A clash over whether or not a US covered bond market would squeeze small banks and require government support appears likely at a House Financial Services Subcommittee hearing today (Friday), with the opinions of witnesses due to appear differing sharply.

Stephen Andrews, president and chief executive officer of the Bank of Alameda, a community bank in California, argues in his testimony that a covered bond market would harm the interests of small and medium sized banks, and rely upon government support.

“Unfortunately, the lion’s share of the benefits of a covered bond market in the US would be to help the largest banks in the US to the detriment of excellent community banks,” reads his testimony. “Moreover, instead of the covered bond market being an effort to privatize mortgage finance obligations as is sometimes touted as a benefit, it seems pretty clear that in Europe the government is viewed as backing up the covered bonds issued by the large European banks and indeed the various governments in Europe have stepped in to support the covered bond markets when difficulties arose.”

Andrews makes reference to a “study on borrowings and credit” in the proposed United States Covered Bond Act of 2011, whereby “the Comptroller General of the US shall conduct a study on whether the Federal Reserve banks should be authorised to lend funds or otherwise extend credit” to a covered bond estate post-issuer insolvency and under what circumstances.

“The legislation also request that a study be performed on how the government could provide a backstop to the covered bond market,” says Andrews. “If a backstop is put in place, large lenders could have a government guarantee in a way that could be riskier and more expansive than Fannie Mae or Freddie Mac.”

Rayburn House Office Building: covered bond hearing setting

Andrews is understood to have been given the opportunity to testify by the Democrat members of the Capital Markets and Government Sponsored Enterprises subcommittee and has previously testified in Congress on behalf of the Independent Community Bankers of America (ICBA), although his written testimony on this occasion does not make reference to that association. The ICBA has in the past proved itself open to covered bond issuance and indeed argued that a 4% cap on covered bond issuance as a percentage of total liabilities introduced by the Federal Deposit Insurance Corporation in a Policy Statement on covered bonds was too low.

Pooled issuance has previously been suggested as a means by which community banks might issue covered bonds and that is a feature of Garrett’s new bill, but Andrews argues that this would probably be at a higher cost than individual issuance by big banks.

“The US has over 7,000 banks while Germany and other European nations often have three or four major banks and a small number of additional institutions,” reads his testimony. “The latter financial market structure, with fewer and larger banks, is more conducive to covered bond issuances. Smaller community banks would be at a competitive disadvantage in a covered bond market because they do not have the volume of mortgages necessary to support covered bond financing.”

He also argues that covered bond issuance by big banks could result in small banks contributing an unfair share of FDIC deposit insurance premiums.

“I do not think that we as a country need to expend the time, energy and resources to attempt to create a covered bond market in the US,” says Andrews. “In my opinion, and I believe that I am supported in this view by Treasury Secretary Geithner, we already have a covered bond market: it is the Federal Home Loan Bank System. I am a member of the Federal Home Loan Bank of San Francisco.

“We do not need to try to import from Europe an experimental housing finance tool that would be deployed under greatly different conditions and circumstances and as far as I can see would largely benefit the biggest banks in the industry.”

Those lined up to support the case for a covered bond act are witnesses including Scott Stengel, partner at King & Spalding, who will be speaking on behalf of the US Covered Bond Council. In his written testimony, he aims to dispel what he calls myths associated with covered bonds, including some arguments made by Andrews. These include, in Stengel’s words:

• Myth: US covered bonds would have an implicit federal guarantee
• Fact: US covered bonds would not be backed, either explicitly or implicitly, by the federal government
• Myth: US covered bonds would benefit only the largest banks
• Fact: The US covered bond market would be available to regional and community banks under the proposed legislative framework
• Myth: US covered bonds would merely replace FHLB advances and therefore result in a reallocation of, and not an increase in, funding for financial institutions
• Fact: US covered bonds would constitute an additive source of liquidity for financial institutions and, as a result, would facilitate increased lending.

Tim Skeet, board member of the International Capital Market Association, will argue that Andrews’ description of the European experience of covered bonds is wrong, with regard to who they benefit and government support.

“Covered bonds are now perceived as a very stable source of wholesale term liquidity for banks, including for smaller regional institutions, and not exclusively major institutions or too big to fail, ‘Strategically Important Financial Institutions’ (‘SIFIs’),” reads his testimony. “In Europe, it is generally accepted that the covered bond market plays a pivotal role in the exit strategies from government and central bank support.

“They have provided lenders with a cost efficient instrument to raise long term funding and importantly offer private investors non state guaranteed, top quality credit exposure to credit institutions. From the consumers’ perspective, the success of the covered bond market has ensured a flow of funds to the mortgage sector and helped keep costs down.”

Bert Ely: bill designed to avoid taxpayer losses

And Bert Ely, a financial institutions and monetary policy consultant, points out in his testimony that rather than increase the deposit insurance burden of smaller banks, the bill highlights how the FDIC can avoid taxpayer losses through its assessments of covered bond issuers.

“The authority the bill grants to the FDIC to assess against all covered bond issuers any incremental losses the FDIC suffers in protecting insured depositors in a failed covered bond issuer further undercuts the argument that covered bonds will have any taxpayer backing, which is the effect of any government guarantee,” he says. “Likewise, any authority the Federal Reserve would be granted to lend against or to purchase covered bonds, as I recommend, can and should be structured statutorily so that such Fed lending or purchasing would not cause any loss to taxpayers, i.e. a reduction in the amount of income the Federal Reserve periodically returns to the Treasury.”

 The written testimony of Ralph Daloisio, chair of the American Securitization Forum board of directors (and former chair of the ASF Investor Committee) and a managing director of Natixis, also argues in favour of covered bonds, pointing out their private sector nature.

“The proposed legislation would create a new and disciplined market structure around which free market forces can organize to better balance the flow of money, capital, and credit in our highly sophisticated financial system,” reads Daloisio’s testimony. “The concentrated US banking system market structure invites the creation of new financing channels, so we can better democratize the flow of credit to Main Street in an effort to improve its post-crisis affordability and accessibility to American consumers and businesses.”

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