Could Covered Bonds Help Mend the Mortgage Market?

The housing bubble and subsequent taxpayer losses have shown us that there could be significant dangers to the U.S. government backing most mortgages. Unfortunately, you can't simply remove that support without lenders running into a funding shortage. One potential way to help fill the funding gap would be to establish a covered bond market in the U.S. Today, a the House Financial Services subcommittee on capital markets and government sponsored entities held a hearing on the topic. One witness raised some concerns about covered bonds. Would the new market do more harm than good?

First, what is a covered bond? It is a bond secured by mortgages sold by banks to investors. But unlike mortgage-backed securities, a covered bond does not transfer ownership of specific mortgages to investors. Instead, banks continue to own and maintain the pool of mortgages and make covered bond payments from their general revenue. Since the bonds are secured, but also backed by the bank like an unsecured bond, they are generally very safe investments. The structure also requires the bank to remove non-performing mortgages from a pool and replace them with others that are performing well.

Last summer, a legal framework for a covered bond market was nearly established by Congress as a part of the big financial regulation bill. But at the last minute, during the conference process, the covered bond provision was rejected by Senate Democrats, mostly due to worries by the Federal Deposit Insurance Corporation.

In today's hearing this and other concerns were brought up by Stephen G. Andrews, president and CEO of Bank of Alameda, a community bank. The other four witnesses, however, spoke in favor of establishing a covered bond market. Here are four concerns raised during the hearing and responses.

FDIC Resolution

The FDIC is concerned that if banks have pools of mortgage dedicated to covered bonds, it will hamper their resolution process during failures. When a bank collapses, the FDIC sells its assets to pay back depositors. Any shortfall comes out of the FDIC's insurance fund, which is created by fees paid by banks for the insurance it provides.

First, the FDIC fears that it won't be able to get its hands on the mortgages in a bank's cover pool. This fear is legitimate, but the FDIC can take measures to mitigate this risk. One way it could do so might be to requiring higher assessments by banks that deal covered bonds.

Second, Andrews raised a concern for the FDIC that deals with the practice of swapping bad mortgages out of the covered pool and putting in good ones. He worries about a situation where a bank is near collapse, and swaps out all the bad mortgages in a cover pool with good ones. That would provide investors will all the good stuff, and leave the junk for the FDIC -- which he says would result in bigger losses to its insurance fund. Again, however, the FDIC can take measures to guard against this. For example, the FDIC could rule that banks must provide additional cash to reserve against any loan swapped out until its performance improves.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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