Are Covered Bonds the Answer?

Author: Bob Eisenbeis, Post Date: July 24, 2008

In yet another effort to resuscitate the mortgage market (remember the Super SIV?), Secretary Paulson is now urging that a market be created for covered bonds.  What are covered bonds?  They are a German creation dating back to the late 1700s. 

A bank-issued, covered bond is an obligation backed by an interest in a pool of assets, usually mortgages.  They are similar to mortgage-backed securities in that the bonds are backed by the cash flows from the underlying assets.  In addition, they are usually, but not required to be, issued by a special-purpose vehicle.  However, the underlying assets remain on the bank’s balance sheet and the bond is an uninsured debt security of the bank.  The bank can alter the composition of the asset pool to maintain its quality and also alter the terms of the mortgages, should that prove necessary.  This latter feature gets around a current problem with mortgage-backed securities over who has the right to alter the terms of the underlying mortgages should the borrower get in trouble.  In Europe, the bonds are typically rated by rating agencies and presumably would be here in the US as well.

Five key issues exist with trying to jump start this market in the US.  First, covered bonds are not familiar investments at this point, and in particular, they look a lot like mortgage-backed securities, which have lost their luster.

Second, the status of covered bonds in the event of a default by the issuing institution has been uncertain.  Only recently (July 15) did the FDIC issue a policy statement on how covered bonds would be treated in the event of a default by an insured depository institution.1  The FDIC also indicated that the outstanding amount of covered bonds by banks would be limited to 4% of an institution’s total assets.  Thus, the supply of bank-issued covered bonds would initially be very limited when compared, for example, to mortgage-backed securities.

Third, demand is also likely to be very cautious and limited.  Despite the claim that these instruments are rated and are of high quality, memory is long right now about the quality of credit ratings and the quality of mortgages that were supposedly highly rated. 

Fourth, there is the issue of the accounting treatment of such instruments, as well as how they would be treated from a capital adequacy perspective by regulators.  It is suggested that covered bonds would be a source of liquidity, but given that these instruments are likely to be very long-term securities, it is possible to see how they might be a source of funding but certainly not liquidity.   Without a broad, active market, the claim that such instruments would be a source of liquidly is only a hope.

Finally, and perhaps most importantly, in the event of a failure, covered bonds, like Home Loan Bank advances and Federal Reserve discount window loans, would represent senior claims that would stand ahead of uninsured depositors and other creditors, including the FDIC.  Thus, promoting covered bonds is really a way to compartmentalize and shift risk to the FDIC and uninsured depositors.  This would effectively make uninsured deposits even less attractive to bank customers because of the reduced protections that capital might otherwise afford them. 

In short, covered bonds aren’t necessarily the attractive instrument for investors that they are touted as being, particularly when considered from the broader interests of bank creditors.  Attempting to shore up the housing market without considering the potential unintended consequences is short-term policy making that may provoke taxpayer indigestion down the road.  The FDIC recognized this potential risk in its policy statement, but right now it appears that in Washington any risk that might remotely help housing is worth taking.

The bottom line is that from the perspective of an investor who is concerned about safety and has more than $100K to place, other alternatives, like Variable Rate Demand Notes, clearly look like an attractive option.  When properly backed by a liquidity provider, they certainly offer protection and the market is better developed.

Covered Bond Policy Statement, FDIC, July 15, 2008.  According to the current structure of such instruments, should a failure occur, the special-purpose vehicle would take possession of the underlying mortgages and continue payment on the bonds.  However, since the bonds are an uninsured debt of the bank, the FDIC as either conservator or receiver would have the discretion to honor the obligation or not.  Under the Federal Deposit Insurance Act (FDIA), there is either a 45-day (in the case of a conservatorship) or 90-day (in the case of a receivership) waiting period, during which holder of the debt cannot terminate the agreement because of the insolvency and the FDIC must honor the terms of the debt obligation.  While the FDIC can, after the waiting period, repudiate the debt and either pay off the debt or liquidate the underlying collateral and debt, the FDIA does provide protections up to the value of the underlying pledged assets to valid debt contracts. 

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