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What Are Covered Bonds?

We generally see banks as primarily lenders and deposit gatherers. That is, banks simply take deposits to fund higher interest loans. This is descriptive of smaller banks, but many larger banks are also in the business of originating loans to sell to investors.

The typical process includes issuing loans, packaging them as a group, and then selling pieces as "asset-backed securities," which generate returns from the cash flows of the underlying loan pool. Covered bonds offer an alternative solution that allows banks to finance loans with cheap capital, but with the additional requirement that the bank backstop losses should the loan pool turn sour.

Where covered bonds come into play

There is an inherent conflict of interest in separating the origination process from the investor. The originator (and eventual seller) earns profits and fees on the sale, not from the long-run performance of the loans it sells. Said another way, the sellers make money based on the quantity of the loans they package and sell. The buyer makes money based on the quality of the loans.

Covered bonds help bridge the gap of incentives between loan sellers and loan buyers. Whereas asset-backed securities are backed only by a specific pool of loans, covered bonds are backed by a specific pool of loans plus all the other assets of the issuer.

Source: Adapted from a graphic by Morrison & Foerster

Source: Adapted from a graphic by Morrison & Foerster

The additional claim to a bank's assets is a very important differentiator that makes covered bonds less risky than similar asset-backed securities. If a bank stuffs a cover pool with poorly performing loans, it can't just walk away unscathed. It has to continue to pay on the covered bonds as if the pool were fully performing.

Furthermore, in the event the bank itself becomes insolvent from unrelated issues, the covered bond investors have first claim to the pool backing their bonds, protecting their collateral from the claims of other investors in the bank. In short, covered bonds offer better downside protection to investors than an asset-backed security. Naturally, the lower risk can create a lower funding cost for the bank, resulting in a bigger spread.

Who issues covered bonds?

Covered bonds are more popular in Europe, where investors enjoy the benefits of investing in a specific pool of assets and getting additional protection from the issuer on top. In the United States, an active market for loan securitizations and the ability to sell mortgages in virtually unlimited quantity to Fannie Mae and Freddie Mac makes covered bonds less attractive for issuers.

The attractiveness of covered bonds relies on the availability of cheap money. Fannie Mae and Freddie Mac borrow at rates consistent with the U.S. Treasury's borrowing rates -- an entity that can literally print money -- making covered bonds a poor funding mechanism for banks. Likewise, other collateralized loans, like auto loans, benefit from a very healthy securitization market in the United States, which allows banks to offload loans without a hitch. But in the future, there is reason to believe covered bonds may become a key funding source for banks, particularly as investors focus more on the conflicts of interest between originators and investors.

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The article What Are Covered Bonds? originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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