At this point, investors are right to be wary when it comes to banks stuffing lots of junk loans into securities and advertising them as pristine bonds. After all, that's one of the primary reasons why there was a financial crisis, resulting in a credit crunch and the deepest recession in generations. So when a new alternative in the U.S. to mortgage-backed securities called covered bonds are offered, will the banks try to play the same game all over again? That's precisely the complaint of a German financial industry group after reading U.S. legislation to create a covered bond market.

As a brief refresher for those who aren't familiar with covered bonds, they're sort of like a hybrid between asset-backed securities and unsecured corporate bank debt. Banks create a "cover pool" containing a bunch of loans. They then issue bonds using that pool as collateral. But the principal and interest payments that the bank pays are not directly based on the cash flows of those loans, like in an asset-backed security. Instead, the bank pays investors like it would for its regular corporate debt, but in a bankruptcy event, those investors have a first claim to those loans in the cover pool.

Covered bonds have a long history in Europe. They've been around for more than a century. But the U.S. lacks the rules necessary to allow a covered bond market to thrive, because special bankruptcy provisions are necessary to ensure that investors will get first claim to the loans in the cover pool if a bank fails. Such legislation was offered last year as a part of the big financial regulation bill, but failed to make it through conference to be included in the final bill. Now, Republicans have created a stand-alone version of the legislation, which is being considered by Congress.

The U.S.'s conception of covered bonds is a little different from the type that Europeans have successfully relied on for more than a hundred years. U.S. banks want to put loans in covered pools other than just pristine mortgages, such as auto loans and student loans. According to an article in the Financial Times today by Jennifer Hughes, the Association of German Pfandbrief Banks fears that the U.S. might give covered bonds a bad name by including such loans. The article quotes Jens Tolckmitt, the group's chief executive:

"European-style covered bonds are bought by a very stable investor base that likes seemingly boring products," Mr Tolckmitt said. "If you create something that appeals to hedge funds, those investors may not be there in a crisis."
"Will it be possible to safeguard the quality if you have covered bonds secured by other assets? I'm not sure," Mr Tolckmitt said. "It's wrong to think you name something a covered bond and it will be as well-liked and in demand as European covered bonds."

Are Americans gearing up to create more junk products like they did during the housing boom using the well-respected name of covered bonds? There are a few ways to look at this question.

What's So Special About Mortgages?

For starters, it's unclear why mortgages can be the only loans in a covered bond. Look at auto loans, for example. They can perform very well if prudently originated. You can see this by considering the auto loan-backed securities market. The prime bonds that were issued even before the financial crisis have held up pretty well. For example, Nissan's NAROT 2007-A security was issued in February 2007 and has incurred a mere 0.94% cumulative net loss rate through February 2011. That's all the losses in the last four years -- during one of the worst recessions the U.S. has ever known. Its Class A bond holders will not incur a loss, as the credit enhancement provided was more than sufficient to cover these losses. Obviously, if good auto loans can last through a recession like the recent one, they can last through anything.

This holds true for most other asset classes as well. As long as lenders are careful to only put high quality loans in a cover pool, the type of loan shouldn't matter. Underwriting criteria could be easily written into the covered bond's terms and conditions to provide the high quality loans covered bond investors would want, no matter the asset class.

Replacement Provisions Will Provide Protection

Moreover, one of the nice features of a covered bond is that if a loan in the cover pool begins to go bad, the bank must replace it with a new one. So if it turns out that some of the loans are uglier than anticipated, investors will be protected due to this feature. For example, once a handful of student loans went delinquent, they would be kicked out, and better loans would take their place.

But Ultimately, What's the Point?

Clearly, there are some arguments that suggest that banks could put assets other than mortgages in cover pools without causing much harm, but their desire to do so also raises an important question: what's the point? The asset-backed securities market re-opened last year. Deals have been getting done in a variety of asset classes, including auto loans and even commercial mortgage-backed securities. If these markets have already mostly regained their health, then why do banks need to include their loans in covered bonds? Banks might say that they want covered bonds to serve as another funding option, but it isn't clear that they really need the new legislation to include other assets beyond residential mortgages.

There's little doubt that covered bonds will help U.S. banks grapple with less government support for residential mortgage funding. The market could also help with the funding of other loans if the legislation that allows a market to flourish provides the needed bankruptcy protection. Such a deviation from historical conception of covered bonds could work out okay, but it's unclear why banks really need to include other types of loans in cover pools.

For now, it might be best to get a traditional covered bond market started in the U.S., and then consider additional assets after the market has proven a stable and reliable source for funding. The market might do this on its own: if investors are concerned about covered bonds that contain loans other than mortgages, they can just convey that to banks, which could exclude other types of loans. The legislation would only provide a framework, while the market could dictate how the new products evolve.

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