In the wake of the bubble, all mortgage finance is political finance. Even though the house prices on which debt was built have disappeared, the debt is still with us as a debt overhang, or better, hangover. Fannie and Freddie are broke. Should US dollar-denominated, US issuer covered bonds be an important part of the reformed US housing finance sector? Yes.

Covered bonds can provide long-term financing for mortgages. They represent 100% "skin in the game" by the issuer-a very good feature. So covered bonds should be the policy agenda on the basic financial merits, but the political outcome of the current covered bond proposal introduced in the House of Representatives is not assured by any means.

Legislation is imperative to make covered bonds a reality. Protecting the rights of the covered bond investors to the collateral are essential. Regulation is not enough to achieve this-- especially regulation by the FDIC. The FDIC is in a zero-sum game with secured creditors. This is a fundamental, inescapable conflict.

As we know, covered bond legislation has just been introduced by Congressman Scott Garrett (R-NJ). It is bipartisan, co-sponsored by Carolyn Maloney (D-NY). There is said to be interest in a Senate companion bill. Recall that Senate debate during the Dodd-Frank Act left out the covered bond provisions. By the way, the Dodd-Frank Act is actually the "Faith in Bureaucracy Act."

The Treasury Departments of both Secretaries Hank Paulson and Tim Geithner have supported the development of covered bonds. Treasury's recent housing finance paper also made some pointed comments about limiting the role of Federal Home Loan Banks (FHLBs). If this happens, it will create more opportunity for covered bonds. But there is meaningful opposition from within the government.

FDIC has five arguments against the Garrett Bill:

i. Lopsided benefits to covered bond investors

ii. Unfair to unsecured bond holders

iii. Takes collateral away from the FDIC and therefore depletes the deposit insurance fund

iv. Disproportionately benefits big banks and therefore not good for small banks

v. Gives incentives to maximize overcollateralization, which will make the other problems worse.

Their formal paper doesn't discuss it, but really there is another key perceived negative for the FDIC: It is that covered bonds are just like the FHLBs-- and FDIC hates the FHLBs. Why? Because FHLBs grab good collateral and have every ability to maximize overcollateralization of their "advances" to banks, to the detriment of the FDIC.

Consider the Indy Mac story: the FHLB lent about $10 billion to Indy Mac, but took about $22 billion in collateral out of total assets of $32 billion. When Indy Mac failed, the FHLB had the collateral, and the FDIC had an estimated $10 billion loss. On top of this, the FHLB charged the FDIC a prepayment fee of more than $300 million to pay off the advances and get the collateral.

So when FHLBs say rightly that they have had "no losses on advances since 1933" (although they have lent to many failed institutions), this only increases the hostility of the FDIC to them, and derivatively, to covered bonds.

Since covered bonds are functionally like and therefore competitive with FHLB advances, another source of political opposition is of course the FHLBs. Indeed, the FHLBs' own debt can be viewed as covered bonds with maximum overcollateralization and a government guaranty. This is hard to compete with and makes especially important the Treasury's proposed limitations on FHLB lending to big banks.

As a matter of political clout, the FHLBs themselves are not as important as the small banks which tend to support the FHLB agenda. Congress does not like to hear opposition from thousands of hometown banks. Is there something in the development of covered bonds that is manifestly good for small banks? Could there be? Here are what I view as the essential covered bond issues from a political finance point of view:

A. What kind of loans should constitute the basis for covered bonds? Should we start with complexity or simplicity? I favor simplicity and thus beginning a US covered bond market with mortgage loan collateral. As we all know, this would give us a $10 trillion loan market to work on: a covered bond share of 10-20% would represent $1-2 trillion.

B. What quality of assets should be financed by covered bonds? I recommend high credit quality, prime loans with conservative LTVs and income ratios.

C. How should we address the extent of overcollateralization? The higher the credit quality of the loan pool, the lower the overcollateralization will be and the happier the FDIC.

D. How about the asset-liability match-mismatch between the covered bonds and the collateral pool? How tight should it be?

The issue of asset-liability match has been a key topic in recent European discussions of covered bonds. The tighter the asset-liability match, the smaller the overcollateralization. The ultimate match would be a pass-though covered bond. This would replicate the Danish covered bond structure:

-100% credit skin in the game

-100% of the interest rate/liquidity/option risk passed through to bondholders.

Result: the tightest overcollateralization.

E. How should we address the interaction of covered bonds and the FDIC? Note that under the new deposit insurance law, the FDIC will assess all liabilities, so covered bonds will be paying fees to protect deposits and build up the reserves of the FDIC.

In general, the way to think about the FDIC's issues is the "two-bank theory." Analyze a covered bond-issuing bank as financially composed of a covered bond bank A, of which the capital is the overcollateralization; and the rest of the bank B, of which the capital is all the rest of the assets minus all the other liabilities. It is clear that if the overcollateralization ratio of Bank A is equal to or less than the capital ratio of the whole bank, then the capital ratio of Bank B has not been reduced by the covered bond. There is also the dynamic of the potential movement of assets from Bank B to Bank A, which suggests there might be an aggregate limit on overcollateralization linked to the capital position of Bank B. Covered bonds will be very high quality assets in any case, but such a rule would suggest that-unlike FHLB advances-they would not be able to pass all their risk to the FDIC. In other words, they would be very low risk assets, but not "no risk" assets.

F. How can covered bonds help small banks?

There are European models in which little covered bonds from smaller institutions are aggregated into big marketable ones. This might be an interesting model, depending on how housing finance restructuring affects the FHLBs. In sum, it would be good to have a US covered bond market with a firm statutory basis. Achievement of this is no means sure. My proposal:

Start with a narrow asset eligibility, high credit quality loans, and tight overcollateralization Make sure a pass-through covered bond structure is a possibility

Think through the two-bank logic to ensure a durable and practical arrangement with the FDIC. And most important, we should make sure we seize the opportunity of the post-bubble environment to advance housing finance reform.

Photo Credit: Flickr user afagen/creative Commons