Once-stable covered bond market dries up for banks

LONDON (Reuters) - New issues have dried up and spreads have widened sharply over the past month in the covered bond market, which had been one of the most reliable and cheapest ways left for European banks to raise money.

"Investors are in a safe-haven mode now, and that doesn't extend to covered bonds," said a specialist on a bond syndicate desk. "Trading now is horrifically illiquid and horrifically volatile."

In the secondary market, spreads for stronger names such as Eurohypo and Dexia Municipal Agency (Dexma) have moved from single and low double-digit range to around 20 to 40 basis points, he said. Weaker names such as Hypo Real Estate HRXG.DE and Spanish savings banks have moved to the mid- to high double digits.

Covered bonds are backed by a pool of assets that remain on a borrower's balance sheet, giving an investor a claim on the bank itself and a priority claim on the assets as well. They are usually rated triple-A because of their multiple types of protection against default.

Until mid-September, banks relied on covered bonds as a way to raise money relatively cheaply in the credit crisis after demand disappeared for asset-backed securities and other areas of funding.

The covered bond market was typically the first to reopen following periods of deadlock in bank debt issuance, and 18 banks even tapped the market for the first time this year.

U.S. Treasury Secretary Henry Paulson has looked to the introduction of covered bonds as one way to help revive the U.S. mortgage securities market.

"The covered bond market is still the best funding asset class, but it is not functioning properly. Right now, it is hard to place anything in any market," said Franz Rudolf, covered bonds analyst at UniCredit (HVB).

European banks issued $237.6 billion worth of covered bonds this year through September 9, which compares with a total of $346.4 billion in 2007, according to Dealogic.

Germany accounted for the biggest chunk this year at 42.1 percent, followed by France at 20.9 percent and Spain at 7.1 percent, based on data from Dealogic and Bond Analytics.

HIT LIKE EVERYTHING ELSE

Issuance has halted in the last couple of weeks, despite a relatively good year until then, Rudolf said.

The last new issue was on September 8, when French mutual banks group Caisse D'Epargne (CNCE) raised 1 billion euros ($1.4 billion) in a debut two-year covered bond at 51 basis points over mid-swaps.

Covered bonds have since been hit along with the rest of the market by the Lehman Brothers (LEHMQ.PK) bankruptcy and a series of European rescue operations and nationalizations including HBOS Plc HBOS.L, Bradford & Bingley BB.L, Dexia (DEXI.BR), Glitnir Banki GLB.IC, Fortis (FOR.BR) and a government guarantee for Irish bank deposits.

One of the biggest blows came on Monday, when the German government and a consortium of banks agreed to provide 35 billion euros in credit guarantees for Hypo Real Estate, one of the two biggest issuers of covered bonds in Germany along with Commerzbank-owned (CBKG.DE) Eurohypo.

All three major rating agencies on Tuesday said they might downgrade the covered bonds of certain Hypo Real Estate Group entities.

"We expect that the willingness to support the covered bond ratings will remain strong," Standard & Poor's wrote, but "the ability to maintain required levels of over collateralization needs to be reassessed."

"They want to clarify certain things about the business strategy and whether they will provide more over collateralization," Rudolf said.

Covered bond investors, while untouched by losses, have been hit by declines in the market value of their holdings as spreads have widened.

A number of investors sold Irish covered bonds on Tuesday after the government guarantee helped prices recover, not fully but to a large extent, the covered bond specialist said.

He expected spread widening to continue for the foreseeable future -- at least until the U.S. and European governments provide clarity on policy toward the banking sector.

"Once the dust clears, the market will have to go through a discovery process to determine what prices will be, what executable sizes will be and what really the investor base will be saying about the produce," he said.

(Editing by Elaine Hardcastle)