Hank the Great? Paulson Copies Frederick With Covered-Bond Plan

By Sebastian Boyd and Jody Shenn

Aug. 7 (Bloomberg) -- In 1769, short of funds to rebuild Prussia after attacks by Russia, Sweden and Austria, Frederick the Great let aristocrats, churches and monasteries raise money by pledging their estates as security to investors.

From those beginnings emerged what today is Europe's $3 trillion market for covered bonds -- securities backed by assets such as mortgages as well as the seller's promise to pay. Now U.S. Treasury Secretary Henry Paulson, faced with carnage in the housing market that led to $480 billion of losses and writedowns at the world's top financial institutions, is using a similar strategy to help America's banks turn assets into cash.

While the European market has grown for 250 years, Paulson's plan confronts obstacles Frederick never faced: Besides competition from the biggest U.S. housing-finance companies, the debt would be tied to mortgages and banks that are sliding in value with America's homes and economy.

``Not every bank is going to be able to do this,'' said William Isaac, the chairman of the Federal Deposit Insurance Corp. from 1981 until 1985. ``Even the banks people are not concerned about are probably only going to be able to do it in a limited amount right now.''

Covered bonds get higher ratings than notes sold by banks and pay less in interest because they augment the issuer's repayment pledge with assets that can be sold in a default.

Paulson's blueprint, unveiled last month, allows banks to sell bonds backed by mortgages made to homeowners who provide down payments of 20 percent and are current on their loans. U.S. covered-bonds might yield as much as 0.75 percentage point less than unsecured bank debt over time, according to analysts at New York-based JPMorgan Chase & Co.

Relative Yields

European investors have snapped up pfandbriefe, as they are known in Germany, because they're considered almost risk free. No bank has missed a payment on the securities in at least 100 years, according to Germany's Pfandbrief Association.

While elements of covered bonds have been used in the U.S., the market has yet to catch on. Seattle-based Washington Mutual Inc. started the first U.S. program two years ago, followed by Bank of America Corp. in Charlotte, North Carolina. The two companies have issued a combined $20 billion of covered bonds.

Sales in the U.S. may total $10 billion this year, rising to $20 billion in 2009, according to Dan Markaity, head of agency debt at New York-based Merrill Lynch & Co. The potential is between $180 billion and $228 billion, according to Morgan Stanley, also based in New York.

``It's an idea whose time has come,'' said John Cerra, a managing director and fixed-income fund manager at New York- based TIAA-CREF. Cerra, who helps manage $15 billion, has owned covered bonds sold by Bank of America.

`Time Has Come'

The bonds are Paulson's latest initiative to revive lending among banks and boost the housing market, stuck in the worst slump since the Great Depression. The S&P/Case-Shiller home- price index that tracks 20 metropolitan areas dropped 15.8 percent from a year earlier, the biggest decline since records began seven years ago.

Paulson's plan for a ``SuperSIV'' to bail out the $400 billion market for structured investment vehicles failed last year after Wall Street firms rescued the credit funds independently.

On July 13 he unveiled a plan to buy unlimited equity stakes in Fannie Mae and Freddie Mac if needed, while the Federal Reserve agreed to lend directly to the companies. Congress included Paulson's proposals in a broader housing bill that President George W. Bush signed into law last week.

Little Use

Banks have had little use for the securities partly because they can sell mortgages to Washington-based Fannie and Freddie of McLean, Virginia, the U.S. government-chartered companies created to provide financing to banks and promote home ownership. There is no comparable system in Europe. By keeping the loans on their balance sheets, banks are unable to free up capital.

The U.S. system dates to back to President Franklin Delano Roosevelt's administration, and includes the 12 Federal Home Loan Banks, or FHLBs. The regional cooperatives extend loans secured by mortgages to banks, thrifts, insurers and credit unions. Those loans are cheaper for the financial institutions than they could get by selling covered bonds.

The FHLB of New York offered four-year fixed-rate loans secured by mortgages at 4.4 percent last week. Bank of America's $2 billion of covered bonds maturing in June 2012 were trading at yields of 5.03 percent, according to data complied by Bloomberg. The company's $1 billion of unsecured notes due in September 2012 yielded 5.42 percent.

Any Open Market

``The covered bond has been a very useful and widely accepted vehicle in Europe, but in the U.S. it remains an expensive financing mechanism versus home-loan banks and it doesn't offer the same capital relief as a true sale,'' said Richard Dorfman, chief executive officer of FHLBank Atlanta, the Georgia Federal Home Loan Bank, which has $150 billion of loans.

While the costs of covered bonds look worse to banks than financing options, such as deposits and FHLB loans, that may change if Paulson's ``initiative is successful,'' Morgan Stanley strategists George Goncalves and Michelle Bradley wrote in an Aug. 1 report.

No matter the costs, banks ``recognize, having lived through the shutdown of the structured finance market, that there are times that any markets that are open are useful, even if the pricing isn't always what you want,'' said James Tanenbaum, a partner in New York at law firm Morrison & Foerster, which worked on Bank of America's deals.

The FHLBs have ``unwritten rules'' about how much a member bank can borrow as a percentage of overall liabilities, often looking to cap the amount at about 50 percent, according to Robert Pardes, the former chief lending officer at OceanFirst Financial Corp. in Toms River, New Jersey.

`Unwritten Rules'

For investors, a pledge this month by 13 banks and securities firms including Bank of America, London-based Barclays Plc and Goldman Sachs Group Inc. of New York to appoint dedicated traders, provide pricing information and make a market in the bonds may be the most important development, said TIAA- Cref's Cerra. The ability to easily trade and value the debt falls short of what's available in Europe, he said.

Another hurdle is that so-called risk-based capital rules require banks to hold more than twice as much in reserves to issue covered bonds than if they worked with Fannie to create mortgage securities, and kept the bonds on their balance sheets.

Frederick the Great's financing plan worked so well that Denmark followed suit in 1797 after a fire destroyed much of Copenhagen. By 1850, France had joined in. Whether the idea catches on in the U.S. is another question, said Richard Kemmish, head of covered bond origination at Credit Suisse Group in London and member of the European Covered Bond Council's steering committee.

``The jury is still out on whether this is going to make economic sense,'' he said.

To contact the reporters on this story: Sebastian Boyd in Santiago at sboyd9@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net.