Expert witnesses testifying before the House Financial Services Committee this week suggested that covered bonds, long-standing debt instruments in European markets for more than two centuries, should have a home in the U.S.
These bonds, which are backed by a pool of high-quality loans, differ from traditional asset-backed securities in that they remain on an issuing institution's balance sheet. The bonds also offer investors a dual recourse to both the assets included as collateral as well as the underlying institution.
Rep. Scott Garrett, R-N.J., last month offered an amendment to the Financial Stability Improvement Act that he says would provide the statutory framework necessary to facilitate covered bonds' use stateside. Under Henry Paulson's watch, the Treasury Department began making strides in a similar effort in the summer 2008, but last fall's market crash stopped those measures in their tracks. To date, only two covered bonds have been issued in the U.S. – one by Bank of America and one by Washington Mutual (now owned by J.P. Morgan).
Covered bonds would benefit U.S. investors by allowing for greater portfolio diversification, and they would benefit consumers by increasing liquidity to the credit markets, Garrett says. Additionally, because of their on-balance-sheet structure, covered bonds would strengthen lenders' flexibility in restructuring assets, such as residential mortgages, which has revealed itself as a major pain point.
"This is not a problem with covered bonds because they are held and serviced by the lender," Garrett said in his opening statement on the House floor Tuesday. "The lending institution, thus, has a greater ability to modify consumer mortgage loans, which will benefit both the consumer and the lender."
Another attractive feature of covered bonds, witnesses said, is that they essentially circumvent debate over credit risk retention. Bert Ely of Ely & Company Inc., a financial institution and monetary policy consultancy, explained that lenders that fund loans with covered bonds retain all of the risk.
"That is far preferable to a 5 percent or 10 percent risk retention, as the lender is then on the hook for 100 percent of his lending mistakes," Ely said.
The House committee hearing focused largely on how covered bonds could be woven into Congress' efforts to renew private mortgage lending. Lawmakers from both parties indicated that covered bonds could play a part in bringing government-sponsored enterprises Fannie Mae and Freddie Mac back into a competitive marketplace – a sentiment shared by Alan Boyce, CEO of Absalon.
Doing so, Boyce said, would require specialized covered-bond laws and specific regulatory requirements.
"In particular, more specific legislation often includes restrictions on collateral type, loan-to-value requirements and appraisal standards," Boyce testified. "In addition, investors' ability to assess the product characteristics are enhanced by the standardization and transparency offered by more specific legislation."
Views diverged, however, on which specific collateral types are best suited for an early-stage covered-bond market in the U.S. Boyce opined that commercial mortgage-backed securities have "no place in a covered bond," saying, "the added complexity and risks they bring would unduly complicate a nascent U.S. covered-bond market."
Investcorp International Inc. Managing Director J. Christopher Hoeffel, speaking on behalf of the Commercial Mortgage Securities Association, took a different stance. While conceding that covered bonds "should not, and cannot, replace CMBS" as a capital source for the commercial mortgages, the cost of capital related to a covered-bond deal could be less volatile than for CMBS.
"Such conditions also could assist financial institutions in aggregating collateral for a covered-bond issuance, in contrast with the aggregation difficulties now being experienced in the CMBS market," Hoeffel stated.
Covered bonds would be a "useful adjunct" to commercial mortgage securitization, he added.
– John Clapp, editor, Servicing Management