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Tuesday, July 29, 2008


covered bonds

treasury secretary and goldman man hank paulson is fronting for the latest liquidity scheme for the housing market over the last couple days -- covered bonds. of the longtime staple of housing finance in europe, i earlier said

moving to a covered bond format in the distant future seems very possible, but what are its near term ramifications? this is private finance, and the covered bond market in europe has been shuttered for a year. capital is currently too threatened to step into a quagmire of highly questionable valuations and bottomless house price forecasts. so the chances of a workable covered bond market in the near term seem very remote to me -- and if one is attempted, i would expect the flow of capital to mortgage markets to be severely restricted.

while moving to downsize and disassemble fannie and freddie is a laudable longer-term goal -- and while a privately-financed covered bond market is a more reasonable substitute for the originate-and-distribute model -- how this format is supposed to liquify american mortgage markets in the depths of the greatest credit unwind of the last 70 years is beyond me. so while its longer-term raison d'etre is plain, one has to begin to ask what other ends this scheme is being presented just now as a means toward.

given the desperate state of high hypocrisy and open thievery that wall street is in, one should have the most cynical view possible of this adventure from the outset. investment banking has a very long martial history of making a shield of noble aims from behind which the spear and sword of self-interest are brandished with vulgar zeal.

as such, consider this prologue via rge monitor by london banker:

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.

When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.

Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America's banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I'm not sure on this one, so I'm looking forward to views from those more expert here.

one does not have to consider this to be the solitary goal of the push for covered bonds to realize that it will be one of several dynamics that emerge from the establishment of the market. this is a means to strengthen large banks by raping smaller ones -- and strengthening banks too big to fail is very much in the front of the minds of washington financial markets authorities.

UPDATE: more via david merkel.

UPDATE: even more from steve waldman, who rightly points out that, for the short run anyway, covered bonds serve mostly to strengthen large banks' claims on the united states treasury.

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