Could Covered Bonds Help Mend the Mortgage Market?

In a Congressional hearing today some concerns were raised -- and answered

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.

Big Banks Will Have an Advantage

The biggest criticism from Andrews was that covered bonds give big banks an advantage. He says that they have greater access to capital markets and more mortgages, which will allow them to facilitate covered bond transactions more easily. As a result, they will be able to provide lower-cost mortgages.

The other witnesses disputed this point. They believe community banks will be able to participate in the covered bond market by pooling their mortgages together in multi-bank cover pools. Tim Skeet, chairman of the Committee of Regional Representatives within the International Capital Market Association, provided a real world example. He said community banks take this strategy in Europe, where covered bonds have functioned for a century. He used an example of several Norwegian banks having cooperated to sell a covered bond deal recently.

But We've Already Got Federal Home Loan Banks

Additionally, Andrews doesn't see the point of the covered bond market, because we've already got Federal Home Loan Banks. This isn't really an argument against covered bonds, argue the other panelists. They believe that FHLBs will continue to function as they have in the past, but covered bonds will provide another funding mechanism for the mortgage market. Moreover, they say that covered bonds will benefit taxpayers if they shrink the size of the FHLB's portion of the market. The funding provided by FHLB contains a federal guarantee; covered bonds would not.

Covered Bonds May Require 20% Down

Andrews also worries that covered bonds will require 20% down payments, which would limit home ownership to lower- and middle-class Americans. This worry is fairly misguided. First, it's likely that mortgage-backed securities will soon have similar requirements -- why shouldn't covered bonds? Second, this actually may work as an advantage for community banks like his, which might rely less on the covered bond market than big banks. It could create a niche for smaller institutions to provide slightly higher-cost loans to Americans who want lower down payments.

None of these concerns appear to be so great that they should kill the prospects for creating a covered bond market in the U.S. And it has many benefits, which include providing another funding source for mortgages, minimizing the market's reliance on government support, and giving banks greater incentive to care about the mortgages they originate by keeping them in-house. Legislation should be carefully crafted with ensure the criticisms above are answered, but it's easy to see how covered bonds would improve the U.S. mortgage market.