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.