'How Covered Bonds Could Extricate the U.S. Government from Residential Mortgage-Backed Securities'
Commentary by Jerry Marlatt
04/22/2009
Editor's Note: Jerry Marlatt helped engineer the first issuance of covered bonds in U.S. history (by Washington Mutual). Currently senior of counsel in the New York office of the Morrison & Foerster law firm, he also serves on the Steering Committee of the U.S. Covered Bonds Council. His comments below are the first in a four-part series.
Jerry MarlattLet me begin by stating the obvious: what began as a liquidity crisis a year and a half ago has now developed into a full-blown international banking crisis. Around the world, banks are on government support and emergency financing. In the U.S., this crisis has destroyed the private market for financing residential mortgage loans, and financing today is heavily reliant on U.S. government support. Mortgage finance has largely been nationalized with devastating effect-it has doubled the balance sheet of the U.S. government.
It is my personal conviction that covered bonds are the solution to extricating the U.S. government from the U.S. mortgage finance system, notwithstanding the recent travails of the market in Europe. The U.S. is one of the few countries in the industrialized world to have such extensive national financing of mortgage loans. And it has proved very costly for U.S. taxpayers through the nationalization of Fannie Mae and Freddie Mac.
Many European countries have home ownership participation levels as high as the U.S. without the need for government support. Moreover, the European market is showing signs of some recovery when nothing is stirring in the U.S. except government-guaranteed Fannie and Freddie debt. Covered bonds could allow us to transition away from this heavy dependence on direct government financing.
For many investors, covered bonds are a more attractive investment than residential mortgage-backed securities (RMBS) for a number of reasons:
1. The dual recourse nature of a covered bond. The investor looks primarily to the issuing bank for repayment. The investor is not reliant solely on an isolated collateral pool.
2. The dynamic character of the cover pool. Unlike an RMBS mortgage loan pool, which is frozen at the time of issuance, a covered bond cover pool is retested every month and updated to maintain coverage requirements.
3. Because the collateral pool must be updated every month, the issuing bank has a continuing interest in how the collateral will perform and is likely to adopt more conservative underwriting criteria.
4. As bullet pay instruments, covered bonds do not expose an investor to the prepayment risk inherent in RMBS and the complexity that this produces.
Current accounting developments provide some additional incentive to issue covered bonds. Beginning with 2010, it will be much more difficult to obtain off-balance sheet accounting treatment for RMBS and asset-backed securities (ABS) transactions. To the extent that mortgage loans are retained on-balance sheet, covered bonds, if attractively executed, likely will be a favored financing option-since ABS and RMBS will no longer provide balance sheet relief.
In transitioning away from a government guaranteed market, covered bonds are likely to be the first to find investors, for the reasons noted above. And the structure of covered bonds aligns well with the policy interest of requiring originators to retain an interest in the assets they originate, rather than follow an originate-to-sell model.
Read the other commentaries in this series:
- Part Four: Prospects for a Future Covered Bond Market to Finance Home Mortgages in the United States
Mr. Marlatt's comments are adapted from his remarks as keynote speaker at the Second Annual Covered Bonds Forum in Toronto earlier this year. They do not necessarily reflect the views of Covered Bond InvestorTM.
Copyright © 2009 by Jerry Marlatt. All rights reserved.