Wa ashingt Mu ton utual’s C Covered Bond ds September of 20 was not a calm time fo the world’s capital mark 008 or s kets. On Sept tember 7 fede erallybacke mortgage loan compani Freddie M and Fann Mae were placed into c ed l ies Mac nie conservatorsh by hip the U. S. governme a move de ent, esigned to sta abilize the em mbattled lenders. On Mond day, Septemb 15, ber global investment bank Lehma Brothers filed for Cha an apter 11 bank kruptcy protection. Broa US ad equity market inde y exes dropped by as much as 5 percent as rumors s d h t spread about potential liqu uidity crises at other majo financial in or nstitutions.

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A slight marke recovery th following d was attrib et he day buted to rum mors that the Federal Reserve was wo e orking on a ba ailout for the insurance co e ompany Ame erican Intern national Grou (AIG). 1 up Ea arly on the morning of Sep m ptember 16, W Washington M Mutual’s cove ered bonds tr raded down to 75, from 83. 05 the pre evious day (see Exhibit 1 Washingto Mutual (W 1). on WaMu) was one of the la argest saving and loans in the Unite States. Its covered bon program, i gs ed nd initiated two years earlier just r, before the housing market had begun a precipitous slid consisted of €6 billion in covered b e g d de,bonds outsta anding. Like many large ba m anks, WaMu was now in c considerable d distress. Th situation at WaMu had deteriorated in recent mo he t onths, with th bank repor he rting $6 billion loss n for ye ear-to-date June 2008. By e early Septemb WaMu’s covered bond had dropp by around 13% ber, ds ped d from January, as investors fore i ecast a possib distressed acquisition or seizure o the bank b the ble d of by Feder Deposit Insurance Co ral I orporation (F FDIC). With the chaos of September 15-16, the bf bonds appea ared to have dropped fur rther. Yet, ev ven at these prices, the b bonds were s still at a prem mium relativ to the bank unsecured debt, which was trading as low as 30 c ve k’s d cents on the d dollar.

Page 2 Washington Mutual’s Covered Bonds Essay

Co overed bondswere new instruments in the Unite States, hav s ed ving been iss sued by only two y dome estic banks to date (Bank of America and WaMu) Could the low prices o these bonds be o k ). of justifi by the poor fundamen outlook a WaMu? An even if the bonds were cheap, might they ied ntal at nd e t drop f further? Thes questions w se were on the m minds of many analysts stu y udying the situ uation at WaM Mu. Covered Bonds Co overed bonds were fixed i s income obligations issued by a financi institution and secured by a d ial n dpool o mortgages or other asse They diffe of ets. ered from mo ortgage backe securities ( ed (MBS), in whi an ich issuer would pool mortgages, p r pass them thr rough to a sp pecial-purpos vehicle, and then allocate the se d return from that vehicle to inv ns v vestors. In the case of cove e ered bonds, t underlyin mortgages were the ng kept o the balance sheet of the issuer. The m on e mortgages ser rved as collat teral for the covered bonds In a s. standard mortgage e-backed secu urity, the inve estor in the se ecurity had re ecourse only t the mortgag in to ges

Professo Daniel B. Bergs ors stresser and Robin Greenwood and R Research Associate J James Quinn prepa ared this case. This case was develop from s ped publishe sources. HBS ca ed ases are developed solely as the basis for class discussio Cases are not in s on. ntended to serve as endorsements, so s ources of primary data, or illustratio of effective or in y ons neffective managem ment. ght nt Harvard College. T order copies or request permission to reproduce mat To n terials, call 1-800-545-7685, Copyrig © 2009 Presiden and Fellows of H write Ha arvard Business Sc chool Publishing, Booston, MA 02163, o go to www. hbsp or p. harvard. edu/educators. This publica ation may not be digitized, photoco opied, or otherwise reproduced, poste or transmitted, w ed, without the permis ssion of Harvard Bu usiness School. 209-093 Washington Mutual’s Covered Bonds the pool; an investor in a covered bond had recourse to the issuer, as well as a claim that was secured by the mortgages. 2 The mortgages collateralizing the covered bond were called the “cover pool”. Covered bonds were typically structured so as to receive a rating of AAA or AA from the major rating organizations (AAA denoted instruments of the highest quality).

One important difference between covered bonds and MBS was that the set of mortgages securing the covered bond were dynamic; in contrast, mortgages comprising a MBS remained static once the security was issued. In the case of a covered bond, mortgages that experienced delinquencies were generally substituted out of the pool, with performing mortgages replacing them. Just as the individual mortgages in the cover pool were dynamic, the total size of the cover pool was dynamic as well. The amount of overcollateralization (i. e., the extent to which the size of the cover pool would exceed the face value of the covered bonds) would adjust dynamically depending on the financial health of the issuer.

Exhibit 6 shows how recently, as WaMu had been downgraded by the major rating agencies, the “Asset Percentage” used to calculate the sufficiency of the cover pool had been reduced from 86. 6% to 67. 0%. Thus with $7. 78 Billion in bonds outstanding under the covered bond program, the required size of the cover pool for the WaMu covered bonds had risen from roughly $8. 98 Billion (8. 98 x 86. 6% = 7. 78) up to $11. 61 Billion (11.61 x 67. 0% = 7. 78). Covered bond trustees usually relied on the ratings agencies to establish the quality of the underlying collateral. 3 In recent market turmoil, this task had become more difficult. As mortgage default rates increased, the ratings agencies became increasingly conservative in assigning value to mortgage pools, valuing them at substantial discounts to face value. A variety of models could be used to assess the market value of a mortgage pool, all considered measures of asset quality such as the loan-to-value ratio and the credit quality of the borrowers as summarized by their FICO scores.

4 In the event of a collateral downgrade, the trustee would ask the issuer to replenish assets in the pool. The inability or refusal to update assets at the trustee’s request would constitute issuer default. While new in the United States,5 covered bonds were a long-standing part of the housing finance system in Europe, dating back to bonds issued in 1769 in Prussia. In Continental Europe these bonds, called ‘Pfandbriefe’ or (‘Pledge letters’) in the German-speaking countries, amounted to €2. 1 trillion (see Exhibit 2). By 2008, covered bonds were the second largest fixed income market in Europe.

6 Part of the recent growth could be tied to Basel II banking regulations, coming into full effect in 2008. Torsten Althaus, head of the European covered bonds at credit rating agency Standard and Poors, explained: “With Basel II aligning regulatory with economical capital requirements, there are fewer incentives to use securitization for regulatory arbitrage. […] Consequently, as there are fewer incentives to move assets off-balance-sheet, retaining assets on-balance-sheet allows issuers to fuel further covered bond issuance. ”7

Covered bonds were predominately held by European investors and had generally been viewed as being extremely safe. This view derived in part from the high credit quality of the issuers, in part from the high value of the cover pool assets, and in part from the fact that the status of covered bonds in many European countries was enshrined in specific legislation. This gave covered bond investors a high level of confidence that, should an issuer default, they would be able to successfully enforce their legal claim to the assets in the cover pool.

The low perceived risk of covered bonds had led many investors to view the bonds as a ‘rates-plus’ product – effectively a yield-enhanced substitute for sovereign debt. 8 2 Washington Mutual’s Covered Bonds 209-093 Rating Covered Bonds The three major credit rating agencies all had specific approaches to rating covered bond issues. Broadly speaking, the ratings approaches focused on ‘notching’, or raising, the credit rating of the bond above the credit rating of the issuer in order to reflect the greater protection of the cash flows promised under the covered bond program.

Although the methodologies differed by agency, all three implicitly linked the rating of the covered bond sponsor to the rating of the issue. Fitch Rating Methodology:9 Fitch started with credit quality of underlying sponsor. Fitch assumed that bonds had recourse to the underlying issuer, so the credit quality of the issuer would provide a floor for the credit quality of the covered bond. Starting from this floor, the credit rating was then ‘notched’ depending on the ‘discontinuity factor,’ which essentially reflected the bankruptcy remoteness of the assets in the covered pool.

To calculate the discontinuity factor, Fitch looked at the strength of the asset segregation mechanism. One important factor was whether the overcollateralization of the covered bonds was kept out of reach of the unsecured creditors until the covered bonds had been fully repaid. In practice, this could be accomplished through the legislative framework under which the bonds were issued, or through protections built into the structure of the bond. In countries like Germany and France, covered bonds were governed by and issued under specific legislation.

This legislation governed the structure of the instruments and the treatment of investors and collateral in the event of default. Covered bonds issued in the United States were issued under the general US contractual law environment, rather than any specific legal statute. In the Fitch rating approach, a low discontinuity factor implied complete separation; a high discontinuity factor implied that distress at the sponsor would result in delays or payment problems for the covered bond. In practice, very few covered bonds had a discontinuity factor of zero.

Consider for example the case of Coreal Credit, a German Bank with a BBB- default rating, with a set of covered bonds that were 17. 8% overcollateralized by mortgage assets. Fitch calculated a discontinuity factor of 11. 7%, leaving the covered bond with a rating of AA, a notch below the highest rating. Another issue considered by Fitch was the difficulty bonds faced in replacing the swap agreement, which matched the payments on the bonds with the payments from the mortgages. This hedge could be disrupted by a default at the issuer level, and Fitch adjusted the discontinuity factor in line with the likelihood of disruption.

These hedges were important because payments under the bonds often failed to match the currency, timing, or interest rate exposure of payments from the underlying mortgage. Moody’s Rating Methodology:10 Moody’s based their credit rating on a “joint-default analysis. ” Moody’s model simulated the performance of the covered bond each month through maturity. The probability of issuer default in each month was based on the issuer credit rating. This probability in each month was multiplied by the relevant loss to give the expected loss to covered bond investors in each month.

The resulting number was the expected loss on the covered bond, which was the source of the bond’s rating. The factors affecting the rating were divided into the issuer credit rating, which affected the issuer’s probability of default, the credit quality of the cover pool, the costs likely to be incurred in refinancing the cover pool in the event that the issuer defaulted, and market risks. Market risk was based on the likely impact of interest rate and currency movements during the period after the default, and reflected the possibility of disruptions in the swaps that were in place to hedge those risks.

Standard and Poor’s Methodology:11 Standard and Poor’s focused on the probability of timely payment, rather than explicitly on default of the sponsor. Standard and Poor’s identified four 3 209-093 Washington Mutual’s Covered Bonds contributors to the covered bond’s rating: (i) the legal framework, (ii) the quality of the collateral, (iii) the cash flows, especially losses due to credit, maturity, and currency mismatches, and payment delays and servicing costs imposed by disruption at the issuer, and (iv) the degree of overcollateralization.

While it was possible that the covered bond was delinked from the rating of the issuer, in practice Standard and Poor’s recognized that default scenarios would likely impose significant payment delays, thereby linking the rating of the issuer with that of the issue. Washington Mutual Washington Mutual was the largest savings institution and 6th largest depository finance institution in the United States. Founded in 1889, the bank had survived the Depression and the savings and loans scandals of the 1980s.

By late 2006, the bank had amassed assets of $346 billion, with $214 billion in deposits. Exhibits 3a and 3b show select financials. WaMu offered a range of financial services typical to savings and loan institutions, including: home and home equity loans; multi-family and other commercial real estate loans; credit facilities and cash management for small businesses; credit cards, annuities and insurance products; as well as securities and brokerage services. 12 Historically, WaMu had been a regional bank, with retail banking operations in California and the U. S. Northwest.

However, starting in the 1990s, the bank undertook a major expansion initiative, led by CEO Kerry Killinger. Part of the expansion occurred through a series of acquisitions. In 1999, for example, WaMu purchased Long Beach Financial, a Californiabased lender specialized in subprime mortgages – loans to borrowers with poor credit. 13 Over the course of a few years, WaMu increased its retail banking network from 412 stores on the West Coast in 1996 to 1,700 locations across the country by 2003. 14 WaMu became known as a particularly aggressive lender, willing to extend loans even to clientswith low incomes or poor credit histories. 15 In 2003, as part of this WaMu’s expansion, the bank introduced an advertising campaign backed by the slogan “The Power of Yes. ” While some of WaMu’s loans were financed by the bank’s large deposit base, the majority were securitized –i. e. , pooled and packaged – and then sold to the secondary market. Sustained by a buoyant housing market, Wamu shareholders collected substantial profits between 2000 and 2004 (see Exhibits 3a and 3b). In 2004, for example, U. S. home prices appreciated by nearly 20 percent.

Urban areas in California, Florida, Nevada, and Arizona experienced particularly rapid price appreciation. In an environment of rapid housing price appreciation, a borrower who suffered a decline in household income could avoid default by selling or refinancing the home. As housing prices rose, WaMu expanded its product mix from home loans and home equity loans into lines of credit, subprime mortgages, and other real estate products. WaMu was an early seller of mortgage products known as “option ARMs,” which were adjustable rate mortgages that offered low initial payments designed to escalate over time.

For WaMu, these loans were attractive because they carried high fees, and allowed the bank to state profits for interest payments that borrowers had not paid yet. In 2003, adjustable rate mortgages comprised about a quarter of WaMu’s lending portfolio; by 2006, about 70 percent. 16 Housing prices in most U. S. markets peaked in 2005, as shown in Exhibit 4. As housing prices leveled off in 2006 and began to fall in 2007, (see Exhibit 4), WaMu profits initially remained relatively flat. In 2006, WaMu posted profits of $3. 5 billion on $13. 5 billion in total revenue.

Nevertheless, the bank took some precautionary measures, cutting jobs in an effort to contain costs. 17 It was in this environment of cooling home prices that WaMu turned to the covered bond market in late 2006. 4 Washington Mutual’s Covered Bonds 209-093 WaMu’s Covered Bond Program WaMu entered the covered bond market in September 2006 with a dual-tranche 4B EUR issue. 18 One tranche followed closely by analysts was a €2 billion 5-year fixed rate issue, maturing on September 27, 2011. The bond paid a coupon of 3. 875 percent and was not callable. 19 At the time the bond was issued, WaMu was the only covered bond issuer outside of Europe. (The remaining covered bonds were issued in May 2007 and matured in 2014). WaMu’s covered bonds were popular with investors – the initial placement of the bonds was four times oversubscribed. 20,21 While it was impossible to tell the exact identities of the current holders of the bonds, it was widely speculated that the Euro-denominated bonds had ended up with European pension funds and banks. The covered bonds initially traded at a yield to maturity of 3. 90%, compared to the yield on a 5-year German government bond of 3.62%. LIBOR, the average dollar denominated interbank rate was 5. 40% and EUROIBOR, the average interbank lending rate denominated in Euros was 3. 06%. The covered bonds were issued by WM Covered Bond Program (WMCB), a statutory trust organized in the State of Delaware. The covered bonds were secured by a series of mortgage bonds issued by WaMu Bank and purchased by WMCB, who sold the bonds via a placement agent to institutional investors. The mortgage bonds, in turn, were secured by a pool of residential mortgage loans owned and serviced by WaMu Bank.

The covered bonds could also be secured by “substitution assets” pledged by WaMu Bank. 22 Exhibit 5 summarizes the structure of Washington Mutual’s covered bond program. Under the terms of the covered bond program, each series of mortgage bonds was held as collateral for a separate series of covered bonds, and would secure only that series of covered bonds. However, if Washington Mutual Bank were to default on any of its mortgage bond obligations, each series of the covered bonds would share pro rata in any proceeds from the cover pool.

As holder of the mortgage bonds, WMCB was required to use the proceeds to pay interest and principal on the related series of covered bonds. However, as the covered bonds were denominated in Euros, WMCB first had to swap the dollar proceeds from the mortgage bonds into Euros. The swap program, typical of covered bond programs, was used to manage timing and currency mismatches between payments to the covered bond holders and payments from the underlying portfolio of mortgages.

The asset monitor of the cover pool periodically applied an “asset coverage test” to check that the mortgages in the pool would be sufficient to pay the interest and principal on the covered bonds. A breach of the asset coverage test would constitute default for WaMu Bank, which would then allow the monitor (who also, in this case, acted as a trustee) to enforce its interest over the cover pool. Provided that WaMu Bank preserved investment grade status, the asset coverage test would be performed annually or anytime that a substitution was made in the cover pool.

But, as WaMu Bank had recently been downgraded, the program required that the asset coverage test be performed monthly. The Asset coverage test: If on any “determination date”23 the adjusted aggregate loan amount was less than the aggregate principal amount of all outstanding mortgage bonds, then WaMu Bank was required to add additional eligible mortgage loans. The adjusted aggregate loan amount was the lower of (a) the sum of the Loan-to-Value current balance of each mortgage loan in the cover pool, which was itself the lower of (i) the unpaid principal balance and (ii) the indexed valuation of the loan multiplied by 0.75; and (b) AP times the sum of the “adjusted current balance” of mortgage loans in the cover pool, which itself was the lower of (i) the unpaid principal balance of the respective 5 209-093 Washington Mutual’s Covered Bonds loan, and (ii) the index value of the mortgage loan. Indexed valuations were based on regional housing indices. 24 AP denoted the “asset percentage,” usually 93 percent, although this figure could be revised downwards if the ratings agencies felt that expected loss rates on the underlying mortgages could be higher. The expected losses would be based on Standard and Poor’s or Fitch, two of the three ratings agencies.

Some analysts felt that the ratings agencies had been increasingly cautious in recent months, revising upwards loss rates on mortgage backed loans. As shown in Exhibit 6, the asset percentage had been lowered to 67 percent. Under the terms of the covered bond program, WaMu Bank was not allowed to merge or consolidate with any other persons or entity, or to change its bank holding company status, unless the new entity acquired all assets of the issuer and agreed to the punctual payment of principal and interest on the mortgages bonds. Distress at WaMu

WaMu’s 2007 first-quarter profit, reported in April, showed a roughly 20% decline relative to Q1 2006. At the time, the U. S. economy was approaching a sharp decline in housing starts and sales, and the business press warned against an inevitable run of foreclosures. CEO Kerry Killinger spoke publicly of “unprecedented deterioration” in the subprime-mortgage market. Inventories of unsold homes were reaching their highest levels in eighteen years, with the supply of single-family homes on the market, which had averaged six months historically, reaching 10 months nationally.

In California, the supply of single-family homes in inventory stood at 15 months. By December 2007, WaMu’s stock price reached a low of $13. 07,25 as the bank cut its dividend by 73%. 26 Throughout banking and financial services, evidence pointed to sector-wide failure: In February, leading London bank HSBC, whose American mortgage unit HSBC Finance had originated the majority of U. S. subprime mortgages, announced $11 billion in write-downs to offset anticipated losses related to failed loans. 27 In March, Bear Stearns shut down two of its hedge funds, in the midst of large losses.

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