End of Mortgage Interest Deductions? Primer On Covered Bonds.

Occasionally I am asked, “How safe is the mortgage interest tax deduction?” In the past I was much surer of my answer (“Safe – what politician wants to take away even one of the advantages of home ownership?”), but ongoing talk of ending this homeowner tax benefit makes me think twice. Whether eliminating it for 2nd homes, lowering the cap, or whatever, one can smell gradual change in the wind.

REIT’s are garnering much of the press in the mortgage world right now. But we have other capital market “ideas” that companies are watching. One of these is the drive to restart Wall Street’s securitization machine with instruments known as “covered bonds” which some feel will give private investors the comfort they need again. Covered bonds aren’t new, and they’re used extensively in other countries. They are pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets.

The bank that issues the bonds, meanwhile, retains the credit risk. If losses arise, the bank that issued the covered bonds must offset the loss with its own capital, letting investors sleep better at night but making banks “near the edge” that much more nervous. If an asset in the pool defaults, a separate entity would be required to remove the assets from the bank’s control. The assets would then be out of reach of the FDIC should the bank fail and the agency step in as receiver. The investors who bought the covered bonds would have first call on the assets, ahead of the FDIC. Banks bypassing the FDIC? Don’t bet on that happening in the US.

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