The model of securitizing mortgages was born around the time of the S&L crisis and has spent the last 20 years building momentum. The problem was that the so-called high-yield mortgage backed securities were constructed from subprime loans … only they received A-paper credit ratings on a relative basis. For example subprime mortgage backed securities would be divided into tranches. It was all flimsy paper that was underwritten with minimal standards–these were the low and no docs loans that were given to borrowers to buy homes with low or no down payments and that had rates that adjusted in 2 or 3 years.
But the trick was that a pile of bad paper would be split into three segments and rated from A on down. So it was all bad, but the best of the bad still got an A rating … and the tranches below that got internal investment banking nicknames like the “Scratch & Dent” pools (no joke). Now that this is all past us and investment bank lawyers are trying to strong arm their former mortgage origination partners into buying back the defaulted Scratch & Dent loans, Treasury Secretary Henry Paulson has been pushing covered bonds. We’ve talked about them a bit here (in the ‘Overall Market Impact’ section), and Bloomberg just did a long piece on covered bonds. Some excerpts below:
Paulson’s blueprint, unveiled last month, allows banks to sell bonds backed by mortgages made to homeowners who provide down payments of 20 percent and are current on their loans. U.S. covered-bonds might yield as much as 0.75 percentage point less than unsecured bank debt over time, according to analysts at New York-based JPMorgan Chase & Co.
While elements of covered bonds have been used in the U.S., the market has yet to catch on. Seattle-based Washington Mutual Inc. started the first U.S. program two years ago, followed by Bank of America Corp. in Charlotte, North Carolina. The two companies have issued a combined $20 billion of covered bonds. Sales in the U.S. may total $10 billion this year, rising to $20 billion in 2009, according to Dan Markaity, head of agency debt at New York-based Merrill Lynch & Co. The potential is between $180 billion and $228 billion, according to Morgan Stanley, also based in New York.
The article discusses how covered bonds have never caught on here despite being very popular in Europe because Fannie, Freddie, the Federal Home Loan Bank system, and private-label MBS (the previously gangbusters Jumbo mortgage market) have provided alternatives for banks to securitize and raise money. As an example for why covered bonds are not as favorable as alternatives:
The FHLB of New York offered four-year fixed-rate loans secured by mortgages at 4.4 percent last week. Bank of America’s $2 billion of covered bonds maturing in June 2012 were trading at yields of 5.03 percent, according to data complied by Bloomberg. The company’s $1 billion of unsecured notes due in September 2012 yielded 5.42 percent.
But as the markets look to find a better way, covered bonds will remain part of the discussion. Here’s the Treasury’s Best Practices Guide For Residential Covered Bonds.