Covered bonds are almost unheard of in the US, but their use has grown throughout Europe since the single currency was created and in Germany covered bonds have existed for more than 200 years.
Mr Paulson’s Treasury department is now working with an assortment of regulators to discuss the potential for a US covered bond market. The first such issues were sold by Washington Mutual and Bank of America just before the credit crunch hit but the market is in its infancy.
“As [the] Treasury seeks to encourage new sources of mortgage funding in the United States, improve underwriting standards and strengthen financial institutions’ balance sheets, covered bonds have the potential to serve these purposes and reduce the costs for first-time home buyers, and for existing homeowners to refinance,” Mr Paulson said this week.
Yet, even in Europe, the sector has been hit by the credit crunch, particularly in markets affected by house price declines. UK banks, for example, have been unable to issue deals since late last year and many mortgage lenders are facing greatly increased costs of borrowing in the market.
Despite this, the US efforts are gathering momentum.
The Federal Deposit Insurance Corporation, the US bank regulator, began work on covered bonds in April and was due to deliver its findings some time in the autumn. Now, the issue has shot up the agenda, and the FDIC is expected to report on the matter next week.
“The process in the US is clearly gathering momentum and the fact that the Treasury is reaching out to the whole range of interested parties is a sign of the dynamism surrounding the initiative,” said Tim Skeet, head of covered bonds at Merrill Lynch in London and a member of the American Securitization Forum’s covered bond working group.
Covered bonds have a number of differences to other mortgage-backed bonds that explain why US regulators believe investors stung by the loose underwriting standards of the housing boom might be coaxed into buying these bonds instead.
First, covered bonds generally have much stricter limits on the loan-to-value ratio of the mortgages used in them and are never used to fund subprime borrowers. Secondly, while the pools of mortgages that back each bond are ringfenced to protect them from problems at the issuer, the issuing bank has to guarantee that it will pay back the bond if the mortgages themselves turn sour. These conditions could encourage better underwriting by mortgage lenders in the first place, while also inspiring confidence among investors.
Mr Paulson hopes they could provide much-needed credit for prospective homebuyers and help revive the flagging US housing market, where purely private sources of finance have all but evaporated. So far, only the government-sponsored mortgage financiers Fannie Mae and Freddie Mac have taken up the slack but they are also facing financial pressure.
In addition, Fannie and Freddie’s increased dominance of the market could pose systemic risks if either was to run into trouble.
The American Securitization Forum told the FDIC in a recent letter: “From the perspective of regulators and the banking system more broadly [covered bonds] have the potential to complement recent policy initiatives designed to keep the capital markets liquid without putting undue strain on government-sponsored enterprises, the Federal Home Loan Banks, and similar institutions.”
While issuers from countries such as France and Germany without serious housing market concerns have been able to sell new bonds since the crisis, even they have had to pay slightly higher costs.
Meanwhile, the risk premiums, or spreads, on deals from countries with house price falls, such as Spain, have leapt to many times the levels common in the years before the credit crunch. Banks from the UK, Canada, Ireland and the US have not issued any deals at all this year. “These markets still need to undergo a repricing . . . in order to adapt to the new reality in the covered bond market,” said Fritz Engelhard, analyst at Barclays Capital.
Covered bond markets rely on demand from large bases of very conservative investors who would normally buy low-return, safe debt issues such as government bonds.
One of the biggest potential prizes for a US covered bond market would be the opening up a whole new set of domestic investors who previously have not funded mortgage lending. Many bankers believe such an investor base has the potential to make a US covered bond market bigger than the European one.
But it will not be a cure-all for the US, rather an extra source of funds alongside Fannie, Freddie and other private sources to help return the mortgage market to some form of health.
“Today we are also looking more broadly for ways to increase the availability and lower the cost of mortgage financing to accelerate the return of normal homebuying activity,” said Mr Paulson.