EUROPEAN BANKS TAKE COVER / THE WALL STREET JOURNAL

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SEPTEMBER 25, 2009, 11:33 A.M. ET

European Banks Take Cover

By RICHARD BARLEY

The future of finance may lie in its past. Covered bonds, which have been around since the 18th century, are finding new fans among bankers and regulators looking for a less risky alternative to securitization. Over the past few months, issuance has surged. Some big names like Barclays and UBS are set to issue covered bonds for the first time.

That's a good sign. A financial system with a greater role for covered bonds should be more stable. The snag is that it is also likely to mean less credit for consumers and possibly lower economic growth.

Covered bonds share some features of securitizations, as they are backed by pools of loans. But crucially, unlike in a securitization, the underlying loans remain on the issuing bank's balance sheet, meaning investors have a claim both on the bank and on the pool. What's more, the bank is required to maintain the quality of the pool, replacing deteriorating credits with new good loans. This means they avoid the skewed incentives that led to subprime mortgages being originated solely because the risk could be transferred virtually instantly to Wall Street banks and the securitization market.

This dual claim means covered bonds achieve very high ratings and offer cheap funding. Euro-denominated covered bonds currently yield 93 basis points over government bonds, much tighter than euro senior financial bonds at 155 basis points over, according to Markit iBoxx. In the deepest markets, such as Germany, the difference is even greater, with covered bond spreads of just 45 basis points.

The European Central Bank has been keen to point these advantages out. In December, it argued that "the smooth functioning of these markets is important from a financial stability perspective" as well as being a key funding source for mortgages and public-sector lending. In May, it put its money where its mouth was, pledging to spend up to €60 billion ($88.35 billion) buying covered bonds. That kick-started the market from its post-Lehman torpor, and more and more banks have taken advantage: Bank of Ireland this month sold the first public Irish covered bond since 2007, and Spanish, Italian and Greek banks have also been active. In the U.S., legislation is being worked on to encourage the development of a covered bond market.

But good things don't come for free. Since the structures remain on balance sheet, they will count toward the leverage cap that the G-20 countries are seeking to impose on the banking sector to reduce risk. The International Monetary Fund argued this week that if covered bond financing became dominant, the prospects for credit and economic growth would be lower than in an economy in which securitization played a bigger role. Still, given the turmoil that the pursuit of growth over financial stability has caused, that might be no bad thing.

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