Covered Bonds May Play Role In Mortgage-Financing Fix

Mortgage Meltdown
Mortgage Meltdown

A little-noticed bill introduced in the House last March may be the first step in connecting financial reform efforts with the eventual attempt to restructure the nation's housing financial system and the deeply troubled Fannie Mae and Freddie Mac .

The U.S. Covered Bonds Act, introduced by Scott Garrett (R-NJ) and co-sponsored by Spencer Bachus (R-Ala.) and Paul Kanjorski (D-Pa.) and others, would add liquidity to the still sluggish credit markets and offer a private-market mortgage lending alternative to the government loans and guarantees of the two firms, which were taken over by the Treasury in September 2008 as the financial crisis was about to explode.

Garrett failed to get the measure included in the either the House or Senate versions of the financial reform bill, but there's some speculation it could wind up in the compromise bill that will will be crafted in the coming weeks by a House-Senate conference committee, of which Garrett could be a member.

"We're certainly going to certainly push it," Garrett told in an interview Tuesday. "We always saw it as a slice of the reform process. It's one of the few pieces that will do what the markets' need--provide certainty. It's not a total solution, but a piece of the puzzle."

The proposal is also likely to come up when the House subcommittee on capital markets—whose senior members are Kanjorski and Garrett—takes up the issue of the government-supported housing market with Edward J. DeMarco, acting director of the Federal Housing Finance Agency, at a hearing Wednesday.

The proposal hopes to free up mortgage lending through the use of so-called covered bonds—debt securities that are backed by the cash flow of a loan such as a mortgage. The loan is secured—or covered—by a pool of assets that investors can claim rights to if the issuer, or originator, becomes insolvent.

Though covered bonds are common in European countries, they are relatively rare in the U.S. Bank of America and the old Washington Mutual, now a unit of JPMorgan Chase , have issued them and firms like BlackRock and Pimco invested in them. But proponents in the US argue that covered bonds need a solid legal framework with clear rights of onwership to create and drive a healthy, dynamic marketplace.

The push for covered bonds is not new, but the timing is probably better.

In mid 2008, with Fannie and Freddie clearly in trouble, Treasury Secretary Henry Paulson lined up four large US banks to kick-start a covered-bond market, largely as an alternative to mortgage-backed securities. The mortgage market meltdown and broader financial crisis snuffed out the effort.

Today, it's exactly that MBS alternative that's makes covered bonds so relevant, especially since the Obama administraion and Congress opted to keep any overhaul of the two mortgage giants and the mortgage finance system out of the regulatory reform bill. Legislation won't happen until 2011 at the earliest.

"There's not a lot of certaintly about how the GSE debate will evolve and play out," says one market player, referring to Fannie and Freddie's special status as government sponsored enterprises. "The securitization business is obviously still struggling. You need more tools, It's better you have the options."

Proponents point to the dark early days of the financial criss when the government's plan to buy toxic assets from a market with little or transparency was dropped.

Rep. Scott Garrett (R-N.J.)
Scott J. Ferrell | Getty Images
Rep. Scott Garrett (R-N.J.)

"It's a very feasible financing option," said Alex Pollock, a former CEO of the Federal Home Loan Bank of Chicago and now a resident fellow at the American Enterprise Institure. "The loan stays on the balance sheet. You get skin in the game with the retention of credit risk. The bank issuing the bond mantains 100 percent of the credit risk."

Covered bonds do not have the complex and sometimes vague ownership structure of the securitization market that made dealing with mortgage-backed securities a legal and logistic nightmare.

"There's no 127 holders and knowing what they want to do," said Lawrence White, a former regular and White House economist now with NYU's Strern School of Business. "Those poblems go away."

Just how much of an impact covered bonds would have is a matter of some debate.

Some proponents go so far as to say that the MBS market could eventually be replaced entirely by covered bonds, assuming the right transition leading up to the eventual dissolution of Fannie and Freddie.

"I see no reason why you need to have a government securitizer," says independent bank analyst Bert Ely, who argues that the current model emphasizes an originate-to-sell rather than the originate-to-hold biz model. "If you have covered bonds by mortgage originators I'm not sure you need Fannie or Freddie."

Others don't see that kind of impact. "It's a tiny first step," says White. "I don't think we are going to see $5 trillion of this stuff replace the $5 trillion Fannie and Freddie either own or have securitized."

Certainly not any time soon, but the time may be right just the same.

"It's been a long haul over the past two years to keep it alive, but the market is still interested in covered bonds" says Sean Davy, a covered bonds expert and managing director at the Securities Industry and Financial Markets Association.