Friday, 25 July 2008

What's up with the covered bond push?

I've been particularly busy this week, nonetheless, I hope to convey enough background on the topic of covered bonds to start a discussion that I think may lead to interesting ideas.

Whenever Henry Paulson at Treasury, Ben Bernanke at the Fed and Shiela Bair at FDIC agree on anything, American taxpayers should check for their wallets to see if they are being mugged. As a result, my eyebrows rose a bit when these three started pressing in concert for covered bond issuance in US markets some weeks ago.

Covered bonds are a huge market of over $3 trillion in Europe, but have never been popular in the USA where securitisation was the preferred model for financing banks. They are perfectly legal and raise no issues, they just haven't been as profitable as securitisation so haven't been supported by the US markets. Covered bonds allow for extension of credit to a bank SIV or trust that will be serviced by income from hypothecated assets on the bank's balance sheet. The assets stay on the bank's balance sheet unless there is a default on the bonds, at which time the assets are forfeit as collateral to the trust vehicle servicing the covered bond.

Last week the FDIC released a policy statement on covered bonds that provides for "expedited release of collateral" if an issuing bank is taken into FDIC receivership or liquidation. The Treasury is expected to release a protocol on best practices for covered bond issuance in a high profile event next week. Hmmmm. What could be up?

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.
When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America's banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I'm not sure on this one, so I'm looking forward to views from those more expert here.

16 comments:

Senna said...

LB,
in your opinion are we heading down the path of hyperinflation or will credit destruction cause deflation? Not worried about the USD in deflation, but if HD occurs, what do you recommend to hedge? Gold? Even as its manipulated?
Thanks

London Banker said...

I'm expecting parallel inflation and deflation at the same time. Inflation as imported commodities (oil, metals) rise in dollar terms and are subject to competitive demand while the serial bailouts and stimulus gimmicks blow out debt some more. Deflation as Americans get too squeezed to buy much in the way of inessentials (second homes, new electronics, investments, etc.). Deflation lasts longer.

Dragos Popa said...

that type of piecemeal would be the typical WS dog eat dog thing to do...

but, as timing might go, would they dare adding another burden on the taxpayer after F&F and potentially FHA?

Anonymous said...

You're the one with the experience, but when a bank goes into receivership, wouldn't the fdic sell all the assets (getting good money for the best ones) and essentially left taking big hits on the bad ones? I'm not sure what the difference is, except here we let the wolves out to go and identify the good assets ahead of time and take their money earlier rather than later.

The real rub would be if the wolves were allowed to issue the covered bonds with larger haircuts than the fdic would if they were selling them outright.

To the extent that the whole situation is deteriorating rapidly, wouldn't the early money be the best money?

I see the early 'investments' (now worthless) of the SWF's in our banks to be similar.

m

Anonymous said...

I was going to say something similar to "m" (although probably not so cogently). What kind of ratio of bond $amount/asset do covered bonds have? If it were 1/1, then this wouldn't really make much difference, as the bank would have cash in hand to use, and so its demise would simply be delayed, and FDIC would gain some time and lose nothing. If the haircut ratio was substantial, then this would truly be a worrisome scheme.

I'm glad you have a blog of your own, LB. I bookmarked it, so it will be much easier to find that the sub-site at RGE. I have enjoyed reading your comments and think you have some great insights.

suecris

Anonymous said...

I don't think Secretary Paulson has made clear why he thinks covered bonds are a great alternative to MBS. It seems he has successfully gotten the FDIC to "ring fence" the assets securing a covered bond in the case of a bank issuer which fails. Perhaps the assets are not viewed as part of the estate under the U.S. Bankruptcy Code for a non-bank issuer. However, my understanding is that the assets in a trust for MBS cannot be touched by other creditors in both the case of bank insolvency law and the Bankruptcy Code. covered bonds do not seem to have an advantage in this respect.

Also, one of the advantages of MBS is that the issuer gets rid of interest rate risk, though may retain credit risk if it guarantees the MBS, as Fannie and Freddie do. With covered bonds, it would seem that the issuer retains both type of risks.

What am I missing?

Anonymous said...

should get more info from the Crooks soon enough!

09:48 U.S. Treasury says to issue guidance for development of covered bond market at 2:30 pm - Reuters

gamma

Anonymous said...

anonymous 5:31

With mbs, the cash flows are all very exact. I would guess they are thinking more along the lines of the 'kitchen sink' bonds of the late 80's, mixing up asset classes, etc.

m

Anonymous said...

anonymous 5:31

With mbs, the cash flows are all very exact. I would guess they are thinking more along the lines of the 'kitchen sink' bonds of the late 80's, mixing up asset classes, etc.

m

Anonymous said...

Hey, LB

I guess we will know soon enough if you were paranoid or not. In the meanwhile, your scenario is credible enough.

RGE's AfA

TMoney said...

Cynical ? No I don't think so. More like money good ! A brillant way (and well explained too) to skim off the last shreds of value and leave taxpayers holding a bigger bag.

icanhasforce said...

You're the one with the experience, but when a bank goes into receivership, wouldn't the fdic sell all the assets (getting good money for the best ones) and essentially left taking big hits on the bad ones? I'm not sure what the difference is, except here we let the wolves out to go and identify the good assets ahead of time and take their money earlier rather than later.

From what I read, Covered bonds would get pulled out of the banks assets and go directly to the investors. That would mean that the FDIC would only get the garbage. Covered bonds can be repackaged at any time as the offering institution sees fit, so just before they go into receivership they can repackage all the underperforming loans into junk bonds, and the performing ones into their "good clients" bonds. This way friends stay solvent and the US taxpayer is guaranteed to pay a bailout.

Anonymous said...

icanhasforce,

you are getting money for the covered bonds, aren't you? (not that i would buy them.)

the fdic, in the event of receivership, would theoretically:

sell good assets for good money and sell bad assets for a lot less money.

under this plan the bank would "sell" the good assets for good money NOW, and leave the fdic to sell the bad assets for a lot less money later.

i'm still not sure i see a difference. The caveat would be the extent to which current management at the bank pillaged for bonuses and renumeration between now and receivership.

Anonymous said...

Wouldn't there be a revolt by already existing bank bond holders? Can a bank subordinate existing bond holders in this way?

Knute Rife said...

Absolutely spot on LB. In fact that's effectively what happened (sans covered bonds) with the S&Ls 20 years ago. So why are the bonds entering the mix this time? Churn, baby, churn! There are fees to be pocketed. Then the bonds can be repackaged and sold as "high quality" paper on a secondary market. I smell another derivative bubble.

Then comes the inevitable bail-out (The history books will one day conclude that our civilization suffered death by moral hazard.), and things really go to Hell in a handbag. Fannie and Freddie could double the national debt overnight. What would the FDIC do? By then the system will be under so much pressure, it will be impossible to predict which gasket will blow first.

MyInvestorsPlace said...

Your guess and suspect is going to happen. Good prophecy! I think that we are standing before a deep waterfall ahead of us!

MyInvestorsPlace - trading, value, investing, forex, stock, market, technical, analysis, systems