BLOG VIEW: Easy, Breezy, Beautiful – Covered Bonds?

If you think the world of mortgage-backed investments could use a bit less Fannie and Freddie these days – and bit more of something else – the ‘something else’ you've been looking for could be covered bonds.

The Federal Deposit Insurance Corp. defines a covered bond as a ‘a non-deposit, recourse debt obligation of an [insured depository institution] (IDI) with a term greater than one year and less than 30 years that is secured, directly or indirectly, by perfected security interests under applicable state and federal law on assets held and owned by the IDI consisting of eligible mortgages or, not exceeding 10 percent of the collateral for any covered bond issuance or series, AAA-rated mortgage-backed securities secured by eligible mortgages.’ Because of the cover pool's quality, high credit ratings for these bonds are the norm.

Covered bonds have also been loosely described as ‘something kind of like mortgage-backed securities’ – the audience shudders – ‘but with recourse.’ Or securitization with an emergency floatation device in the form of a balance sheet.

Last week, Rep. Scott Garrett, R-NJ and a member of the House Financial Services Committee, introduced H.R.6659, the Equal Treatment for Covered Bonds Act. The act is intended to spur the growth of a healthy market for these structures and, in the process, help the staggering real estate finance market and credit markets learn to walk again.

‘Covered bonds have the potential to aid in returning liquidity to the mortgage market through improved underwriting and may also serve as an alternative to securitization,’ Garrett said in a statement announcing his bill. ‘If we want to truly level the playing field and foster the growth of covered bonds in the U.S., we need to develop a legislative structure for covered bonds.’

Garrett's proposed framework for a covered-bond marketplace includes amendments to the Federal Deposit Act to ensure covered bonds receive the same treatment as comparable financial contracts, officially defines a covered bond as ‘non-deposit recourse debt obligation of an insured depository institution,’ allows for a minimum one-year maturity term and no maximum maturity term, and gives federal financial regulatory agencies power to create new covered-bond rules.

The bill also adds a clause ‘ensuring that a bank failure will not impair the value of the covered bonds’ – a comforting provision now that bank failures are regular realities rather than vague possibilities.

High-profile proponents of a covered-bond marketplace include none other than Treasury Secretary Henry Paulson, who even wanted banks to begin issuing the bonds before Congress gives its approval, Bloomberg reported last month.

Paulson views the benefits of covered bonds as two-fold: provide an alternative to writedown-plagued mortgage-backed bonds, and give big-enough-to-monumentally-fail Fannie and Freddie some true competition.

Everything sounds promising so far, but if this market materializes in its currently proposed form, a significant piece of the pool action will be missing. Commercial mortgages, anyone?

Commercial Mortgage Securities Association (CMSA) has voiced its support for the FDIC's general interest in encouraging covered bonds, but the association points out that only residential loans are included in the current proposal.

‘Including commercial loans as collateral for covered bonds will support enhanced liquidity for mortgage finance without increasing the risks to the Deposit Insurance Fund,’ Dottie Cunningham, CEO of CMSA, said in the association's July 2 statement of support-with-this-critical-modification. ‘We believe covered bonds will provide a desirable funding strategy even following a recovery of the commercial securitization market.’

CMSA weighed in again when Garrett introduced his bill, noting that this ‘timely legislation comes as borrowers in fundamentally sound markets, such as commercial real estate, are finding limited financing options due to the recent credit crisis.’

Fortunately for the commercial mortgage crowd, Garrett's vision of the covered-bond marketplace does include commercial mortgages and commercial mortgage-backed securities. ‘Covered bonds are not a 'silver bullet' for ending the credit crunch, but can provide supplementary liquidity for commercial real estate finance,’ CMSA says.

Makes sense. On the most basic level, if the residential mortgage business can poison the overall market enough to share its liquidity ailment with the commercial mortgage side, then it's only fair to share the potential remedy, too.

Jessica Lillian, Commercial Mortgage Insight


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