Do Covered Bonds Have a Government Guarantee?

Steve Waldman reckons he's worked out what the problem is with covered bonds:

A covered bond offered by Citi or Bank of America would only default if a titan collapsed. Investors might reasonably believe that would not be permitted to happen. If they are right, then these bonds are indeed covered. They are covered by you, dear taxpayer...
Covered bonds issued by "too big to fail" banks are basically equivalent to mortgage backed securities guaranteed by Fannie and Freddie. It's just another way of putting private-sector bells and whistles on a public sector assumption of risk.

This is all true, but it's not quite as bad as it might look. For one thing, the moral-hazard play on bank debt exists whether there are covered bonds or not. If Bear Stearns creditors were paid off in full one can reasonably assume that the creditors of Citi and BofA will be bailed out in extremis as well. So the extra risk borne by the taxpayer when these banks start issuing covered bonds is simply the extra risk put on these banks' viability by the issuance of covered bonds.

And as it happens, covered bonds tend to be very safe things. What's more, because they're collateralized, a bank failure doesn't necessarily imply that there's going to be a taxpayer-financed bailout of covered bonds as well as senior unsecured debt, since the bondholders should be able to rely on their collateral.

The introduction of covered bonds is unlikely to massively increase banks' balance sheets -- not least because the banks' regulators won't allow it to. So the size of the implicit government guarantee on the debt of too-big-to-fail banks probably won't go up all that much, at least for the time being. Meanwhile, the banks will have access to lower-cost funding, making it that much less likely they'll fail in the first place. And we'll slowly move away from the unhealthy system where substantially all new mortgages are bought by Fannie and Freddie, who now have a more-explicit-than-ever government guarantee.

A move towards covered bonds is hardly a panacea, of course. But I don't think that it increases public-sector risk as much as Steve thinks it does. At the moment, mortgages are all-but-explicitly guaranteed by the federal government, because Fannie and Freddie are the only game in town. If covered bonds take off, then the implicit guarantee on too-big-to-fail banks is weaker than it is on Fannie and Freddie, and it also kicks in only after those banks' equity cushions are wiped out. And remember that banks are much more strongly capitalized than Fannie and Freddie are. Plus, of course, the collateralization would have to fail as well.

Are covered bonds risk-free from a taxpayer perspective? Ultimately, nothing is. But I'm not losing sleep over any new risks here.