Prospects for a Future Covered Bond Market to Finance Home Mortgages in the United States
Commentary by Jerry Marlatt
05/20/2009
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. Today, in the last of a four-part series, he takes a look ahead at the possibility of a U.S. covered bond market in the home financing arena.
Jerry MarlattSo what are the prospects that covered bonds become a major financing vehicle for residential mortgages in the U.S? I believe their future will ultimately be determined by the fate of Fannie Mae and Freddie Mac—the two giant government sponsored enterprises (GSEs) I discussed in an earlier commentary. If their mandate is reduced to their original purpose of supporting affordable housing, there would be a very large funding void for conforming mortgage loans.
In addition, the prospects for covered bonds will be affected by the activities of the Federal Home Loan Banks (FHLBs), which have been a significant lender in this crisis. FHLB advances, however, are usually accompanied by fairly severe covenants and business restrictions that would make covered bonds more attractive in normal markets than FHLB funding. As the credit crisis eases, the attractiveness of covered bonds should grow.
Meanwhile, the federal emergency financing programs have provided a stiff challenge for any issuer of covered bonds in the U.S. market. This applies in particular to the FDIC's Temporary Liquidity Guarantee Program (TLGP), which was set up to guarantee senior bank debt through July 2012.
In January of this year, the FDIC proposed opening eligibility for the TLGP to secured bank debt with maturities of up to 10 years—which gave rise to hopes that the TLGP might provide a guarantee of some form of covered bond. However, such action has not yet materialized to date, and a May 15 statement from the FDIC indicated that the plan has been placed on hold.
On the other hand, recent initiatives relating to another federal program—the Term Asset-Backed Securities Lending Facility (TALF)—could prove helpful to covered bonds. The U.S. Federal Reserve announced May 1 that the TALF program will be expanded to provide financing to commercial mortgage loans (i.e., for commercial real estate projects such as office buildings or shopping centers) starting in June.
Like home loans, commercial mortgage loans have the potential to be funded using covered bonds. If such covered bonds could be financed through TALF at attractive haircuts, this would encourage development of a U.S. covered bond market.
Legislative Prospects
Some think a legislative initiative is needed to kick-start covered bonds. While the current legislative session of the Congress could see developments favorable to covered bonds, in this crisis the agenda is likely to be very crowded with financial reform bills and stimulus and social bills.
Some of the possible favorable legislative initiatives could include:
1. A decisive move to address Fannie Mae and Freddie Mac to reduce the growing burden on the government.
2. A statute for ring-fencing covered bond cover pools beyond an insolvency event. This would avoid the "fire sale" of mortgage loan collateral required under current U.S. covered bond structures upon insolvency of the issuing bank.
3. A statute expressly permitting direct issuance of covered bonds. Current U.S. structures issue covered bonds indirectly through a "special purpose vehicle" (SPV). Direct issuance would permit the bonds to be included in major bond indices and permit the monthly reports of the collateral pools to be publicly available to the analyst community. Better analyst coverage would allow a much stronger secondary market to develop.
4. Capital relief for U.S. banks that invest in covered bonds. In the European Union, the Capital Requirements Directive (CRD) provides very favorable capital treatment of covered bond investments. It does make sense that less capital should be held against secured bank debt than against unsecured bank debt.
5. Capital relief for U.S. banks that issue covered bonds. Under the CRD in Europe, residential mortgage loans held on-balance sheet have a 50% risk weighting compared to 100% risk weighting under current U.S. capital requirements.
6. Stabilization of U.S. housing prices. Any action or event that helps stabilize U.S. housing prices would bring private investors back to the mortgage finance market and permit financing without the need for government guarantees of mortgage related debt. Should stabilization of housing prices begin to emerge, then because of their dual recourse nature, covered bonds are likely to be the first to find investors.
Ultimately, the challenge for the U.S. government is to craft a transition away from dependence on government-supported financing. The answer, I think (to steal the words of David Power of the Royal Bank of Canada), is: "The government debt market may turn out to be a perfect segue into the covered bond market. Especially in the U.S.-as the government guaranteed markets fade away, covered bonds may step in as their natural successor."
Read the previous commentaries in this series:
- Part One: "How Covered Bonds Could Extricate the U.S. Government From Residential Mortgage-Backed Securities"
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 Investor™.
Copyright © 2009 by Jerry Marlatt. All rights reserved.