What’s up with the covered bond push?

I’ve been particularly busy this week, nonetheless, I hope to convey enough background on the topic of covered bonds to start a discussion that I think may lead to interesting ideas.

Whenever Henry Paulson at Treasury, Ben Bernanke at the Fed and Shiela Bair at FDIC agree on anything, American taxpayers should check for their wallets to see if they are being mugged. As a result, my eyebrows rose a bit when these three started pressing in concert for covered bond issuance in US markets some weeks ago.

Covered bonds are a huge market of over $3 trillion in Europe, but have never been popular in the USA where securitisation was the preferred model for financing banks. They are perfectly legal and raise no issues, they just haven’t been as profitable as securitisation so haven’t been supported by the US markets. Covered bonds allow for extension of credit to a bank SIV or trust that will be serviced by income from hypothecated assets on the bank’s balance sheet. The assets stay on the bank’s balance sheet unless there is a default on the bonds, at which time the assets are forfeit as collateral to the trust vehicle servicing the covered bond.

Last week the FDIC released a policy statement on covered bonds that provides for “expedited release of collateral” if an issuing bank is taken into FDIC receivership or liquidation. The Treasury is expected to release a protocol on best practices for covered bond issuance in a high profile event next week. Hmmmm. What could be up?

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas – particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) – will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks’ balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets. When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation. Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America’s banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I’m not sure on this one, so I’m looking forward to views from those more expert here.


In response to renewed fears about a purge of non-fee paying subscribers over on the Professor’s blog, I’ve finally set up my own blog as an alternative venue for the regulars’ chitter chatter. I’m encouraged to see some valued and dear friends there already in the initial comments.

My blogs here will be cross-posted at LondonBanker.blogspot.com. I’ll also write less formal interim blogs as and when motivated to keep discussion going. Drop in if you’re in the neighbourhood.

[UPDATE]:  The Professor squelches concerns about a purge in a comment below.  No change of policy.  Stop worrying!

20 Responses to "What’s up with the covered bond push?"

  1. CHBanker   July 25, 2008 at 7:13 am

    London Banker,Not sure that I agree that this is pillaging the bank (other than the fees the IB’s will get). The bank will be getting cash from the proceeds of the covered bonds which could help the bank remain solvent longer. Those bonds will carry a lower interest rate due to the requirement to maintain overcollateralization of good assets over the bond notional and the requirement to replace defaulted mortgages while the bond is outstanding and prior to a notification event resulting from the bank default or ratings downgrade. The overcollateralization I would imagine would have to be much higher for a bank that is at risk of going insolvent in the near term due to the inability of the bank to replace defaulting assets. That overcollateralization will go back to the bank or to the FDIC if in liquidation. So I am not sure I see a difference if the FDIC has to liquidate them or has to wait for the last cashflows once bondholders have been paid off.

  2. Senna   July 25, 2008 at 7:13 am

    Informative post, LB.Rome had Goths, Visigoths, and Justinian plunder them when ripe. We have our own institutions cannibalizing. Covered bonds sound like a fancy marinade making gobbling down the less palatable easier.As the dominoes crash, eventually ending with the taxpayer (who is supposed to be an unlimited and ultimate backstopper), it will be found that the hollowing within the banks mirrors the hollowing within Mr. Taxpayer…and he will tumble too easily as well. Then TPTB will scour and glean every resource by whatever means warranted. Iron fist stuff. The work-arounds in finance which imploded it will find counterpart as constitutional work-arounds empty the Bill of Rights. We may wake up suddenly very poor and very oppressed…very soon.

  3. Guest   July 25, 2008 at 7:32 am

    @LBNice post. I would add the reason this is being done is when you have no plan and things are going to heck in a hand basket AND you want to keep the incumbents in power something must be done. If that means borrowing from Peter to pay Paul you do it. As it will also make a tidy sum for your friends (GS, MS, etc.) what the heck! This is all and has been about buying time. Pity all of us after the election when reality sits in. We are still a wealthy nation and can come back, but only when true value added activities are rewarded and we have a plan.A national superconductive energy grid would be a start. Far better than pissing what little cash at hand we have on bailouts of greedy people and failed institutions. That stimulus package was the exact same things as covered bonds. The dumbed down populace stopped caring for a few moments whether Britney had any undergarments on… TGIF!!

  4. Free Tibet   July 25, 2008 at 7:39 am

    I don’t understand the mechanics of covered bonds at all. But the CEO’s of banks & much of corporate America have been looting those companies for years. If there is a way for them to land on their feet – forget about it. But I believe your analysis depends on that.

  5. Alessandro   July 25, 2008 at 8:32 am

    London Banker,if the FDIC "expedited release of collateral" really means putting covered bond holders before the retail depositors in the FIDC line of creditors, that’s clearly a trivial piece of financial warfare. Good asset to the usual suspects, taxpayer (actually foreign central banks) bailout for everybody else.Where in the line is the FHLB? I know it is before the depositors, but what about the covered bonds? If the covered bond holders have precedence even on the FHLB then the US people have one more agency to bailout.

  6. eparisi   July 25, 2008 at 1:50 pm

    This is a great post and I fear that you might be right. CHBanker is right in pointing out that the amount of overcollateralization should be higher the less creditworthy the issuer. However, in absence of a covered bond legislation that clearly states the credit quality requirements of the cover pool at any point in time (i.e. dynamic pool management), the amount of required overcollateralization is established by Credit Rating Agencies. Interestingly, Ben Bernanke wants to pass covered bond legislation first but Paulson wants to develop a market on a contractual basis as is the case in the UK and in Spain (i.e. the covered bond markets that are disrupted right now as are WaMu’s and Bank of America’s covered bond issues, the only ones in the U.S.)Most important, however, is the fact that banks ALREADY have the chance to refinance sound collateral anytime and on anonymous basis with the TAF and TSLF. What they can’t refinance is the garbage but this is not what covered bonds are designed for…

  7. MA   July 25, 2008 at 3:12 pm

    Hey there LB,Interesting concept.I must admit, I didn’t know the first thing about covered Bond until 10 minutes ago.It sounds plausible (rather then “cynical”).Likewise, Nouriel’s theory of Brokerage firms and Banks buddy-ing up. (due to investment models that no longer work)Where I’m at harkens back to a post of mine from many months ago. “Survivor Wall St.” I believe that since we moved to an “every man for themselves” scenario, it has become abundantly clear that all will lose in this scenario. (…and the “failed investment model” will be proven)With that said, I believe there will be an adjustment made on Wall St. I believe we will now see a move towards Hedge Funds and Brokerage houses joining up. Where unregulated HFs will become off balance sheets for bad debt. ….or something like that. (I’m working out the details for a future post.) Miss America

  8. Nouriel Roubini   July 25, 2008 at 3:39 pm

    LB, great you will have your own blog. I am not sure about the source of the rumor that my blog will soon be restricted to only paid users of RGE. That is utterly false; the blog is always free subject to free registration. But it is good you have your own forum. Many congrats. Nouriel

  9. interested reader   July 25, 2008 at 3:58 pm

    The ‘innocent’ explanation for Paulson’s push is that since covered bonds are designed to be more secure for investors than RMBS that should be a way to reignite investor interest in the secondary mortgage market. The banks cannot rely on the Fed facilities forever, can they? And the Fed’s balance sheet is limited as well.

  10. Guest   July 25, 2008 at 6:10 pm

    Anybody who still trusts our politicians and financial czars to do anything other than fatten their own pockets at workers’, consumers’, and taxpayers’ expense will get exactly what they deserve: continued theft, theft, and more theft. Trust the banks, brokers, and government at your own risk. If you haven’t figured it out yet from watching the events of the last 7 years (as well as those unfolding right now before your eyes) there’s no hope for you. Just as socialists insist planned economies solve all problems, capitalists claim free markets solve all problems, and both of them are lying through their teeth to maximize their own power to pick your pocket. They don’t solve any problems, they merely provide opportunities for the most aggressive among us to rip off the most trusting. The current "crisis" (which is simply the much-predicted – because very familiar – crumpling of the overextended debt markets) will end up further concentrating financial power and wealth for the fortunate ones and set up next round of overextending gluttony. Now, who was it that said 130 years ago this was how capitalism is actually supposed to work? Oh yeah, Karl Marx.

  11. 2cents   July 25, 2008 at 11:33 pm

    @LBJust let them do one expedited release of capital before covering all retail depositors including uninsured, and I beleive all &$%# will break loose! People are starting to get fed up with this crap! I honestly hope you are wrong.

  12. John M.   July 26, 2008 at 6:54 am

    Paulson, Bernanke and Bair! Oh My!

  13. DrexelBurnem   July 27, 2008 at 7:06 pm

    Creative! To quote the watchword of the previous wave of derivatives of derivatives. The result is clear: more over-leveraging! Which will need to be undone in the future after cascading failures of credit and the guarantees behind them come undone. Who’s to blame? As in the end of all good unsolved murder cases (where the murderer gets off, the lawyers collect and the victim is left silent forever): "The perpetrators are still at large"!

  14. What What? Indubitably   July 27, 2008 at 7:07 pm

    Does a covered bond just wrap garbage in pretty packaging? Like gilded chocolateries of inferior manufacture? Gold foiled lead bars? Financial innovation is really just a counterfeit of counterfeiting. It enables selling painted pork at beef tenderloin prices. Just extraction of value wherein lies none. If truth make you free, financial innovation makes bondage sure.Anymore than pigs can fly or grow feathers, investors will no-bid the future, or do such due diligence that little may be marketed. Fitting, indeed.Selling compromised securities in guise of covered bonds would be like the Creature from the Black Lagoon sprouting fledges and flighting wing! What is in a name? A rose by any other article…Take direction from wise counselors and not from well-dressed packages and one may do well.

  15. Anonymous   July 28, 2008 at 7:32 am

    I don’t think Secretary Paulson has made clear why he thinks covered bonds are a great alternative to MBS. It seems he has successfully gotten the FDIC to "ring fence" the assets securing a covered bond in the case of a bank issuer which fails. Perhaps the assets are not viewed as part of the estate under the U.S. Bankruptcy Code for a non-bank issuer. However, my understanding is that the assets in a trust for MBS cannot be touched by other creditors in both the case of bank insolvency law and the Bankruptcy Code. covered bonds do not seem to have an advantage in this respect.Also, one of the advantages of MBS is that the issuer gets rid of interest rate risk, though may retain credit risk if it guarantees the MBS, as Fannie and Freddie do. With covered bonds, it would seem that the issuer retains both type of risks.What am I missing?

  16. Taxpayer   July 28, 2008 at 8:13 am

    If the covered bonds deal jeopardizes the "call on assets" status of depositors, then it is a bad deal for them.

  17. Alesssandro   July 29, 2008 at 3:08 pm

    Looks like someone else is asking questions as well:http://dealbreaker.com/2008/07/who_is_covering_covered_bonds.phpAfer all the question is easy: what happens exactly in the event a bank goes into FDIC liquidation?

  18. Skeptk   July 29, 2008 at 7:58 pm

    Covered bonds have been popular in Europe but they don’t seem to have cured the housing or financial crisis there. As someone else similarly said, "It is pap for the masses."

  19. Knute Rife   August 10, 2008 at 9:08 pm

    Absolutely spot on LB. In fact that’s effectively what happened (sans covered bonds) with the S&Ls 20 years ago. So why are the bonds entering the mix this time? Churn, baby, churn! There are fees to be pocketed. Then the bonds can be repackaged and sold as “high quality” paper on a secondary market. I smell another derivative bubble.Then comes the inevitable bail-out (The history books will one day conclude that our civilization suffered death by moral hazard.), and things really go to Hell in a handbag. Fannie and Freddie could double the national debt overnight. What would the FDIC do? By then the system will be under so much pressure, it will be impossible to predict which gasket will blow first.

  20. Anonymous   August 21, 2008 at 11:48 am

    What is your view on the derivatives market? Do you foresee that collapsing any time soon?If so, what would be the likely global impact? Specific economies / currencies hit?Thanks.