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America should not have a covered bond law

10 June 2019

At the recent Euromoney North American covered bond conference we held an Oxford Union style debate on the motion that “This house believes that America should have a covered bond law”. To many people’s surprise I opposed the motion. Here’s why.

There are many reasons why I love covered bonds. But, contrary to the saying, love is not blind, I know that their strengths rely on several costs. My argument was that covered bonds are beneficial in ways that are less important in the US, and the costs more costly.

A defining characteristic of covered bonds is their ability to mobilise risk averse and largely unsophisticated capital markets investors for the benefit of the real economy.  With a financing system so heavily skewed towards the bank rather than capital markets, measures to make banks safer (and therefore less able to serve the real economy) are always going to hit European economies heavily. I believe that is a large reason both for Europe’s more sluggish recovery from the financial crisis and, therefore for the need to promote instruments that can channel real money investors into the banking system safely and simply. 

Sure, there are European investors who are sophisticated, but by and large they are leveraged investors – they don’t invest their own money. The ‘real money’ investors that are the bedrock of the US capital markets, including the racier bits like high yield loans and deeply subordinated securitisations, are risk takers. In Europe, we are not. Our pension funds, mutual funds and asset managers have safety in their DNA. Whether the difference is hereditary – our ancestors are the ones who turned down the risks and returns of colonising a new continent – I wouldn’t like to speculate.  

Another characteristic of covered bonds worth highlighting is their incredible ability to stop banks from defaulting. The arguments about market access and funding delinked from credit ratings are well known. The use of own issue covered bonds as collateral for emergency liquidity from a central bank are, to the market’s detractors, just an example of the egregious favours that set covered bonds apart from securitisations. But for me, a believer in the rationality of central bank credit decisions, they are the private sector equivalents of the market access point.

Quite simply, central banks accept own issued covered bonds in emergency liquidity operations out of pure self interest – the need to protect themselves. Nothing egregious about that.

The value derived from an instrument that mobilises capital markets for the real economy is an obvious difference between the US and Europe. But I would also argue that the greater value of avoiding defaults is another. Americans intuitively understand the ‘gale of creative destruction’, the need for bad banks to fail and the need for ways to mitigate failures  – contrast the importance of the Federal Deposit Insurance Corporation in every American discussion about banking to the tortuous debate about the European Deposit Insurance Scheme.

But if the benefits of covered bonds are less in America, what of the costs?

A case in point about the importance of the FDIC: the subordination of other creditors, in particular retail depositors, is far more of a concern there than in Europe. So many Americans that I speak to are shocked that the vast majority of countries in Europe do not cap covered bond issuance to protect other creditors.

Then there is the impact of strict asset eligibility rules on the overall appetite for risk in mortgages. Americans do have higher loan to value mortgages on average than Europeans, a large reason for that is the fact that 1 in 4 mortgages in Europe are financed by covered bonds with strict limits on that ratio.  Am American bank would be more competitively disadvantaged by a need to create safer assets than it’s European peer.

Finally there is the greater aversion to any possibility of government intervention in the capital markets. True, the US government took Fannie and Freddie into conservatorship. But as those agencies only exist to help Americans buy homes, that intervention was more politically acceptable than the bail-out of a bank for whom mortgages are just one business line among many. Covered bonds do not provide government guarantees. But they do create a much stronger nexus between the credit worthiness of the government and that of the funding of homeloans. That is more tenable in Europe than in America.

I’m not, and never will, say that covered bonds won’t happen in America. Its just that their potential benefits are less and costs higher than they are in Europe. 

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