Concerns about Covered Bonds
Discussed below are current issues and concerns that have been raised in connection with proposed U.S. covered bond legislation. Also set out are responses to the issues and concerns, which do not purport to represent all views or be complete. Comments and other views are welcome.
- Cannibalizing Securitization. Some commentators have raised the concern that if legislation for covered bonds were adopted in the U.S. it could cannibalize securitization, particularly mortgage securitization. The comment was raised in a post-crisis environment in which no private sector mortgage securitization was occurring. Even today, more than six years after the crisis, there is little private sector securitization of residential mortgage loans.
Response. Investors in covered bonds generally do not purchase RMBS or other ABS. Covered bond investors tend to purchase sovereign debt and agency debt and find covered bonds to present similar risks. They are attracted by the dual recourse nature of covered bonds, the statutory framework for issuance and issuance by regulated financial institutions. Covered bonds present no convexity risk, no complex class structures and generally are protected by high quality collateral. At a conference in Barcelona before the crisis, HSBC, which was a heavy user of both RMBS and covered bonds, stated that the bank viewed RMBS and covered bonds as alternative means of financing, the choice of which for any particular financing was determined by a variety of market and regulatory factors. There is every reason to expect that RMBS and covered bonds would co-exist in the U.S. market also as viable alternative means of financing.
- Cost to the Treasury. The Congressional Budget Office has released an assessment of the reduced tax revenue to the U.S. Treasury under H.R.940 as a result of banks using covered bonds rather than RMBS to finance mortgage loans. This loss is estimated to be about $500 million over ten years. The Joint Committee on Taxation sent a revenue estimate to the House Financial Services Committee. David Camp, Chairman of the House Ways and Means Committee, sent a letter transmitting the JCT revenue estimate and enclosing an amendment to H.R.940.
Response. One can quarrel with many of the CBO assumptions in this analysis, but perhaps the most misleading aspect of the conclusions is the failure to acknowledge that, as a result of a change by the FDIC in calculating the assessment for each bank to support the DIF from being based on deposits to being based on all liabilities of a bank, issuing covered bonds instead of securitizing will result in the FDIC collecting higher assessment fees. Moreover, the CBO does not appear to assume any value for the residual interest the FDIC would hold in a cover pool. This residual is intended to provide the FDIC with access to the excess value in the cover pool above what is required to repay the covered bonds.The amendments proposed by the Ways and Means Committee do not appear to do any harm to H.R.940 as a covered bond statute.
- Encumbrance of Assets. Among the concerns on covered bonds raised by the Federal Deposit Insurance Corporation is a concern that cover pools for covered bonds will tend to consume the better assets of a bank, leaving the FDIC with poorer quality assets to satisfy the claims of depositors and increasing the risk to the deposit insurance fund. The FDIC has also expressed a concern that over-collateralization levels can become larger as a bank's credit position deteriorates. They point to the nearly 50% over-collateralization in the Washington Mutual covered bond program shortly before the FDIC took over the bank. The FDIC also points to high over-collateralization in some European covered bond programs.
Response. First, the higher levels of over-collateralization seen in some European covered bond programs are perhaps a misconception. These levels generally are due to structural aspects of the mortgage business in some jurisdictions which result in a bank's entire portfolio being available to repay covered bonds. Second, many other forms of bank financing encumber assets, including central bank financing, repo financing, securitization, FHLB borrowings and various types of collateralized derivatives. To focus only on covered bonds tends as a policy matter to encourage the other forms of financing over covered bonds, which does not seem to be a wise policy choice. See a more complete analysis at A Battle over Collateral.
In the case of the Washington Mutual program, the high over-collateralization level arose from the peculiar structure used for that program. Under the terms of the program, in the event of the insolvency of the issuer the entire mortgage pool was to be liquidated and the proceeds were to be placed in a guaranteed investment contract. The proposed legislation would not conduct a fire sale of the entire cover pool at insolvency. Instead the assets in the cover pool would be retained in a separate estate and administered to pay the bonds in accordance with their terms.
The former general counsel of the FDIC has reported that prior to his departure the agency had agreed internally that the risk from encumbrance would be ameliorated by an 8% cap on issuance of bonds. This would certainly be an acceptable starting place for U.S. banks issuing covered bonds if it could be agreed to.
- Loss of Repudiation Power. The FDIC has complained that under the proposed legislation it would lose its traditional power to repudiate the obligations of a bank in resolving the receivership of a failed bank in the case of covered bonds. Instead, the cover pool would be separated from the failed institution and administered to continue making payments on the bonds.
Response. The FDIC has already lost its repudiation power in connection with several other means of financing bank assets: repurchase agreements, FHLB borrowings, central bank financings, securitizations and collateralized derivatives.
- Only the Largest Banks Benefit. One of the criticisms of covered bonds is that they would only benefit large, money center banks.
Response. The potential benefit to smaller and regional banks seems to be largely overlooked. Covered bonds would permit financing of commercial mortgage loans and loans to municipalities, assets for which smaller and regional banks do not currently have capital markets access.Moreover, the European jurisdiction with the most similar banking system in terms of number of banks is Germany. Germany has more that 2200 banks. It is the smaller banks in Germany that provide the bulk of the residential mortgage financing and they fund that activity in the covered bond market. Germany has a two-tier covered bond market: a domestic market (or private market) and an international market. The smaller banks finance in the domestic covered bond market, which does not attract international investors but which nevertheless continued to provide funds throughout the financial crisis. The purchasers in the market tend to be other local banks, local insurance companies, smaller retirement funds and other local investors who are able to focus on regional institutions. There is good reason to think that a similar market would develop in the U.S.
- Adversely Affect the FHLBs. Several of the Federal Home Loan Banks have raised the concern that covered bonds could damage the FHLB system by reducing usage of FHLB borrowings and that as a result the FHLBs might not be able to provide important support and liquidity during the next financial crisis.
Response. This argument seems to ignore the effect on the FHLBs of securitizations and the support provided by Fannie Mae and Freddie Mac for mortgage loans. Although some institutions relied heavily on FHLB borrowings to finance their mortgage lending prior to the financial crisis, there was extensive use of securitization and the GSEs; nevertheless, the FHLBs moved rapidly to inject massive liquidity into the banking system as the crisis developed. While it is possible that reliance on covered bonds could reduce borrowings from the FHLBs, it is also possible that instead the reduction would, at least in part, be a reduction in RMBS issuance or GSE financings. Moreover, there is nothing to suggest that heavy reliance on the FHLBs prior to a crisis is an essential predicate to the ability of the FHLBs to provide important liquidity as a crisis develops.
- Best assets are taken away. Sometimes regulators are heard to complain that banks will use their best assets for covered bonds thus leaving the regulator, in the case of a failure of the issuing bank, with lower quality assets to meet the claims of depositors.
Response. There are several responses to this concern. First, there is a certain level of risk in financing long term assets like mortgage loans with short term deposits and therefore some benefit to financing mortgage loans with longer term liabilities. Second, the same complaint could be made, but never seems to be, about securitization - the bank will securitize its best assets and leave the regulator with lower quality assets. Third, the complaint says something about the regulatory environment that lets a bank originate lower quality assets. Mortgage loans cannot be the only quality assets a bank can originate. And fourth, the complaint probably reflects a concern more with the size of the covered bond program relative to the bank's mortgage portfolio and therefore might be addressed with limits on issuance appropriate for the balance of different business lines of the bank.
- Refinance risk. Sometimes a concern is heard that covered bonds expose a bank to refinance risk when the covered bonds mature. Unlike a securitization, a bank continues to own the mortgage loans that are part of the cover pool. Thus when a series of covered bonds mature, the bank needs to find a new source of financing to pay off the maturing bonds and provide continued financing for the mortgage loan assets it holds. Most often this will be a new series of covered bonds, but there are also many other sources of funds available to a bank.
Response. This risk is reduced if covered bond maturities more closely match the maturities of the mortgage loans. But this response ignores the fact that the bank is continuously originating new mortgage loans and the mortgage portfolio is not in run-off mode. The answer to the concern really is that banks are always faced with refinance risk as funding matures - this is not unique to covered bonds. If a bank is unable to securitize it will face similar problems as loans pooled for a securitization are usually financed temporarily by short term warehouse lines of credit that require loans to be withdrawn after a period of time. Similar risks arise whether a banks finances with deposits or term funding of any nature. If deposits are withdrawn or funding is not renewed, there will be a need for emergency funding typically provided through central banks.
- Continued origination required. By design, covered bonds are not pass-through securities. As assets amortize or mature, funds received are used to purchase more loans to maintain the required asset coverage ratio of the cover pool. This requires the continued origination of new mortgage loans. Thus there is risk that if the bank is unable to originate mortgage loans in sufficient volume the cover pool may breach the asset coverage test, resulting in an event of default for the covered bonds.
Response. This is a risk that does not exist with securitization, but only exists with on-balance sheet funding. The concern is addressed in part with a limit on the portion of the mortgage loan portfolio that can be used for covered bonds. But the larger concern is that if a bank is unable to originate new assets, it will need to begin shrinking its liabilities. After all, assets and liabilities need to match (accounting for equity of course). An over reliance on long term funding increases a bank's exposure to this risk, so it is properly addressed through managing the balance of funding maturities.
- Covered bonds do not provide capital relief. True. The mortgage loans will continue to be carried on the balance sheet of the bank since they are owned by the guarantor, which is a subsidiary of the bank and consolidated on the bank's balance sheet. But few options exist for obtaining capital relief short of the outright sale of the mortgage loans.
Response. With the changing regulatory and accounting requirements, it is increasingly difficult for a bank to obtain capital relief through securitization, particularly when investors look for the securitizer to have a real continued interest in the performance of the assets. This requires a bank to keep a significant retained interest in the mortgage loans, complicating achieving capital relief. Funding mortgage loans through deposits or senior debt will not provide capital relief either. If there is a desire for capital relief, there will be a tendency to keep the best assets and sell or securitize the riskier assets as that probably will achieve the most capital relief. In that sense it is likely that the best assets will be used for covered bonds as some regulators complain.