Bernanke Pushes Covered Bonds as GSE Alternative

In wide-ranging remarks that admitted the fundamental breakdown of the mortgage financial machine, Federal Reserve chairman Ben Bernanke last week discussed the three big-picture options now on the table as they relate to both Fannie Mae (FNM) and Freddie Mac (FRE) in particular, and as they relate to mortgage finance, in general: privatization of the GSEs, nationalization of the GSEs, and the development of a viable covered bond market. “The financial crisis has upset the linkage between mortgage borrowers and capital markets and has revealed a number of important problems in our system of mortgage finance, including weaknesses in the structure and oversight of the GSEs and perhaps in the originate-to-distribute model of credit provision itself,” he said at joint UC Berkeley/UCLA symposium covering the nation’s mortgage meltdown. While he discussed prospects of nationalization and privatization of the GSEs, it’s clear from his remarks that Bernanke sees covered bonds as the potential best-hope scenario for replacing much of the liquidity now missing from the private-party mortgage market. “GSE-type organizations are not essential to successful mortgage financing; indeed, many other industrial countries without GSEs have achieved homeownership rates comparable to that of the United States,” he suggested, arguing that covered bonds have become the primary source of mortgage funding in major European countries. U.S. regulators and policymakers, including Treasury chief Henry Paulson and FDIC chair Sheila Bair, have been pushing covered bonds as a replacement for off-balance sheet securitization in recent months; we’ve been told this is largely because the Federal Accounting Standards Board is likely to push through changes to key accounting rules that will disallow much of the off-balance-sheet treatment central to most securitization activities. “Covered bonds do help to resolve some of the difficulties associated with the originate-to-distribute model,” Bernanke said in his remarks. “The on-balance-sheet nature of covered bonds means that the issuing banks are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization.” While the four major commercial banks — Bank of America Corp. (BAC), Citigroup Inc. (C), JP Morgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) — made a commitment to issue covered bonds and build a market, analysts remain especially unconvinced given other forms of available funding for banking operations. “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. “The FDIC guarantee program ends on June 30th, 2009 and we may see institutions focus on diversifying their sources of funding.” Most analysts said they could see covered bonds as a potential replacement for securitization in the jumbo mortgage market, which has literally died in the current credit crunch; no one yet sees the market for covered bonds competing the with GSEs or FHA as sources of mortgage funding. But even that market slice is likely to be limited, given the new FDIC guarantee on bank debt and the Treasury’s capital injection program, as both are seen as superior sources of funding relative to covered bonds. Neither of those weaknesses were mentioned by Bernanke, however, during his speech. He did note that banks’ current access to the FHLB system would hinder covered bonds as a funding source, as well, saying that “given longstanding features of the U.S. system such as the prominent role of the Federal Home Loan Banks, covered bonds may remain an unattractive option to U.S. banks.” Which in many ways leaves us back at ground zero: how does this now-largely broken industry fund loans other than those that squeeze into a government guarantee, explicit or otherwise? And even for those loans receiving an “effective” guarantee via Fannie and Freddie, as FHFA director James Lockhart suggested last week, can we ever consider placing that funding machine back into private hands and expect it to capitalize the nation’s mortgage banking system? “We must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but that does not create institutions that pose systemic risks to our financial markets and the economy,” the Fed chair said in his closing remarks. “Government likely has a role to play in supporting mortgage securitization, at least during periods of high financial stress.” Like, well, right about now. Write to Paul Jackson at

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