Mortgage backed securities and covered bonds are issued for different reasons, implying that they may not be substitutes, according to a paper published by the Federal Reserve Bank of Chicago, with increased liquidity a primary benefit of covered bonds and risk reduction and agency problems more relevant to the use of MBS.

The study, “Are Covered Bonds a Substitute for Mortgage-Backed Securities?”, was written by Santiago Carbó-Valverde and Francisco Rodríguez-Fernández, of the University of Granada, and by Richard Rosen, at the Federal Reserve Bank of Chicago, and published last month.

The authors identify as their premise the suggestion that covered bonds, because they are similar to MBS in allowing banks to finance mortgages using duration-matched bonds, could be a good substitute for MBS.

However, they found no evidence that covered bonds and MBS were being used for similar reasons before the financial crisis, and said that the different reasons for using one or the other are related to differences between the types of debt.

“Both types of SMS [secondary mortgage securities] seem to increase profit, although only weakly in the case of MBS,” they said. “But, our results are consistent with liquidity improvement being a primary benefit of covered bond issuance, but not of MBS issuance.

“There is some indication, albeit indirect, that banks used MBS when they were attempting to reduce risk. Finally, agency problems may have pushed banks to issue MBS as there is evidence of herd behavior in their issue. The same is not true for covered bonds.”

The authors believe that their results strongly suggest that liquidity increases when covered bonds are issued, but not when MBS are issued, but note that while structural differences between MBS and covered bonds are consistent with results showing greater use of MBS for risk management, it is more difficult to come up with a reason why covered bonds but not MBS are useful for liquidity.

“Issuing a SMS can add to liquidity by bringing forward future revenues or by financing mortgages with long term bonds (those backing the mortgage pool) rather than with deposits,” they said. “Both of these are available whether the SMS is covered bonds or MBS.”

However, they said that while covered bond issuance is associated with liquidity increases banks that issue MBS are reducing risk and may be taking advantage of agency problems. This reflects a key difference in the structures of the two types of debt, namely that MBS offer an opportunity to transfer risk that covered bonds do not. The authors note that the transfer of risk from banks to bondholders is more complete with MBS than with covered bonds.

“This ability to shed risk also makes moral hazard problems more severe,” they added. “A bank that ‘fools’ investors by putting mortgages that are riskier than the market thinks into a covered bond pool gets little benefit from this because if the mortgage holders default, the bank must replace the defaulted mortgages with new ones.

“However, once mortgages go into the SPE [special purpose entity] backing MBS, all risk is borne by bondholders.”

The authors also noted that agency problems may have pushed banks to issue MBS as there is evidence of herd behaviour.

“Faster growth in MBS issuance in a country was positively associated future more MBS issuance by banks in that country but faster covered bond growth in a country had no significant impact on future covered bond issuance in that country,” they said.

They said that banks may have decided to securitise loans because securitisation markets were “hot”, which may mean that bankers can take advantage of bond buyers (or the principals of the buyers) by issuing bonds at interest rates below their steady state (or fair) value, perhaps because bond purchasers are not paying close attention to markets.

The authors also examined whether banks that issued MBS or covered bonds were more vulnerable during the financial crisis, and found that, even after controlling for size, issuing MBS during the final years before the crisis (2006-2007) made a bank more likely to have been bailed out during the crisis. They said this does not hold true for banks that had issued covered bonds during those years, which suggests that banks involved in MBS were among those that took excessive risk.

Securitisation proponents have argued that there has been an overreaction against the technique because of problems in the US that are not necessarily relevant to the asset class in general. The paper’s authors noted that in four of the six countries in their sample there was at least one, and that while there was only one in Germany, the technique was not rare in Italy, Spain and the UK. They nevertheless acknowledge that securitisation was most prevalent in the US.