Ingrid Ellen, John Tye, and Mark Willis on Covered Bonds replacing GSES

They write:

Covered bonds have three potential advantages over MBSs as a method of mortgage finance.

First, they have the potential to reduce principal-agent problems, because the banks themselves

would hold the loans underlying covered bonds, giving them an interest in originating better

loans. Second, because the mortgage loans would simply remain on bank balance sheets and not

be put into special trusts subject to the incentives of servicers, banks could modify failing loans

far more easily than MBS trusts can. This could reduce foreclosures and maximize loan value.

Third, depending on how they are implemented, covered bonds also hold the possibility of

improving the options available to homebuyers who find themselves underwater. In Denmark,

covered bonds operate according to the “balance principle.” The balance principle requires a

match between each mortgage written and every bond issued. It permits homebuyers two options

for paying off their debt: they may either pay off their mortgage at par, or they may repurchase

their lender’s bonds on the open market, in an amount corresponding to the size of their

mortgage, and return those bonds to the lender. Falling house prices will often depress the

corresponding bond prices (though this may not always happen). When house and bond prices

fall together, homeowners can sometimes refinance their homes at the new, lower house price,

by buying back their bonds at the lower bond prices, and surrendering the bonds to the original

lender. This new option for refinancing could reduce foreclosures in the event of a widespread

decline in housing prices.

There is uncertainty, however, in the extent to which covered bonds would deliver the same level

of liquidity as GSE MBSs, because in a covered bond system, mortgage loans remain on bank

balance sheets. Moreover, it may be difficult for covered bonds to achieve the minimum efficient

scale to compete with government-backed GSE MBSs. As in Denmark, an effective covered

bond market would require standardized bond forms, and a high-volume market that could

demonstrate liquidity to potential buyers. If covered bonds were issued by hundreds of banks

across the country, each with different underwriting standards and bond structures, the extensive

market fragmentation would seriously reduce trading volume and liquidity for any particular

covered bond issue. The Danish covered bond system is effective because the market is highly

structured and homogenized, with only a few participating banks.

Me again: one of the selling points of covered bonds is that they remain on bank balance sheets, and, in Denmark anyway, have no explicit of implicit backing from the government.  But do they really lack such backing?  If the government is willing to inject liquidity into banks (and in Denmark, it is), do the bonds really lack a guarantee?  I am not so sure.