The Conundrum of Covered Bonds

Covered bonds, which have been part of European finance since the time of Frederick the Great, are now being widely touted as the answer to securitization's imperfections. There is great confusion, though, about the nature of covered bonds and their relationship to secured bond financing and securitization. This article attempts to demystify covered bonds, examining how they fit within a larger financing framework, analyzing their legal rights and obligations, and comparing their costs and benefits. The benefits of covered bonds are similar to those of securitization; both can access low-cost capital market funding with low risk to their investors, and both can be used to regenerate lending markets. The costs of covered bonds may be higher; though, because the "dynamic" collateral pools and "dual" recourse to the issuer that protect covered bonds shift virtually all risk to unsecured creditors. Whether that risk should be allowed to be shifted so asymmetrically is a policy question for any nascent covered bond regime.