Many people are asking about Treasury Secretary Paulson’s Covered Bond Plan.

Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. threw their support behind Treasury Secretary Henry Paulson’s effort to spur covered bonds as a new source of mortgage financing.

“We look forward to being leading issuers as the U.S. covered bond market develops,” the banks said in a joint statement in Washington. They applauded Paulson’s release today of guidelines for issuers of covered bonds, which detail the types of loans that should go into the securities and how their payments ought to be made.

Even in Europe, where covered bonds are a market in excess of $3 trillion, investors are shunning the debt amid a collapse in appetite for investments in housing.

“Mortgage-backed securities investors are not in the mood right now to buy bonds with anything less than government backing,” Kenneth Hackel, managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in an interview, referring to debt guaranteed by Fannie Mae and Freddie Mac.

Paulson said the four U.S. banks are “ready to go” and that sales by the largest banks can help encourage smaller mortgage lenders to proceed. “Covered bonds have the potential to increase mortgage financing, improve underwriting standards and strengthen U.S. financial institutions,” he said.

Covered bonds offer greater protection to investors because banks keep the home loans on their books, and must make up shortfalls if homeowners fail to pay.

Covered bonds achieve higher ratings than regular notes by augmenting the issuer’s pledge to pay with a group of assets such as mortgages that can be sold in a default. The extra security allows lenders to pay less interest.

While the securities are backed by loans and bank assets to get AAA ratings, most are valued, on average, as if they were three levels lower.

The Treasury’s guidelines spell out a formal definition for covered bonds. The bonds should have maturities of at least one year and no more than 30 years. Home loans in covered-bond pools would have a maximum loan-to-value ratio of 80 percent.

First off, I like the idea of covered bonds. Over time they could allow for a somewhat graceful unwinding of Fannie Mae and Freddie Mac. See Nature of the Fannie Mae Bailout for more on this idea.

In addition, forcing banks to keep responsibility for the loans will encourage far sounder lending practices than the current originate and securitize model, especially after the debacle we are in with Alt-A and subprime loans.

However, note that the maximum LTV is 80%. How many people have 20% down payments? The second problem is that banks are capital impaired and selling off assets. How likely is it for those same banks to be taking on additional debt? The answer is not very.

Finally, the credit crunch is not going away anytime soon. The general idea at many banks right now is We’re Saying No To Almost Everybody.

So while covered bonds are a reasonably good idea in a sea of horrid ideas, they simply are not going to do much to alleviate any problems in the mortgage markets, anytime soon. What politicians should do is give this market time to develop but politicians never want to wait.

Mike “Mish” Shedlock
Click Here
To Scroll Thru My Recent Post List