Banks may skirt GSE uncertainty with covered bonds

More banks based in the United States will establish covered bond programs to fund future mortgages on the perception of less risk and still lingering uncertainty over private and agency securitization markets, according to Moody's Investors Service. New covered bond frameworks could take the place of mortgage-backed securities issued by either the government-sponsored enterprises or the private market. The House Financial Services Committee cleared legislation in July from Reps. Scott Garrett (R-N.J.) and Carolyn Maloney (D-N.Y.) establishing regulatory guidelines for covered bonds. "New covered bonds in the U.S. will also not have the low quality assets that were common in pre-crisis residential mortgage-backed securities." Moody's said in a research note released Tuesday. "We expect future U.S. covered-bond deals will have much less market risk following a bank default than pre-crisis U.S. covered bonds because we assume future covered bond legislation will establish mechanisms permitting liquidation of a portion of the pool over a period of time." Standard & Poor's analysts said Tuesday mortgage covered bonds globally are "booming." Roughly $164 billion in jumbo issuance appeared in the first seven months of 2011. However, they are not wholly risk free. "S&P believes that the common perception of mortgage covered bonds as a homogeneous and universally low risk product is misleading," analysts at the credit-rating agency said. "The characteristics of individual mortgage covered bonds are not only diverse, but can change over time. Credit enhancement levels, the degree of asset-liability mismatch (ALMM), and collateral performance all vary." After a bank failure, the Federal Deposit Insurance Corp. could allow an entire pool to be liquidated in a short amount of time or pay the covered bond holders damages limited to the market value of those pools, likely at highly discounted prices during times of crises. This market risk is not as extreme in Europe, Moody's said, as governments often allow only a portion of the pool to be sold over a longer period of time. However, the FDIC is said to be lobbying against the passage of the Covered Bond Act, as it would wish to hold unconditional recourse to assets in the case of a bank failure. Moody's analysts said future covered bond deals would hold stronger collateral. Banks will have 100% skin-in-the-game and hold the loans on their balance sheets. Future legislation, analysts said, should require the covered bond regulator to set minimum credit quality standards. "The absence or contraction of other forms of financing will likely encourage more banks to issue covered bonds than before the crisis, assuming legislation reduces the market risk feature," Moody's said. "Uncertainty about the future availability of GSE and private-label securitization will encourage more banks to establish covered bond programs to expand their financing alternatives." Write to Jon Prior. Follow him on Twitter @JonAPrior.

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