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. 

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