FEATURE: A new finance option?

The introduction of legislation to create a covered bond market in the US could help to fill the financing gap, but the question is whether it will receive Congressional and ultimately industry support. PERE Magazine, April 2011 issue

On March 9, legislation was introduced by Rep. Scott Garrett (R-NJ) and Rep. Carolyn Maloney (D-NY) that would provide a legal framework for covered bonds in the US. The impetus for the bill’s introduction, a version of which originally was introduced last spring but never made it through the Senate, is to promote an additional source of liquidity to support commercial real estate lending and investment.

“It is critical that policymakers tailor reforms to promote credit availability and support the return of sound and vibrant securitisation markets,” said Lisa Pendergast, president of the CRE Finance Council, a trade association dedicated to promoting the strength and liquidity of commercial real estate finance worldwide. “Amidst a changing regulatory environment and the enormous uncertainty that brings, the market must have access to a variety of financing mechanisms to best serve the needs of commercial borrowers and thus support a recovery.”

Although covered bonds have been around in Europe for centuries in some shape or form, the debt instrument is new to the US. Much like CMBS, these bonds are secured by a pool of assets (such as mortgages) and provide funding to the issuing institution. Interest on the covered bond is paid to investors from the issuer’s cash flows, while the cover pool serves as secured collateral. The biggest difference is that the issuer retains the assets and related credit risk on its balance sheet.

That difference could be a huge obstacle for covered bonds to overcome, particularly with Basel III set to require banks to hold higher capital reserves against their loans and other risky assets. The major advantage versus CMBS is that collateral can easily be swapped in and out of the cover pool, providing the issuer with greater flexibility.

John D’Amico, president of the CRE Finance Council, believes covered bonds would be an additive option for commercial real estate finance and not a replacement for securitization, which is pretty firmly established in the US. “I don’t think covered bonds will supplant CMBS, particularly given capital reserve requirements, but they may co-exist,” he said. “Much will depend on global rules and regulations regarding capital reserve requirements and, of course, investor response.”

The covered bond bill still needs to progress through hearings, committees and votes before becoming law, D’Amico noted, adding that it is subject to the process like any other bill. The bill’s chances for passage are unknown at this point, as is its level of support in Congress.

“I’m not in a position to handicap Congress, but it is not considered major legislation,” D’Amico said. “It would be another arrow in the quiver for real estate finance and would be nice to have, but it is not viewed as critical.”