U.S. representative Scott Garret have proposed a legislation on how to create a functional market for the massive amount of covered bond that has been issued during the financial crises. This is the way governments have tried to solve every economic crisis over the last 250 years. And they’ve basically failed every time.
“The proposal seems designed to solve a wide range of pressing asset refinancing problems facing banks, not to create a market that will last decades or centuries to come.”
“Covered bonds are a proven and useful tool for supporting mortgage finance in Europe – and the Congress is right to be considering legislation to start such a market the US. But the bill introduced by Congressman Scott Garrett in the House needs to be changed if it is to restore investor trust and provide needed new liquidity to real estate markets,” Hans-Joacim Dübel at Finpolconsult writes.
Covered bonds work when they are simple, conservative and transparent. These principles, and not the interests of bankers or intermediaries, should drive legislative design, Mr. Dübel points out in an article published by Institutional Risk Analyst.
Hans-Joacim Dübel is an independent, international mortgage finance consultant and founder of Finpolconsult, a financial sector think-tank based in Berlin/Germany.
He has authored several European mortgage market studies in the past 15 years and was member of the E.U. Commissions Mortgage Funding Expert Group in 2006. He has been continuously working on U.S. housing finance system issues for the past 10 years.
Achim recently consulted on the creation of covered bond laws in Turkey and Uruguay.
Covered bond laws often come from crises
According to Dübel, the deep German real estate and banking crisis of the 1890s helped create the Pfandbriefe. The bankruptcy in the 1990s of the Credit Foncier de France, Europe’s oldest mortgage bank founded in 1852 led to the Obligations Foncieres.
The new laws always required very secure cover assets (high quality real estate or state guarantees) and conservative lending practices.
The simple, yet clearly defined design of covered bonds limits the number of counter-parties involved and keeps issuers accountable.
As a result, covered bonds became attractive for generations of European investors and required no external ratings until very recently.
Denmark May Be On To Something
There are varying types of European covered bonds, and they performed very differently last year. Denmark’s Realkreditobligationer, a pass-through bond basically unchanged since 1850, survived the financial crisis without tapping government support, Dübel notes.
“More common portfolio covered bonds require regular rolling over because of the mismatch in maturity between the cover assets and the bond; many of these ran into trouble last year. Governments and ratings agencies are taking notice.”
“Covered bonds weren’t exempt in Europe from the liberalization trend of the past decades. Issuers tried take a free ride on the existing simple and accepted bond products, introducing loans secured by movable assets or securities as cover assets. However, such departures from the basic concept of the bonds were occasional and did not alter the character of backing by either high-quality real estate or state guarantees.”
“The key point to make in all successful covered bond programs such as Denmark is that the interests of the borrower and the investor who ultimately holds the loan, not of the banker that makes the loan and issues the bond, must be paramount.”
Disregarding Historical Lessons
The current US proposal sponsored by Rep. Garrett, in contrast, seems to disregard many lessons learned from the financial crisis in the U.S. proper, Mr. Dübel says.
“Garrett’s proposal seems to ignore the bias for conservativeness needed to build investor trust when a new product is launched. In fact, the current covered bond proposal before the US Congress seems designed to solve a wide range of pressing asset refinancing problems facing banks, not to create a market that will last decades or centuries to come.”
“This follows a pattern of US financial history over the past century where the immediate wants and needs of the banks have been put ahead of the long-term interests of consumers and investors.”
For example, the Garrett bill allows for an unusual menu of eligible collateral in the covered bond pool, including securities that may introduce legal and agency (rating) risk, financial assets not backed by real estate or public guarantees, and short-term assets that can be perfectly financed by deposits. Even home equity loans, a symbol of irresponsible lending practices, have found their way into the Garrett bill.
“The present bill leaves lending standards – for real estate and other purposes – up to the primary regulator’s discretion and even allows ex-post inclusions of financial assets underwritten under historic standards. It ignores the importance of low loan-to-value ratios and specific real estate valuation standards.”
“Clear standards have featured prominently in European legislation; they are particularly relevant for a jurisdiction recovering from the financial fallout of large residential and commercial real estate price cycles.”
Moreover, the proposed transparency requirements over the cover pool assets fall behind established US standards. And the absence of a clear definition of the basic asset-liability management principles renders market and liquidity risk exposure of issuer and cover pool an unknown.
“These issues, seemingly, are left de-facto to the discretion of his primary regulator. Precisely those aspects of bonds that proved problematic last year are encouraged or ignored by the Garrett legislation; the best practices of the Danish balance principle are unnoticed.”
A potentially unlimited range of counter-parties involved in derivative and insurance protection of the cover translates into an ambiguous credit support structure that can vary from issuer to issuer, and is hard to analyze for investors.
Bonds issued under the bill, in fact, will be closer in character to so-called ‘structured’ covered bonds, bonds that were created as arbitrage products in Europe allowing for lower precision of design, than to general statutory covered bonds.
These hybrid bonds faced even greater problems through the crisis.
“Because of loosened standards on asset eligibility, risk management and counter party selection, high amounts of overcollateralization will be required by the market to render the product suggested by the Garrett proposal palatable for investors.”
“These loser standards promise to highly subordinate bank depositors and unsecured bondholders on the bank balance sheet, and also raise the likelihood that insufficient funding liquidity will be available to a trustee appointed in insolvency. The result is an increased reliance on, and adverse selection of, public insurers of first and last resort, i.e. the Federal Deposit Insurance Corporation and the Federal Reserve System. This reliance on federal backstops comes even though an explicit role for the Federal Reserve System in liquidity provision, such as present in the case of Fannie Mae and Freddie Mac, has been avoided until now.”
A bond with such an unusually high level of implicit government support will still be only mildly attractive for large, too-big-to-fail US banks who can save issuance costs by relying on unsecured bonds.
However, it will be very attractive for mid-sized banks that currently face strict market discipline through the threat of FDIC intervention, including possible claw-backs of securitized or pledged assets, and by implication high unsecured and even occasionally secured funding costs.
“In its current version, the Garret proposal in effect promises to just extend even further the life preserver of implicit federal guarantees for the U.S. financial system.”
“The U.S. would be better off with a bill that tries to truly lay the foundations for a new private bank bond market, a “gold standard” for financing retail and commercial mortgages that is based on high-quality assets and restoring private market discipline in a vital sector of the economy, namely real estate finance,” Hans-Joacim Dübel concludes.
“Legacy problems with shaky assets of all colors of bank balance sheets should be solved via bad banks and/or bank insolvency and restructuring, not in legislation that seeks to create an entirely new secondary market for selling bank mortgages to investors.”
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