Why a Covered Bond Market Did Not Develop Sooner in U.S. History
Commentary by Jerry Marlatt
04/28/2009
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 second of a four-part series, he discusses the historical factors that discouraged development of a U.S. covered bond market before now.
Jerry MarlattYou might ask: why isn't there already a substantial covered bond market in the U.S.? Why has the very successful European covered bond market not been replicated in the U.S.? The answer, as with many things, lies in decisions made long ago.
In the depths of the Great Depression as banks were struggling to survive, Congress saw a need to increase the funding available for residential mortgages for low-income housing—a need the banking sector was unable to meet. To achieve this, Congress chose a government solution, not a private sector one. In 1938, Congress created a federal agency called Federal National Mortgage Association, which is known today as Fannie Mae.
To inject funds into the low income housing market, Fannie Mae was authorized to purchase for investment in the secondary market mortgage loans insured by the Federal Housing Administration (FHA) and to finance those purchases by issuing bonds in the capital markets. This provided an important flow of funds to banks that could not fund enough mortgage loans from their shrinking deposit base.
With its conversion to a stockholder-owned corporation in 1968, Fannie Mae's charter was expanded to include non-FHA insured loans. This conversion was a curious decision that allocated the profit to private investors, but the risk to the taxpayers. In 1970, Congress also chartered Federal Home Loan Mortgage Corporation, another stockholder-owned corporation known today as Freddie Mac, to compete with Fannie Mae. Freddie Mac and Fannie Mae are both known as "government-sponsored enterprises" (GSEs).
In 1981, as an alternative to issuing its own bonds to the capital markets, Fannie Mae began guaranteeing mortgage pass-through certificates issued by trusts holding pools of mortgage loans. In the early 1980s, this Fannie Mae pass-through trust model, with its attendant convexity risk, was adopted when the private sector residential mortgage-backed securities (RMBS) market emerged.
Today, more than 50% of all outstanding U.S. residential mortgage loans—about $5.5 trillion—are either owned by Fannie Mae or Freddie Mac or are pooled into MBS guaranteed by them. About 20% of mortgage loans are in private MBS. And the remaining 30% or so, which are held on balance sheet in whole loan form by originating banks and others, are financed primarily by deposits.
So the financing of residential mortgage loans in the U.S. has long been dominated by the federal giants. And with the implicit guarantee of the federal government and the authority to borrow from the Treasury, the GSEs financed mortgage loans at rates the private sector couldn't approach.
Accordingly, only mortgage loans that didn't qualify for GSE financing were used in private sector RMBS. But the GSEs continuously encroached on this private sector niche as Congress constantly raised their individual loan limits. Ironically, Congress also enabled the extension of their investment activity into subprime and Alt A mortgage loans, contributing to their downfall last year as the real estate crisis accelerated. Today, Fannie Mae and Freddie Mac are majority-owned by the U.S. government.
The Federal Home Loan Bank (FHLB) system is another government-sponsored enterprise created to address the housing crisis of the Great Depression. It was created by Congress in 1932 to provide funds to its member banks and savings and loan associations through the joint issuance of debt in the capital markets. The FHLB System has enjoyed the same implicit government support and the borrowing rights at the Treasury as Fannie Mae and Freddie Mac.
Loans by the FHLB to the banking system, secured by mortgage loans as collateral, mushroomed as the real estate crisis grew. Outstanding FHLB advances today stand at more than $1 trillion. Some would say that the FHLBs are the unsung heroes of this crisis for their quick and massive intervention. But the subsidized financing rates provided by the FHLBs, like those provided by Fannie Mae and Freddie Mac, also crowd out covered bonds.
Read the other commentaries in this series:
- Part One: How Covered Bonds Could Extricate the U.S. Government from Residential Mortgage-Backed Securities
- 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 Investor™.
Copyright © 2009 by Jerry Marlatt. All rights reserved.