Covered Bonds: A Better, Safer Instrument to Finance Mortgages?

WASHINGTON, SEPTEMBER 24, 2008--With the recent government bailouts of Fannie Mae and Freddie Mac and the uncertainty about whether they will be privatized, nationalized, or liquidated, mortgage markets need an alternative financial instrument that can help shoulder the burden of creating the fixed-rate, thirty-year mortgages that the government-sponsored enterprises (GSEs) have traditionally funded. At an AEI conference on September 19, Peter J. Wallison argued that covered bonds fit the bill, claiming that they could "in the future replace GSE securitization as the principal mechanism for financing residential mortgages . . . without any government involvement or liability."

Covered bonds, which are already widely used in Europe, are very different from the mortgage-backed securities (MBS) issued by the GSEs, explained Neel Kashkari, the assistant secretary of the treasury for international economics and development. When a covered bond is created, "a depository institution originates a bunch of loans and holds those loans in a pool. That pool is collateral for the [covered] bond that it issues." The loans remain on the institution's balance sheet, making it liable for the credit risk of the mortgages. If any of the loans become delinquent, the institution is obligated to "replace them with new, performing mortgages." In contrast, an MBS is composed of mortgages that have been "sliced and diced" and sold to investors, so the originating institution does not hold them on its balance sheet and does not have a vested interest in a delinquency.

One of the main barriers to the proliferation of the covered bond market is investors' apprehension about using a new type of financial instrument. Issuers are trying to counteract this anxiety by making bonds as "simple as possible in the early stages," explained Tim Skeet of Merrill Lynch. Initially, the structure of covered bonds will be almost identical from issuer to issuer. Greg Baer of Bank of America said that "homogeneity is key . . . so investors can get comfortable with one set of terms"--and so they will only have to base their investing decisions on interest rate variance.

Another key component of covered bond market growth is establishing a framework to govern and guide the functioning of the market. Such a framework can be either legislated by Congress or structured by banking regulators such as the Federal Deposit Insurance Corporation (FDIC) and the Treasury Department. At this time, only a structural framework exists for the covered bond market. Guidance to market participants is given by the FDIC through policy statements and by the Treasury Department, through its recent publication, "Best Practices for Covered Bonds." Kashkari said that the current supervisory system is sufficient for the market, because it will allow interested parties to "move forward quickly" while also providing investors with regulatory clarity and certainty. He worried that legislation would "stifle the market from innovating on its own" and suggested that covered bonds have an "implicit government guarantee." Baer agreed with Kashkari's conclusion, saying that "legislation is the garnish" on the covered bond market.

Representative Scott Garrett (R-N.J.) is a strong proponent of a legislative framework for covered bonds. Indeed, this July he introduced HR 6659, the "Equal Treatment of Covered Bonds Act of 2008," to help define the structure of the covered bond market. At the conference, Garrett contended that his legislation is necessary because the FDIC "is too restrictive and prevents us from recognizing the full potential of a covered bond marketplace." Specifically, he disagreed with the FDIC's limitations on the quantity of covered bonds that an institution can hold and the type of assets that can be included in the covered pool. "Codification," Garrett explained, "will provide greater stability and permanency," as well as simplicity and standardization that will "result in lower transaction costs." AEI's Alex J. Pollock affirmed that "for covered bonds to work in the United States, they must have a legislative base."

Wallison envisioned a future in which covered bonds would compete directly with Fannie and Freddie, a view echoed by Bert Ely, a financial institutions and monetary policy consultant. Ely believes that the GSEs will diminish in power because they "will not regain all of their pre-conservatorship competitive advantages." At the same time, banks and thrifts that use covered bonds will thrive because they will "avoid the [high] costs [associated with] selling mortgages to Fannie and Freddie" and enjoy "greater flexibility in mortgage design and modification." Other panelists demurred, suggesting that these bonds will be a complement to, rather than a substitute for, Fannie and Freddie. Kashkari insisted that "there is no silver bullet . . . there is a role for all kinds of mortgage finance," and Baer agreed that covered bonds are "not the answer to mortgage problems, [though they] have some important contributions."

Despite the debate, all panelists agreed with Kashkari's observation that "this is a tough environment in which to launch a new financial product . . . but never has the market needed a financial product as much as we need it now."

--KAREN DUBAS

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