Covered Bonds: Paulson Pushes New Capital Source

"This market can grow in the United States absent federal legislative action," the Treasury secretary thinks.

Although it wants to keep government out of mortgage funding, the U.S. Treasury Department wants to do its bit to get liquidity flowing again. At a major press conference on Monday, Treasury Secretary Henry Paulson, accompanied by officials from four of the largest banks—Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo—issued a document outlining what Treasury considers best practices for residential covered bonds, a new tool it feels is needed to help unfreeze housing funds. And the banks say they plan to start issuing the bond.

The program may become a cornerstone of the Treasury’s plan for turning the reeling housing market around. “We have been looking broadly for ways to increase the availability and lower the cost of mortgage financing to accelerate the return of normal home buying and refinancing activity,” Paulson said. “We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing.”

But unlike the situation in Europe, where covered bond markets are already established, Paulson wants to keep the government out of covered bond issuance. “While many European countries have dedicated covered bond legislation, the U.S. regulatory environment is different. Covered bonds are a promising financing vehicle, and we believe this market can grow in the United States absent federal legislative action,” he said at the press conference.

A covered bond is a secured debt instrument that provides funding to a depository institution. The funding is collateralized by high-quality mortgage loans (the “cover pool”) that remain on the issuer’s balance sheet. Interest on the covered bond is paid to investors from the issuer’s cash flows, while the cover pool serves as secured collateral.

Covered bonds provide dual recourse to both the cover pool and the issuer. In the event of an issuer default, covered bond investors first have recourse to the cover pool. In the event the cover pool returns less than par in a liquidation, investors maintain an unsecured claim on the issuer.

Covered bonds differ from mortgage-backed securities in several ways. For instance, unlike mortgage-backed securities, in which “mortgages are packaged and sold to investors,” mortgages securing covered bonds remain on an issuer’s balance sheet, according to the Treasury’s best practices statement.

Further, pools of loans securing covered bonds are dynamic, meaning that non-performing (or prepaid) loans must be removed from the cover pool and replaced by performing mortgages. In contrast, mortgages buttressing mortgage-backed securities are static, remaining in each MBS until maturity.

Covered bonds differ from unsecured debt because of the absence of secured collateral underlying the obligation of the issuer. While investors in unsecured debt retain an unsecured claim on the issuer in the event of issuer default, covered bond investors possess dual recourse to both the underlying collateral of a covered bond and to the individual issuer. Covered bonds provide investors with more protection on their investment than unsecured debt, the Treasury asserted.

While a big European covered bond market already exists—it was valued at $3.3 trillion in 2007–only two U.S. institutions to date have issued covered bonds. The Treasury Department explained that market participants sought structural clarity to develop the U.S. covered bond market.

Treasury says that its document is intended to provide clarity and homogeneity to the new market. It’s also meant to define a starting point for the U.S. covered bond market and serve as a complement to the Federal Deposit Insurance Corporation final policy statement.

Treasury said it believes the $11 trillion mortgage market can benefit from all forms of mortgage finance. Covered bonds can serve as a complement to the housing government sponsored enterprises, helping to provide additional funding to homeowners, it explained.

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