Covered bonds are bonds issued by financial institutions. These bonds are backed by pools of loans. The performance of these loans and hence the performance of these bonds is guaranteed by the financial institution. If a loan becomes delinquent by 60 days, it must be replaced with either cash or a new performing loan.
In the event of bankruptcy of the issuing financial institution, these bonds have priority to the cash flow from the loans in the pool. More importantly, as proposed in the Act, these bonds also have priority over the FDIC claim to the cash flow of the failed financial institution.
The bonds are therefore effectively guaranteed by the US government.
The authors of the Act recognized this. They also recognized that it would increase the losses incurred by the FDIC in resolving financial institutions that had outstanding covered bonds. To protect the US taxpayer, they instructed the FDIC to increase its deposit insurance premium to cover any losses incurred as a result of the covered bonds.
Would the US taxpayer be protected?
Imagine that private label residential mortgage backed securities did not exist. Instead, as allowed under the Act, financial institutions issue $2 trillion of covered bonds backed by sub-prime mortgages. Unfortunately, as they are prone to do, the sub-prime mortgages stop performing.
As the hundreds of billions of non-performing sub-prime mortgages are taken out of the covered loan pool, the issuing financial institutions are required to recognize the loss in value from the impairment of these mortgages. Bottom-line, the financial institutions do not have the capital to absorb the losses and the financial institutions themselves require an FDIC resolution.
Is it realistic that the FDIC could increase its deposit insurance premium on the surviving banks enough to cover $1 trillion in covered bond related losses? No!
The US taxpayer is fully on the hook for the losses under the US Covered Bond Act of 2011. This design flaw is so obvious that even the Administration commented on it in the following article by Reuters [if this legislation progresses, a subsequent post will address another major design flaw: the lack of information on the underlying loan performance],
Treasury Secretary Timothy Geithner on Tuesday backed efforts by U.S. lawmakers to create a new market for financing mortgages that would help wean the $10.6 trillion U.S. mortgage market from government support.
Geithner said he backed efforts to create a market for covered bonds, which are securities issued by banks and backed by pools of loans. The loans underlying covered bonds remain on the issuer's balance sheet.
That is different from the the current U.S. mortgage system, where lenders sell many of the loans they make to Fannie Mae and Freddie Mac, which then repackage them as securities for investors.
"We would support legislation that would help create better conditions for a covered bond market," Geithner told the Senate Banking Committee in response to a question from Senator Charles Schumer.
Republican Representative Scott Garrett, a strong proponent of covered bonds, last week called advocates to testify to a House panel heads to push the idea. He thinks a covered bond market could lessen the role of Fannie Mae and Freddie Mac.
Schumer, a Democrat, said he was considering introducing a Senate version of Garrett's bill.
... In Europe, covered bonds have long been in use. But they have failed to catch on in the United States.
In a covered bond system, banks can borrow against the value of the underlying mortgages to obtain fresh capital to extend further loans. The bond investors have the right to those underlying assets in the case of a bank default.
The Federal Deposit Insurance Corporation has warned a covered bond system could put its bank deposit insurance fund at increased risk for losses because the investors would have seniority over the agency in the event of default.
Geithner said the FDIC concerns are legitimate and would have to be worked out.
"For this to work, you would be putting the taxpayer in some sense behind private investors, and that has its own consequences, but that is something we can work through and I think it can play a greater role in our system," Geithner said.
The White House and Congress are in the midst of a major policy debate on how to overhaul the finance system for buying U.S. homes, which collapsed in 2008.
The Obama administration last month announced several steps to make those government-backed mortgages more expensive in a bid to lure private capital back to the mortgage market.