Paulson Discusses Covered Bonds in Talk on GSEs

Discussing possible future scenarios for the GSEs—which will have a big impact on how the U.S. secondary mortgage market evolves—Treasury Secretary Henry Paulson did not have very much to say about where covered bonds might fit in.  Even so, it is worth looking at the few things he did say on that topic in his address to the Economic Club of Washington (Jan 7).

In the main part of the speech, Paulson basically came out in favor of replacing Fannie Mae and Freddie Mac with up to two “public utility-like mortgage credit guarantor[s]” that “would purchase and securitize mortgages with a credit guarantee backed up by the federal government, and [that] would not have investment portfolios.”  These mortgage credit guarantors would be strictly overseen by a “rate setting commission that would establish a targeted rate of return.”

After recommending that approach as the “best” way to proceed, Paulson moved on to the question of  how to “enhance the ability of depository institutions to fund mortgages, either as competitors to a newly-established government structure or as a substitute for government funding.”  In this context, Paulson noted that as of 2010, the GSEs will be required to pay the government a fee in return for its continued “backstop” of their guarantees.   He pointed out that if that future fee accurately reflects the risk, there will no longer be a government subsidy to mortgage availability through guarantees.  

“[A]nother approach,” in Paulson’s view, “might be to offer other financial institutions the opportunity to pay a fee for government backing on securitized, conforming loans, a structural transformation that would lower entry barriers, and increase competition and innovation in housing finance.”

Finally, Paulson raised the topic of covered bonds—as “another private sector alternative worth exploring.”  He said there is “strong interest in developing a U.S. covered bond market,” but gave no details about who still has that interest, what plans for development might actually be in the works, or when he thinks the first new U.S. covered bonds might actually be issued.  His only reference to time was a caution that “we will have to work through the credit crisis before a new market might actually take hold.”

Paulson also made a positive remark about “dedicated covered bond legislation”—perhaps a reference to the possibility of laws that would enable issuance of so-called statutory covered bonds, like those in some countries of Europe (which can have certain advantages over wholly “structured” ones).  He said such legislation “could be helpful to establishing this market, and should be considered in the context of broader housing finance reforms.”

But all that lies well down the road (if it happens at all).   For the time being, Paulson seems to see the market as continuing to rely on Fannie Mae and Freddie Mac in more or less their current role.  “The GSEs are critical to getting through this current period,” Paulson said, “and that is our first priority.”

Here are Paulson’s remarks on covered bonds in full:

“Covered bonds are another private sector alternative worth exploring. The FDIC has made regulatory changes to support the emergence of covered bonds, which could provide enhanced opportunities for depository institutions to fund and manage mortgage credit risk. There is strong interest in developing a U.S. covered bond market, but we will have to work through the credit crisis before a new market is likely to take hold. Some have advocated dedicated covered bond legislation, which could be helpful to establishing this market, and should be considered in the context of broader housing finance reforms.”

To download a PDF of Paulson’s complete speech, click on “20090107 Paulson on GSEs” under “Attachments,” below.