Covered Bonds: an Idea Whose Time Has Yet to Come

Today, July 28, 2008, the Bush 43 administration announced, with great fanfare, another idea for alleviating the mortgage crisis which it had seemingly sketched out on the back of an envelope: covered bonds. Covered bonds consist of a pool of mortgages, like mortgage-backed securities, in which investors buy interests. What makes covered bonds different is that the bank that packages the mortgages retains an interest in the pool, effectively guaranteeing some portion or all of the mortgages. This structure ensures that the sponsoring bank keeps some skin in the game. That way, it will have an incentive to underwrite mortgages that actually comport with reasonable credit standards, unlike the no income, no doc, no chance of repayment mortgages that became so fashionable in recent years. And, perhaps, best of all from the Republican standpoint, covered bonds can be underwritten privately, without seeming to require governmental assistance (including involvement by Fannie Mae and Freddie Mac, which are part of the government even though their profits accrue to their managements and shareholders).

This is a nice idea. It is logical. Covered bonds are already found in European financial markets, and may have helped to limit the extent of the mortgage losses there. So there is a track record that may lead one to think they could work here. In fact, the basic concept underlying covered bonds--that the underwriting bank guarantee the soundness of the loans--was commonplace in the U.S. 30 or more years ago, in syndicated bank loans. These loans were made to business corporations by a bank (the "lead bank"), which sold off portions of the loans to other banks (the "syndicate"). The lead bank was typically responsible for buying back the loan if the debtor defaulted, at least under some circumstances. The buyback obligation provided a strong incentive to the lead bank to make sure it dotted its "i's" and crossed its "t's." It couldn't afford to play fast and lose with credit standards.

The problem with the covered bond idea today is that banks need to have a nice cushion of capital in order to underwrite them. The sponsoring bank would have to keep the covered bonds on its balance sheet, and that would require capital. As we know from every day's financial news, banks are kind of short of capital right now, and there ain't no easy way for them to lay their hands on more. In the ordinary course of business, it will be years before banks have enough capital to issue covered bonds in volume. The only way the covered bond concept could be rapidly adopted would be to make massive infusions of taxpayer money into the capital structures of banks. Sadly to say, one suspects that senior officials at the Treasury Department may not have dismissed this idea as ludicrous.

What the covered bonds proposal reveals is the enormous dependency of the real estate market on securitization as its principal means of finance. And that, in turn, reveals the great extent to which the government relies on rising real estate values to keep the economy growing. But, as we now know, real estate values can't rise continuously. And asset speculation isn't a sound basis for an economy. Production of goods--manufacturing and agriculture--is at the heart of any healthy economy. However, instead of building for the long term, the Bush 43 administration, having only six more months in office, is acting like a short timer by proposing a supposed boost to the real estate markets it can't effectively implement. The upcoming presidential election can't come soon enough.