Undercover agents

The US has been eyeing covered bonds – a safer option than mortgage-backed securities. But will investors ever value such a market?


Undercover agentsThe US has suffered more than most as a result of the credit crunch. The collapse of the subprime market triggered the downfall of the global economy, leaving major institutions in dire straits.

Two of the largest US mortgage lenders, Fannie Mae and Freddie Mac, are desperate for government financial aid. With both lenders issuing more than 70 per cent of US mortgages in 2007, the collapse of the two companies demonstrates the severity of the credit crisis in the US.

A loss of capital markets and mainstream mortgage financing in the US has resulted in dwindling workflow for US firms, and firms with large securitisation practices felt the crisis more than others. Cadwalader Wickersham & Taft is a prime example. Having completed two rounds of layoffs this year, the firm has shed 131 lawyers in the US and UK because of the sharp decline in ­structured finance work.

Needs must
Desperate times call for desperate measures. Rather than wait for the structured finance market to bounce back again, firms such as Cadwalader are pinning their hopes on covered bonds.

Covered bonds, while considered an outdated European method of mortgage financing, are new to the US and have been pushed by the Federal Deposit Insurance Corporation (FDIC) so that the mortgage finance market can be kicked back into gear.

The policy statement issued by the FDIC enables regulatory relief for covered bonds. The hope is that these bonds, new to the US, will become a crucial part of the US ­mortgage finance industry.

Backed by mortgages but kept on the bank’s balance sheet, covered bonds are ­considered a safer type of investment ­compared to the risky mortgage-
backed securities that have caused so many ­problems in the global economy.

“Covered bonds been a part of the ­European markets for over 200 years, but are completely new to the US,” says Cadwalader New York partner Jordan Schwartz. “We don’t know yet whether this market will be a success, but the lack of a thriving securitisation market means it’s worth ­giving it a chance.”

Bonding session
Cadwalader has put together a 12-partner transatlantic team to focus on a possible market opening up in the US. But with just two US-covered bond programmes being issued in the US – by Washington Mutual and Bank of America – looking to the ­covered bond market to rescue a structured finance firm is more than a little risky.

“The reality is that if the securitisation market came back tomorrow, covered bonds would be unlikely to take off,” says ­Cadwalader covered bond practice head Mike Gambro. “We like to be ahead of the curve, and bringing together a group of practitioners who have the right expertise to take advantage of this potential development puts us in a good position.”

Cadwalader’s new practice group is a marketing technique that sits well with the firm’s new mantra of diversification. Since the structured finance market collapsed last summer, the firm has geared up to diver­sify into other practice groups, such as private equity, with the hire of Latham & Watkins private equity head Ron Hopkinson, and litigation.

Rather than a standalone group, the ­covered bond team comprises several individuals who have the right knowledge to work in this area.

“We aren’t taking a financial risk because we’re not investing in a new group,” says Gambro. “We already have the right ­expertise. It’s just a matter of bringing those ­people together to be able to respond to opportunities in this new market.”

Cadwalader is not the only US firm that has high hopes for covered bonds in the US. Other firms, such as Katten Muchin, Heller Ehrman and Mayer Brown, have underscored their dedication to building a significant practice. In Europe, Mayer Brown advised ABN Amro as arrangers on CIBC’s €8bn (£6.51bn) covered bond ­programme last month, with partner Dominic Griffiths leading the firm’s team on the deal.

Katten Muchin has joined Cadwalader in pooling its structured finance partners to create a new team, with US partners Eric Adams and Hays Ellisen leading the team comprising securitisation and structured finance partners on both sides of the Atlantic.

“It’s not crucial to have expertise in Europe, but it certainly helps as the product is so new in the US,” says Adams. “Being able to show clients you have the right skills to address this area is important. A firm with structured finance and securitisation skills will be doing the same thing.”

There are certainly many firms talking a lot about covered bond expertise. But talk is cheap and until a successful covered bond programme is issued in the US, it will be hard for any investor to take this trend ­seriously.

“Covered bonds aren’t going to replace residential mortgage-backed security [RMBS] or commercial mortgage-backed security [CMBS]. That’s the reality,” says Cadwalader London partner Conor Downey. “Those products were lucrative for banks as an off balance sheet instrument. By contrast, covered bonds are on balance sheet and a relatively risk-free instrument. They won’t be as lucrative as these other mortgage finance instruments.”

There is grave uncertainty about how investors will take to covered bonds in the US. With investment traditionally being geared towards European markets, in the German market, for instance, there is some doubt as to whether investors will value a US covered bond market.

“We’ve seen all sorts of weird and wonderful programmes coming out of Europe and also New Zealand, which offers hope to investor appetite in the US,” says Downey. “But since activity has been concentrated in Europe for some time, we simply have no way of knowing whether this will be something the US markets and investors will take advantage of.”

Knowledge range
Despite uncertainty about the potential of US covered bonds, Downey insists that ­providing a diverse range of methods is ­really what marketing this expertise is about.

“The banks are waiting for markets to return. They have significantly reduced the sizes of their RMBS and CMBS teams and are increasingly looking for diversity in financing,” says Downey. “They will want to have lawyers who can advise on a range of products, including private equity funds and covered bonds. This is why firms are launching new groups that demonstrate the flexibility to advise in a range of areas.”

Cadwalader’s core focus on structured finance in recent years transformed it into a highly profitable firm that took advantage of a dramatic boom period. Taking steps to show diversity and flexibility to clients will be beneficial in the long run.

US firms that have taken the step to ­establish a formal covered bond practice seem optimistic about the future. While recruiting into these teams is not on the cards yet, some firms feel confident this could be the next step.

“If it’s successful, then of course we would look at expanding the team,” says Ellisen. “Recruitment isn’t on the agenda right now, but if this proves to be a valuable aspect of the market in the future, building a larger team could be necessary.”

A range of firms have shown a keen ­interest in taking advantage of the latest trend of covered bonds. While it is wise to be ahead of the curve and up to speed with any potential market developments, ­creating practice groups dedicated to a trend that has not actually arrived could be viewed as a desperate attempt to give structured finance and securitisation lawyers some much needed work.

If covered bonds do not take off, the likes of Cadwalader will be in the same ­predicament until structured finance and securitisation show signs of recovery.

“What we’re seeing is a marketing ploy for many firms,” admits Downey. “But there’s a potential in offering clients what they’re asking for – and that’s diversity in the range of products and services you can provide. That’s why we decided to create this group. So far, it has got a good response.”