The Great New Mortgage Financing Hand-Off!

Securitization, Private Label & Covered Bonds!

Introducing the: USCoveredBondCouncil.Com

By Richard Ivar Rydstrom, Esq., LL.M.,

Chairman CMIS, US Covered Bond Council

As we debate what to do with Freddie and Fannie in 2011, we are not yet ready to terminate its
life-support because there is no other sufficient alternative mortgage financing structure in place.
When Freddie and Fannie are lessened in volume or terminated, alternative mortgage financing
must be in place to fund the pipeline. This great mortgage financing hand-off must be done „just-
in-time‟ as real estate recovers. As the U.S. delays its new mortgage financing hand-off, U.S.
institutional investors are funding foreign housing through foreign covered bonds. Covered
bonds, and private label funding, must step up and take form as alternative financing necessary
to fill the securitization and covered bond pie. One of the final covered bond issues to be
resolved revolves around who-gets-what through bankruptcy.

Relatively new to the United States, covered bonds have been used extensively throughout the
world. On July 28, 2008, Treasury Paulson, the FDIC, and 4 major banks, announced their
support to create a “covered bond” market that would help create liquidity. For more information
visit: www.USCoveredBondCouncil.com, Joint Covered Bond Press Release.

Approaching year end in 2010, over $25 billion in covered bonds were sold to American
institutional investors by European, Norwegian or Canadian banks, not U.S. Banks. As the U.S.
mortgage banking markets suffer, U.S. institutional investors are funding the foreign housing
market, not the U.S. housing market.

New covered bond legislation (H.R. 5823, the United States Covered Bond Act of 2010) is
pending in the House of Representatives. On September 15, 2010, Rep. Scott Garrett (R-NJ) in
his statement to the Senate Banking Committee stated: “There are many potential benefits for a
wide variety of interested parties that can be derived from a U.S. covered bond market:

 Consumers will experience lower loan rates because of the additional liquidity in the
various asset classes.

 Consumers will also be able to more easily have their loans modified because the loans
will still be on the balance sheet of the originating institution.
  Investors will have a new transparent and secure vehicle to invest in. This will allow for
additional diversification within their portfolios.

 And finally, the broader financial markets will benefit by having an additional, low cost,
diverse funding tool for financial institutions.

 “Covered bonds will ensure more stable and longer term liquidity in the credit markets,
which reduces refinancing risks as well as exposure to sudden changes in interest rates
and investor confidence. And they will allow U.S. financial institutions to compete more
effectively against their global peers.

Covered bonds are mortgage debt that remains on the balance sheet of the issuer (bank or special
purpose entity). In theory, covered bonds should attract more investment monies as they provide
the investor dual recourse from the “cover pool” and the “issuer.” The market value is in
multiple excess of the face value of the covered bond pool (i.e. overcollateralized). In addition
covered bond pools are partitioned and protected from default and the bankruptcy risks of the
other assets of the bank. So far, in the U.S., the covered bond market has met with little
acceptance or interest primarily because Freddie and Fannie offer securitization financing, and
the FDIC has effectively opposed the covered bond bankruptcy protections over the bank‟s other
assets as creating a contingent loss event over bank deposits, and it wants authority to reach the
overcollateralized assets after discharge. However, bondholders will think twice before allowing
the FDIC control the cover pool. When this balance is reached the stage for the development of
the Covered Bond market will be set. However, the timing of the mortgage financing hand-off
and recovery of the real estate market is uncertain, as the economy remains weak, over 1.6
million consumer bankruptcies are expected year-end 2010, unemployment remains high, 19
million homes remain vacant, the foreclosure inventory may take over 40 months to sell off,
seven million homes are REO and in some form of the foreclosure process, and defaults and
foreclosures are rising. S&P reports that if Fannie and Freddie are extinguished, and a new
federally backed government GSE is formed it could cost upwards of $700 billion.

Covered bonds also avoid the contingent liability of mortgage/deed transfers required in the
normal securitization model, as there is no sale, transfer or re-sale of the loan or mortgage. Banks
make loans which remain on its balance sheet, and issue covered bonds, without transferring,
selling or re-selling the mortgage, loan or deed. Rating agencies should find comfort in issuing a
triple-A rating on covered bond pools based upon its conservative product design.

Also, interest (money flow) is paid from an identifiable projected cash flow, not just out of
financing operations. Since, non-performing or prepaid loans must be replaced, the pool is
always performing. Unlike the „securitization method‟ which is designed to transfer and shield
credit risk and prepayment risks with great contractual, regulatory and governmental restrictions
on the ability of the “securitization vehicle” (Trust/Conduit/REMIC) to replace or effectively
modify mortgage loans, (Pooling & Servicing Agreement, IRC 860, Financial Accounting
Standards Board Statement 140, 114, etc.), covered bonds are designed to allow replacement of
non-performing loans to keep the portfolio performing.
Let‟s look back at H.R. 3221, the Housing and Economic Recovery Act of 2008. It imposed a
duty on servicers to maximize net present value for the securitization vehicle (investors‟
interests). Moreover, although the new U.S. covered bond device is a critical part of the overall
solution, private label securitization and covered bonds, and/or new credit enhancement or
private and federally backed guarantees or products must remain or be introduced into the market
for the real estate market to recover. The U.S. Treasury reports that during the 2005 to 2007HI
private label securitization exceeded or was equal to funding by GSE (MBS). During such
periods FHA remained fairly constant and insignificant. Balance Sheet Lending was about the
same as the GSE (MBS) and private label securitization until 2007H2 and 2008Q1, where it
decreased significantly. But private label securitization fell significantly in 2007H2 and almost
ceased to exist by 2008Q1. Private label securitization or the liquidity that it supplied the
mortgage finance industry has all but dried up. Investors are not willing to put money into the
securitization vehicles as it exists today for fear that they will lose their money with little or no
recourse. During 2005, 2006 and 2007H1, private label securitization exceeded $1 Trillion
($1.2T). Now it is still anemic. Additionally, H.R. 3221: Housing and Economic Recovery Act
of 2008, addresses this problem and supports as public policy increased securitization by stating
as follows: (1) securitization of mortgages by the enterprises (GSEs) plays an important role in
providing liquidity to the U.S. housing markets; and (2) Congress encourages them to securitize
mortgages acquired under the increased conforming loan limits established by this Act.

It is time for the development of the Covered Bond marketplace. It will help add some important
portion of needed liquidity. The market desperately needs the return of a vibrant mortgage
funding system, whether it be composed of securitization and covered bond vehicles, for agency
(government sponsored entities (GSEs) such as Freddie Mac and Fannie Mae or a new
replacement), non-agency paper (or private-label securitization and/or covered bond loan
funding), and overall new creative sources of mortgage funding, with external and internal credit
and product enhancements, including Covered Bonds (www.uscoveredbondcouncil.com).

Richard Rydstrom, Esq., Chairman of CMIS Mortgage Coalition,

rrydstrom@gmail.com; 949-678-2218; Founder, The U.S. Covered Bond Council
To Join the Debate, Sign In on www.USCoveredBondCouncil.Com;
info@uscoveredbondcouncil.com)