After the mortgage securitization market shut down and the Treasury Department put the government-sponsored enterprises Fannie Mae and Freddie Mac into conservatorship in 2008, the Treasury issued a white paper suggesting covered bonds as an alternative. The administration and Congress are currently working on enabling legislation.

The Federal Home Loan banks have issued trillions of notes and bonds collateralized by their mortgage holdings over the past three-quarters of a century without missing a single payment, and now have over $800 billion of debt outstanding. Private-label covered bonds aren't necessarily that much different and could evolve into a quite similar structure but without the implicit federal backing enjoyed by the FHLBs on which their current triple-A rating relies. How do private-label covered bond issues compare to securitization, sales to Fannie and Freddie or FHLB funding when appropriately structured? Borrowers are no worse off and everybody else is better off.

Regulators: Covered bonds are a balance-sheet financing, whereas the whole point of securitization and sales to GSEs is to get assets off the balance sheet, with the adverse consequence that originators have little long-run stake in the performance of the loans. The amount of equity in securitizations is not very transparent, but as a result of various capital-avoidance strategies available under Basel I and II rules, the required capital for private-label MBS was generally only 40%-50% of the 4% capital required for retained mortgages and only 30% for mortgages sold to and retained by Fannie or Freddie.

Setting the overcollateralization of the pool of assets for a covered bond equal to the risk-based capital requirement for retained assets (currently 4%) eliminates the potential for regulatory arbitrage.

The only other legitimate issue for the government is whether the collateral maintenance agreements favor the bondholders over the FDIC in the event of liquidation, a minor issue that can be worked out as it has been for collateral pools backing FHLB advances.

Investors: The uncertain and unpredictable cash flows of mortgage-backed securities are eliminated, replaced by simple debt. In addition, the credit risk is much easier to evaluate. The obligors are mostly regulated banks with transparent balance sheets. In the rare event of an issuer failure and takeover, the bondholder is protected by the collateral pool. Hence the initial credit review is focused on the collateral maintenance agreement and trustee credibility, both of which will quickly become standardized.

Issuers: Any community bank should be able to issue a covered bond, as the collateral cover will be the most important factor in evaluating the default risk and determining the credit rating. This essentially expands a bank's funding source beyond deposit funding and potentially to longer maturities at a much lower issuance cost than private-label securitization, and virtually eliminates the prior concern with excessive MBS credit ratings. Finance companies and mortgage banks can also issue these bonds, but they will have to post the same issuer excess collateral and hence capital as a bank. Intermediate banks may evolve as bond issuers to diversify the credit risk of community banks, something like a private FHLB system.

Investment banks: They will do what they always do, underwrite and distribute the securities to the same investors that buy both private-label and GSE securities. They will then make secondary markets in these bonds.

Borrowers: They will deal with their local bank and/or the entire array of mortgage bankers and brokers they currently do with the same array of loan products available under the new consumer regulations, including fixed-rate loans. But these loans can be sold, servicing retained or released, in the local market where credit conditions can be better assessed.

Private mortgage insurers: They will play the same role as they currently do. Insurance should probably be required for loans with a loan-to-value ratios above 80%, and loan balances above that shouldn't be counted as collateral in any event.

FHLBs: This is a sound program and should operate essentially as is during a transition to a covered bond market. But the 5% capitalization requirement for private-label securitization will drive all conventional loans not funded on the balance sheet with deposits into FHLB advances where the capital requirements are much lower. Hence FHLB capital requirements should be raised to the same level as that of banks and their implicit guarantee phased out, creating a level playing field.

Worst Case: Covered bonds have not defaulted internationally and required government bailouts due to their conservative structure, but the details of what happens in liquidation still need to be worked out. While the collateral pool can be actively managed up until the time an issuer defaults, the debenture becomes a cash-flow mortgage-backed bond at that point, where the trustee pays the interest and principal out of the mortgage cash flow. Managing monthly cash flow to meet biannual interest payments should not be a problem for the trustee. But depending on the prepayment penalties assessed the borrower, refinancing and default could accelerate the bond repayment as they do now for all MBS.

So everybody wins, including the taxpayers who are off the hook for defaults. There are no limits once the legislation is passed and rules are promulgated.

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