Commentary: Covered Bonds Attractive, Aside From Policy Issue

Dr. Robert A. Eisenbeis is Chief Monetary Economist at Cumberland Advisors, an independent, fee-for-service money management firm. Prior to joining Cumberland he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. He is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. 

Robert A. EisenbeisAs the financial crisis has begun to wind down, attention has turned recently to what should be done about Freddie and Fannie.  For example, Congressman Barney Frank has publicly questioned whether their existence is justified and whether it is now time to reconsider the government's support of housing.  One option that has been around awhile and that is the subject of a legislative proposal by Congressman Garrett [R-NJ] is to foster the use of covered bonds.  There are plenty of primers on covered bonds available, so it is not the purpose of this commentary to rehash all the nuances of these instruments.

Suffice it to say that these are not a new type of bond.  Rather they originated in Germany about the time of the U.S. revolutionary war; and they have been subject to substantial regulation, legal scrutiny, and supervision in Europe for many years.  They are, however, relatively new instruments in the U.S., with the first issues being made by banking organizations in 2006.  Essentially these are bonds issued by financial institutions which are collateralized by a pool of designated assets.  They remain as liabilities on the books of the issuing institution and may or may not involve the use of a special-purpose vehicle.  The assets may be mortgages or other types of loans.  Interest payments are made by the issuer, so the income stream is dependent upon the profitability of the firm and its ability to meet cash flow obligations.  What makes these instruments low-risk and desirable to investors is the fact that, in the case of default, the holder can take possession of the underlying collateral and the terms of the debt instrument require that collateral values be maintained.

European investors have liked covered bonds because of their low credit risk.  Issuers like the instruments because they bear low rates and are perceived as being another potential source of liquidity.  The liquidity feature results from the fact that the financial institution, at least here so far in the U.S., sells the bonds to a special-purpose vehicle or trustee who intermediates the bonds to investors.  In the event of a failure, the trustee takes possession of the underlying collateral.  Politicians like covered bonds because they look like another low-cost way of channeling funds to housing — hence the Garrett bill.  Regulators have had little to say about covered bonds, with the exception of the FDIC.  It published a rule in 2008 clarifying the status of covered bonds in the event of a financial institution failure, with the intent of fostering the development of the market.

With so many positives, why shouldn't everyone jump on the covered bond bandwagon?  There is a good reason why regulators and politicians should be careful about covered bonds.  The forgotten potential parties at risk in covered bond transactions are shareholders, the deposit insurer, and taxpayers.  Consider first that, unlike an MBS [Mortgage-Backed Security], where the proceeds from the underlying mortgages are used to meet the cash flow obligations of the security, in the case of a covered bond, payments come from the general cash flows generated by the institution.  In the event of financial distress, depending upon the priority of the instrument, cash flows continue to go to the covered bond holders and aren't available to shareholders or other creditors without similar priority claims.  Should the institution fail, and this is where the deposit insurer and taxpayers come in, the pool of assets available to protect the interests of the deposit insurance fund, and ultimately the taxpayer, is reduced.  In this sense, a former colleague pointed out to me that covered bonds are almost like [Federal] Home Loan Bank advances.  Put simply, covered bonds shift risk and costs to the deposit insurer and taxpayer in the event of failure to protect the covered bond holders.  There is no free lunch, and mechanisms need to be put in place to ensure that fostering covered bond issuance will not in fact generate another form of moral hazard that will come back to bite the FDIC and taxpayers.

What might be done?  First of all, given that the instruments are collateralized — and this proposal should apply to all collateralized obligations — the accounting computation of shareholder equity should exclude the collateralized assets when subtracting liabilities.  This would have the effect of reducing measured equity.  At the same time the collateralized assets should be included in calculating regulatory capital-to-asset ratios and in determining capital adequacy.  These simple steps would essentially require the issuer of covered bonds to have more equity and would be a conservative way of protecting the interests of the FDIC and taxpayer.  Without such regulatory treatment, covered bonds are a pig in a poke from the perspective of taxpayers.

Aside from the policy issue, as mentioned previously, covered bonds would be attractive to investors under certain circumstances, and Cumberland would certainly consider them for our clients.  The bonds have an extra margin of protection built into them when it comes to credit risk, which would make them attractive to more risk-averse investors.  While returns are likely to be a bit lower, the determining factors will be the nature and quality of the collateral — that is, mortgages versus other assets — what the spreads are relative to comparable investments, and what investor risk and return preferences and investment objectives are.

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The commentary above was originally released as a Cumberland Advisors Market Commentary (April 7).  Bob Eisenbeis can be reached by email at bob.eisenbeis@cumber.com.