Is the United States ready to embrace the world’s oldest form of structured finance?
Momentum is gathering in Congress for the creation of a market for covered bonds, which were introduced nearly 250 years ago and have since become a $3 trillion market throughout Europe.
Covered bond legislation was passed in the House of Representatives in July but was not taken up by the Senate. Still, the legislation’s sponsors—Rep. Scott Garrett (R-N.J.), Paul Kanjorsky (D-Pa.) and Spencer Bachus (R-Ala.)—plan to re-introduce it early next year.
Covered bonds, which are debt securities backed by mortgages, are similar to commercial mortgage backed securities (CMBS). But there are some striking differences. First and foremost, banks have to hold onto the loans, unlike CMBS loans, which leave a bank’s balance sheet once they're sold off.
This balance-sheet execution is a double-edged sword. On the plus side, the lender has a vested interest in the loan, which should lead to higher credit standards. Investors view them as a much safer alternative to CMBS—almost like investing in Treasuries—since they have two layers of protection (investors have recourse to both the pool and the issuer). And borrowers would be able to modify loans more easily than a CMBS loan.
On the flip side, covered bonds present capacity—and capitalization—challenges for banks. Ultimately, covered bonds could limit the issuer’s lending volumes by requiring them to hold loans in portfolios and retain capital reserves in case of losses. So there are big questions as to just how much liquidity, and counter-cyclical liquidity, covered bonds could bring to the multifamily market.
The National Multi Housing Council (NMHC) recently testified on covered bonds before the Senate Committee on Banking, Housing and Urban Affairs. NMHC believes that covered bonds might augment the multifamily debt marketplace, but probably wouldn’t provide a huge boost of liquidity to the multifamily market. “It can play a role, but it’s not some silver bullet,” says Doug Bibby, president of the Washington, D.C.-based trade association. “They’re a very vibrant market in Europe, but they’re not used for multifamily, more for single-family and commercial. So we haven’t even tested them in this kind of a marketplace."
Still, the uncertain fate of the GSEs has turned a brighter spotlight on the private sector’s ability to provide liquidity. And in that jigsaw puzzle of capital, every little bit helps. “We’re supportive of covered bonds as one of the alternatives that will help give us a broad menu of capital,” says Michael Berman, chairman-elect of the Washington, D.C.-based Mortgage Bankers Association. “But it’s just for a select group of big players, for the big banks basically. We don’t think it could be the solution to the whole problem, but we think it can play an important role.”
A few years ago, the creation of a covered bond market appeared imminent. Treasury Secretary Paulson announced in July 2008 that, with the help of Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo, the Treasury would try to start a market for these securities. Less than two months later, the onset of the recession brought on by the collapse of financial institutions such as Lehman Bros. and Washington Mutual put those plans on hold.
Garrett also introduced covered bond legislation in 2008 and again in 2009. Perhaps the third time’s the charm. In addition to the House vote and Senate hearings, the Congressional Budget Office this month completed a study measuring the financial impact on the government and the private sector of a covered bond marketplace.
Translation: Stay tuned.