Discussion: (0 comments)
There are no comments available.
View related content: Financial Services
What are the prospects of the bipartisan covered bond bill introduced in the House by congressman Garrett, R-N.J., co-sponsored by congresswoman Maloney, D-N.Y.?
In the wake of the bubble, Fannie Mae and Freddie Mac, the big ideas of the 1990s, are broke, and the government-sponsored-enterprise idea has failed along with the GSEs. We need better housing finance structures and ideas: The timing of the covered bond bill is certainly appropriate.
Let us begin by answering the main question: Should U.S. dollar-denominated, U.S. issuer covered bonds be a growing part of the reformed U.S. housing finance sector? Yes.
Covered bonds can provide long-term funding, which is essential for mortgages, without GSEs. Moreover, they represent 100% credit “skin in the game” by the issuer (not a mere 5%)–a very good feature. Covered bonds should become part of our financial markets on the basic financial merits, but the political outcome is by no means assured.
For covered bonds to make a serious contribution, enacting legislation is imperative. This is because the rights of covered bond investors to the collateral backing the bonds are essential. Regulation is not enough to achieve this–especially regulation by the Federal Deposit Insurance Corp. The FDIC is in a zero-sum competition with secured creditors. This is a fundamental, inescapable conflict.
The Treasury Department has supported the development of covered bonds. The Treasury’s recent housing finance paper also made some pointed proposals about limiting the role of the Federal Home Loan banks. If such limitations occur, it will create more need and more opportunity for covered bonds.
But there is meaningful opposition to covered bonds from within the government, and from the FDIC, in particular.
The FDIC’s arguments against the Garrett-Maloney bill include these:
Why? Because the FHLBs control the collateral and have every ability to maximize overcollateralization of their “advances” to banks, to the detriment of the FDIC.
Consider the IndyMac story: The FHLB lent about $10 billion to IndyMac, but took about $22 billion in collateral out of total assets of $32 billion. When IndyMac 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! So when FHLBs say correctly 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.
Here are the essential covered bond issues from a political finance point of view:
Remember that under the new deposit insurance law, the FDIC will assess all liabilities, so covered bonds will be paying fees to the FDIC but not getting insured.
In general, the way to think about this interaction is the “two-bank theory.” Analyze a covered bond-issuing bank as financially composed of 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.
In sum, it would be good to have a U.S. covered bond market with a firm statutory basis, but political achievement of this remains uncertain.
Alex J. Pollock is a resident fellow at AEI.
There are no comments available.
1150 17th Street, N.W. Washington, D.C. 20036
© 2014 American Enterprise Institute for Public Policy Research