Covered bonds could be the next U.S. repo collateral

Covered bonds appear to be a candidate to replace asset-backed securities and asset-backed commercial paper as collateral for repo loans on the U.S. repurchase market, because they may be more acceptable to post-crisis investors. But covered bonds will not prevent the next panic, unless regulators do a much better job of monitoring them.

New York Times columnist Gretchen Morgenson writes March 27 about the growing interest Wall Street has in developing a U.S. market for covered bonds, which have been used for years in Europe.

She does not explain that the drive for covered bonds, and their potential danger, is tied to the repurchase market.

In the past decade, the housing bubble was financed mainly by repurchase agreements collateralized by asset-backed securities and asset-backed commercial paper. Since the financial crisis of 2007-2008 and the death of securitization, financial institutions have relied on government debt and securities backed by the U.S. taxpayer – that is, those insured by agencies like Fannie Mae and Freddie Mac – as repo collateral.

But with Fannie’s and Freddie’s future uncertain, and asset-backed paper out of favor since its rout in 2007-2008, it’s unclear where financial institutions will get the repo collateral to finance their growth.

One idea is covered bonds, which are similar in many ways to asset-backed securities, with one big difference, at least in theory.

In asset-backed securities, financial institutions (1) make or buy loans and (2) sell or repo them to trusts that (3) pool them and (4) sell or repo asset-backed securities backed by the loans to investors. The financial institution no longer owns the loans.

In covered bonds, financial institutions (1) make or buy loans, (2) pool them, (3) issue securities backed by the loans, and (4) sell or repo the securities to trusts that (5) sell or repo covered bonds backed by the securities to investors. The financial institution still owns the loans.

Some Wall Street critics are looking on the covered bond approach with favor as a way to avoid the originate-to-distribute problem, that is, banks making loans without a care for their quality because the bank intends to sell the loans to others.

But as RepoWatch readers know, the problem in 2007-2008 was not that financial institutions were off-loading risk by selling the loans to others. Instead, the problem was that financial institutions kept one-fourth of the securities themselves and used many of them to collateralize repo loans. When their values tanked, so did the banks.

In that sense, covered bonds may be a safer deal for investors than asset-backed securities, but in the long run they could pose the same threat to the financial markets.

From “Frequently asked questions about covered bonds” by lawyers with Morrison & Foerster last year:

Banks, which comprise a significant portion of the covered bond investor base, tend to hold covered bonds as collateral for their repo activities….

Covered bonds are not limited to mortgage funding. Similar to securitization, covered bonds are a way to fund originations of receivables, such as auto loans and credit card receivables. For now, while the securitization market is closed, it may be the only way to fund the origination of such receivables. Ultimately, as markets re-open, it is a way to diversify funding sources and to compete with European depository institutions that regularly access the covered bond market.

With the securitization market closed to financial institutions and other sources of lending either scarce or more expensive, the U.S. government views covered bonds as another funding source that may assist in reviving the lending  market….

Both the FDIC and the Treasury Department issued statements in July 2008 giving guidelines for the use of covered bonds.

Here are other ways covered bonds are similar to asset-backed securities:

– In both, investors are unaffected if the bank becomes insolvent. The payments they’re receiving cannot be seized by the bank’s creditors, including the FDIC.
– In both, regulators require banks holding them to have a lot less equity, or capital, than for some other kinds of debt.
– In both, the bank can change the loans that are in the pool.

Some theoretical differences, which could change when we’re not looking:

– Covered bonds aren’t tranched.
– Covered bonds have to represent high-quality loans, whatever that means.
– Since in covered bonds the loans stay with the banks, regulators will require banks to have reserves and equity to cover the loans.

Morgenson calls attention to Wall Street efforts to use covered bonds to restart securitized banking:

…  the big banks and the housing-financial complex are arguing that if private investors are to return to the mortgage market, we must create a new instrument that will let the good times roll again.

Covered bonds are pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets. The bank that issues the bonds, meanwhile, retains the credit risk. If losses arise, the bank that issued the covered bonds must offset the loss with its own capital. That could push troubled banks closer to the edge.

If an asset in the pool defaults, a separate entity would be required to remove the assets from the bank’s control. The assets would then be out of reach of the F.D.I.C. should the bank fail and the agency step in as receiver. The investors who bought the covered bonds would have first call on the assets, ahead of the F.D.I.C.

This structure would wind up bestowing a new form of government backing to the major banks issuing the bonds, raising the potential for losses at the F.D.I.C. insurance fund, which protects savers’ deposits.

Equally troubling, the covered bond structure favored by the banks would let the pools invest in risky assets such as home equity lines of credit. These loans have been among the worst-performing assets out there. Covered bonds issued overseas, by contrast, typically consist solely of high-quality loans.

“The industry is trying to do an end run around the F.D.I.C.,” said Christopher Whalen, publisher of the Institutional Risk Analyst. “This proposal is about restarting the Wall Street assembly line for selling toxic waste to investors.”


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