Covered Bonds: The Latest Scam or a Real Rescue

The new game in town is “covered bonds,” Paulson’s latest attempt to rescue financial firms now mired in the toxic swamp they created. How exactly these bonds will work–and whether they will work–is a hot debate. Business Week offers the following description of these new instruments:

A covered bond is kind of bond back by mortgages.

with the following provisions: Banks must hold onto the mortgages, paying the “bondholders out of their own cash flow, not from the proceeds of the mortgages.” Additionally,

Covered bonds are considered safe investments because they must meet numerous standards. The loan-to-value ratio of the mortgages cannot exceed 80%, and borrowers must have documented income, according to the Treasury Dept.’s guidelines. In addition, no more than 20% of the underlying loans can be from one metropolitan area.

The catch is:

In lieu of a law spelling out the requirements of a covered bond, the Treasury and FDIC have issued guidelines. Banks can issue covered bonds with whatever specifications they want, but if they want the government’s stamp of approval—which they presumably will—they will stick to the guidelines.

The devil is always in the details:

  • What counts as borrower documentation?
  • Why not a law governing requirements?
  • What kind of regulatory frame will be in place?

Somehow, guidelines do not do it for me. I wonder why? Are we supposed to trust the bank specifications. Methinks the print will be very fine. And if a bank does indeed say it is following Treasury and FDIC guidelines, just how loose will those guidelines be?

Peter Morici sees the initial problem as one of trust: Why should we trust banks when their compensation schemes encourage:

…bank executives to make risky bets that allow them to profit when things go well and to push the losses on bond and stockholders when things go sour. Upon taking over Merrill Lynch, John Thain increased executive bonuses, but established a risk management scheme. That hasn’t worked.

While I would agree with Morici that it is becoming increasingly difficult to trust the fat cats who always seem to land in the honey even as they shed employees and turn to the government for help, would it not be wise–just once–to put some regulatory teeth–not guidelines–into the whole business?

Paulson continues to admire financial innovation, but so far those who pushed us over the edge have yet to pay a real price. CEO’s hiding behind “too big to fail” should be, by law, required to cough up a goodly portion of their own assets instead of sitting on their golden thrones, requiring the tax payer to foot the entire bill.