Community Banks Fear Impact of Covered Bonds

WASHINGTON — While Rep. Scott Garrett, R-N.J., and other top policymakers continue to push for the creation of a covered bond market in the U.S., some community bankers are raising concerns.

At a House subcommittee hearing Friday, Steven Andrews, president and chief executive officer of the $255-million asset Bank of Alameda, said a covered bond market was unnecessary and could put small banks at a competitive disadvantage.

"We have a covered bond market today, and that's called the Federal Home Loan Banking System," Andrews said. "I'm not sure, or certain that we need to enforce, or mirror, from other places a system that differs when we have the tools in place today. This new system would benefit the largest banks. By contrast the Federal Home Loan Bank [system] today is alive, and is vibrant, and is doing its job."

During the crisis, the Home Loan Banks provided liquidity through increased advances to large and small banks. A covered bond market, which would provide more liquidity to the mortgage market, was not needed, Andrews said.

Garrett held the hearing Friday in an effort to drum up support for his bill, which would set up a legal framework for a covered bond market.

But he faced skepticism from some quarters that the primary beneficiaries would be the largest banks. In a 15-page statement submitted to the capital market subcommittee, the Federal Deposit Insurance Corp. warned the legislation could have a competitive impact.

"The creation of this new government program will primarily benefit large complex financial institutions, which already enjoy funding advantages over smaller financial institutions and non-financial entities of all sizes," the agency wrote. "To provide these firms with additional government-backed funding advantages over smaller banks and nonfinancial firms would be at odds with everything we learned coming out of the crisis and work in contravention to current efforts to end 'too big to fail.' "

The FDIC previously fought against a covered bond provision introduced by Garrett during the regulatory reform debate last year. Despite support from Rep. Barney Frank, then chairman of the Financial Services Committee, the measure was stopped by Senate conferees over concerns raised primarily by the FDIC and the Treasury Department.

Covered bonds are touted as an alternative to securitization. But unlike securitization, in which loans leave the originator and are packaged into securities sold on the secondary market, the mortgages behind covered bonds stay on a bank's balance sheet. The collateral is refreshed with new loans if the original assets stop performing.

Supporters tout it as a safer system than the current secondary market, which was hit with waves of losses in the wake of the housing crisis.

Some proponents denied such a system would hurt small banks or the Home Loan Bank System.

"There will still be a role for the Federal Home Loan Banks; in effect it will be another form of funding," Bert Ely, an independent consultant in Alexandria, Va,, said. "The whole idea of covered bonds is to put another channel for financing out there for depository institutions of all sizes. Some have speculated that Federal Home Loan Banks might be more competitive in the shorter-term maturities; whereas covered bonds might be more appropriate for a longer-term maturity of debt. But there is room for both."

Still, Andrews warned that the government could be seen as backing the covered bond market if another crisis hit.

Tim Skeet, chairman of the Committee of Regional Representatives for the International Capital Market Association, disputed the claim. In Europe — with perhaps only Ireland as an exception — governments do not provide guarantees and investors do not factor in government support, he said.

"There are no implicit guarantees," Skeet said. "What there is, and we mustn't confuse the two things, there is explicit legislation and there is good supervision provided by arms of the state, but that is not the same as any form of guarantee nor do the investors factor that in."

Scott Stengel, partner of King & Spalding LLP, on behalf of the U.S. Covered Bond Council, noted that the Home Loan Banks, like Fannie Mae and Freddie Mac, are government-sponsored enterprises.

"This shouldn't be lost; the Federal Home Loan Banks are GSEs with an implicit federal subsidy," Stengel said. "They have every implicit subsidy that Fannie Mae has and Freddie Mac has. So of course they can provide more economical pricing for community banks."

But Andrews said small banks would be unable to participate in a covered bond market because they do not have sufficient volume of mortgages.

"Smaller banks in this struggling market may simply not have the number of loans to provide competitively priced covered bonds," Andrews said. "The government or market might be able to consolidate mortgage loans for smaller banks into covered bonds, but even this solution is likely to be at a higher cost compared to larger national originators with substantial deal flow." Others argued there were parts of the legislation that would help enable community banks to access the covered bond market, just as larger financial institutions do, through a pooling process.

But Andrews was not persuaded.

"Practically, what's going to happen is that all of this business will end on the books of the large banks and they will price out the little guys," he said. "Community banks do have access to liquidity through the Federal Home Loan Bank, but it's difficult for them to tap into the capital market because they are not significant enough in size."