Like the now government-owned Fannie Mae and Freddie Mac, large investment banks helped create funds to finance new mortgages by issuing securities backed by pools of existing mortgages. But private firms have abandoned these instruments, and with them a large source of mortgage funds has disappeared. Four large investment banks plan to create a new U.S. market for an old instrument, hoping to bring liquidity back to the mortgage market.Mortgage loans ; Mortgage-backed securities

O. Emre Ergungor

English

Research Papers in Economics

ECONOMIC COMMENTARY July 2008
Covered Bonds: A New Way to Fund 
Residential Mortgages
O. Emre Ergungor
Like the now government-owned Fannie Mae and Freddie Mac, large investment banks helped create funds to ﬁ  nance 
new mortgages by issuing securities backed by pools of existing mortgages. But private ﬁ  rms have abandoned these 
instruments, and with them a large source of mortgage funds has disappeared. Four large investment banks plan to 
create a new U.S. market for an old instrument, hoping to bring liquidity back to the mortgage market.
  ISSN 0428-1276
Until the summer of 2007, mortgage lenders increasingly 
tapped capital markets for quick and cheap funding. Through 
a process called securitization, they could sell the loans they 
had originated to the government-sponsored enterprises 
(GSEs) Fannie Mae and Freddie Mac, or to large invest-
ment banks, which then packaged these loans into various 
securities and sold them to investors. Lenders used the sale 
proceeds to make new loans, which were also sent through 
the same securitization process.
Since the credit market turmoil started, however, this source 
of funding is less convenient and abundant than it used 
to be. While lenders can still sell prime mortgages smaller 
than around $417,000 to Fannie and Freddie (the exact limit 
depends on the region), one segment of the securitization 
market has essentially disappeared: Large investment banks 
have stopped issuing their mortgage-backed securities and are 
no longer buying mortgages to repackage for that purpose. 
This source of funding until recently constituted a trillion 
dollars (see ﬁ  gure 1) and was used primarily by lenders that 
made subprime loans and loans larger than $417,000. Its 
disappearance has the potential to further disrupt credit ﬂ  ows 
and damage the ailing housing sector.
Despite this setback in the mortgage-backed securitization 
market, new funding sources are emerging. In July of this 
year, four large investment banks—Bank of America, 
Citigroup, JPMorgan Chase, and Wells Fargo—unveiled 
their plan to kick start a covered-bond market for residential 
mortgage lenders. Whether such a market is the solution to 
mortgage lenders’ funding needs remains to be seen. But cov-
ered bonds do have one feature that should make them an 
improvement over the mortgage-backed securities previously 
issued by private institutions. Securitized mortgages were not 
backed by the capital of the loans’ originators against losses, 
but covered bonds are. 
Securitization: What Went Wrong  
When a bank makes a mortgage loan and keeps it on its 
balance sheet, regulators require the bank to ﬁ  nance at least 
four cents of every dollar of that loan with the bank’s own 
capital. This requirement ensures that the institution maintains 
a cushion against unexpected losses, protecting the bank, its 
customers, and the agency that insures the bank’s deposits. On 
the other hand, when a bank securitizes a loan, it is permit-
ted to remove the loan from its balance sheet, eliminating the 
cushion requirement and freeing the bank to use the capital for 
other purposes. Recent experience has shown that while loans 
may have been removed from the balance sheet through the 
securitization process, all the associated risks were not. We have 
learned that, in essence, the process moved loans from a heav-
ily regulated, well-monitored, and generally understood arena 
into one where risks were difﬁ  cult to trace or quantify. 
The underlying risks behind most securitized mortgages 
are obscured by their complexity and the number of parties 
involved in their packaging. The securitization process begins 
with the underwriter (an investment bank, Freddie, or Fan-
nie), who purchases mortgages from various lenders and then 
transfers ownership to a special-purpose entity (a separate cor-
poration or business trust). The special-purpose entity creates 
securities that represent claims on the interest and principal 
payments of the pooled mortgages. 
0708.indd   1 10/21/2008   12:34:20 PM1.  Mortgage Originations by Source of Funding
*Annual rates.
Source: Inside Mortgage Finance.
Rating agencies then judge the level of risk in the pool and 
suggest credit enhancements that will elevate the securities’ 
ratings to some desired level. Any number of enhancements 
might be added that involve other parties. For example, insur-
ance against mortgage defaults might be purchased from a 
third party and added to a set of securities. 
At this point the securities were sold to investors, and often, 
they underwent further securitization. A number of mort-
gage-backed security issues could be purchased by another 
party, thrown into a new asset pool, and used to back the 
issue of new securities, called collateralized debt obligations. 
Those securities in turn could be put into structured invest-
ment vehicles—another type of investment pool—and another 
set of securities could be issued against that pool’s assets. 
Securities issued at each stage have different characteristics, 
and these attracted investors with different goals and risk 
tolerances, so all this securitization and re-securitization 
happened for a reason (I reviewed some of these reasons in 
“Securitization,” Federal Reserve Bank of Cleveland Economic 
Commentary, August 15, 2003). The initial consequences of the 
securitization boom looked great: It increased the amount of 
low-cost funds available to lenders (and it gave them a way 
to generate fee income for originating loans without putting 
their own capital at risk), it increased borrowers’ access to 
low-cost loans, and it gave investors an alternative means of 
generating cash ﬂ  ow. But features unique to these securities 
set the stage for the crisis we are dealing with now.
The complex structure of mortgage-backed securities creates 
a big problem for investors. Because the mortgage loans that 
back a security can be lost under layers of securitization deals, 
determining anything about those loans or who is really bear-
ing the default risk is practically impossible. In such a situ-
ation, investors cannot be sure that lenders have done their 
due diligence or even that they are not dumping poor-quality, 
improperly originated loans into the securitization pools. 
Without that kind of information, investors typically would 
not buy, but in the case of mortgage-backed securities, inves-
tors relied on alternative mechanisms that they assumed were 
sufﬁ  cient to ensure that lenders had done the right thing. 
These included the opinions of credit-rating agencies, the 
presence of credit enhancements, and the contractual arrange-
ments between the underwriter and the lenders. Those con-
tractual agreements, for example, include a recourse clause 
(in the representations and warranties) that obligates lenders 
to buy back loans that are later discovered not to have been 
originated with proper due diligence. Furthermore, reputation 
often functions to regulate behavior in credit markets, and 
investors may have expected this mechanism to drive lenders 
that had sold low-quality loans out of the market.
As the housing market declined, the weaknesses of the ar-
rangement became obvious. It turns out that credit-rating 
agencies failed to properly estimate the risks involved in the 
residential real estate business. Mortgage insurers lacked suf-
ﬁ  cient cushion to absorb losses and back their promises when 
the losses grew large. Representations and warranties were 
not as effective as investors had anticipated. While some large 
banks and investment banks had the capital to bring poorly 
performing loans back onto their balance sheets and recog-
nize the losses, some mortgage lenders were so thinly capital-
ized that they did not have the capacity to absorb the growing 
losses; they simply went out of business and left investors 
holding the nonperforming loans. 
In hindsight, the lack of capital signiﬁ  cantly weakened our 
mortgage ﬁ  nancing system not just by curtailing its ability to 
survive large losses but also by impairing its motivation to 
do the necessary due diligence at the time of origination. The 
latter issue is known as moral hazard in economics: When 
the lender has less of its own skin in the game, it may have a 
reduced incentive to screen applicants before approving them 
for a loan. The lender earns fee income as soon as the loan is 
approved, but if the loan defaults later on, it is the investors 
who lose, not the lender. 
Recourse clauses might check lenders’ behavior, but in a 
booming real estate market with declining interest rates, 
lenders would not normally expect massive loan returns since 
borrowers who cannot afford their mortgage often reﬁ  nance 
before they become delinquent. The insurance companies 
that guaranteed these pools of loans and the investors who 
purchased them must have been similarly blindsided by the 
decades-long appreciation in real estate markets. If the risks 
were underestimated, it is no surprise that capital cushions 
were not built up anywhere in the ﬁ  nancial system in prepara-
tion for a downturn.
Federal Housing Administration lending Balance-sheet lending
GSE mortgage-backed securities Private securitizations
2002 2003 2004 2005 2006 2007
H1 *
2007
H2*
2008
Q1*
0
1
2
3
4
Trillions of dollars
0708.indd   2 10/21/2008   12:34:37 PMCovered Bonds
Covered bonds are bonds issued by banks and collateral-
ized by a dedicated pool of mortgages, known as the cover 
pool. Unlike securitized mortgages that are removed from the 
bank’s balance sheet, the mortgages in the cover pool remain 
on the balance sheet, and the bank must hold capital against 
potential losses just like any other mortgage. Like securitiza-
tion, the issuance of covered bonds converts illiquid mort-
gages into a funding source for the bank. 
Covered bonds have been around for more than 200 years 
in Europe, but they have yet to catch on in the United States. 
One of many reasons why securitization may have become so 
popular instead in this country is because it enabled banks to 
remove loans from their balance sheets and to free up capital 
they would have had to hold in reserve. U.S. investors may 
also have preferred securitized assets because they provided a 
low-cost way of gaining some exposure to the real estate market 
at a time when risks seemed low and returns above average. 
By contrast, covered bonds do not offer investors any expo-
sure to the residential mortgage market even though they 
are backed by residential mortgages. There is no exposure 
because the interest and principal payments are the bank’s 
obligation—they do not depend on the cash ﬂ  ow from mort-
gages in the pool. If a mortgage defaults or is prepaid, the 
bank has to replenish the cover pool with other mortgages on 
its balance sheet. If the bank becomes insolvent, the loans in 
the pool are separated from other assets and are used solely 
to repay the bank’s obligation to covered bondholders. It is 
also possible for the bank to enter into contractual arrange-
ments with ﬁ  nancially sound third parties to continue mak-
ing the principal and interest payments on the bonds if the 
bank becomes insolvent. In other words, a covered bond is a 
secured debt obligation of the bank, for which the mortgages 
serve as collateral but have little impact on the cash ﬂ  ow of 
the bond. Despite their low-risk features, covered bonds could 
not compete in the past for investors’ attention against the 
seemingly high, risk-adjusted returns of the mortgage-backed 
securities.
One other important barrier to the development of a covered 
bond market in the United States was the regulatory uncer-
tainty surrounding the enforceability of the senior claim of 
the covered bondholders on the cover pool. Technically, de-
positors are the most senior claim holders of a bank. After the 
Federal Deposit Insurance Corporation (FDIC) seizes a failed 
institution and takes over its deposits, the bank’s assets are 
used to pay off the depositors before the bondholders. Cov-
ered bonds require a change in the seniority structure. The 
cover pool must be outside the reach of the FDIC and the 
insured depositors. Until recently, it was not clear whether 
the FDIC would recognize the covered bondholders’ secured 
interest over the cover pool. With the collateral in doubt, it is 
perhaps not surprising that the market never really took off.
In July 2008, the FDIC cleared the uncertainty (“Covered 
Bond Policy Statement: Final Statement of Policy”). If the 
cover pool meets certain conditions, it will remain outside 
the reach of the FDIC. Namely, the bonds must be secured 
primarily by a geographically diversiﬁ  ed pool of perform-
ing, ﬁ  rst-lien, one-to-four family residential mortgages with 
loan-to-value ratios not exceeding 80 percent, underwritten 
at the fully indexed rate, and relying on documented income. 
Some fancy concoctions of recent years, such as negative 
amortization mortgages, are not eligible. The FDIC also put 
some rules in place to protect its interests (and the taxpayers’) 
should an institution fail. When the FDIC takes over an insti-
tution, it should not be the case that all the high-quality assets 
are promised to covered bondholders, with only the poorest-
quality assets left to pay off the depositors. To prevent such 
an occurrence, the share of covered bonds in the institution’s 
total liabilities cannot exceed 4 percent if they are to remain 
outside the reach of the FDIC.
In addition to the FDIC’s conditions, the Treasury Depart-
ment came up with its own suggestions, mainly to increase the 
transparency of the covered pools (“Best Practices for Residen-
tial Covered Bonds,” July 2008). Investors will receive month-
ly updates on the changes in the make-up and performance of 
the pool. The issuer will also test the pool for its performance 
under different shock scenarios, and the results of the test will 
be available to investors. Having more information about the 
condition of the pool will go a long way toward ensuring that 
investors do not pull out of the market en masse in a future 
crisis because they can’t value the collateral.
Do We Need a Covered Bond Market?
Covered bonds address a major weakness of the securitization 
market: lack of capital to absorb losses. Investors now realize 
that mortgage originators’ promise to do the necessary due 
diligence depends on them putting their own money behind 
that promise. In the past, that money was close to nil. With 
covered bonds, a ﬁ  xed percentage of capital will now be held 
in reserve by the lender for each loan because the loans are 
kept on the balance sheet.
The securitized loan market will also revamp itself to address 
its weaknesses. For example, investors are unlikely to sign up 
for securitization deals in which the sellers of loans do not 
stand to lose money if the loans turn sour. With or without 
the introduction of covered bonds, the build-up of capital 
across the ﬁ  nancial system to back mortgage assets may bring 
some conﬁ  dence back to the securitization market.
In the very short term, however, the challenge is to restore the 
ﬂ  ow of credit to the real estate market. One way to convince 
banks to lend more is to make the originating and carrying of 
mortgages more attractive than they currently are. Securitiza-
tion accomplished this goal by removing the loans from the 
balance sheet and erasing their capital charge. We can say 
with a reasonable degree of certainty that the securitization 
market is not going to make a comeback until the capital and 
transparency problems we have identiﬁ  ed are ironed out. 
0708.indd   3 10/21/2008   12:34:39 PMO. Emre Ergungor is an economist at the Federal Reserve Bank of Cleveland. The views he expresses here are his and not necessarily 
those of the Federal Reserve Bank of Cleveland or the Board of Governors of the Federal Reserve System or its staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed 
on the mailing list, e-mail your request to 4d.subscriptions@clev.frb.org or fax it to 216.579.3050. Economic Commentary is also available 
on the Cleveland Fed’s Web site at www.clevelandfed.org/research. 
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In the meantime, covered bonds increase the attractiveness of 
mortgage lending by converting illiquid mortgages into collat-
eral against which the bank can borrow. These bonds are also 
attractive to investors because even though their liquidity may 
be low early on in a brand-new market, they are eligible as 
collateral at the Federal Reserve’s borrowing facilities as long 
as they are highly rated by rating companies.
Whether the increased transparency and improved capital 
cushions will be enough to calm down jittery investors and 
whether the covered bond market will be up and running in 
time to revive the ailing housing market still remain to be seen.
0708.indd   4 10/21/2008   12:34:39 PM

Covered bonds: a new way to fund residential mortgages

http://www.clevelandfed.org/research/commentary/2008/0708.pdf

Covered bonds: a new way to fund residential mortgages

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