Monday's embrace of covered bonds by U.S. Treasury Secretary Henry Paulson and senior representatives of the Fed, the Federal Deposit Insurance Corp. and the country's largest banks to help thaw the U.S. mortgage market is a laudable step, appealing to market proponents and skeptics alike. Introducing covered bonds to the U.S. is a great idea. In fact, covered bonds can help more than just the mortgage market.
At its most basic, a covered bond is a bond issued by a bank and backed by a dedicated group of loans kept on the issuing bank's balance sheet. While the introduction of covered bonds in the U.S. is not a magic bullet, covered bonds may be more than just a way to restart the mortgage market. They may also help unlock sorely lacking investment for U.S. infrastructure.
Covered bonds are, for the U.S. at least, a long time coming. They've existed in Europe for centuries and are a mainstay of the global capital markets landscape. While few in the U.S. have heard of them, the market for covered bonds in Europe is well established, large and an important tool for banks to fund themselves. By pooling together lots of smaller loans into a larger bond, which is then sold to investors, a covered bond is large and liquid enough to generate interest from large investment funds.
Crucially, unlike the way banks securitized and sold mortgages in the U.S., the underlying loans for a covered bond stay on the bank's balance sheet. This leaves less risk that the bank will ignore prudent lending standards. The loans that "cover" the bond are also highly regulated. They are monitored by independent third parties and must be of high quality. Any deteriorating loans in the cover pool must be replaced with stronger ones. If something goes wrong, covered bond holders have both the bank and the underlying collateral to protect their investment.
But Paulson's effort to introduce covered bonds backed by mortgages leaves a very real opportunity on the table. An entire market for covered bonds backed by public sector debt thrives in Europe alongside its sister mortgage-backed equivalent. In Europe, public sector covered bonds are a centerpiece of infrastructure finance and an important investment vehicle for global investment funds and central banks.
These bonds typically pool loans given to regional and local government authorities or public-private partnerships, and are guaranteed by the public authorities. They finance projects like roads, bridges, high-speed rail, hospitals, schools and utilities. By pooling these loans and issuing large covered bonds, banks in Europe are able to attract the large pools of global capital that shy away from U.S. municipal markets, the traditional source for financing much state and local infrastructure.
Municipal bond markets in the U.S. have functioned well for years, channeling private capital into financing public infrastructure. But municipal bonds are unable to take advantage of the world's largest pools of capital that are available for infrastructure financing elsewhere. The universe of investors willing to invest in U.S. municipal bonds is limited because of the relatively small size of most individual municipal finance debt issues and the subsequent illiquidity of the bonds. It is hard to get a large global investor interested in a bond issue of less than a billion or so.
Also municipal bonds in the U.S. exclude investors who are unable to take advantage of the tax-based incentives. This includes every non-U.S. pool of capital and many U.S. pension funds.
While federal, state and local governments struggle to fund basic infrastructure, there is abundant private capital available for infrastructure investment using the right market mechanisms. Covered bonds provide that mechanism in other parts of the world. Investors in Europe's public sector covered bonds come from a universe of roughly $30 trillion held by central banks, sovereign funds and global pension funds. There is certainly enough capital to bridge what has now become a trillion-dollar infrastructure financing gap in the U.S.
Elsewhere in the world, many commercial banks and specialty public-sector banks use public sector covered bonds as a cheap source of funding. In particular, as a result of the enormous availability of funds for infrastructure projects through securities like covered bonds in Europe, European banks have developed great comfort with infrastructure as a core part of their general banking activities.
Their experience with infrastructure makes them often the lenders of choice for U.S. infrastructure projects, in contrast to their American counterparts. Notably, the loans for public-private partnership infrastructure projects like the Chicago Skyway, the Indiana Toll Road, the San Diego Toll Road and the Pocahontas Parkway in Virginia all came from European, not U.S., banks.
As we search for ways to improve America's outdated--and in some cases, failing--infrastructure, we must look to creative mechanisms to address the very real question of how to pay for it in the most cost-effective manner. What is missing in the U.S. is a mechanism for channeling enormous global pools of capital into our long-term infrastructure development.
The U.S. government, as it seeks to unlock the mortgage market deadlock, should not miss the opportunity to include the public sector in its newly proposed covered bond framework. Creating U.S. covered bond legislation that incorporates public sector debt as well as mortgages is one tool in the financial toolbox we can use to both help jump-start the mortgage market and open channels for attracting infrastructure investment through the global capital markets.
Heidi Crebo-Rediker and Douglas Rediker are co-directors of the Global Strategic Finance Initiative at the New America Foundation.
