Are Covered Bonds a Safe Way to Finance Mortgages? Not Likely

Promoted by Paulson as a safer way to fund mortgages, the bonds just transfer risk from buyers to the FDIC

Treasury Secretary Henry M. Paulson Jr. is promoting covered bonds, a mortgage-financing vehicle popular in Europe, as a safer way to raise money for home buying in the U.S. The question is, safer for whom? If covered bonds catch on, they will magnify the losses the Federal Deposit Insurance Corp. suffers in the case of bank failures, thus exposing taxpayers to the risk of more big bailouts.

To put it bluntly, covered bonds wouldn't reduce risk as much as transfer it from bond buyers to the U.S. taxpayer. Surprised? No wonder, since this hasn't been a big theme of the Treasury Dept.'s publicity blitz. Paulson sees covered bonds as a new funding source for mortgages at a time when investors are backing away from the radioactive mortgage-backed securities market.

Covered bonds are familiar in Germany and Britain but barely exist in the U.S. That may change. On July 28, Bank of America (BAC) , JPMorgan Chase (JPM) , Citigroup (C), and Wells Fargo (WFC) said they are planning to issue the bonds. They resemble mortgage-backed securities in that they pay a fixed rate of interest and are backed, or "covered," by the cash flows from a pool of home mortgages.

But the covered bond is safer for investors because it's supported not only by the mortgages but by the full faith and credit of the bank that originates the mortgages. The loans stay on the bank's balance sheet instead of being stashed in a trust, as they are with mortgage-backed securities. Only prime mortgages are eligible for inclusion in the pool. If some of the mortgages go bad, the bank must replace them with better ones.

A More Vulnerable FDIC?

Here's where the risk to taxpayers comes in: If a bank goes belly-up for whatever reason, owners of the covered bonds stand in line for payment ahead of the FDIC. The FDIC must pay off the bondholders in full even if that means there's not enough money left to pay insured depositors. The FDIC has to make up the difference out of its own insurance fund. And, of course, if the insurance fund runs low, taxpayers have to ante up.

"Promoting covered bonds is really a way to compartmentalize and shift risk to the FDIC and uninsured depositors," argues Robert A. Eisenbeis, a former Federal Reserve and FDIC official who is chief monetary economist at Cumberland Advisors, a Vineland (N.J.) money manager.

FDIC Chairman Sheila C. Bair is aware of the threat of covered bonds to her insurance fund, so she has decided that the FDIC won't allow covered bonds to exceed 4% of bank liabilities at first. Trouble is, that low ceiling prevents covered bonds from making a meaningful contribution to mortgage availability. So count on it: If covered bonds catch on, there will be political pressure to increase that ratio, allowing more bank assets to be encumbered, and thus beyond the FDIC's reach.

Higher Ceiling

In fact, arguments for a higher ceiling are already being made. Ben Colice, an investment banker at Barclays Capital (BCS) in New York, notes that banks can raise money less expensively when they pledge mortgages as collateral. That, in turn, increases their profitability, which decreases the likelihood that the FDIC will need to step in. But as history has shown, banks can lend themselves into trouble even if they have low financing costs. And if they do fall into receivership, covered bonds will raise the cost of shutting them down.

Michael H. Krimminger, a special adviser to Bair who is the FDIC's point man on covered bonds, says the agency"will consider changes in the ceiling only after a careful review." The agency will need to ensure that Wall Street interests don't trump taxpayers'.

Coy is BusinessWeek's Economics editor.

Too Cool for Crisis Management
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