Two hundred and forty years ago Frederick the Great of Prussia found covered bonds a handy tool to rebuild a shattered nation after the Seven Years’ War. Could the same technique now bring relief to America?
Hank Paulson, Treasury secretary, is currently discussing ways to kickstart the domestic market for covered bonds. These rock-solid securities, issued by banks and collateralised by mortgages or public-sector loans, offer investors dual recourse: both to the asset pool itself and to the issuer’s balance sheet. That makes them as safe as safe gets, with nary a single default in their history.
So far, however, US banks have more or less ignored them. Global issuance of close to €2,000bn is almost entirely from European institutions, which use covered bonds to finance about a fifth of all home loans. Only a couple of US lenders have tried them out so far.
The traditional obstacles are clearly falling away. Some alternative sources of funding, such as residential mortgage-backed securitisation, have dried up completely, while money from the Federal Home Loan Banks, a government-sponsored system, comes with onerous conditions and capacity constraints. The lack of a specific covered bond law should not be seen as a drawback: in recent years the UK and the Netherlands have shown it is possible to develop a decent market without one. US investors, meanwhile, have shown the makings of an appetite; HBOS and Depfa, among others, have sold well to American accounts.
But this will not be a quick fix. Unlike asset-backed securities, the loans used to secure the obligations in covered bonds remain on the issuer’s balance sheet, so that their performance runs through the P&L. That, in theory at least, brings a new discipline to the lending desk. For banks accustomed to securitising away loans to “ninja” borrowers (no income, no job, no assets), that could be a tough pill to swallow.