Exploring the Future of Mortgage Securitization: Covered Bonds

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I didn't get to comment on this story yet, but wanted to make sure everyone was made aware of it. The debate on the future of mortgage securitization is picking up momentum in the media. Covered Bonds, which are very similar to regular old Mortgage-backed securities, are being discussed as a possible solution.

Here is some background information from the Mortgage Bankers Association's "Key Considerations for the Future of the Secondary Mortgage Market and the GSEs"

Covered Bonds

  • Large commercial banks and other institutions would issue covered bonds as a form of marketable, collateralized deposits.
  • Guarantees within the system would remain private, with no explicit or implicit government backing for the covered bonds.
  • Underwriting, pricing, and policies on residual guarantees of originators as well as representations, warrants and repurchase requirements would be determined solely by market participants and based on market-determined standards.
  • The institutions would set their own delivery and pricing criteria, and would essentially act as correspondent originators along with their own retail and / or broker networks.
  • Safety and soundness guidelines would be set by the bank regulators.
  • Potential investment vehicles brought to market:Secured debt / covered bonds, shareholder equity,

Hybrid Covered Bonds

  • Similar to the system above, except the banks would only be allowed to issue covered bonds backed by the securities issued by whatever a new government-related securitization entity turns out to be. For example, if something close to the current GSE model were adopted, covered bonds would essentially replace the portfolios of the GSEs.
  • The banks and other institutions issuing the bonds would bear the interest rate risk associated with option-embedded mortgage-backed securities.
  • Given the various layers of capital and guarantees associated with the securities, capital requirements would be set at appropriately low levels by the banking regulators.
  • Potential investment vehicles brought to market: Secured debt / covered bonds, shareholder equity

We will publish more commentary on the subject in near future, for now FYI:

NEW YORK, Dec 15 (Reuters) - Lawmakers aiming to speed development of U.S. covered bonds on Tuesday positioned the securities as an alternative or supplement to mortgage funding programs of U.S. housing finance giants Fannie Mae and Freddie Mac.

At a hearing over a measure to provide a legislative backdrop for covered bonds, Republicans and Democrats raised the possibility that the securities could provide funds in a housing market where Fannie Mae  and Freddie Mac  may be forced to adopt new business models in coming years.

Lawmakers voiced support for a measure presented by U.S. Republican Representative Scott Garrett last month to set up a statutory framework for covered bonds.

Unlike traditional mortgage-backed securities, which are frozen blocks of home loans, covered bonds allow banks to manage a dynamic pool of mortgages. They remain on the bank's balance sheet rather than being packaged up and sold to other banks or investors, or securitized.

Covered bonds are seen safer than a risky type of private mortgage bond that fueled the housing boom since the issuing bank is held responsible for payments to investors.

The $5 trillion part of the mortgage bond market dominated by issuance from Fannie Mae and Freddie Mac, which guarantee payments to investors, thrives but Congress is faced with fixing the firms' public-private model after billions of dollars in taxpayer-funded bailouts.

The degree of U.S. taxpayer backing to Fannie Mae and Freddie Mac securities will be hotly debated.

Congress should explore "all avenues to start leveling the playing field and transitioning Fannie Mae and Freddie Mac back to a competitive marketplace," said Jeb Hensarling, a Texas Republican.

Illinois Democrat Bill Foster said covered bonds could "provide a path forward out of the situation we have with Fannie Mae and Freddie Mac."

Covered bonds are popular in Europe but few have been issued in the United States, and none since the credit crisis hit. The bonds were initially seen a threat to Fannie Mae and Freddie Mac and the Federal Home Loan Bank financing programs.

The Garrett measure last month was presented as an amendment to a wider bill on regulating systemic risk in the U.S. economy, but then withdrawn in the face of more pressing business. Despite support, lawmakers on Tuesday gave no indications the amendment would be attached to legislation.

To move forward, the House committee would likely have to hear views on the securities from bank regulators and mortgage banking groups next month, said Jerry Marlatt, an attorney at Morrison & Foerster LLP.

"People are positive about it, and hoping that Chairman Frank keeps his interest in the bill," Marlatt said, referring to Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee.

(Reporting by Al Yoon; Editing by Leslie Adler)