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 boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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