FDIC Paves the Way to Covered Bonds

In a move that at least one market expert has been suggesting was needed for months, the Federal Deposit Insurance Corp. suggested late Friday that it would look to expand a key debt guarantee program to accommodate covered bond issuances; the move represents the latest and most significant effort yet to bring in fresh liquidity to an ailing national mortgage market. In a Friday statement announcing further aid to Bank of America Corp. (BAC), the FDIC also said that “it will soon propose rule changes” to its Temporary Liquidity Guarantee Program, extending the maturity of the current guarantee from three to up to 10 years and changing the program to cover all debt issuances backed by collateral. Linda Lowell, a veteran ABS/MBS researcher, had suggested in the January/February issue of HousingWire Magazine that such a move was clearly needed. An excerpt from that story: “There is a step the government can take now to accelerate development of this market [covered bonds]. The FDIC could extend the TLGP facility to include covered bonds issued in accordance with its regulations and the Treasury’s Best Practices. A foreseeable objection would be that covered bonds increase risk to the insurance fund to a degree, by allowing covered bond investors a priority claim over the cover pool assets (thereby reducing assets available to satisfy depositors). Current FDIC policy already addresses this risk by restricting a bank’s covered bond issuance to a maximum of 4 percent of its total liabilities. Furthermore, banks in the TLGP pay an insurance fee for the guarantee—couldn’t the FDIC resolve an appropriate fee to reflect the risk in guaranteeing covered bonds? Another step the FDIC could take to encourage the development of a covered bond market sooner rather than later would be to authorize inclusion of other assets. U.S. regulators have already moved to support consumer-asset-backed securities—simply expanding covered bond collateral to include credit card receivables, auto loans and student loans would be another step in the same direction. Other commentators have recommended adding loans to public sector borrowers, a step that would increase liquidity available to strapped local governments.” FDIC spokesman Andrew Gray confirmed to Bloomberg News on Friday that the decision to expand the TGLP is largely centered on paving the way for covered bonds, which typically have maturities that outrun the three-year guarantee originally put into place via the program. In contrast to off-balance-sheet securitization vehicles, covered bonds are essentially debt secured by assets that remain on the issuer’s balance sheet — and while they’re being touted by some as a new financial instrument, nothing could be further from the truth. Covered bonds have recently been as large as a $3 trillion market in Europe; use of the bonds dates back to the 1770s in Prussia, as well. Outgoing Treasury secretary Henry Paulson and Federal Reserve chairman Ben Bernanke have since spring of last year been talking up the prospects of a covered bonds market in U.S., as a viable method for replacing the private-party securitization market that has largely imploded in the wake of a historic credit crisis. But since the program was first announced last July, and four of the nation’s largest commercial banks pledged to issue the bonds, nothing has been done. At least part of the hold-up, according to market sources, has been the FDIC’s TGLP, which offers banks a superior source of funding; also on the list is the cheap availability of advances via the Federal Home Loan Bank system. “As a form of mortgage funding, covered bonds are unlikely to be very competitive versus the alternatives of equity capital from the Treasury and 3-year FDIC-guaranteed senior unsecured bank debt,” analysts at Bank of America said in a late October research report. Of course, that was before the FDIC signaled that it might make the TGLP the vehicle to drive the covered bond market into existence. That said, don’t expect such a market to emerge overnight. On-balance sheet financing of any form — covered bonds included — is going to remain scarce so long as banks need further capital infusions to cushion against further losses in existing loan books; covered bonds use capital, after all, rather than releasing it. And investors will closely scrutinize the capital position of any issuing bank, given that covered bonds provide recourse to the issuing entity. Nonetheless, the news from the FDIC comes as serious cracks are beginning to show in the nation’s FHLB system, and the future of Fannie Mae (FNM) and Freddie Mac (FRE) continues to be debated. See an earlier HW report that broke news of trouble at the FHLBs. In other words, the GSE market as we have long known it is more than likely to go through a dramatic shake-up all its own over the course of the next year or two. Something is going to have to fill the funding void, and that may be true of more than just the currently-frozen non-conforming mortgage space. Write to Paul Jackson at [email protected]. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.