Is mortgage securitisation dead? What with Fannie and Freddie unfit for purpose, foreign capital draining from the market, and ratings regarded as more or less worthless, there are plenty of indicators that would have you believe the MBS has left the building
Linda Lowell at Housing Wire assesses the situation in some detail.
One possible panacea that has had a particularly warm reception from US Treasury officials is the covered bond, something we’ve covered in a little depth before.
Covered bonds though, aren’t enjoying quite the takeup Hank Paulson might have hoped for. Felix Salmon over at Market Movers notes the recent downgrading of covered bonds issued by Washington Mutual. Says Salmon:
Remember covered bonds? They’re ever so safe, because not only are they overcollateralized, they’re also guaranteed by the issuing bank. As a result, Hank Paulson has been dropping hints that he’d like to see the mortgage industry move in the covered bond direction in future
But “safe” doesn’t mean “immune to downgrades”, of course — and Fitch has already started downgrading covered bonds issued by Washington Mutual. One problem is that it’s very hard for a ratings agency to assign a rating to a both-and probability, which is what a covered bond is.
Salmon suggests that a key way to move forward might be a little more clarity on how CB’s get their triple-A ratings from the agencies: an idea of how the two main props to a CB rating, institutional risk and collateral risk, are modelled and apportioned.
So one thing I’d like to see, if and when covered bonds become more popular, is the ratings agencies showing their work, as it were. We know what the rating of the bank is, and we know what the rating of the covered bond is, too. But in the interests of transparency, also tell us what the rating of the covered bond would be, if it didn’t have the bank’s guarantee. That would definitely help investors get an idea of what the chances are of one leg or other being kicked out from under the bond.
It’s a great idea. There is a problem though - which Salmon seems to allude to (emphasis ours):
It’s tough. Mathematically speaking, if the chances of the collateralization failing are genuinely independent of the chances of the bank failing, then the chances of them both failing (which is what you need for a covered bond to default) are just 5% of 5%, which is 0.25%: easily low enough to be triple-A. But there’s something intuitively a little dubious about two single-As making a triple-A quite so easily.
If indeed. The problem is that in many cases, the two measures - institution risk and collateral risk - aren’t genuinely independent at all, but in fact, correlated. In some cases highly so. Consider: banks currently are in trouble because of the crash in price of mortgage-backed bonds.
Rating agencies do model this correlation. And the failure to capture it accuracy is exactly the reason why triple-A ratings have fallen so spectacularly from grace. Too often, different rating metrics were treated as independent, when in fact, they were correlated. Most ABS ratings suffered this problem.
We could talk a bit about gaussian copulas vs exponential vasiceks here, but this post is about covered bonds. So back to them.
Irregardless of the rating assumptions behind them, not everybody can be happy with the use of covered bonds as a market pick-me-up. Certainly not the Europeans anyway. Covered bonds are something of a sacred cow in most of Europe. Nowhere more so than in Germany, where most Landesbanken like to recount the 18th century Prussian provenance of the pfandbrief.
The covered bond market over here is very conservative. It’s strictly regulated by law. That is really what makes covered bonds so special. And there’s a very high emphasis on the exclusivity of the CB brand.
For example: Until earlier this year, the UK didn’t have its own covered bond law. Instead, it relied on a blend of contract laws to simulate the security of a covered bond through legally seperate shell companies. The nascent US model is the same. There was though, outcry when the the UK introduced its first “structured” CB. French banks in particular complained it was sullying the sanctity of the covered bond brand. In the end, the UK government, by coincidence or design, took their complaints seriously. It now has its own covered bond legislation, under which banks have to register with the FSA to issue covered bonds.
Even with that though, the UK is cautious with CBs. So much so, that even with a covered bond law, the government has still put an effective hold on UK covered bond issuance in the current market. The FSA has held off on inking the issuer registration forms that would allow the UK’s mortgage banks to issue.
Basically, the FSA did not want to do what they see as irreperable damage to the deep, liquid CB markets by lowering the bar - or even being seen to.
The US, of course, isn’t proceeding with quite the same caution. It seems that there covered bonds are being envisaged as safe products - but not necessarily the safest.
This is where the US might be shooting itself in the foot. At a time when foreign capital is flooding out of the mortgage market what they really want to do is attract some back. If they made covered bonds as strong as their European forebears, they might be able to tap the very deep and liquid European market.
It is, of course, a big might.
One thing is for sure though, under the current design, European CB buyers would be fools to touch the US stuff. They’re probably pretty narked that the things are being called Covered Bonds at all. What really makes a covered bond isn’t the issuers cover, but what the issuers cover gives: a very, very stable triple A rating.
