Focardi on Covered Bonds—Update #1

Craig Focardi is a Research Area Director for TowerGroup, which describes itself as "the leading research and advisory services firm focused exclusively on the financial services industry."  In year-end articles for two financial publications—Mortgage Banking and Mortgage Strategy—Focardi has attempted to predict what the near future will bring to residential mortgage financing.

In both articles Focardi spends a few paragraphs on covered bonds.  Here are his basic opinions on that topic:

• Big banks would love to change the balance of power vis-à-vis Fannie Mae and Freddie Mac—and covered bonds are “the conceptual solution” that eventually could “put large banks in the driver's seat.”

• The need to work out legal and structural issues will prevent covered bonds to start growing significantly as a funding source for at least “a year or two.”

• The loans underlying covered bonds will have to be “squeaky clean”—which means issuers will have to compete for loans currently going into government-backed MBS.

• Another impediment is that before launch a major covered bonds initiative, the banks must accumulate more capital and improve their credit and operational risk management.  In particular, Focardi points to Basel II and delays with its adoption in the U.S.

• Focardi does not expressly reference the low cap on covered bond issuance that the FDIC currently imposes in order for FDIC-insured banks to reap the benefit of the FDIC’s Covered Bond Policy Statement—4% of  an issuing bank’s liabilities.   But he notes that since covered bonds are an on-balance sheet funding source, regulators (and investors) would have to get comfortable with a ballooning of residential mortgage liabilities on banks’ balance sheets.

Focardi’s bottom line is that securitization through government-related entities “will remain the primary form of permanent mortgage funding in the U.S. until at least 2010,” regardless of what fate the government eventually decides for Fannie and Freddie.

You can read one of Focardi's articles on the Mortgage Strategy website: “US mortgage banking, 2012.”