Financial Update (Third Quarter 2008)

Covered Bond Framework Discussed as New Financial Tool

photo of man viewing chart on computer screen A covered bond framework, in which banks are allowed to manage pools of loans, substituting new loans into the pool as others become delinquent, might attract investor interest and increase access to mortgage credit, said Federal Reserve Board Gov. Kevin Warsh.

During a late July news conference, Warsh, U.S. Treasury Secretary Henry M. Paulson, and other bank supervisors discussed the financial tool that could help ease stress in the nation's residential mortgage finance markets.

Popular elsewhere, catching on in U.S.
Covered bonds are widely used in Europe, but not in the United States. That situation could be changing, however. The four largest American banks—Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo—also announced in July that they intend to issue covered bonds.

"I believe covered bonds have the potential to increase mortgage financing, improve underwriting standards, and strengthen U.S. financial institutions by providing a new funding source that will diversify their overall portfolio," Paulson said.

Many European countries have laws regulating covered bonds, but Paulson said he and other regulators and market participants believe a market for those instruments can grow in the United States without congressional action.

Gov. Warsh's remarksoff-site image
Secretary Paulson's remarksoff-site image

To spur broader choices in mortgage finances, the Treasury Department in July published a best practices guide for U.S. residential covered bonds. The guide is meant to outline practices that will promote covered bond market simplicity and homogeneity, using high-quality mortgages as collateral. The document complements a final policy statement of July 15 from the Federal Deposit Insurance Corp., Paulson said.

One tool, not a cure-all
"Covered bonds are simply one tool for mortgage financing and will not, alone, complete the housing correction," Paulson said. "We will continue to pursue our efforts to avoid preventable foreclosures and to speed, without impeding, the necessary course of this housing correction."

Warsh noted that at its discount window the Federal Reserve has long accepted a variety of quality collateral from depository institutions. Highly rated, high-quality covered bonds would generally fall within that broad range as eligible collateral, he said. Private lenders also will likely view such bonds as good collateral for credit extensions, Warsh added.

"Financial innovation," he said, "properly understood, can increase the diversity of funding sources, improve the distribution of risks, and provide incentives to monitor such risks—all helping to promote economic growth."

In addition to helping the U.S. economy, a covered bond market also will create opportunities for more international investment in the United States, Paulson said.


August 28, 2008