Covered Bonds Come Riding To The Rescue?

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Standing alongside representatives of Bank of America and Washington Mutual, Treasury Secretary Hank Paulson sought to strengthen financial institutions by issuing "Best Practices for Residential Covered Bonds," a move some hope will make it easier for banks to borrow money.
Hold on. We have that wrong. It turns out that Washington Mutual, which is the one of the only two issuers of covered bonds in the United States, didn't get its place in the spotlight today. Instead, Paulson was surrounded by Bank of America (the other issue of covered bonds), JP Morgan Chase, Citigroup and Wells Fargo. Did someone just forget to invite Washington Mutual to the party? Or does the impending doom of Washington Mutual make them an awkward guest at the party?

Whatever the rationale behind the guest list, the theme of the party was that covered bonds would relieve stress on the credit markets in general and the mortgage markets in particular. "Stress on the credit markets" is, of course, a polite way of saying that nobody trusts anybody else enough to lend to them, except perhaps under the most stringent terms and inconvenient pricing.
A covered bond, the Treasury department tells us, is a fashionable instrument in Europe. It allows a bank to issue debt secured by assets--say mortgages--that remain on its balance sheet. It is an alternative to the preferred method in the US, where banks have tended to bundle mortgages in so-called securitization vehicles and raise money by selling those products.
The difference between a mortgage backed security and a covered bond is that the sale of mortgage backed securities was final--the banks had no ongoing obligation and little near-term incentive to control the quality of the products. (The long term incentive for ensuring credit quality is now obvious to Lehman Brothers and the late Bear Stearns.) A bank issuing a covered bond, on the other hand, remains "on the hook" for the loans, and gets to keep the assets so long as the bond continues to perform. With the securitization market frozen up--mainly because investors no longer trust issuing banks and ratings agencies to properly assess the risk--the hope is that investors will be ready to hand over much needed capital to banks under the new instruments.
For investors, the main attraction of covered bonds seems to be an implicit promise by regulators that they will permit the bonds to continue to perform even if the bank issuing the bond fails. You'd think we've had enough of implicit promises from the government about our mortgage markets. But that seems to be what the government is relying on to get investors back in the habit of lending money to banks. Sure there is lots of jaw-jaw about the quality of the mortgages underlying the covered bonds--the best practices describe measures meant to ensure that these aren't loaded up with underperforming subprime junk--but the real action is in the promise that you'll get paid even if the bank fails
That should sound familiar to anyone paying attention to Fannie Mae and Freddie Mac, and for good reason. If the government made good on this promise, it would mean that a failed bank's assets would be funneled into the bond holders pockets while the taxpayers, through various federal agencies ensuring deposits, would be on the hook for its liabilities. In the past, many of those assets may have gone to reduce the burden of paying back depositors, which would decrease the cost to taxpayers of a bank failure.
In other words, we're introducing moral hazard back into the market. Buyers of unsecured bank credit want to know about the quality of a bank's balance sheet, knowing they could be wiped out if the FDIC is forced to take over a bank. Buyers of covered bonds will be confident that their bonds are safe even if the bank fails. Sounds like just what we'd expect from the people who brought us the mortgage bailout bill and the broker-dealer discount window.