Covered Bonds: What the Paulson Plan Means for You

JPMorgan, BofA, Wells Fargo, and Citi will issue the new bonds. Will they help the markets? Should investors bite? Here's what you need to know

Treasury Secretary Henry Paulson announced a plan on Monday to encourage banks to issue a new form of debt known as a covered bond. Paulson said that if investors buy enough of these bonds, which are generally considered safer than many of the risky mortgage-backed securities that proliferated during the housing boom, banks will feel more comfortable financing mortgages again. That, along with various other measures, could restart the stalled housing market, Paulson said. Four banks—JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C)—have agreed to begin issuing covered bonds to "kick-start this market in the U.S."

What are covered bonds?

A covered bond is a kind of bond that is backed by mortgages. That might sound suspiciously similar to the mortgage-backed securities that got us into this mess in the first place, but there are several important distinctions. Whereas asset-backed securities generally take the mortgages out of a bank's hands and put the investor holding the security at risk when the home buyer defaults, covered bonds stay on the bank's balance sheet. They work like this: Banks make mortgage loans to customers. They use those mortgages as collateral to issue covered bonds, which, like other bonds, offer specified yields and maturities and trade on a public market. The banks hold onto the mortgages, however, and pay bondholders out of their own cash flow, not from the proceeds on the mortgages.

Covered bonds are considered safe investments because they must meet numerous standards. The loan-to-value ratio of the mortgages cannot exceed 80%, and borrowers must have documented income, according to the Treasury Dept.'s guidelines. In addition, no more than 20% of the underlying loans can be from one metropolitan area.

These types of bonds are popular in Europe, so why haven't they gained a foothold in the U.S. yet?

The European covered bond market is booming; it was valued at $3.3 trillion last year. Until Secretary Paulson's announcement, only two U.S. institutions—Bank of America and Washington Mutual (WM)—issued covered bonds, and the total value of the bonds in the U.S. was less than 1% of the European market.

Europeans were issuing covered bonds long before Americans were even officially American. As far back as 1770, Prussians issued covered bonds to finance agriculture. In the 1990s covered bonds took off with a vengeance in Europe as investors pushed for more liquidity in the mortgage market. Most European countries have legislation dictating what can and cannot be used as collateral, so the regulatory framework was firmly in place.

The U.S. mortgage market developed much differently. U.S. banks had already turned to asset-backed securities long before European banks ramped up the covered-bond market there. The U.S. also has institutions like Fannie Mae and Freddie Mac, which for many years successfully injected liquidity into the housing market. Now that the asset-backed securities market is essentially frozen and Fannie and Freddie are on the ropes, the U.S. government has decided it's time to try the European way.

In lieu of a law spelling out the requirements of a covered bond, the Treasury and FDIC have issued guidelines. Banks can issue covered bonds with whatever specifications they want, but if they want the government's stamp of approval—which they presumably will—they will stick to the guidelines.

Will covered bonds make it cheaper or easier to buy a home?

A robust covered-bond market could be expected to make it easier to get a mortgage. With the securities market stalled, banks are much less willing to make mortgages because they can't expect to sell them. Mortgage originations, not surprisingly, have plummeted. In 2003 lenders originated nearly $4 trillion in mortgages; as of the first quarter of this year, the value of originations had fallen to about $2 trillion on an annualized basis, according to the Treasury.

If covered bonds catch on here, banks will presumably become more interested in offering loans to home buyers with good credit who can afford a substantial down payment, because they can then use those loans as collateral. Once banks can generate income through covered bonds, that should "free up space for other classes of mortgages," allowing borrowers who may have more trouble meeting all of the stringent requirements surrounding covered bonds to get loans, said Assistant Treasury Secretary Neel Kashkari in an interview.

Interest rates are determined by lots of things, so it's hard to say whether a robust covered-bond market would drive down rates. But a little movement in the mortgage market couldn't hurt.

Are they a good deal for investors?

Like any investment, the payoff on covered bonds will depend on how risky they are. Kenneth Froewiss, a professor of finance at Stern School of Business at New York University, said he expects yields on covered bonds to fall somewhere between Treasuries and most corporate debt, depending on the underlying risk and maturity date of the bonds.

Covered bonds have a few important upsides for investors. Unlike with mortgage-backed securities, for instance, investors in covered bonds won't see their investments deteriorate if homeowners default on the mortgages. If a loan in the underlying "cover pool" of mortgages goes bad, the bank is expected to take that mortgage out and replace it with a high-performing one. As long as they trust the underwriting and credit ratings on the mortgages, investors don't have to worry about them. They do, however, need to pay attention to the health of the issuer. If a bank that issues a covered bond goes under, the bondholders have a senior claim.

What does that mean? If the FDIC seized a bank, the agency could continue to pay bondholders with whatever cash flow the bank could generate. It could pay investors the value of the underlying collateral. Or it could liquidate the mortgages and pay that out to the bondholders. If the mortgages were properly underwritten, the bondholders could expect to get back most, if not all, of their investment once it was sold, according to the FDIC. If the investors' debt wasn't fully paid off, they would have a senior claim on the bank's assets.

Will covered bonds stop, or at least slow, the free fall in the banking industry?

Banks could ostensibly use covered bonds to generate new funding from the mortgages already on their balance sheets. That could make some of the mortgage-related assets on bank balance sheets more productive. But the really nasty stuff—securities and derivatives backed by mortgages—can't be used as collateral for covered bonds.

That said, covered bonds are one tool banks can use to climb out of the holes they have dug for themselves.

Editor's Note: An earlier version of this story incorrectly stated that banks could use covered bonds to remove some mortgage-related assets from their balance sheets.

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