Bernanke's speech on mortgage finance

Linking the Mortgage Market and the Capital Markets: Some Alternative Approaches

How might the GSEs be reorganized in the future to address the problems that have been revealed with their traditional structure? Are there approaches that do not rely on GSEs to create a robust mortgage securitization market that will function in bad times as well as good?

Privatization. One option that has been discussed is to privatize the GSEs and let them compete in the market as private mortgage insurers and securitizers. To eliminate the presumption of government support and to stimulate competition, some proposals advocating privatization call for breaking up the companies into smaller units before privatizing them.

Privatization would solve several problems associated with the current GSE model. It would eliminate the conflict between private shareholders and public policy and likely diminish the systemic risks as well. Other benefits are that private entities presumably would be more innovative and efficient than a government agency, and that they could operate with less interference from political interests.

However, whether the GSE model is viable without at least implicit government support is an open question. From a public policy perspective, a greater concern with fully privatized GSEs is whether mortgage securitization would continue under highly stressed financial conditions. As I have noted, almost no mortgage securitization is occurring today in the absence of a government guarantee. So, if the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil. One possible approach, suggested by Federal Reserve Board economists Diana Hancock and Wayne Passmore, is to create a government bond insurer, analogous to the Federal Deposit Insurance Corporation (FDIC).3 This new agency would offer, for a premium, government-backed insurance for any form of bond financing used to provide funding to mortgage markets. For example, debt and mortgage-backed securities issued by the (privatized) GSEs as well as mortgage-backed bonds issued by banks would be eligible for the guarantee. That approach would clearly limit the government's exposure while making the benefits of explicit government support available to the market.

Covered bonds. GSE-type organizations are not essential to successful mortgage financing; indeed, many other industrial countries without GSEs have achieved homeownership rates comparable to that of the United States. One device that has been widely used is covered bonds. Covered bonds are debt obligations issued by financial institutions and secured by a pool of high-quality mortgages or other assets. Today, covered bonds are the primary source of mortgage funding for European banks, with about $3 trillion outstanding. These instruments are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank. Legislation typically specifies the types of collateral permitted in the cover pool, defines a minimum over-collateralization level, provides certainty of principal and interest payments to investors in the case of insolvency, and requires disclosures to regulators or investors or both. In addition, the government generally provides strong assurances to investors by having bank supervisors ensure that the cover pool assets that back the bonds are of high quality and that the cover pool is well managed.

Issuance of covered bonds in Europe has not been unaffected by the financial turmoil, and at times the interest rate spreads relative to government debt have risen. But generally speaking, European banks have been able to find buyers for these bonds. For example, issuance of covered bonds totaled more than $16 billion in September 2008, although this amount represents a decline of 45 percent from a year earlier. Moreover, interest rate spreads on covered bonds have typically been much narrower than the comparable spreads on senior unsecured debt and mortgage-backed securities. This relationship has continued to hold throughout the market turmoil, perhaps because of the comprehensive regulatory and statutory frameworks associated with covered bonds in most European countries.

To date, not many covered bonds have been issued in the United States, for several reasons. First, the Federal Home Loan Banks (FHLB) can tap capital markets and provide cost-effective funding for mortgage assets. In addition, as a source of financing, covered bond issuance today is not generally competitive with FHLB advances. Second, Fannie Mae and Freddie Mac have traditionally securitized U.S. prime mortgage assets. The GSEs' implicit government backing and their scale of securitization operations have made it difficult for banks to use covered bonds to finance their own prime mortgages. Third, the United States does not have the extensive statutory and supervisory regulation designed to protect the interests of covered bond investors that exists in European countries. To this end, the recent introduction of the FDIC policy statement on covered bonds and the Treasury covered bond framework were constructive steps. Finally, the cost disadvantage of covered bonds relative to securitization through Fannie and Freddie is increased by the greater capital requirements associated with covered bond issuance.

Covered bonds do help to resolve some of the difficulties associated with the originate-to-distribute model. The on-balance-sheet nature of covered bonds means that the issuing banks are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed--non-performing assets are replaced with similar, but performing assets--ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. The structure used for such bonds tends to be fairly simple and transparent. These features, together with the demonstrated success of covered bonds in other countries, make this approach attractive. That said, given longstanding features of the U.S. system such as the prominent role of the Federal Home Loan Banks, covered bonds may remain an unattractive option to U.S. banks.

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