Economist's Commentary: September 19, 2008
Covered Bonds - A Low Risk But Limited Availability Mortgage Product
By Jed Smith, Managing Director, Quantitative Research
In recent years Fannie Mae and Freddie Mac have provided much of the liquidity in the housing market by packaging home mortgages (typically generated by mortgage bankers) into Mortgage Backed Securities (MBS), subsequently sold to investors or retained in Fannie's and Freddie's own portfolios. An MBS is an asset-backed security whose cash flows are backed by the principal and interest payments of a group of underlying mortgage loans. In the past year there has been increasing concern over the use of MBS, and in July Treasury Secretary Paulson advocated the use of covered bonds "to increase mortgage financing, improve underwriting standards and strengthen U.S. financial institutions by providing a new funding source that will diversity their overall portfolio" (Treasury Press Release, July 28, 2008).
Covered bonds are issued by banks, are backed by a portfolio of mortgages specifically dedicated to the bonds, trade on a public market, and meet a number of Treasury defined safety standards. For example, the loan-to-value ratio of the underlying mortgages cannot exceed 80 percent, the borrowers must have documented income, and no more than 20 percent of the underlying loans backing the bond can be from one metropolitan area. Covered bonds are different from mortgage-backed securities in terms of the underlying credit requirements, and the banks hold onto the mortgages underlying the bonds and pay the bondholders out of the banks' cash flow, not from the proceeds on the mortgages. The bonds and mortgages stay on the banks' balance sheets. Accordingly, covered bonds are considered safe investments, for they meet higher quality standards than has been the case for mortgage backed securities-whose funding comes from the underlying mortgages, whose borrowers in many cases have high loan-to-value ratios, and which are not on the books of the issuing institutions. Mortgage Backed Securities have generally taken the mortgages off of the issuer's balance sheet and have put the investor holding the security at risk in the event of a home buyer default. In the case of a credit problem with covered bonds, the bank is at risk-not the investor. If a loan in the underlying "cover pool" of mortgages defaults, the bank is required to remove the mortgage and replace it with a performing mortgage. In the event that the issuing bank fails and is seized by the FDIC, the agency would be expected to pay bondholders from the underlying pool of mortgages.
The use of covered bonds can provide a different and additional source of liquidity to the housing markets and can be used to generate new funding from mortgages already on bank balance sheets. Essentially, a covered bond is a corporate bond with recourse to a pool of assets that secures and covers the bond if the originator becomes insolvent. Covered bonds generally receive high credit ratings. The debt and underlying asset pool are on the issuer's financials, and the issuer must ensure that the pool consistently backs the covered bond. In the event of default, the bond holder has recourse to both the pool and the issuer.
The Treasury has published a Best Practices guide for U.S. residential covered bonds. The guide includes provisions for cover pool disclosure (information about underlying securities), asset coverage tests (monthly review and tests of underlying collateral quality and substitutions necessary to maintain quality), issuance limitations (e.g., covered bonds may account for no more than 4 percent of an issuer's liabilities), and collateral eligibility (e.g., type of property, quality of loan)., The FDIC has issued a policy statement providing that the consent of the FDIC as conservator or receiver is provided to covered bond obliges to exercise their contractual rights over collateral for covered bonds transactions: That is, the bond holders get their money if a bank becomes bankrupt.
The Comptroller of the Currency, Secretary of the Treasury, Chairman of the FDIC, and a Governor of the Federal Reserve advocated the use of covered bonds in July 28 press conferences. The bonds would clearly be more credit worthy than many types of Mortgage Backed Securities-due to stricter underwriting standards and balance sheet liability. In addition, by being a part of a bank's balance sheet the bonds and their issuers would be subject to substantial regulatory scrutiny-which has not been the case with Mortgage Backed Securities. However, use of the bonds would restrict credit in the relevant transactions to only prime customers-those able to provide 20 percent down payments as well as pass scrutiny by bank lending officers. Accordingly, just as some Mortgage Backed Securities have been at one extreme of the range of risks, covered bonds are at the other-more conservative-end of the range. The use of covered bonds would bring the relevant mortgages into banking system regulation, permit mortgage funding on a basis similar to other loans, and would provide enhanced stability and higher credit standards to mortgage lending. However, the use of covered bonds-without the availability of other types of mortgage products-could substantially decrease the availability of mortgages to less credit worthy prospective home buyers.
During a time of financial turmoil there clearly is a focus on risk reduction and de-leveraging-which increases the appeal of covered bonds. However, these products are at one extreme in terms of risk and coverage. Clearly there have been a number of mortgages written that were inappropriately risky; however, the availability of appropriately structured mortgages for individuals with less than a 20 percent down payment is crucial to the housing markets serving the broad public. Furthermore, the covered bond market may protect investors in times of crisis, but this system will not permit new mortgage originations to flow easily. Accordingly, the covered bond approach fails a crucial test of lacking the ability to provide mortgages in times of need. A reformed Fannie and Freddie model should have this one key facet of having this ability to provide credit in the times of need.
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