Treasury Secretary Hank Paulson, in cooperation with officials from the Fed and executives from four of the five largest U.S. banks, has outlined his latest plan to save the banking system and housing markets: creating a covered bond market.
What is a “covered bond”?
A collateralized debt instrument that, instead of being securitized and sold off to someone else for cash, remains on the issuer’s balance sheet. As with plain vanilla mortgage bonds, interest and principal on the covered bonds is paid by homeowners. But the bonds also backstopped by the banks that issue them. Felix Salmon at Portfolio.com explains:
Now it’s true that covered bonds are, technically, mortgage-backed. But all the mortgages could default and go into foreclosure tomorrow, and so long as the bank remains in operation, the covered bond will pay out as normal. Similarly, if the bank blows up for some non-mortgage-related reason, investors in the bond will still get paid back in full.
Their main risk is that the bank blows up because the mortgages blow up, and they’ll be left holding a bag of damaged loans – but because two things have to happen rather than just one, that risk is relatively low.
So covered bonds may provide a less risky means by which to prop up the secondary mortgage market–by doing the same thing that morgage-backed securities used to do before they collapsed. By issuing covered bonds, banks can raise capital from lenders that would have shied away from riskier CDOs, allowing them to leverage their mortgage assets to raise capital. This, theoretically, will inject more liquidity into the system and thereby bolster the secondary mortgage market, making inter-bank lending cheaper and easier and bringing down mortgage rates for home-owners.
Again, sounds great in theory, but covered bonds will likely end up being part of a broader solution, rather than a one-stop panacea that will dissolve all mortgage worries.