Paulson, Banks Push Covered Bonds

Take that, Fannie and Freddie. U.S. Treasury secretary Henry Paulson didn’t utter those exact words during a press conference Monday announcing a set of best practices for residential mortgage covered bonds, but he may as well have done so; flanked by major banking execs, Paulson unveiled a set of best practices for the bonds and talked about “increasing mortgage funding availability” and “strengthening our financial system.” Paulson, along with officials at the Federal Deposit Insurance Corp. and the Federal Reserve, have been eying covered bonds as a replacement for the frozen non-agency mortgage securitization market for months now. The FDIC already issued its own final guidance on their use by regulated banks on July 15. HW’s sources suggested that the Treasury secretary has been anxious to find something, anything that can potentially replace a growing reliance by mortgage originators and legislators on Fannie Mae (FNM) and Freddie Mac (FRE) — doubly so, given the Treasury’s likely soon-to-be expanded role as a direct backstop for their multi-trillion dollar operations. “In addition to securitization done by housing GSEs, private mortgage-backed securitization benefits the American consumer and our markets,” Paulson said in prepared remarks during Monday’s press conference. Translation: my free-market nerves cannot sit idly by and allow the GSEs to become the only game in town. What’s old is new again Covered bonds are essentially debt secured by residential mortgage assets that remain on the issuer’s balance sheet — and while they’re being touted by some as a new financial instrument, nothing could be further from the truth. Covered bonds have recently been as large as a $3 trillion market in Europe; use of the bonds dates back to the 1770s in Prussia, as well. But it’s worth noting that even the established covered bond market in Europe has been faltering as of late, as much of the country runs into residential housing headwinds of its own; sales of the debt have fallen to a six-month low and prices have dropped 2.5 percent this year, according to a recent report by Bloomberg News. Worse yet, the securities tend to trade well below their AAA-rated levels. But something is better than nothing. And when it comes to non-agency securitization, we’re most certainly talking about nothing; and that’s helped make what one market participant called “securitization’s red-headed step-child” start to look like an option, at least to the Treasury. “As we are all aware, the availability of affordable mortgage financing is essential to turning the corner on the current housing correction,” Paulson said. “And so we have been looking broadly for ways to increase the availability and lower the cost of mortgage financing to accelerate the return of normal home buying and refinancing activity.” This, of course, isn’t entirely about turning the corner on housing. It’s also about providing additional liquidity to financial institutions most in need of it. Four of the nation’s leading banks said on Monday that they’d look to jumpstart the covered bond movement here in the States, as a result. In a joint statement, Bank of America Corp. (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) announced their support for the initiative to create a covered bond market in the States. “We look forward to being leading issuers as the U.S. covered bond market develops,” the banks said in a statement in Washington. None of the four provided details regarding planned issuance of the bonds. Attorneys at Paul, Hastings, Janofsky & Walker LLP weighed in with a report Monday on the prospects for covered bonds in the U.S, noting that hurdles yet remain to widespread adoption. “It remains to be seen whether the current restrictions and inherent execution costs on covered bonds will allow the vehicle to become a viable substitute for alternatives such as Federal Home Loan Bank advances,” they wrote. “Covered bonds, which may have execution costs comparable to a securitization, do not provide capital relief.” But covered bonds may also be one of the only real options that can provide immediate capital for many banks; and for a mortgage market that has been battered over the past 12 months, that could end up being very good news, for everyone involved. Disclosure: The author was long FRE when this story was published, and held no other positions in firms mentioned in this story when it was published; indirect holdings of some firms may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.