Yesterday Treasury Secretary Hank Paulson set forth guidelines on covered bonds, the secured debt instrument being urged by the government as a way to ease the credit crisis. Now we are wondering whether taxpayers might be on the hook for covered bonds if a bank fails.
The question was raised by a statement on covered bonds from the FDIC.
"As conservator or receiver for an IDI, the FDIC has three options in responding to a properly structured covered bond transaction of the IDI: 1) continue to perform on the covered bond transaction under its terms; 2) pay-off the covered bonds in cash up to the value of the pledged collateral; or 3) allow liquidation of the pledged collateral to pay-off the covered bonds."
If we're reading this right, it seems the FDIC is saying that a failed bank could be permitted to perform on its covered bonds. Allowing funds to continue to be funneled to bondholders could raise the cost of bank failures by leaving less money for depositors. There's no indication that the "continue to perform" obligations would be limited to the value of the collateral.