In Aug. 3 testimony before the Senate Banking Committee, Thomas Hamilton, speaking on behalf of the Securities Industry and Financial Markets Association, stated that possible steps to take to solve the issues currently affecting our mortgage finance system could include the government limiting the amount of borrowing that banks can do from the Federal Home Loan Banks, and developing a market for covered bonds in the United States.
Certainly, given the dire economic situation we find ourselves in, any additional sources of funding should be explored, but not at the cost of limiting the effectiveness of the Federal Home Loan Banks. Indeed, the Home Loan Banks came through the mortgage crisis in stellar fashion, providing advances to their members—more than 7,000 local lenders across the country—that reached $1 trillion at the height of the crisis. This vital liquidity was provided without a single loss on these advances, and therefore, not a penny of loss to taxpayers. Why cripple a winner to give a competitive advantage to an untested competitor—a potentially riskier one at that?
Covered bonds are a common source of mortgage funding in Europe and are similar to our country's mortgage-backed securities, with the exception that the loans in these pools remain on the balance sheet of the issuing bank and the pool is actively managed. Obviously, this structure is only workable for very large banks, which explains its appeal in Europe, where large, state-sponsored banks dominate.
Today, large U.S. banks can structure and bring to market issues of covered bonds. But the transactional costs and the absence of a government guarantee produces a relatively unattractive yield for investors, which leaves the covered bond proponent looking for some level of government support, or the option to expand the categories of assets in the pool—in addition to mortgages—to increase the yield potential. And we know what happened in the MBS market when the mortgage packagers and investors started chasing yield.
While the European covered bonds typically consist of high-quality loans, the proposed U.S. model would allow risky assets such as home equity loans, student loans, auto loans and credit card debt to be pooled into the securities. As Christopher Whalen, publisher of the Institutional Risks Analyst, was quoted in a March newspaper article as stating, “This proposal is about starting the Wall Street assembly line for selling toxic waste to investors.”
Another detriment to impairing the advances capacity of the Federal Home Loan Banks in order to encourage the growth of covered bonds is the adverse impact such a move would have on small banks. As Stephen Andrews, a community banker with the Bank of Alameda, a member of the Federal Home Loan Bank of San Francisco, stated in March 11 testimony before the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises: “Smaller community banks would be at a competitive disadvantage in a covered bond market because they do not have the volume of mortgages necessary to support covered bond financing.” So small banks would be shut out of the covered bond market and likely face higher advances fees from diminished and smaller-scale Federal Home Loan Banks.
Community bankers are not the only ones concerned with the prospects of a covered bond market. In March, the Federal Deposit Insurance Corp. issued a statement on the legislative proposal to create a covered bond market in the United States. “The creation of this new government program will primarily benefit large complex financial institutions which already enjoy funding advantages over smaller financial institutions and nonfinancial commercial entities of all sizes,” the organization stated. “To provide these firms with additional government backed funding advantages over smaller banks and nonfinancial firms would be at odds with everything we learned coming out of the crisis and work in contravention to current efforts to end too big to fail.”
The FDIC, referring to the expanded asset types to be included in the pools, added that the proposed structure of a U.S. covered bond market “will thwart the nascent efforts to enhance market discipline in the wake of the financial crisis.”
Given the magnitude of the housing and mortgage crisis we recently experienced, it is important that we continue to debate and explore new initiatives that might enhance market opportunities and reduce future crisis. But we shouldn't jump into proposed solutions without fully vetting the pros and cons, given the significance of the issue to our economy and the consumer's well being.
Joseph Melone is chairman emeritus of The Equitable Companies Inc., where he formally served as president and CEO. He has served as a director of the Federal Home Loan Bank of New York since 2007.
