Covered Bonds - A New Solution or an Old Danger?

In response to the liquidity crisis, particularly with regard to home mortgages, the FDIC last week announced new guidance for covered bonds.  So what are covered bonds?

Here's how the FDIC describes covered bonds:
"Covered bonds are general, non-deposit obligation bonds of the issuing bank secured by a pledge of loans that remain on the bank's balance sheet. Covered bonds originated in Europe, where they are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank. By contrast, covered bonds are a relatively new innovation in the U.S. with only two issuers to date: Bank of America, N.A. and Washington Mutual. These initial U.S. covered bonds were issued in September 2006."

Unlike the legal and regulatory framework in Europe, which is extensive, U.S. regulators find that our banks do not need express statutory or regulatory authorization to issue covered bonds. 

So why don't U.S. banks just go ahead? Well, in light of the current crisis involving residential mortgages, investors are understandably reluctant to go anywhere near something that could represent more of the same risk as the subprime mortgage derivative investments.

Here's where the U.S. regulators step in.  The FDIC and the Federal Reserve are taking steps to reassure investors that the covered bond product is not so risky.  The FDIC's July 15, 2008, Covered Bond Policy Statement tells investors how the FDIC will treat covered bonds in the event the bank that issued the covered bonds fails:

FDIC says, "As conservator or receiver for an IDI, the FDIC has three options in responding to a properly structured covered bond transaction of the IDI: 1) continue to perform on the covered bond transaction under its terms; 2) pay-off the covered bonds in cash up to the value of the pledged collateral; or 3) allow liquidation of the pledged collateral to pay-off the covered bonds."

This is designed to reassure potential investors in covered bonds that even if the issuing bank fails, they will still get paid or have access to the underlying mortgages which have been pledged as collateral.

Concerns that Fannie Mae and Freddie Mac will be unable to provide sufficient liquidity, given their own precarious financial conditions, to allow the U.S. housing market to recover underly this new regulatory "reassurance" to the market.

In addition to spelling out how covered bonds will be treated in a bank liquidation, the Policy Statement prescribes the "eligible collateral" -- setting the standards for the underlying mortgages:

• The issuing bank must retain the underlying mortgages on its books -- although the bonds themselves are nonrecourse.
• The mortgages which secure the covered bonds must be perfected security interests in performing (paying as agreed) one-to-four family residential properties, underwritten at the fully indexed rate, and based on documented income.
• In addition to eligible mortgages, the covered bonds could be secured by a limited volume (up to 10%) of AAA-rated mortgage securities and certain substitution collateral (cash, Treasuries, and agency securities).
• Securities backed by tranches in other securities or assets such as CDOs are not acceptable collateral for covered bonds.
• An issuing depository institution (IDI) may issue covered bonds that comply with FDIC's Policy Statement only up to 4% of its total liabilities after issuing the bonds.

Okay, so the FDIC's Policy Statement has identified and excluded some of the risky (or stupid) loan characteristics, such as "teaser rate" loans where the borrowers can qualify at the initial rate only -- and may have no idea that they will be unable to afford mortgage payments when the loan reprices.  No-doc or "liar's loans" are also out.  And exotic, poorly understood, and extremely risky products involving CDOs are not eligible collateral.

BUT there remains substantial room for poor underwriting.  It used to be said that no banker intends to make a bad loan.  Even in the old days when prudent underwriting was a precept honored in the observance, lenders make mistakes in evaluating capacity to repay and borrowers' financial conditions change. So these eligible mortgage pools could still contain loans that turn out to be losses.  And given the real estate market, some properties may continue to decline in value. 

CAUTION:  Investors need to recognize that these covered bonds are NOT risk-free.

It is to be fervently hoped that the regulators are more on top of the risks these covered bonds may present than they were with subprime mortgages and their derivatives, which were also addressed in Policy Statements.

On the one hand, I applaud the FDIC and the Federal Reserve for thinking creatively to find solutions to the liquidity crisis in home mortgage lending which continues to threaten the overall U.S. economy (not to mention global markets).

On the other hand, I hope covered bonds won't be another source of "imprudent investments."  We can't stand another innovation that solves one problem (just like subprime mortgages were intended to solve the problem of no access to home ownership for those with less than stellar credit) but lands us in a bigger mess.

I'm not saying this can't work.  I'm saying banks, regulators, and investors need to retain their common sense as well as "safe and sound" implementation.

Link to FDIC Covered Bond Policy Statement:  http://www.fdic.gov/news/news/press/2008/pr08060a.html

Link to Treasury Secretary Henry Paulson speech describing and supporting covered bonds:  http://www.treas.gov/press/releases/hp1070.htm

(ag) July 23, 2008