The Treasury guidance on such bonds – widely used by mortgage banks in Europe but rare in the US – is a significant move towards stimulating US issuance following this month’s crucial policy statement from the Federal Deposit Insurance Corporation.
Covered bonds are a form of secured bank debt that gives investors recourse to an issuing bank’s balance sheet as well as to a pool of collateral – usually high-quality mortgages or public-sector loans – if the bank is unable to repay its debt.
Mr Paulson hopes the bonds will provide a new source of funding to the US’s mortgage lenders when the private, off-balance-sheet mortgage-backed bond markets remain in effect shut and the government sponsored agencies Fannie Mae and Freddie Mac face constraints.
Bankers involved in the field reckon that a US covered bond market could ultimately outstrip the roughly €2,000bn European market. However, it faces limitations in the near term because of restrictions placed on the bonds’ treatment by the FDIC, which importantly has oversight of banks if they become insolvent.
For example, the FDIC said banks should be restricted from using covered bonds for more than 4 per cent of their funding in order to avoid depleting the assets available to repay ordinary depositors and other unsecured creditors if a bank failed.
In the US, the cost of issuing covered bonds and the FDIC restrictions mean they could lie low in the pecking order of banks’ funding preferences, at least initially, according to analysts at Citigroup. Funding through Fannie and Freddie or through the Federal Home Loan Banks both appear more attractive for now, the analysts said.
Washington Mutual and Bank of America are the only US banks to have issued covered bonds so far, although HBOS of the UK has sold a deal in US dollars.
Covered bonds in Europe have not been immune to the turmoil in credit markets, either, in spite of being seen as much safer than other mortgage-backed bonds, in which investors do not have recourse to the issuers’ balance sheet. European issuance is down 35 per cent this year.