Federal Deposit Insurance Corp. Chairman Sheila Bair and that agency's general counsel, Mike Krimminger, have frequently expressed concern about covered bonds harming the Deposit Insurance Fund.
These concerns are completely misplaced — they reflect a fundamental misunderstanding of covered bonds and FDIC finances.
The FDIC's failure to understand the positive benefits covered bonds will bring to housing finance is especially critical, for on Tuesday the House's Government-Sponsored Enterprises and Capital Markets subcommittee will consider a bill from the subcommitte's chairman, Scott Garrett, R-N.J., to enact a strong covered bond statute.
Covered bonds are simply on-balance-sheeet debt issued by a bank secured by assets owned by that bank. Home mortgages are the most common asset funded and secured by covered bonds, but commercial mortgages, public-sector loans and other types of loans also can secure covered bonds.
Covered bonds must always be overcollateralized with performing loans that meet other quality tests, such as a loan-to-value ratio not exceeding a certain percentage. The bonds also are an unconditional liability of the bank. For these reasons, covered bonds are usually triple-A rated even if the issuing bank is not.
Crucial to covered bonds' high credit rating is the certainty of timely payment of principal and interest no matter what happens to the bank. If the bank fails, principal and interest must still be paid as contracted until the bonds are transferred to another entity, they mature or are paid off. Rep. Garrett's bill will cement those absolute protections into law.
The FDIC has a long-standing bias against any form of secured debt, stemming from its experience with Federal Home Loan bank advances. Unfortunately, Bair and Krimminger have bought into that bias even though covered bonds will produce cheaper funding for banks. Competition among lenders will force those lower interest rates through to borrowers.
The FDIC has proposed two limitations on covered bond issuance by banks — limiting the percentage by which covered bonds can be overcollateralized and the amount of covered bonds a bank can issue as a percentage of its total assets.
Neither limitation makes any sense for banks, borrowers or the FDIC, for two reasons.
First, while secured borrowings of any type will raise the percentage of loss experienced by unsecured creditors in a failed bank, "depositor preference" legislation Congress enacted in 1993 gave domestic depositors (and the FDIC with regard to insured deposits), a liquidation preference over other unsecured creditors.
Consequently, the FDIC suffers no loss until all other unsecured creditors are wiped out. Hence, while the loss percentage the FDIC experiences in a failed bank rises somewhat if a substantial portion of a bank's liabilities are secured, that increase is relatively modest.
More importantly, on April 1 of this year, the FDIC's deposit insurance assessment base increased from total domestic deposits to total assets minus tangible equity capital.
Banks will now pay deposit insurance premiums on covered bonds they issue even though the bonds are not FDIC insured. As a result, the FDIC's loss percentage in a failed bank will not vary materially as a percentage of the FDIC's new assessment base regardless of the amount of covered bonds the bank has outstanding.
Because covered bonds can only be backed by high-quality assets, these bonds will be a moneymaker for the FDIC — they should generate more premium income for the FDIC than it will incur in additional deposit insurance losses.
Bottom line, neither Congress nor the FDIC should limit covered bond issuance by a bank. In fact, covered bond issuance by banks of all sizes should be encouraged.
Second, the FDIC has sought to limit covered bonds' overcollateralization percentage, on the puzzling theory that overcollateralization could harm the FDIC because bondholders presumably would keep that overcollateralization should the bank fail.
That simply is not true. Overcollateralization of any secured loan, such as a home mortgage, merely increases the likelihood that the debtholder will be paid in full, which is crucial to a high credit rating. Any overcollateralization remaining when the debt is repaid reverts to the borrower. That would be the FDIC, as the receiver of a failed bank. The greater the overcollateralization the better.
Therefore, Congress should not limit the amount that covered bonds can be overcollateralized. Minimum overcollateralization requirements, though, would be appropriate to help ensure high credit ratings for, and lower interest rates on, covered bonds.
Despite the FDIC's professed support for covered bonds, it is trying hard to block the growth of covered bond issuance by U.S. banks. Congress must unequivocally reject the FDIC's misguided attempts to torpedo covered bond financing that the Garrett bill seeks to encourage.
