U.S. shouldn’t get too excited about covered bonds

March 22, 2011

By Antony Currie
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

NEW YORK, March 17 — U.S. politicians on both sides of the aisle are persevering with their efforts to develop a covered bond market. Importing this European method of funding home loans makes sense, not least considering the blows dealt to the reputation and efficiency of mortgage securitization. And there’s even a growing appetite for the product among U.S. investors, who bought $30 billion worth of foreign covered bonds sold in America last year. But no one should get too excited about covered bonds just yet.

Lobbying for a U.S. version of the market has so far been an unrequited labor of love. Representative Scott Garrett introduced essentially the same legislation last week as he did last year, both times with bipartisan support. Former Treasury Secretary Hank Paulson pushed for the idea during the 2008 crisis. The Federal Deposit Insurance Corp even issued a policy statement earlier that year to encourage issuers, though none stepped forward in the U.S. market. And it has been a regular topic at industry conferences for a decade.

This time may, finally, be different. Last year’s Dodd-Frank Act mandated that mortgage lenders keep 5 percent of any loans they securitize, while other changes mean they lose much if not all of the capital and accounting benefits once associated with securitization. That puts covered bonds on a more even footing. Like mortgage-backed securities, the bonds are secured by mortgage loans, but in the case of covered bonds they remain on the bank’s balance sheet.

But the FDIC and investors need to reconcile their differences. To minimize losses to its insurance fund, the regulator wants to be able to liquidate covered bonds if a bank fails. Investors, though, fear that would expose them, in the worst case, to the FDIC selling the loans at knock-down prices.

Even if that’s resolved, though, the dominance of Fannie Mae and Freddie Mac — likely to continue despite planned reforms — will limit the appeal of covered bonds. The bonds offer banks cheaper funding than unsecured debt, but not as good a deal as selling mortgages to the two government-sponsored mortgage giants. Moreover, a healthy market is no guarantee of prudent lending, as property busts in Spain and the UK show.

That doesn’t mean legislators and regulators should abandon their attempts to breathe life into covered bonds. It should, over time, become a useful funding tool. But there’s a long way to go before it takes over from Fannie and Freddie.

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