issuers outside of Europe, raising US$42.4bn (equivalent) in 2012 US$ covered bonds have grown 10x since 2005 with $115bn in benchmarks currently outstanding (~10% of -benchmark market and ~3.5% of total covered bond market) Issuance of US$-benchmark covered bonds reached a record $40bn in 2012 (vs. $37bn in 2011 and $25bn in 2010) US$-denominated covered bonds mainly sold under private placements to institutional investors, but issuing under covered bond legislation makes them eligible for major bond indices and allows the bonds to be sold to retail investors Globally, we expect primary market supply and secondary market liquidity to expand further as both implicit support via regulatory developments and explicit support from central banks favor covered bonds over competing products 1 Source: Bloomberg 12

33 Market Growth Issuer Perspective COST-EFFECTIVE FUNDING 13

34 Market Growth Issuer Perspective COST-EFFECTIVE FUNDING RESILIENT SOURCE OF ALTERNATIVE FINANCING 13

35 Market Growth Issuer Perspective COST-EFFECTIVE FUNDING RESILIENT SOURCE OF ALTERNATIVE FINANCING EXTENSION OF LIABILITY MATURITY PROFILE 13

36 Market Growth Issuer Perspective COST-EFFECTIVE FUNDING RESILIENT SOURCE OF ALTERNATIVE FINANCING EXTENSION OF LIABILITY MATURITY PROFILE ASSET-LIABILITY MATCHING 13

37 Market Growth Issuer Perspective COST-EFFECTIVE FUNDING RESILIENT SOURCE OF ALTERNATIVE FINANCING EXTENSION OF LIABILITY MATURITY PROFILE ASSET-LIABILITY MATCHING DIVERSIFIED INVESTOR BASE 13

38 Market Growth Investor Perspective SAFETY / CREDIT QUALITY 14

39 Market Growth Investor Perspective SAFETY / CREDIT QUALITY LIQUIDITY / TRANSPARENCY 14

40 Market Growth Investor Perspective SAFETY / CREDIT QUALITY LIQUIDITY / TRANSPARENCY YIELD PICK-UP 14

41 Market Growth Investor Perspective SAFETY / CREDIT QUALITY LIQUIDITY / TRANSPARENCY YIELD PICK-UP PORTFOLIO DIVERSIFICATION 14

42 Market Growth Investor Perspective SAFETY / CREDIT QUALITY LIQUIDITY / TRANSPARENCY YIELD PICK-UP PORTFOLIO DIVERSIFICATION PREFERENTIAL TREATMENT 14

43 Market Growth Investor Perspective SAFETY / CREDIT QUALITY LIQUIDITY / TRANSPARENCY YIELD PICK-UP PORTFOLIO DIVERSIFICATION PREFERENTIAL TREATMENT HIGHER / LESS VOLATILE CREDIT RATINGS 14

44 Market Growth Government Perspective A smoothly functioning covered bond market is highly important in the context of financial stability. 1 European Central Bank (ECB) January 2011 Funding conditions have important macro-economic repercussions via credit supply and allocation Mortgage credit availability impacts the real estate market, thereby affecting overall consumption and investment behavior Covered bonds are favored by government authorities due to: Safety Reliable Credit Supply Cost-Effective Financing for Public/Private Borrowers Positive Long-Term Economic Benefits Financial Stability (banks less susceptible to market turmoil) Lack of Moral Hazard Problems (issuers retain risk of assets on-balance sheet) These benefits are demonstrated by the abundance of privileges covered bonds enjoy in various financial market regulations 1 The impact of the Eurosystem s covered bond purchase Programme on the primary and secondary Markets; Occasional Paper series, No. 122 /January 2011, page 9 15

45 Market Growth Regulatory Support Basel II: Treats covered bonds as unsecured bank bonds for risk-based capital requirements In Europe, risk weightings are linked to the covered bond rating and not the rating of the issuer 10% for covered bonds rated at least AA-/Aa3; 20% for those rated between BBB-/Baa3 and A+/A1 (vs. 20% and 50%, respectively, for similarly-rated senior unsecured bonds and general-law covered bonds) 16

46 Market Growth Regulatory Support Basel II: Treats covered bonds as unsecured bank bonds for risk-based capital requirements In Europe, risk weightings are linked to the covered bond rating and not the rating of the issuer 10% for covered bonds rated at least AA-/Aa3; 20% for those rated between BBB-/Baa3 and A+/A1 (vs. 20% and 50%, respectively, for similarly-rated senior unsecured bonds and general-law covered bonds) Basel III: Introduces liquidity and funding restrictions Liquidity Coverage Ratio (LCR) requires banks to hold high-quality assets in excess of 30 days cash outflows o Classifies covered bonds as Level 2 assets, allowing banks to hold 40% at a haircut of 15% Net Stable Funding Ratio (NSFR) ratio between the amount of Available Stable Funding (ASF) to Required Stable Funding (RSF) to match long-term assets and liabilities o Motivates issuers to fund long-term with bias to covered bonds due to favorable RSF risk weighting vs. alternatives 16

47 Market Growth Asset Encumbrance and Issuance Limits US Canada Australia Over-Collateralization (OC) 105% 103% 103% Issuance Limit 4% of Liabilities 4% of Total Assets Maximum Potential Issuance ~US$500bn ~CAD 127bn (US$ 125bn) 8% of Domestic Assets for deposit taking institutions ~AUD 150bn (US$ 156bn equiv.) 17

48 Market Growth Who Invests in Covered Bonds? From a credit/risk perspective, covered bonds fall in between high-grade government bonds and senior unsecured bank debt. However, due to their strong bondholder protections (dual recourse; priority claim to assets over unsecured creditors; regulatory supervision/oversight) and the nature of the cover assets (dynamic pool; over-collateralization), covered bonds are not highly correlated with either government bonds or with senior unsecured corporate bonds. While covered bonds attract buyers from both of these markets (for different reasons), these are two very different asset classes with limited investor overlap and virtually no similarity in terms of investment strategy. For example, Central Banks/SWFs are active buyers of covered bonds but not senior unsecured debt, and Asset Managers/ Pension Funds typically have higher investment limits for covered bonds than for senior unsecured bank debt. As a result, covered bonds offer distinct diversification opportunities for both groups of investors. Rates investors buy covered bonds to enhance the yield of government bond portfolios without diluting their credit rating. Credit investors buy covered bonds to improve the overall credit quality of their credit portfolios. Traditionally, Banks have ranked among the largest buyers of covered bonds, but the proportion of Asset Managers and Insurance Company/Pension Funds participating in new issue benchmark covered bonds has steadily increased in recent years. In terms of geographical distribution, demand for benchmark covered bonds becomes increasingly international with Germany, France, the UK, Ireland, Scandinavia, the Netherlands, and Spain being the major investor areas. Source: European Covered Bond Council (ECBC) 18

49 US Dollar-Denominated Covered Bonds 19

50 US Dollar-Denominated Covered Bonds Situation Overview US housing finance relies heavily on the securitization market, supported by guarantees from Fannie Mae and Freddie Mac Due to a variety of factors, such as the impact of the financial crisis on the GSEs and a resurgence of US$ covered bonds that mainly benefits non-us lenders, new housing finance alternatives such as covered bonds are being considered in Washington With over $13 trillion in total US mortgage debt and over $8 trillion in US mortgage-related securities outstanding, covered bonds are an intriguing source of private capital for the US mortgage market, but the hurdles are substantial We estimate the capacity of a bank-only domestic issuer market of approximately $500 billion, a small fraction of the agency-backed mortgage market, based on a limit of 4% of bank liabilities (included in the 2008 FDIC policy statement) The US lacks a legal framework for covered bonds, but the bipartisan introduction of covered bond legislation in the Senate (joining a similar House bill that passed the Financial Services Committee) in November 2011 was a key development However, no Senate hearings have been held to date and the new Congress must re-introduce the legislation US covered bond legislation will resolve uncertainty regarding treatment under FDIC receivership and allow US issuers to access this cost efficient funding source The political dimension of developing a special-law-based US covered bond market leads us to believe it will be incorporated within a resolution on housing finance reform, including the fate of Fannie Mae/Freddie Mac and the future role of FHLB Meanwhile, large issuers have tasted success and plan to expand their covered bond programs, while similar success has been experienced by other foreign issuers that have not yet tapped the US$ market 20

51 US Dollar-Denominated Covered Bonds Historical US$ Covered Bond Issuance TOTAL US$ COVERED BOND ISSUANCE Issuance (in $bn) Cumulative Total Total US$ Covered Bonds Issued By Country/Region North America Others France Nordics United Kingdom Benelux Ireland Germany Spain By Tenor/Maturity < 3 Years Years Years Years Years > 12 Years Source: European Covered Bond Council (ECBC) 21

52 US Dollar-Denominated Covered Bonds Canadian Covered Bonds US debt markets remain a very important funding source for Canadian banks with total US$ issuances outstanding of US$51.6 billion, or 84.7% of all Canadian covered bonds outstanding 1 With $21.9bn of US$ covered bond issuance in 2011 and another $16.85bn in 2012, Canadian issuers dominate this market Canadian Covered Bonds Outstanding (in USD equivalent) 1 Issuer Name USD Issues ($mm) Non-USD Issues ($mm) TOTAL ($mm) BANK OF NOVA SCOTIA (BNS) 15,750 1,048 16,792 CANADIAN IMPERIAL BANK (CIBC) 7,850 3,303 12,036 ROYAL BANK OF CANADA (RBC) 5,500 4,900 10,387 TORONTO-DOMINION BANK (TD) 10, ,000 BANK OF MONTREAL (BMO) 7, ,806 NATIONAL BANK OF CANADA (NBC) 3, ,000 CAISSE CENTRALE DESJARDINS (CCDQ) 2, ,500 TOTAL 51,600 9,250 60,850 mm 17,500 15,000 12,500 10,000 7,500 5,000 2,500 0 Canadian Covered Bonds Outstanding by Currency BNS CIBC RBC TD BMO NBC CCDQ CAD EUR CHF AUD USD On April 26, 2012, Canada introduced legislation protecting the cover pool upon bankruptcy of an issuer and charging Canada Mortgage and Housing Corporation (CMHC) with administering a legal framework for covered bonds On December 17, 2012, CMHC announced the covered bond legal framework, with eligible assets limited to uninsured residential loans (max. 80% LTV) and Government of Canada securities (up to a max. of 10%) Insured mortgage loans are no longer permitted as collateral in the cover pool We expect Canadian banks to continue actively issuing covered bonds due to increased funding diversification, access to new investors, and the banks established reputation as covered bond issuers 1 Source: Bloomberg, as of February 28,

53 US Dollar-Denominated Covered Bonds Current Issuance Alternatives Foreign banks issuing into the US market relied on their domestic covered bond framework, using cover pool assets that are foreign (not in the US) and program issuances (or syndicated takedowns) conducted on an exempt basis Section 4(2) and Rule 144A 23

54 US Dollar-Denominated Covered Bonds Current Issuance Alternatives Foreign banks issuing into the US market relied on their domestic covered bond framework, using cover pool assets that are foreign (not in the US) and program issuances (or syndicated takedowns) conducted on an exempt basis Section 4(2) and Rule 144A Section 3(a)(2) 23

55 US Dollar-Denominated Covered Bonds Current Issuance Alternatives Foreign banks issuing into the US market relied on their domestic covered bond framework, using cover pool assets that are foreign (not in the US) and program issuances (or syndicated takedowns) conducted on an exempt basis Section 4(2) and Rule 144A Section 3(a)(2) SEC Registration 23

56 Valuation of Covered Bonds 24

57 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework 25

58 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework Credit Quality 25

59 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework Credit Quality Collateral Quality 25

60 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework Credit Quality Collateral Quality Product Maturity 25

61 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework Credit Quality Collateral Quality Product Maturity Price Performance/Volatility, Liquidity, and Transparency 25

62 Valuation of Covered Bonds Traditional Risk Factors To assess the different covered bond products, and to identify investment as well as relative value opportunities, investors typically take into account the following: Strength of the Legal and Regulatory Framework Credit Quality Collateral Quality Product Maturity Price Performance/Volatility, Liquidity, and Transparency Regulatory Environment 25

63 Valuation of Covered Bonds Non-Traditional Risk Factors Due to the extraordinary measures taken by governments and central banks around the world, the domicile state of a covered bond issuer is one of the most prominent risks in today s covered bond market Savvy investors analyze strengths/weaknesses of an economy and financial system, the systemic risks, as well as the interconnectedness of the financial sector In addition to the traditional risk factors, all aspects of support for individual issuers, individual states, or the nation s banking system as a whole should be analyzed Investors must analyze political/regulatory risk in their investment decisions quite difficult with a long-term investment horizon when the rules/regulations have not been finalized and a broad range of initiatives and measures are being considered The clear regulatory preference for covered bonds vs. other assets is a positive but should not lead to investor complacency 26

64 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt 27

65 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt vs. Sovereign Debt 27

66 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt vs. Sovereign Debt vs. (Sovereign and Issuer) Credit Default Swaps (CDS) 27

67 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt vs. Sovereign Debt vs. (Sovereign and Issuer) Credit Default Swaps (CDS) vs. GSEs and SSAs 27

68 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt vs. Sovereign Debt vs. (Sovereign and Issuer) Credit Default Swaps (CDS) vs. GSEs and SSAs vs. Residential Mortgage-Backed Securities (RMBS) 27

69 Valuation of Covered Bonds Relative Value Covered bonds are generally priced vs. 3-month LIBOR (USD issues), although some covered bonds (mostly those issued out of peripheral European countries) have increasingly been priced against the underlying government bonds. On a relative value basis, there are several meaningful measures of comparative covered bond performance, including: vs. Senior Unsecured Debt vs. Sovereign Debt vs. (Sovereign and Issuer) Credit Default Swaps (CDS) vs. GSEs and SSAs vs. Residential Mortgage-Backed Securities (RMBS) vs. Interest Rate Swaps 27

70 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 Valuation of Covered Bonds US$ Covered Bond Performance bps 150 Historical Short-Term Asset Swap Spreads (25) (50) USD Covered Bonds 1-3 yrs Liquid US Corps 1-4 yrs SSA 1-4 yrs 2yr OTR Agencies 3yr OTR Agencies bps 225 Historical Medium-Term Asset Swap Spreads (25) USD Covered Bonds 3-5 yrs Liquid US Corps 4-7 yrs SSA 4-7 yrs 5yr OTR Agencies 7yr OTR Agencies Source: Bloomberg; Jefferies 28

71 Valuation of Covered Bonds During Times of Stress Sovereign Debt Crises vs. Financial Crises During the 2008 financial crisis, covered bond spreads to sovereign debt widened from ~60bps to as much as ~350bps or more in some names/jurisdictions In contrast, during the sovereign debt crisis some covered bonds (from first-tier banks) have traded inside that of the sovereign Relationship Between Covered Bonds and Sovereign Debt Link between covered bonds and sovereign debt is most obvious in public covered bonds (backed by loans granted to central, regional, and municipal governments), while the link between sovereign debt and mortgage-backed covered bonds is less direct Covered bonds are most highly correlated with the issuer s senior unsecured debt, which in turn is correlated with sovereign debt due to shared macroeconomic effects and, to a lesser extent, the ability/extent of any potential sovereign support For example, Moody s Timely Payment Indicator (TPI) leeway measures the number of notches an issuer can be downgraded before the rating of a covered bond is downgraded 1 In addition, banks typically cannot be rated more than one notch above that of the sovereign due to multiple channels of shared exposure and contagion for issuers in the same sovereign environment 2 Sovereign and covered bond debt share this macroeconomic risk with correlation greatest in times of crisis when credit spreads for both are driven wider 1 Source: Moody s, March 4, Source: Moody s February 13,

72 Valuation of Covered Bonds Sovereign Debt Spreads Periphery vs. Core There have been two distinct trends in the performance of covered bonds relative to the respective sovereign over the course of the Eurozone debt crisis. In the periphery, covered bonds outperformed sovereign debt in times of stress and underperformed during periods of relief, while the opposite has generally been true in the core European markets. For example, between October and November 2011, investing in Spanish government debt returned a negative 7.6%, while Spanish covered bonds (both single and pooled cédulas) were considerably less vulnerable to this price decline (falling 2.00% and 3.40%, respectively). The outperformance of covered bonds during such times, which was also demonstrated in Italian and even, to a lesser extent, French markets, is due to a significantly lower volatility relative to the sovereign. While prices follow the same directional trend, the magnitude of this move is lower for covered bonds owing to the dual nature of the claim afforded to investors. By contrast, the core safe-haven markets, such as the UK and Scandinavia, received considerable sovereign debt inflows from investors looking for security in volatile and uncertain market conditions. Covered bonds in these markets, due to the less liquid nature of the asset class vs. larger sovereign debt issues, received less risk-off buying during these periods of stress and underperformed sovereign debt in core markets that receive such flows. Spread Margin Between Covered Bonds and Sovereign Debt Periphery Core Source: Jefferies; European Covered Bond Council (ECBC); Bloomberg; as of April 10,