EcONOMIC CoMMENTARY - Covered Bonds: A New Way to Fund Residential Mortgages

Sep 21, 2026

The text explains how large investment banks once helped finance residential mortgages by securitizing pools of loans for sale to investors. It describes how securitization funding became less reliable after credit turmoil, especially as private mortgage-backed issuance largely disappeared. It then introduces a covered-bond market initiative and compares covered bonds with earlier mortgage-backed securities, emphasizing that covered bonds are backed by the originators’ capital. The document also outlines what went wrong in securitization, including risk opacity created by complex multi-party structures, transfers, ratings, and re-securitization layers.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

AccessFree to download

Covered Bonds: A New Way to Fund Residential Mortgages

0.Enre Ergungor

Securitization:What Went Wrong

# EcONOMIC CoMMENTARY Covered Bonds:A New Way to FundResidential Mortgages ## 0.Enre Ergungor Like the now government-owned Fannie Mae and Freddie Mac,large investment banks helped create funds to financenew mortgages by issuing secunties backed by pools of existing mortgages.But prvate firms have abandoned theseinstruments,and with them a large source of mortgage funds has disappeared.Four large investnent banks plan tocreate a new U.S.market for an old instrument,hoping to bring liquidity back to the mortgage market. Until the summer of 2007,mortgage lenders increasinglytapped capital markets for quick and cheap funding.Througha process called securitization,they could sell the loans theyhad originated to the government-sponsored entcrprises(GSEs)Fannic Mac and Freddie Mac,or to large invest-ment banks,which then packaged these loans into varioussecuritics and sold them to investors.Lenders used the saleprocceds to make new loans,which were also sent throughthe same securitization process. Since the credit market turmoil started,however,this sourceof funding is less convenient and abundant than it usedto be.While lenders can still sell prime mortgages smallerthan around $417,000 to Fannie and Freddie(the exact limitdepcnds on the region),one segment of the securitizationmarket has essentially disappcared:Large investment bankshave stopped issuing thcir mortgage-backed securities and arcno longer buying mortgages to repackagc for that purpose.This source of funding until recently constituted a trilliondollars(sce figure 1)and was used primarily by lenders thatmade subprime loans and loans larger than $417,000.Itsdisappearance has the potential to further disrupt credit flowsand damage the ailing housing sector. Despite this setback in the mortgage-backed sccuritizationmarkct,new funding sources are emerging.In July of thisyear,four large investment banks-Bank ofAmerica,Citigroup,JPMorgan Chase,and Wells Fargo-unveiledtheir plan to kick start a covered-bond markct for residentialmorrgage lenders.Whethecr such a market is the solution tomortgage lenders'funding needs remains to be scen.But co-cred bonds do have one feature that should make them an improvement over the mortgage-backed securities previouslyissucd by private institutions.Sccuritizcd mortgages were notbackcd by the capital of the loans'originators against losses,but covered bonds are. ## Securitization:What Went Wrong When a bank makcs a mortgage loan and keeps it on itsbalance shcet,regulators require the bank to finance at leastfour cents of every dollar of that loan with the bank's owncapital.This rcquirement ensuures that the institution maintainsa cushion against uncxpected losses,protccting the bank,itscustomers,and the agency that insures the bank's deposits.Onthe other hand,when a bank sccuritizes a loan,it is permit-ted to remove the loan from its balance shcet,climinating thecushion requirement and frecing the bank to use the capital forother purposcs.Recent experience has shown that while loansmay have been removed from the balance shect through thesecuritization process,all the associated risks were not.We havelcarned that,in cessence,the process moved loans from a heavily regulated.well-monitored.and gencrally understood arenainto onc where risks were difficult to trace or quantify. The underlying risks bchind most sccuritizcd mortgagesare obscured by their complexity and the number of partiesinvolved in thcir packaging.The sccuritization process beginswith the underwriter (an investment bank,Freddic,or Fan-nic).who purchases mortgages from various lenders and thentransfers ownership to a spccial-purpose entity (a scparate cor-poration or business trust).The spccial-purposc entity creatcssecurities that represcnt claims on the interest and principalpayments of the pooled mortgages. Rating agencies then judge the level of risk in the pool andsuggcst credit enhancements that will clevate the securitiesratings to some desired levcl.Any

FAQs

Why did private mortgage funding sources decline after the credit market turmoil began?

Securitization funding became less convenient and abundant, and large investment banks stopped issuing mortgage-backed securities and no longer bought mortgages to repackage them, reducing liquidity for mortgage lending.

How does securitization funding work before the crisis?

Mortgage lenders sold originated loans through securitization to government-sponsored enterprises such as Fannie Mae and Freddie Mac or to investment banks, which then packaged the loans into securities sold to investors.

What is the key difference between covered bonds and mortgage-backed securities?

Mortgage-backed securities were not backed by the originators’ capital against losses, while covered bonds are backed by the capital of the loans’ originators.

Sep 21, 2026

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