The great stumbling block to getting a mortgage-related covered bond market off the ground in the U.S. continues to be the Federal Deposit Insurance Corp. (FDIC)

Congress almost passed covered bond legislation as part of the Dodd-Frank Wall Street Reform in July, but it was jettisoned due to last-minute objections by the FDIC.

Republican sponsors of covered bonded legislation are expected to press for action next year. And no matter what Congress looks like after Tuesday's election, covered bonds are not a partisan issue like GSE reform.

In fact, supporters of covered bonds don't want to see their legislation swept up in the debate about the future of Fannie Mae, Freddie Mac and mortgage securitization market.

Covered bonds are totally different from traditional MBS. Banks retain the mortgages on their balance sheets when they issue covered bonds. They also pledge additional assets as security for the bonds.

This "over-collateralization" feature, which is standard in the European covered bond market, concerns the FDIC. In case of a bank failure, covered bond investors would have title to these additional assets, not the FDIC.

FDIC chairman Sheila Bair claimed it shifts risks from investors to the Deposit Insurance Fund.

"Covered bonds could be valuable source of liquidity to finance mortgages, and properly structured, they provide a way to transfer risk to private-sector investors, rather than the U.S. government," Bair said at a conference on foreclosures and the future of housing finance.
"However, improperly structured, they could lead to another system of implicit government guarantees," she said. The conference was sponsored by the FDIC and the Federal Reserve Board (FRB).

Alex Pollock, a resident fellow at the American Enterprise Institute, told conference attendees that a statutory framework for covered bonds is "absolutely" needed to protect investors and the FDIC. "We have to protect FDIC from super over-collateralization of these covered bonds," Pollock said at the FDIC/FRB conference.

The former Chicago Federal Home Loan Bank (Chicago FHLB) president suggested that FDIC could be protected if over-collateralization is not allowed to exceed the issuer's capital ratio. Essentially, the over-collateralization could not exceed 5% if the bank is only holding 5% capital against the mortgage assets pledged to the covered bond.

"Basing over-collateralization on the issuer's equity should overcome FDIC's objections," Pollock told this newspaper.

Rep. Scott Garrett, R-N.J., is the sponsor of the covered bond bill (H.R. 5823) that also made it into the Dodd-Frank Act.

The House Financial Services Committee member plans to introduce a covered bond bill next year, according to his spokesman Ben Veghte.

"Congressman Garrett has been and will continue to work with the FDIC on the legislation. No timing as been set for reintroduction, but we'll continue to work with all interested parties to ensure broad agreement on the legislation," Veghte said.

Covered bonds are considered an alternative to securitization, according to advocates — not a substitute. Covered bonds by their structure force the issuer to retain 100% of the credit risk.
Banking and financial consultant Bert Ely noted that covered bond investors are looking for safety and certainty. "But FDIC wants a level of discretion that makes investors uncomfortable," he said. 

Investors in the sector are buying a 'AAA'-rated product, Ely pointed out. They don't want a FDIC receivership with the discretion to meter out some of bank's losses to the bond holders, he said.
"If we want to have a good covered bond law in this country, it is going to have to provide as much certainty to the investors as possible," he said. His consulting firm Ely & Co. is based in Alexandria, Va.

The covered bond advocate noted that FDIC can protect itself by charging the issuing bank a premium for the secured borrowings. It already charges a premium on FHLB advances.
"The FDIC, through its premium charge, can compensate the deposit insurance fund," for any potential losses due to over-collateralization, Ely said.

Meanwhile, private-label issuance of MBS has been shackled in the U.S since 2007. The covered bond market in Europe has been strong the past two years with more than $260 billion in product issued so far this year.

Ely said Canada and other countries are starting to utilize covered bonds. "Why aren't we?"

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