Covered Bonds to the Rescue? Don't Make Me Laugh

Covered bonds are all the rage, apparently. The four biggest U.S. banks announced yesterday that they'll start to issue covered bonds—at the behest of Treasury Secretary Paulson—in an effort to create a U.S. market for covered bonds. A covered bond is essentially a bond secured by residential mortgage assets that stay on the issuing bank's balance sheet. Or, as Steve Randy Waldman describes them, covered bonds are "old-fashioned, full recourse, secured and overcollateralized loans, just packaged into tradable securities." They're an alternative to securitization, and they're gaining popularity because it's so hard to securitize residential mortgages right now. The emergence of covered bonds would help stimulate the housing market, and provide much-needed liquidity.

So is the financial market about to be overrun with covered bonds, and awash in Glorious Liquidity? Not a chance in hell.

I've been trying to dig up a long memo I wrote on covered bonds a few years ago, but so far to no avail. When I (attempt to) use my firm's ginormous electronic filing system, there's about a 75% chance that I file the memo in the wrong place, so the covered bonds memo is most likely lost forever. I swear, the federal government probably has a less complicated and less bureacratic filing system. Anywho, this just means I'm writing mostly from memory here.

Covered bonds are widely used in Europe, but haven't been able to gain traction in the U.S., in large part because of regulatory uncertainty. The federal government insists that current law already allows banks to issue covered bonds, and that therefore, no specific regulatory framework for covered bonds is necessary. The government has steadfastly refused to promulgate a new regulatory framework covered bonds. (Part of this refusal stems from the Bush administration's general aversion to regulations, IMHO.)

The result has been too much regulatory uncertainty. For example, without established rules governing the kinds of mortgages that can be used as collateral for covered bonds (i.e., LTV ratios, fixed-rate vs. ARMs, prime vs. Alt-A, etc.), investors have been unwilling to buy covered bonds, since they might be backed by questionable assets. Investors can, in theory, set their own standards for the pledged mortgage assets, and only buy covered bonds backed by mortgage assets that meet those standards. But as with the process of finding a market-clearing price, the process of finding optimal standards for the pledged mortgage assets is a long one, involving a good deal of trial and error, and usually the development of some appellate case law as well. If you go this route (i.e., sans clear regulatory standards), then the covered bond market can only take off after investors and i-banks have felt each other out, settled on a satisfactory set of standards for pledged mortgage assets, and developed some solid case law to provide a degree of legal certainty.

If you don't have time to allow a successful covered bond market to spring up organically—and we don't—then the only way to provide the regulatory certainty needed to jump-start a covered bond market is for the federal government to simply lay down iron-clad standards ensuring that pledged mortgages are of the highest quality. Banks understand this very well—especially if they had some super-smart lawyer write a lengthy memo explaining it, which said super-smart lawyer then lost, through absolutely no fault of his own. I suspect that given current market conditions, banks would welcome clear, iron-clad regulatory standards governing pledged mortgage assets for covered bonds.

But instead of promulgating clear regulatory standards, what do we get from Paulson? Voluntary guidelines. I kid you not. Paulson announced "a set of voluntary industry guidelines intended to provide clarity to issuers and investors." Regulatory uncertainty is one of the biggest hurdles to establishing a U.S. covered bond market, and Paulson's solution is voluntary industry guidelines!? Way to step up to the plate, Hank. Voluntary guidelines oughta do the trick, since they've already worked so well in the mortgage crisis (remember the ridiculous HOPE NOW Alliance?).

There are, of course, other regulatory issues hindering the emergence of a covered bond market in the U.S.—most importantly, the FDIC regulation preventing banks from issuing covered bonds over 4% of their total liabilities, which the FDIC is apparently refusing to budge on. The lack of established standards for pledged mortgages is simply representative of the legal and regulatory problems facing covered bonds. It's a deal-breaker though, so I thought it was appropriate to focus on that issue.

To sum up: After all the huffing and puffing about covered bonds coming to the rescue of the U.S. housing market, we're left basically in the same place we started: with too much legal and regulatory uncertainty to jump-start a covered bond market in the U.S.

(Note: The FDIC was partly responsible for the legal uncertainty, because it neglected to develop a clear policy on how it would treat covered bondholders in the event the issuing bank failed. Two weeks ago, however, the FDIC issued a Covered Bond Policy Statement that cleared up this issue, among others. We could've used that Policy Statement back in 2001-2002, but "better late than never" is about the best we can hope for with this administration.)