Covered bonds are debt securities backed by cashflows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet. Essentially, a covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. This enhancement typically (although not always) results in the bonds being assigned AAA credit ratings.The move at the FDIC comes as the structured finance market for U.S. mortgages has essentially ground to a halt amid the worst housing crisis in at least 50 years. Bair wants to make it easier for U.S. banks to issue so-called covered bonds -- essentially an on-balance-sheet alternative to the off-balance-sheet treatment that has been the norm with most securitizations. Covered bonds are much more common in Europe, where they constitute of $1.8 trillion euro market and have been widely used for many years. The first U.S. issue of such a bond took place in Sept. 2006, with Washington Mutual as the issuer. Reuters reported late Monday that Bair expects the FDIC to issue a statement on covered bond issuance within the next 30 days, opening the issue to comment from U.S. market participants. "The thinking at this stage is we will draft a policy statement and go out for comment," Reuters quotes her as saying. The FDIC chairman sees covered bonds as a way to jump-start the frozen secondary market for mortgages, and has suggested since early February that the regulator will consider how to better accomodate their use. Per an earlier Reuters report:
"My sense is to try and accommodate it, but do it in an incremental way, so we get some experience with it before we open the door," Bair told the Reuters Regulation Summit. ... "Because you are holding on balance sheet perhaps you don't get the same dilution of underwriting standards that you can get when you move them completely off," she said. In the words of the industry source, covered bonds "force the banks to eat their own cooking."A dose of skepticism Despite the interest at the FDIC, secondary market participants appear less enthused about the prospects of keeping mortgage debt on their balance sheets. Reuters reported on reaction to Bair's proposal at last month's ASF 2008 conference in Las Vegas:
... issuers' desire to protect their credit ratings and a lack of liquidity in covered bonds mean they will not pose serious competition for the type of mortgage securities that raised the bulk of funds for housing loans in the past decade. Covered bonds are bank obligations, and overuse of them could hurt issuer ratings, which in turn are important for other debt funding, said Paul Baalman, a Bank of America Corp structured finance executive. "You are never going to load up on this because you have the rating agencies looking at your secured debt," Baalman said at the American Securitization Forum meeting in Las Vegas.While banks clearly prefer to maintain access to off-balance-sheet funding, the accounting treatment of various off-balance-sheet entities is likely to undergo a significant overhaul at the hands of both FASB and the Securities and Exchange Commission. Housing Wire reported in early February that the FASB board is considering elimination of so-called "qualifying special purpose entities," off-balance-sheet vehicles that essentially enable the securitization process. Depending on what FASB and the SEC decide, covered bonds may become a more attractive option for potential issuers in the U.S. than they are now. "I don't think anyone wants to see covered bonds replace securitization," said one Wall Street source, "but it's probably worthwhile to at least explore what it would take to make them a more viable vehicle on this side of the pond, given all of the uncertainty in the market right now."