ABA Banking Journal - October 2008 - (Page 12)
briefing FAN/FRED FALLOUT Covered bonds gain interest after GSE takeover n connection with the recent troubles surrounding Fannie Mae and Freddie Mac, there’s been a good deal of discussion about finding alternative forms of liquidity for the U.S. residential mortgage market. The U.S. Treasury has said it wants to shrink Fannie and Freddie by 10% annually beginning in 2010—from a high of $850 billion to a mere $250 billion. Naturally, the question on everyone’s mind right now is, “How do you replace more than a half a trillion dollars in funding?” One idea that has a track record worth looking at is covered bonds, a financing vehicle Europe has used successfully and safely for a long time. U.S. Treasury Secretary Henry Paulson convened a meeting in Washington this June to ask what steps could be taken to stimulate the growth of a covered bond market. This was followed in July by issuance of the Treasury guide, “Best Practices for Residential Covered Bonds.” (http://www.treas.gov/press/releases/ reports/USCoveredBondBestPractices.pdf). I bank, the cover pool is separated from the other assets of the failed bank and held for the benefit of the covered bond investors and used to pay the bonds. Because covered bonds are issued by regulated entities and are also secured by high quality collateral, they are viewed as being in the same category as sovereign and agency bonds. Covered by the pool, not the bank A covered bond is basically a corporate bond issued by a bank and secured by a dynamic pool of residential mortgage loans. Importantly, new mortgage loans are added to the pool every month as old loans pay down or default. Unlike the mortgagebacked bonds issued by savings and loans in the 1980s, a covered bond has its maturity date protected. In the event of the insolvency of the issuing bank, it is intended that the pool of collateral “covering” the bond will provide sufficient funds to continue to pay the outstanding bonds through their maturity date. The bonds are not accelerated and paid off upon the insolvency of the bank. Covered bonds originated almost 250 years ago in Prussia as a means to finance rebuilding following a war. With the integration of the European financial markets in the 1990s and the introduction of the Euro, the market for covered bonds exploded. In Europe, there are no equivalents to Fannie Mae and Freddie Mac. Nor is there a Federal Home Loan Bank System. As a result, covered bonds developed as significant private-market means of financing residential mortgages. Today there is more than $3 trillion in covered bonds outstanding in the European market—equivalent to about 60% of the financing currently provided by Fannie and Freddie in the U.S. Generally, European covered bonds are provided for in specific statutes that enable the pledged mortgage loans to be “ring-fenced.” In the event of the insolvency of the issuing By Jerry Marlatt, a partner with Clifford Chance U.S. LLP. The author was involved in the first issuance of a covered bond in the United States. Two key differences here Washington Mutual was the first U.S. financial institution to originate a covered bond when it issued four billion euros of covered bonds in September 2006 in Europe. This was followed shortly by a four billion euro offering by Bank of America in April 2007. Both banks issued subsequent series of covered bonds, including the Jerry Marlatt issuance by Bank of America of a dollar-denominated series in the U.S. There is no statute in the U.S. to enable the issuance of covered bonds, so U.S. banks utilize the techniques of securitization to issue what are referred to as “structured” covered bonds. The other significant difference in U.S. covered bonds is that upon the insolvency of an issuing bank, the collateral pool is monetized—either through a repudiation payment by the FDIC, or through a liquidation of the cover pool by the bond trustee. This has the effect of introducing market risk and reinvestment risk into U.S. covered bonds, as the proceeds need to be reinvested by the bond trustee until maturity. The GSEs still dominate While covered bonds have been highly successful in Europe and some are proposing covered bonds as a solution to a broken mortgage finance market in the U.S., there are many skeptics. There are several factors that will influence the growth of covered bonds as a significant alternative means of finance for mortgage loans. When asked, a great many banks say they intend to finance their residential mortgage loans operations through Fannie Mae, Freddie Mac and the FHLB. That’s not surprising, really. Because of the implied (now explicit) government guarantee, no private financing source—including covered bonds—can finance loans as cheaply and efficiently as the GSEs. Certainly, a substantial reduction in the role of Fannie and Freddie would promote covered bond financing. As mentioned earlier, there are proposals to do that. However, this is a politically charged plan, the fulfillment of which will depend on the outcome of the Presidential election and the next Congress. Three factors could promote change There are several other factors that will also influence the reliance on covered bonds by U.S. banks. The first is the changCOVERED BONDS continued on page 63 12 OCTOBER 2008/ABA BANKING JOURNAL Subscribe at www.ababj.com
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