Lost amid its oft-changing response to the housing-inspired financial crisis is the government's seeming abandonment of its once-favored means to stabilize the shaky U.S. mortgage market.
Over the summer, executives from the country's top banks stood side-by-side with Treasury Secretary Henry Paulson and other senior officials from the
and Federal Deposit Insurance Corp. to herald the use of covered bonds -- securities issued by a bank and backed by a dedicated pool of mortgages -- to finance home lending.
Covered bonds, which have been a popular way to finance the European mortgage market, are similar to mortgage-backed securities, but are a more conservative approach to financing the loans, since they remain on bank balance sheets and are given a government seal of approval. But despite an initial pledge to issue covered bonds by several banks -- including
Bank of America
-- not much has happened. Arguably, the outlook for covered bonds has worsened.
The government has responded to the crisis in an ad-hoc way, unveiling major initiatives to boost liquidity and provide stability, then dramatically changing course on the $700 billion bailout plan. One of its latest initiatives was to guarantee mortgages held by mortgage giants
( FNM) and
( FRE), which, combined with Federal Home Loan Bank financing, has rendered covered bonds somewhat obsolete. As a result, ratings agencies have remained circumspect, hesitating to champion the covered-bond market as the future of mortgage financing, while adjusting their methodology.
So far this year, not a single U.S. company has issued a covered bond, according to
data analyzed by
. Over the past five years, just three companies have issued such bonds, mostly to European investors. Washington Mutual, which no longer exists after JPMorgan acquired its deposits following a government seizure in September, and
, which is being acquired by Wells Fargo, were the only banks to do so.
Tim Skeet, a managing director and head of covered bonds at
( MER), acknowledges that the covered-bond momentum of the summer has slowed dramatically. He says government-guaranteed bonds "steal the limelight" as officials unveiled new programs to insure other types of debt.
Still, the pause has given market players time to weigh their options and consider the implications of a new administration taking charge in January. Skeet believes the Obama administration will be supportive of covered bonds, and notes that the U.S. Covered Bond Council will meet for the first time next week to consider the best way to move forward.
The $3 trillion covered-bond market in Europe is a big part of the housing finance system there. Europe was not immune to toxic U.S. housing investments, and their complex derivatives -- just take a look at
-- but, by and large, governments across the pond required much stricter mortgage-lending standards at home.
While the covered-bond market has also slowed in Europe, Carl Johansson, a senior consultant with LECG, attributes that to a "fear factor" in the markets that took hold in the U.S. and spread abroad. For instance, in Germany, a country known for strict lending standards and covered-bond dominance, issuance has dropped 34%, to 33 bonds from 50 last year. Similarly, issuance in France has declined 38%, while Spanish issuance dropped 19%, according to
Johansson also notes that several German banks that were heavily reliant on covered bonds have failed, and home values in some European markets have suffered mightily. "The liquidity there has shrunk quite a bit because
investors realize that there are still mortgages behind it," he says.
Still, Europe's covered-bond market is far from dead. So far this year, the U.K. market has nearly doubled. Even Iceland, which made headlines for its sharp economic decline as a result of a credit crisis far from its shores, has issued two such notes this year.
Under current standards, the pool of mortgages within a
that receives the U.S. government's stamp of approval must meet several strict criteria. Borrowers must document their income; the payment structure must ensure that borrowers are paying at least the full interest; loans must be from a variety of metropolitan areas; non-performing loans must be replaced with healthy ones; and to make sure banks maintain careful lending standards, they are required to hold the loans on their books.
But experts say three factors are preventing broader support in the market: Uncertainty, cost and safer, more liquid government-guaranteed debt.
In terms of uncertainty, to say that the markets have become dislocated is the understatement of the century. Since Paulson's press conference over the summer, the government took over Fannie and Freddie;
nearly collapsed; WaMu is no more, and
are on their way out; and even
found itself on the ropes last week.
In light of the government's rapidly changing response to the crisis, investors have been hesitant to jump into familiar products, much less new ones, like covered bonds, whose future is vague. Furthermore, as economic turmoil has unfolded, the housing market has worsened and banks have cut back lending even to prime borrowers. Those that are providing mortgages and issuing new debt are hesitant to opt for covered-bond financing, which would chain the assets to their books.
William Nolan, a senior managing director in the corporate finance practice of FTI Consulting, says one of his clients is considering covered-bond financing but has not moved forward at this time.
"The quality of the collateral that goes into covered bonds is fairly high and it's meant to be a source of fairly secure financing," says Nolan. "So, if somebody had a lot of good loan products to put in there, that's great. But there are other ways to package those good loans."
The economic climate, combined with better financing options, makes it difficult to predict when, or if, covered bonds will play a bigger role. Fed Chairman Ben Bernanke noted in a speech on Halloween that the strict underwriting standards, combined with covered bonds' success in foreign markets, lent hope that domestic investors could eventually warm to the approach.
"That said," he continued, "given longstanding features of the U.S. system ... covered bonds may remain an unattractive option to U.S. banks."
Those involved in the covered-bond market are hoping that the product can diversify financing options, while offering more attractive yields, even if they don't upend the existing system.
Skeet says the fact that the government put the approach on its back burner could help covered bonds succeed in the U.S. in the long run.
It is imperative that we as an industry use the extra time wisely to design and refine the U.S. covered bond product to maximize the chances of its success and energize investors to support the project once the worst of this market dislocation is behind us," he says.