Tuesday, July 29, 2008

Covered Bonds

Yesterday, the Treasury Department released a best practices guide to covered bonds. Here's a link to press release, which includes a link to the best practices guide: "Treasury Releases Best Practices to Encourage Additional Form of Mortgage Finance". In a nutshell, the way a covered bond works in the context of mortgage financing seems to be like this: instead of selling its mortgage loans to the securitization market, a bank keeps those mortgage loans on its books, and issues a bond using those loans as collateral. On the surface, this would seem to be a more transparent method of financing mortgage loans than the practice of selling those loans to the securitization market, where they are then bundled into MBS (which are then bundled into more complex CDOs and other complex securities).

David Merkel provides a detailed analysis in this post on his Aleph Blog, "Covering Covered Bonds", and in Forbes, Heidi Crebo-Rediker and Douglas Rediker claim that "Covered Bonds can Rebuild America". The co-authors' grandiose claim refers to infrastructure. They write,

Monday's embrace of covered bonds by U.S. Treasury Secretary Henry Paulson and senior representatives of the Fed, the Federal Deposit Insurance Corp. and the country's largest banks to help thaw the U.S. mortgage market is a laudable step, appealing to market proponents and skeptics alike. Introducing covered bonds to the U.S. is a great idea. In fact, covered bonds can help more than just the mortgage market.

At its most basic, a covered bond is a bond issued by a bank and backed by a dedicated group of loans kept on the issuing bank's balance sheet. While the introduction of covered bonds in the U.S. is not a magic bullet, covered bonds may be more than just a way to restart the mortgage market. They may also help unlock sorely lacking investment for U.S. infrastructure.


Elsewhere in the world, many commercial banks and specialty public-sector banks use public sector covered bonds as a cheap source of funding. In particular, as a result of the enormous availability of funds for infrastructure projects through securities like covered bonds in Europe, European banks have developed great comfort with infrastructure as a core part of their general banking activities.

Crebo-Rediker and Rediker note that, because of their familiarity with financing infrastructure,

the loans for public-private partnership infrastructure projects like the Chicago Skyway, the Indiana Toll Road, the San Diego Toll Road and the Pocahontas Parkway in Virginia all came from European, not U.S., banks.

The authors slight (unintentionally, I'm sure) Australia's Macquarie, which has been involved in financing American infrastructure projects, including the Chicago Skyway.

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