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Covered Bonds: The Solution to America's Economic Ills

[Editor's Note: As a former Wall Street insider, Shah Gilani understands the innermost workings of the global financial system. So when he says that "covered bonds" can help fix Wall Street, it's time to listen. For more on covered bonds, please click here to check out a related story that appears elsewhere in today's issue of Money Morning.]

When it comes to the global financial crisis and the Great Recession that followed, this could well be the ultimate irony: The Wall Street invention that got us into this mess may well be the only thing that can get us out.

I'm talking about securitization, a masterstroke of financial engineering in which assets are aggregated in order to reduce risk. Once heralded as the greatest financial innovation of modern times, abusive securitization practices instead generated a feeding frenzy of gross excesses that exponentially multiplied risk and drove the world to the brink of financial Armageddon.

Now, a hybrid form of securitization called "covered bonds" may be our only way out.

Here's why….

A Security to Bank On

Securitization replaced prudent bank lending and fueled a credit binge that artificially inflated the U.S. real estate bubble until it burst. Securitization also drove inordinate growth in credit card lending, auto financing and other areas of consumer and commercial lending.

Now, because investors in the securitization market aren't willing to buy packaged pools of loans, banks have to keep the loans they make on their own books. And because they don't want to hold risky loans in a faltering economy, these "lenders" aren't making enough credit available to spur consumption and production cycles the economy needs to grow.

The good news is a hybrid type of securitization – the "covered bond" – can, and should be, embraced to prime the lending pump.

The bad news is big banks and Wall Street don't want to issue covered bonds because these securities would make banking safe again – thereby destroying the speculative machinery they built to manufacture their egregious profits.

Here's what went wrong and how to fix it quickly.

In order to lend, banks need money. In simpler times, the banks wooed depositors with toasters and competitive interest rates on certificates of deposit (CDs). They borrowed overnight from each other in the Federal Funds market, sold commercial paper to investors and raised funds by other tried-and-true capital-markets methods.

But most important of all: Those banks made loans.

The Gestation of Securitization

Banks kept the loans they made on their books as assets, which required them to set aside "reserves" in case loans weren't paid off. The more loans banks made, the more reserves they had to set aside. And the more reserves they set aside, the less money they had to lend out.

The upshot: Banks constantly had to borrow to keep enough cash in their reserve accounts and to make more loans if they wanted to grow their businesses.

Necessity being the mother of invention, Wall Street innovators (with the help of a few brilliant academics, like Richard L. Sandor, formerly of the University of California at Berkley) figured out that they could pool mortgages from different lenders and package them into a "security" that could be sold to investors. The process was known as "securitization." And it meant that the interest and principal on the pooled mortgages would be "passed-through" from the banks and mortgage lenders that made the loans to the new investors.

Not long after mortgages were pooled and sold as securities, Wall Street began securitizing auto loans, equipment leases and credit-card receivables. Eventually, even "synthetic" pools of securitized loans were securitized and sold to investors. – (Synthetics are made up, not of real asset-backed loans, but of synthetic loans, which are nothing more than paper lists of other real loan portfolios.)

Securitization gave Wall Street and banks a way to originate trillions of dollars of loans without having to keep those loans on their balance sheets. Without any skin-in-the-game – and without having to set aside cash reserves against loans they weren't holding – abuse was inevitable.

Financial "factories" set up to originate, package and distribute pools of mortgages – stamped and sold as investment-grade bonds – made sure that money kept flowing back to lenders, which perpetuated this new business model.

More money flowing through this new "shadow banking system" meant interest rates could be kept artificially low. That, in turn, helped ignite a run-up in U.S. stock prices. Even worse, these ultra-low rates fueled an unprecedented surge in U.S. housing prices, creating a speculative bubble in what was normally an ultra-conservative market. The flowing money was used to bid up the underlying collateral that made the principal part of the scheme workable.

Banks and lenders who sold off their loans got new money to make more loans. They could multiply the loans they made on an exponential basis, and didn't have to worry about collateral or reserves. It was a way around all the regulatory constraints that had previously plagued them.

But it wasn't enough. Wall Street and banks became intoxicated by all the money sloshing around in the marketplace. They began to further multiply the velocity of money they were generating by creating so-called off-balance-sheet entities such as structured investment vehicles (SIVs). That enabled them to borrow in the commercial-paper market and elsewhere in order to buy and hold massive quantities of the securitized instruments they had created.

Then came the credit crisis.

The Death of Securitization

The credit crisis came about because the securitization market experienced an instantaneous death: The value of the underlying mortgage pools dropped faster than investors could sell their holdings.

Securitization had fueled an extension of credit across the economy – and, indeed, the world. So when the music stopped, the credit crisis infected economies around the globe.

We all know what happened next.

The U.S. and global financial systems nearly melted down. And even with the aggressive steps taken by the world's central banks and governments, the securitization market remained in an Ice Age-like deep freeze.

Now, since banks can't easily securitize and sell off loans they make, they're not anxious to make too many of them. As a result, they are choking off the extension of credit that's needed to fuel economic growth.

That's where covered bonds come into play. Covered bonds are a type of securitization. They are widely issued in Asia, the United Kingdom and in Europe – especially Germany.

But the reason they're not popular here in America is because banks and Wall Street don't like them.

Covered Bonds – the Answer to Our Problems?

Covered bonds aren't embraced in the U.S. market because they require lenders who pool, package and sell these hybrid securities to actually keep skin-in-the-game. Bonds are "covered" because they are issued by banks that retain the underlying loans on their balance sheets.

While banks can create covered bonds to sell to investors, and use the proceeds to make more loans – which would promote lending just as securitization did during its heyday – there is a difference: The lending institutions are required to put up more collateral if the original assets used to secure their covered bonds stop performing.

What's wrong with that? Why shouldn't banks and Wall Street be responsible for the loans they make? Why shouldn't they do proper due diligence, collateral checks, income verification and all other necessary documentation checking before extending credit?

Banks and other Wall Street institutions used to be solely responsible for loans they kept on their balance sheets. Why should lenders now be allowed to "escape" and leave taxpayers holding the bag?

Banks and Wall Street cry about free enterprise and over-regulation. But the minute they step on their own tails from the weight of the profits they pile up at the expense of the U.S. taxpayer, they want us to "recognize" that they are the grease that keeps credit flowing and the U.S. economy humming – and push to be protected like sacred cows.

As we know all too well, Wall Street has enjoyed just such a protection for years. But just because we need banks and Wall Street to facilitate lending and maintain our capital markets, that doesn't mean they have the right to make egregious profits and leverage the economy into impotence.

Recently passed financial-regulation-reform legislation calls for banks to retain 5% of the loans they make. That's too small an amount and will be easily circumvented by any number of financial transactions designed to leapfrog any restrictions.

Again, why should banks be able to originate and distribute the risk that they should be 100% responsible for? We tried that model – or, rather, tried its limits. And Wall Street broke through them quite easily.

There's a better way.

Covered bonds are generally all investment-grade securities. That's because they force banks to adopt prudent underwriting-and-lending practices, require them to collateralize the securities they sell, and additionally constrain issuers by mandating reserve requirements on held assets.

Imagine investing in a security that is AAA-rated – not because some rating agency was paid to rate it that high, but because, by law, it is constructed to be that highly rated.

Granted, yields would be lower on these bonds, simply because they are safer. But, so what? If all new loans – mortgages, credit-card receivables, auto loans, or any other type of loans – were packaged into safe, investment-grade "covered bonds," investors would buy them. New money would be put back into the lending system and real transparency and stability would underlie our economic future.

Legislation has been proposed under the U.S. Covered Bonds Act to put in place the framework to make covered bonds an integral part of our capital markets, but it's gone nowhere. Banks and Wall Street have been pushing back because a robust covered bond market upends the machinery they employ to generate their fat bonuses.

We need to write our legislators, call them, e-mail them, and inundate them with demands to instill the needed transparency and stability into our capital-markets system, precisely by promoting a robust covered-bond market as a replacement for the shackles of securitization Wall Street would prefer to have us wear.

Action to Take: A robust covered bond market offers many solutions to the problems that currently ail the U.S. economy, as well as its underlying financial system. A covered bond market would jump-start needed lending by creating a healthy, transparent and "honest" securitization market. It would also enable the United States to regain its title as the financing center for the global economy.

There is legislation – and other proposals – in place that could make this happen. But sacred-cow Wall Street doesn't want to endure the restrictions that would be in place – despite the fact that these restrictions are perfectly reasonable.

We can't wait any longer. Write to your elected representative. Write to the Obama administration. Demand that they champion and install the needed transparency and stability into our capital-markets system, precisely by promoting a robust covered-bond market as a replacement for the shackles of securitization Wall Street will otherwise force us to keep wearing – at a great cost to the American investor and U.S. taxpayer.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready – and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy – and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. George Tull | September 15, 2010

    This is a Great article!!!

  2. Bob Drummond | September 15, 2010

    "And they all lived happily ever after"

    You are right but you miss the point. Without the banking and brokerage Ponzi game, how can Senator Sam Six-Pack get the millions he needs from Goldman and Morgan to get re-elected to represent his best interests. There is always the taxpayer to clean up after the parade.

    You are waisting your time, The President, The Congerss, The House and The Judiciary will act in their own best interest. Remember if voting could really change anything it would be against the law.

  3. Danny Carelock | September 15, 2010

    It's called being responsible for your actions. That has always been a way of life for me and should be for the entire nation. If banks make the loans they and only them should be responsible for collecting these loans. If they want to sell these loans to someone else, they still should be responsible for the loans. The institution buying these loans should be strong enough to take care of these loans in case of default as well as the orginal loan institution. I think both should have equal obligation for payment in case of default. The American tax payer should not have to pay for their mistakes. Do the banks send us part of the income of these loans???? I have not recieved my check………

  4. eliseo Martinez | September 15, 2010

    Am I oversimplifying? A bank issues a covered bond and uses loans it has made as collateral. The interest it would receive from the loan would then be distributed for operation costs, interests to bond buyer, bank's cash reserve == and none to "in-betweens".

  5. Mahant | September 15, 2010

    If real estate mortgage securitisation ended in gross abuse and artficial boom in their prices due to out of control leveraging dictated by extreem greed of wallstreet operators what will happen to securitisation of non real-estate asset-based securitisation? Real issue is honest enforcement of rules and limiting leveraging to managable levels. Honest investors and helpless taxpayers need honest leaders and CEO's and hopefully their staying away from wallstreet might bring some real solutions instead of another Ponzi Scheme of covered bonds.

  6. fraenkl henry | September 15, 2010

    The idea is good in a nutshell but doesn't address the real problem. The real problem of the crises was and still is, not only the problematic of off-balance-sheet and other shady activities of inside the banking system, but that the surplus money which is used for investments had to turn faster in order to generate higher interest. They forgot who will be buying all these products when always less people could participate because they run out of money. The few that had the money didn't know where to invest anymore so they had to create some kind of cony business to get some fresh money in to their closed system. The real topic is the distribution of wealth downwards though that everybody feels that he is and can be responsible. So in order to solve all these complex problems of a feel free and responsible world civilization – quiet allot of different factors have to be priced in. For this new economy the world is not jet ready and later it all will be to late. Now its to little for homo sapience and only for money again!

  7. James | September 15, 2010

    I agree! This is another great article by Shah Gilani. He is an excellent communicator. He explained the underlying causes of our global and national financial meltdown in simple language in previous articles for us ordinary laymen to understand.

    Now he has come up with another great article offering a solution to our financial ills by having banks provide covered bonds to make it easier to expand credit to our economy by creating "new money" to flow into the system. Lack of borrowing power and loans to businesses have been stifling our economy. Making it easier for businesses to obtain loans will help spur it. The ability to provide covered bonds should be granted to small banks in our local communities, the ones that actually serve our local businesses. And now is a perfect time for these loans to be granted to new entrepreneuers, especially the young, energetic ones who have great ideas, but lack the ability to borrow money to get started.

    The big banks are only interested in big money that go to global companies, sovereign wealth enterprises, mergers and aquisitions, derivatives, securitizations, etc. to line their own deep pockets, all in the name of greed! They are not interested in helping the little guys. Let them play their own game and next time when they get caught in their own trap, DON'T BAIL THEM OUT! Let them go the way of the Lehman Brothers who got what it deserved i.e. bankruptcy. The United States of America will survive! … too big to fail? Hmphh!

    This is how Joseph Schumpeter's "Theory of Creative Destruction" works and how economies crumble and get revitalized. However, the US did not learn from our recent economic crisis. The same big players are still around making mischief to our financial system. They are cancers. Until they and their kind are removed from our financial system and new players with a different mindset (like the ones running banks after the Great Depression – they must be tossing in their graves) who are sticklers to the 4 Cs' of credit (CHARACTER, capacity, capital, and collateral) with the emphasis on "character" come in to the system, I am afraid Schumpeter's "Theory of Creative Destruction" will play itself out.

  8. Dave Eddy | September 16, 2010

    A well articulated article. It does demonstrate how our financial system has been manipulated by the banking industry and offers little hope this will change. I doubt the system will change until a major crisis and bankers and politicians are grouped with prostitutes and pimps and I may be offending the latter.

  9. Jerry McCormick | September 16, 2010

    As a prime mortgage broker I can sell loans to worthy borrowers at a profitable rate with no defaults. This is the answer. We are dead in the water until property is moving again. Somebody needs to wake up and get this to main street where people like me work hard to make an honest living helping people finance homes. Instead I have been treated like a criminal, forced to pass exams and send money to newly formed govenment agencies that don't have a clue what their doing. Once again the government has over corrected and we're all screwed. Anybody have a job for me promoting these products?

  10. Nicolás E.Benito | September 18, 2010

    Excellent article under my point of view.
    There is a vicious circle surrounding the world financial system.
    I feel that not only healthy development is menaced: the entire old currencies system is endangered.
    Particularly West currencies,,,particularly the US dollar.
    So maybe if the US doesn´t solve the problem, other will try. Consequencies are inimaginable.

    An under control process, as Mr. Gilani indirectly proposes , is at not doubt safer than other "exoperiments" like turning into the Gold Standard or Copper Standard. That would be a shortcut.
    But maybe necessary if nothing is done.

  11. attendance record | September 27, 2010

    It is a great article, well described the financial crises reasons and the way to get out of it. That will help the investors a lot to recover.

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