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Are Covered Bonds an Alternative to Asset-Backed Securities?

Monday, October 1, 2012

U.S. retail investors were permitted to purchase covered bonds for the first time during the spring when the SEC allowed the Royal Bank of Canada to register and publicly sell covered bonds in the U.S. market.  Previously, only “qualified institutional investors” were permitted to purchase covered bonds.  Meanwhile, separate bills now in the House of Representatives and Senate seek to establish a legal framework for covered bond issuance by U.S. banks.  Why is there now a legislative effort to establish a covered bond market in the United States? 

Covered bonds have attracted the attention of U.S. lawmakers in the aftermath of the financial crisis primarily as an alternative to asset-backed securities (ABS), which have been widely blamed for providing perverse incentives to loan originators and fueling the recent housing bubble.  Securitization, or the process of creating ABS by packaging assets together (such as loans) and selling their payment streams, potentially engenders a principal-agent problem.  The principal-agent problem occurs when one party (the agent) is charged with making decisions on behalf of a second party (the principal) but the agent is not fully incentivized to act in the principal’s best interest.

Senior research associate Brett Fawley and economist Luciana Juvenal of the St. Louis Fed explore covered bonds in an Economic Synopses published earlier this year.  They explain covered bonds, the motives for legislating a market for them, and the pros and cons of covered bonds versus ABS.