With the economy hanging in the balance, the U.S. Treasury met with bank regulators and the four largest U.S. banks to devise a plan to help the mortgage market. At the end of the pow wow, all the big money players agreed to use covered bonds to boost both the housing and mortgage markets.
Unlike with mortgage-backed securities, covered bond investors won’t see as much risk. If homeowners default on the mortgages, the bank will simply swap that mortgage out and replace it with a high-performing one from the “cover pool”. But like any investment, the payoff on covered bonds will depend on the investment and—yes—the risk.
This isn’t a new concept. Evidence of the bonds success can be seen in Europe. European countries like Germany and Britain have had some form of covered bonds for over two centuries. Generally the collateral must be either mortgages or public debt, with terms ranging from 2 to 10 years. European covered bonds are subject to extensive statutory and supervisory regulation designed to protect the investors from the risks of insolvency of the issuing bank. U.S. regulators plan to model their version after the one used in Europe.
The European covered bond market is valued at $3.3 trillion in 2007. Thus far, only two U.S. institutions have issued covered bonds: Bank of America, N.A. and Washington Mutual—two years ago. But that’s all about to change, according to Treasury Secretary Henry M. Paulson Jr., Bank of America, Citigroup, JPMorgan Chase and Wells Fargo plan to establish covered bond programs to kick-start this market in the United States.
He said, “…covered bonds have the potential to increase funding for mortgages and to strengthen financial institutions by offering them a new funding source that will diversify their overall funding portfolio. And unlike mortgage backed securities, covered bonds remain on the balance sheet of the bank that sells the bonds.
Because this approach requires that banks guarantee the bonds, the FDIC released a "FDIC Policy Statement on Covered Bonds" and "Final Interim Policy Statement", which describes the agency’s policies on the bonds. Essentially, covered bonds cannot exceed 4% of an insured depository institution’s (IDI) liabilities. The collateral mortgages are “sold” to a trust or special purpose vehicle (SPV), which is maintained on the IDI’s balance sheet. The SPV can contain up to 10% triple-A MBS, with the remainder being single to four-family residential mortgages. The mortgages must be rated triple-A at the fully indexed interest rate and fully documented. The FDIC must approve each covered bond issue individually. The FDIC set terms from 1 to 10 years.
The obligation to pay interest on the covered bonds is backed by the bank, regardless of the ability of the trusts or SPV to generate income. The FDIC is not specific about exchanging mortgages within the trusts, but has stated that any excess collateral will return to the FDIC, when the FDIC is appointed conservator or receiver of an IDI. In addition, the FDIC is still hammering out the details of their resolve when the collateral is insufficient to pay the obligations of the trusts.
Which isn’t setting well with some experts like Chief Monetary Economist at Cumberland Advisors(Former Federal Reserve and FDIC official) Robert A. Eisenbeis, who argues that "Promoting covered bonds is really a way to compartmentalize and shift risk to the FDIC and uninsured depositors."
The concern stems from the fact that the owners of the covered bonds will not only be the first in line to be paid off in full if a bank fails, but that the FDIC will have to ante up whether there is enough money left to pay insured depositors or not. Presumably, the FDIC to pay the difference out of its insurance fund. But what happens when and if the insurance fund runs low? Taxpayers to the rescue, again of course.
Michael H. Krimminger, a special adviser to FDIC Chairman Sheila C. Bair, said the agency "will consider changes in the ceiling only after a careful review."
Despite apprehension from some, the Treasury Department stands firm and stated that the $11 trillion mortgage market can benefit from all forms of mortgage finance. They further believe that covered bonds will help stabilize the housing GSEs (government sponsored enterprises), by providing additional funding to homeowners.
Once banks begin to generate income through covered bonds that should “free up space for other classes of mortgages allowing borrowers who may have more trouble meeting all of the stringent requirements surrounding covered bonds to get loans, said Assistant Treasury Secretary Neel Kashkari in an interview.
