Rising use of covered bonds by banks triggers warning

The Financial Times Ltd

15 Jun 2011

Jennifer Hughes in Brussels

Investors and regulators must be wary of banks' growing use of covered bonds, two European policymakers have warned.

Banks have increasingly turned to the bonds, considered an ultra-safe form of secured funding, because the market for straightforward securitisations is still struggling to recover from the financial crisis.

Both forms involve repackaging thousands of loans, such as mortgages, into new bonds, but unlike securitisations, the loans backing covered bonds stay on a bank's books, even though they are ringfenced for the bondholders. But encumbering banks' assets like this leaves less for other creditors, including depositors, warned Vicky Ford, an MEP for the UK's Conservative party and a former securitisation banker.

"The more assets passing into covered bonds, the less assets on the balance sheet for other creditors," she told an industry conference in Brussels on Wednesday.

Her comments echoed a warning by Thomas Huertas, banking sector director at the UK's Financial Services Authority, who said bank supervisors would need to keep a close eye on the bonds' use.

"There is a limit to how far this collateralisation can go without significantly raising the risk of deposits or other senior obligations of the bank," he said.

Both warnings chime with the private concerns of many in the securitisation industry over covered bonds' post-crisis rise to regulatory favour. In addition to the record amounts being sold by banks, the notes will be allowed to count towards new liquidity requirements while securitisations are currently excluded. During the crisis the European Central Bank bought ?60bn of the bonds, but limited its dealings with securitisations to allowing high-grade ones to be used as collateral for short-term loans. Some industry experts are also beginning to caution bondholders to consider more carefully the link between the bonds and the issuing bank since that bank has undertaken to replace any dud loans.

Any downgrade in its credit quality would, for example, weaken the bonds' standing.

A study by Fitch Ratings this year noted the amount of assets pledged to covered bonds was greater than even the record sales would suggest because banks were having to "overcollateralise" - pledge more loans than absolutely necessary to cover the bonds - in order to appease jittery investors.