European-Style Covered Bonds Eyed for U.S. Mortgages

By Katherine Reynolds Lewis
c.2008 Newhouse News Service

WASHINGTON -- This week's government seizure of Fannie Mae and Freddie Mac leaves a big question unanswered: What will replace or supplement the two mortgage giants in supporting a healthy and active housing market?

In announcing the takeover, Treasury Secretary Henry Paulson said the companies could increase their mortgage holdings to about $850 billion each by the end of next year, and then he wanted the portfolios cut by 10 percent a year until they're $250 billion each.

Some financial experts say instruments known as covered bonds could fill the void, and develop into a flourishing market that would grease the wheels of U.S. real estate.

Covered bonds are sold by financial institutions and backed by a pool of mortgages that the institution holds separate from its other assets. They've grown to a $3 trillion market in Europe, which has no equivalent of Fannie or Freddie.

"Covered bonds could become a very effective solution to the housing finance system in the United States," said Peter Wallison, a fellow at the American Enterprise Institute, a free market think tank in Washington.

Indeed, Paulson has encouraged more banks to issue covered bonds, while saying they won't replace the activities of housing agencies. Pending congressional legislation would make it easier for banks to do so, but the Federal Deposit Insurance Corp. and others worry that loosening restrictions would create the same kinds of problems for covered bonds that occurred with the complex mortgage securities whose failure sparked the ongoing credit crisis and economic slump.

"Fannie and Freddie are victims of the problems that were abuses in the private mortgage market," said Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee. "This is not a time to lessen regulatory scrutiny."

Since 1968, Fannie Mae and Freddie Mac have had a dual mission: to promote affordable housing and to make money for shareholders. The current housing bust stems in part from the collision of those two goals, as the hunt for profits encouraged them to take on riskier mortgages that eventually imploded.

Banks originate mortgages but quickly sell them in the so-called secondary market, where the biggest buyers are Fannie and Freddie. That frees up the banks to lend still more money to aspiring homeowners, but also encourages them to disregard the creditworthiness of the borrowers because they don't bear any risk from the mortgage.

With covered bonds, the banks keep the mortgages on their balance sheet and must replace any loans that default, so as to maintain the pool of mortgages "covering" a bond.

"That creates a different set of incentives for the banks, and for me is one of the most attractive things about covered bonds," Wallison said. "Covered bonds tend to force banks to be more careful in the lending that they do."

Covered bonds appeal to the same investors who purchase debt issued by Fannie and Freddie: banks, central banks and others looking for high-quality investments with low risk, said Jerry Marlatt, a partner at the Clifford Chance law firm in New York. He handled the first covered bond sale by a U.S. bank, Washington Mutual of Seattle in 2006.

But Marlatt said the development of a U.S. covered bond market will depend on the future of Fannie and Freddie, which is currently up in the air. As long as the two institutions continue providing a large, liquid secondary market for mortgages, banks will flock there, he said.

"The attractiveness of covered bonds is inversely proportional to how active Fannie Mae and Freddie Mac are," Marlatt said. "If the covered bond market develops as we expect it to, it will take some of the pressure off Fannie and Freddie and will add liquidity to the mortgage market. That's probably one of the most important things we can do to sustain housing prices."

So what does the future hold for Freddie and Fannie?

"There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form," Paulson said in a statement Sunday. "The new Congress and the next administration must decide what role government in general, and these entities in particular, should play in the housing market."

Frank said his committee will look seriously at the institutions' role next year, with an open mind. He said covered bonds seem to be a promising supplement to Fannie and Freddie, not a replacement.

"It's not like we have all the housing finance we need right now," he said. "I'm generally supportive; I see no downside."

Legislation proposed by Rep. Scott Garrett, R-N.J., would encourage growth in covered bonds by giving the mortgages that back the bonds the same protection in a liquidation of a failed bank as contracts with other financial institutions, said Bert Ely, a banking industry consultant based in Alexandria, Va.

"We want to make these things as efficient and as cheap as possible," Ely said.

Frank said the banking regulators see no need for additional legislation, and it would take a lot for him to disregard their recommendation.

This article was originally published by Newhouse News Service on Wednesday, September 10, 2008.