In the last six months, banks and credit institutions have experienced the worst liquidity drought in living memory. In the wake of the US subprime crisis, residential property based structured financings have almost completely dried up. The UK government, no doubt keen to engineer a soft

landing for the UK property market, has been looking at ways to increase the access of UK mortgage lenders to cheap, long term funds, in the hope of promoting availability of long term, fixed rate mortgages for UK homeowners. To that end, it has charged the UK Treasury with the task of developing a legislative framework for the issuance of covered bonds.

A covered bond is a debt instrument, which like a securitisation bond has the benefit of a priority

security interest over a dedicated pool of assets, most commonly mortgage loans or public sector loans. Unlike a securitisation bond, a covered bond also retains the benefit of full recourse to the entity that originated the assets.

Covered bonds are typically backed by high quality assets of a sufficient value to ensure a high credit rating for the bonds, usually AAA. German covered bonds or ‘Pfandbrief’ have been around for over two centuries and other continental European jurisdictions also have extremely active covered bond markets. In contrast, the first UK covered bond was not issued until 2003 and so far,

only a handful of UK credit institutions have tapped this market.

The primary reason for this disparity is that the structure of continental European covered bonds makes them more attractive to certain investors than UK covered bonds. Specifically, the most active covered bond markets have all enacted specific covered bond legislation, governing the types of assets that can be used to secure the covered bonds and how those assets should be segregated. Most importantly, it provides for the covered bondholders to have priority rights over the cover assets, even in the event that the asset owner becomes insolvent.