Changing the Window Dressing

Yesterday’s announcement that the Treasury Department has blessed covered bonds for use in the mortgage market made me wonder if Wall Street and the government have learned anything from the credit crisis gripping the national economy. There are two distinct differences between the collateralized debt obligations (CDOs) that got us into trouble in recent years and the covered bonds as announced yesterday by Treasury Secretary Hank Paulson. First, rather than removing the securitized assets from the seller’s balance sheet, the assets remain in the issuer’s control, providing purchasers recourse against those assets. The second difference involves the types of mortgages that can be securitized in a covered bond. So-called “stated income” or Alt-A mortgages, as well as the notorious subprime mortgage, cannot be included in a covered mortgage bond. Beyond these two differences, CDOs and covered bonds are essentially identical.

The idea with a covered bond is that since the assets stay on the issuers’ balance sheets, they are less likely to take risks with the securitized assets. Additionally, the purchaser of these bonds has recourse against specific balance sheet items, a feature intended to limit the default risk associated with mortgage-backed securities. Unfortunately, these debt instruments are still based on residential mortgages, an area of the US economy showing substantial weakness in the foreseeable future.

While intended to provide more liquidity to the mortgage market, covered bonds still rely too heavily on the CDO model. It seems unlikely to me that the minor differences noted above will instill enough confidence in the market for these instruments to have any impact on mortgage availability.

My other concern with covered bonds regards insurance. Bond insurers, having suffered greatly over the past year, are not in a strong position to offer insurance on covered bonds. Given that covered bonds provide recourse, the utility of bond insurance is further reduced. Additionally, I, for one, see little value in the insurance offered by major insurers.

Ultimately, the success of these securities will depend directly on the quality of the underlying mortgages and the health of the US economy, both of which are quite uncertain now and in the near term.