Saturday, July 26, 2008

What's up with the covered bond push?

Voltron says: This article explains how large investment banks can legally rape and pillage smaller failing banks and corporations, and are in fact being encouraged to do so by the FDIC.


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 London Banker | Jul 25, 2008

I've been particularly busy this week, nonetheless, I hope to convey enough background on the topic of covered bonds to start a discussion that I think may lead to interesting ideas.

Whenever Henry Paulson at Treasury, Ben Bernanke at the Fed and Shiela Bair at FDIC agree on anything, American taxpayers should check for their wallets to see if they are being mugged. As a result, my eyebrows rose a bit when these three started pressing in concert for covered bond issuance in US markets some weeks ago.

Covered bonds are a huge market of over $3 trillion in Europe, but have never been popular in the USA where securitisation was the preferred model for financing banks. They are perfectly legal and raise no issues, they just haven't been as profitable as securitisation so haven't been supported by the US markets. Covered bonds allow for extension of credit to a bank SIV or trust that will be serviced by income from hypothecated assets on the bank's balance sheet. The assets stay on the bank's balance sheet unless there is a default on the bonds, at which time the assets are forfeit as collateral to the trust vehicle servicing the covered bond.

Last week the FDIC released a policy statement on covered bonds that provides for "expedited release of collateral" if an issuing bank is taken into FDIC receivership or liquidation. The Treasury is expected to release a protocol on best practices for covered bond issuance in a high profile event next week. Hmmmm. What could be up?

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.
When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.
Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America's banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I'm not sure on this one, so I'm looking forward to views from those more expert here.


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