Covered bonds as a panacea – or a recipe for the FDIC to kick in more taxpayer money

I am getting jaundiced in the banks pushing covered bonds as the panacea for the housing market and the journalists who buy it. This story really got my goat because it is so one-sided.

All a covered bond is is a guaranteed securitisation.

• Currently a bank can borrow money unsecured or subordinated to buy mortgages. In which case the borrowed money carries a bank guarantee, is generally subordinate to depositors, and hits the bank’s capital ratios. In insolvency the assets are there and that helps pay depositors.
• Alternatively a bank can securitize, in which case the funding is secured, but there is no bank guarantee and hence there is no impact on the bank’s capital ratios. Ideally there is no effective guarantee at all on the assets in which case problems with those assets cannot hurt depositors.

What the investment banks want to sell is funding which is secured and carries a bank guarantee.

When a bank sells covered bonds problems with the assets hurt depositors but the assets are not available to help pay off depositors if the bank gets into trouble.

In other words it downgrades the claim of the depositors whilst not reducing the risk to deposits.

Deposits generally carry a Federal Government guarantee. Covered bonds will increase the cost of honouring those guarantees and hence increase the cost to tax payers of bank bail outs.

Paulson wants to allow this. Advice to the Senate: you will be there in 12 months. Paulson will not. Think of it that way.

J

Update

A couple of people (notably Mish) have pointed out the limitations on covered bonds will make them less useful than they might otherwise be and hence reduce the systematic risk. The Aleph Blog also made that point here.

I still think this is very dangerous. Imagine a bank in some trouble selling covered bonds. When the loans go bad they need to replace them. When the insolvency happens the bond holders wind up owning the good assets and the bad assets get left preferentially to the depositors (read the taxpayers). But the limitations which are extensive both reduce this risk and reduce the effectiveness of the bonds as a capital raising tool...