Why is the adoption of covered bond legislation linked to housing finance reform? Housing finance reform is all about the role of the GSEs. While covered bonds certainly can be used to finance residential mortgage loans, they do not require any form of government support. The consideration of the proper role of the government in housing finance can occur independent of covered bonds. However, I hear from many sources that covered bond legislation would only be considered after GSE reform had been adopted or perhaps considered with GSE reform.
There is no apparent logic to this position. Covered bonds are a private sector financing technique that has proved very effective in other jurisdictions. There is nothing in GSE reform that would be a necessary predicate to the issuance of covered bonds by U.S. banks. Covered bond legislation would not touch the status of the GSEs. It is possible that covered bond issuance by U.S. banks could develop into an attractive alternative to financing through the GSE and thus reduce the tension in GSE reform, but that would be beneficial to GSE reform.
It seems as though both sides are determined to keep as much pressure on GSE reform as possible in order to achieve their objectives and not permit any private sector initiatives to sidetrack the discussion until the role of the government in housing finance has been solved. But this seems to put the cart before the horse. Shouldn’t the government intervene only where the private sector is not functioning properly? Wouldn’t it make sense to let private sector initiatives develop first before assigning the government a role? If we can agree that the answer to those two questions is yes, why not adopt covered bond legislation and see how the market develops while we debate how to wind down the GSEs and what would be the appropriate future structure for the government’s role in housing finance?
Certainly we can have a fulsome debate on how the government can support housing access for those who need assistance independent of how covered bond legislation is drafted. Certainly if covered bonds, RMBS and the federal home loan banks fail to provide adequate private sector funding for residential mortgage loans there may be a need to consider a larger government role.
It is not essential that covered bonds be enabled through legislation as it is possible to achieve covered bond issuance through securitization techniques, as has been done in other countries. See, e.g., Time for a US alternative. However, investors will have more confidence in a covered bond sector established through legislation and the market may be expected to develop quicker with legislation. Enacting legislation for covered bonds would be a low cost experiment that would have no harmful side effects. Covered bond legislation, therefor, should be enacted before GSE reform is attempted so that we have a better chance to assess what works in the private sector before designing the government’s role in housing finance.
Why not covered bonds?
Why not pass legislation for covered bonds in the United States? It is easy to do and there is basically no cost to the Treasury. In 2011, covered bond legislation passed the House Financial Services Committee by a vote of 44 to 7, a very strong bi-partisan vote. The only dissenters were hoping to implement provisions requested by the FDIC that were rejected by the majority. The dissenters were unable to retain even members from their own party on the final vote. Probably more than any other development, this demonstrates that covered bonds are not a partisan concept, they are not divisive and they have broad support.
Covered bonds will bring private funding to residential mortgage loans, but there is no good reason that passage of covered bond legislation should be tied to GSE reform. There is nothing about covered bonds that would implicate GSE reform, except that by bringing private funding to the market they could reduce the dominate role of the GSEs. And there is no credible evidence that either party in Congress believes that a continued dominate role for the GSEs is a policy mandate.
An unlike securitization of residential mortgage loans, no concerted effort is needed to get investors to participate. Investors are wary of residential mortgage securitization as a result of the financial crisis, which was precipitated by mortgage securitization. There are many efforts underway to convince investors to return to the RMBS market. Covered bonds carry no such baggage. Covered bonds have been readily sold to U.S. markets since 2010 and investors remain eager for more.
Covered bonds are more transparent to regulators.
Covered bonds are a simpler investment analysis for investors.
Covered bonds are proven financing technology with worldwide acceptance.
Covered bonds are friendlier to mortgage borrowers because the originator retains the right to modify loans to assist borrowers in working out difficult loans.
What’s to lose? Maybe covered bonds could develop into a vibrant private sector funding alternative for residential mortgage loans. If not, no loss. And no cost. But if it works, it’s a plus all around.
In the United States there is a lot of discussion about how to reduce the taxpayers' exposure to housing finance. The conservatorships of Fannie Mae and Freddie Mac were a pointed reminder of the extent of the government's, and the taxpayers', role in housing finance. Additionally, after being taken into conservatorship, the GSEs were intentionally used to prevent a feared collapse of the housing market, further expanding their role.
As a result, the GSEs, together with FHA and GNMA, at one point provided more than 95% of the financing for new residential mortgage loans, and today they still finance roughly nine out of every ten new mortgage loans. At the same time, the private label securities (PLS) market, which provided significant private funding for residential mortgage loans, essentially vanished. The issuance of new PLS declined nearly 99% in the years following the crisis.
Today there is general agreement across the political spectrum that it would be desirable to restore some level of private funding for residential mortgage loans and reduce the role of the GSEs. There are also plans to reform the GSEs and refine their mission in housing finance. There is less agreement on the reform proposals.
On June 27, 2014, Treasury Secretary Jacob Lew requested comment on what steps could be take to restore a functioning PLS market. Almost uniformly the commenters voiced the need to shrink the presence of Fannie and Freddie in the market in order to make room for a PLS market. This reflected the view that under the existing authority of the GSEs, the private market would not be price competitive and would only be able to finance a small number of loans that did not qualify for financing through the GSEs under their very high loan limits.
However, the presence of the GSEs is not the only factor impeding the development of the PLS market. The regulatory landscape for securitizing mortgage loans has been altered dramatically since the crisis. Basel III imposes heavy, in some cases almost punitive, increased capital requirements on banks and most particularly for securitization exposures held by banks. The risk weighting for securitization exposures can range up to 1250% and in some cases, such as non-cash gain on sale, the capital requirements will result in a deduction from Tier 1 equity capital. Rulemaking by the Consumer Financial Protection Board exposes any holder of a mortgage loans to severe penalties for those loans not underwritten in accordance with the CFPB underwriting criteria, which are designed to protect the borrower. SEC requirements for mortgage securitization require 270 data points of information to be disclosed for every mortgage loan in a securitization, both at the time of the offering and in periodic reporting for the life of the securitization. Then there is risk retention, prohibited conflicts of interest, margin requirements for swaps, the Volcker Rule, conflicting requirements in foreign securities markets and a litany of other burdens on the PLS market.
So while shrinking the GSEs may be viewed as a necessary condition to restarting the PLS market, there is no consensus that shrinking the GSEs will by itself restore the PLS market. And there has to be some hesitation in shrinking the GSEs, if there is no confidence that the PLS market, or some form of private funding, will be there. So we have a chicken and egg problem. There is, of course, a bit of a safety valve in that banks can hold mortgage loans on balance sheet and fund them through deposits or senior debt. But that is not viewed as other than a temporary solution.
This situation requires then that any shrinking of the GSEs be done slowly and limited to the extent that private funding alternatives develop. Else you run the risk of severely limiting funding in the housing market. But this approach raises the question of whether the private sector will bother making the necessary investments to issue PLS if the market is going to be so small for quite some time.
It would seem that covered bonds could provide a solution to this problem. Covered bonds provide private sector funding for mortgage loans held on balance sheet at very efficient rates compared to senior debt. And covered bonds provide term funding and a much improved asset-liability mismatch compared to deposit funding. Thus the use of covered bonds could expand the utility of the safety valve, allowing the GSEs to shrink quicker.
Do covered bonds displace the PLS market? The answer is no, but it is a qualified no. Enabling domestic banks to issue covered bonds may induce some greater retention of mortgage loans as a result of the financing efficiency of covered bonds over senior debt. Securitization transfers the risk of mortgage loans to investors, getting the loans off-balance sheet, and investors are repaid solely from cash flows on the mortgage loans. Covered bonds, on the other hand, provide funding for loans that are hold on-balance sheet; the bonds are senior obligations of the issuing bank. Thus the two financing techniques are not directly competitive. And enabling domestic banks to issue covered bonds would allow the GSEs to shrink faster and enhance the likelihood of restoring a PLS market.
The covered bond market has been developing nicely in the United States through sales of covered bonds issued by foreign banks to U.S. investors. There are now about $150 billion of U.S. dollar denominated covered bonds outstanding. There is also well-developed draft legislation that has attracted strong bi-partisan support in Congress. It is legislation that could be enacted quickly if the administration were to push for it.
An idea worth considering.
On August 8, Morrison & Foerster LLP filed a comment letter with the United States Department of the Treasury in response to a request for comments on the private sector development of a well-functioning private label securities (PLS) market for residential mortgage loans. The comment letter notes that perhaps the easiest way to restore private funding to residential mortgage loans in the United States is to implement a covered bond statute in the United States to enable U.S. banks to issue covered bonds. The letter notes that the conditions necessary to the establishment of a covered bod market in the United States are well advanced and that the market could be established quickly. Based on the development of the investor base in the United States, the SEC's establishment of disclosure and reporting standards, and the well-developed legislation, creation of a domestic covered bond market would appear to be low hanging fruit that Treasury should take advantage of.
Speaking in Washington on June 26 before the Making Homes Affordable Five Year Anniversary Summit, U.S. Secretary of the Treasury, Jacob Lew, gave a speech in which he addressed the need for housing finance reform. He also noted almost a complete absence of a private label securities market almost six years after the crisis and a need to restore private funding to the residential mortgage market. He noted that a series of questions was posted to the Treasury website seeking comment by August 8, 2014 on recommendations for reviving the private label securities market.
Neither Secretary Lew’s speech nor the posted questions mention covered bonds. Clearly covered bond legislation for the United States should be considered by the Treasury. The legislation introduced in 2011 by Representative Garrett, H.R. 940, passed the House Financial Services Committee by a very strong bi-partisan vote of 44-7. Passage of covered bond legislation should be easily achievable with Treasury backing and covered bonds could provide an important channel of private funding for the mortgage market. After all, covered bonds provide funding for about €3 trillion in the European market and the domestic U.S. market for covered bonds issued by foreign has shown healthy growth.