American Enterprise Institute

September 19, 2008

[Edited transcript from audio tapes]

8:45 a.m.	Registration
9:00	Introduction:	Peter J. Wallison, AEI
9:15	Keynote Address:	Neel Kashkari, Department of the Treasury
10:00	Presenter:	U.S. Representative Scott Garrett (R-N.J.)
10:30	Panelists:	Greg Baer, Bank of America
		Bert Ely, Ely & Co.
		Jason Cave, Federal Deposit Insurance Corporation
		Alex J. Pollock, AEI
		Tim Skeet, Merrill Lynch & Co.
	Moderator:	Peter J. Wallison, AEI
12:00 p.m.	Adjournment

Proceedings:

Peter J. Wallison [Moderator]: We will have a very interesting conference today on a new idea for mortgage finance, and we have some fascinating experts in this subject.  So, we are delighted to have an audience that can participate. 

The way we will do this, as usual, is we will have a presentation first by Neel Kashkari of the Treasury Department who is our Keynote Speaker, and then we will go through a number of other speakers.  I know you are anticipating some important talks by some of our people on the panel. 

But, after Neel we will have Scott Garrett, Congressman from New Jersey, who has some legislation on the same subject as covered bonds.  And then we will go into a general discussion by the panel and among the panel, and finally questions from the audience.  So, if you have questions as you hear things said, please note them down so we can deal with them when we get to the final hour.

Now that it has become indisputably clear that Fannie and Freddie are backed by the federal government, some change in our system of housing finance is essential.  We cannot continue to pursue a structure in which the profits go to the shareholders and the managements of these two companies, but the losses are picked up ultimately by the taxpayers.  There will be many proposals for reform, but the likelihood, I am afraid, is that Congress will want to retain Fannie and Freddie as they are.  And the supporters of these two companies will undoubtedly argue that the new regulatory structure that was put in place late in July will prevent any problems in the future. 

This is the same argument that was used when the original regulatory structure was adopted in 1992.  And unfortunately once again, it is likely to be a winner.  This outcome, however, becomes a certainty if there is no other system of housing finance in place.  And so the conference today is one that will attempt, at least, to look at some of the alternatives -- at least one major alternative -- to replace the system we are using today.

We are already hearing from Capitol Hill that Fannie and Freddie are the only vehicles for creating the traditional U.S. 30-year fixed-rate mortgage.  And suggestions that anyone who would close them down must make clear how the mortgage market would possible operate without them.  Covered bonds are one of the alternative financing methods that could in the future replace GSE securitization and the originate-to-distribute approach it spawns as the principle mechanism for financing residential mortgages. 

This is actually the second conference on alternatives to Fannie and Freddie.  In March 2004 -- I am afraid a little bit prematurely -- and as part of our long inquiry into the policy implications of the GSEs, we held a conference on residential financing systems that are employed in Europe focusing particularly on the very interesting Danish system.  In your folders you will find a paper on the Danish system prepared by the IMF and you might profitably take a look at that.  The Danish system has similarities to both securitization and covered bonds and deserves serious consideration particularly because it operates successfully without any government support.

In Denmark every time a mortgage loan is made, the lending bank issues a bond to fund it.  Mortgage banks in Denmark finance and take the credit risk at mortgages, but do not take deposits.  The terms of the bond issued by the Danish mortgage bank match the interest and maturity of the mortgage loan.  So, the mortgage bank does not take any interest rate risk.  The bonds are collateralized by a pool of identical mortgages and are callable, so the borrowers pay a premium on issuance for the right to prepay.  Neither the mortgages nor the bonds are due on the sale of the home, so a low-rate mortgage becomes a valuable element in the home selling price.  Credit losses are very low in Denmark largely because an 80 percent loan-to-value ratio is required and mortgage loans are made with recourse.

The most interesting part of the Danish system is that borrowers have the right to buy back the mortgage bonds that finance their homes when interest rates rise.  Higher rates cause the bond to decline in value and by purchasing it homeowners, in effect, create equity in their homes by reducing their mortgage obligation.  In effect, they are paying a slightly higher interest rate on a lower principal amount.  I will not go into all of the details.  Of course, the discussion in your folders will be interesting reading.  But, the point here is that the Danish system allows the creation of the fixed-rate 30-year mortgage that is said to be the hallmark of the U.S. GSE system, but does this without any government support.

We should explore other systems for residential finance including changes in the laws and regulations that will reduce the risk of holding mortgages and the costs of refinancing them.  Due-on-sale clauses, non-recourse mortgages, and lower loan-to-value ratios can all affect how stable our mortgage system is.

The important point is that the subprime meltdown is proof that we have been using a residential mortgage finance system that has large elements of instability and risk built into it, and we should be looking for alternatives before Fannie and Freddie come back to life and resume their svengali-like control of Congress.

In the conference today, we will look at covered bonds as one means of financing residential mortgages.  One of the key issues in the covered bond proposal is that -- is the need to address the FDIC's concern that insured banks could place some of their best assets in the cover pool and thus expose the FDIC and the entire banking system to greater losses in resolving a failed bank.  Issues like this turn out to be difficult and have compelled the FDIC to place significant limitations on the use of covered bonds by insured institutions. 

But, the Danish system reminds us that covered bonds can be issued by institutions that do not take deposits.  In other words, there is no obvious reason why once the way is open for alternatives a covered bonds system for financing mortgages could not be constructed outside the regular banking system.  This would avoid conflicts with the priorities of the FDIC and the insured deposit system.  An entirely separate group of financial institutions could offer mortgages that are financed by covered bonds.  There is no inherent reason why in the efficient capital markets we have today that we should still be financing long-term assets like mortgages with short-term liabilities like deposits.  As everyone knows by now, and it was demonstrated clearly in the collapse of the S&Ls, this is a prescription for instability, for moral hazard, and we now know, for a taxpayer risk. 

Covered bonds offer the possibility of a more stable system of mortgage finance by closely matching long-term mortgages with long-term financing.  They also have other advantages that will be outlined in today's conference.  What we should be thinking about is how to take maximum advantage of the benefits covered bonds offer while minimizing the issues they create for the FDIC. 

The collapse of the S&Ls, and now Fannie and Freddie, should be convincing evidence that we have to find another way to provide the American people with a system of financing home ownership.  Going back again to the old way by resuscitating Fannie and Freddie is not, in my view, the right answer.

Well, I want to thank all of you for coming, and I want to introduce our Keynote Speaker, Neel Kashkari.  Neel is an assistant secretary of the Treasury and has been that for over, well, about a year and a half, and he is now the assistant secretary for International Economics and Development.  Prior to his nomination as assistant secretary, he was a senior adviser to Secretary Henry M. Paulson. 

One of Neel's specialties, it seems, is developing and implementing new ideas.  He did this before he began his career in finance when he worked at TRW developing technology for space missions, when he was at Goldman Sachs in San Francisco and a head of the security firm's investment banking business, earlier at Treasury when he led Treasury's involvement in the administration's plans for developing alternative energy sources, and now when he heads Treasury's work on developing covered bonds as an alternative source of energy for the mortgage finance market.  He has an engineering degree from the University of Illinois and an MBA from the Wharton School.  I hope you will join me in giving a warm welcome to Neel Kashkari.  [Applause]

Neel Kashkari:  Thank you.

Peter J. Wallison:  Oh, let me say one more thing.  Obviously, there is a lot of interest in what Treasury is proposing to do in the financial markets, and Neel is here to talk about covered bonds.  So, after he is finished with his presentation on covered bonds, we will be taking questions.  But, I would like you to limit your questions, please, to covered bonds.  And if you want to know more about what the Treasury is doing or the Treasury is planning, contact the Treasury Department.  But, Neel will talk about covered bonds.  Thanks, Neel.

Neel Kashkari:  Thank you very much, Peter, and thanks to AEI for having this.  This is a really important topic and very timely, and I appreciate having me here. 

So, what I would like to do today is talk to you about Treasury's approach, housing very broadly, but mortgage finance more specifically, and the role that we think covered bonds can play in mortgage finance in America going forward.  And then I am happy to take your questions.

Our housing market objectives.  When the housing correction began, we laid out a series of objectives that we still think are the right objectives.  Number one, avoid preventable foreclosures, and we have had whole huge initiatives to try to do that.  Number two, ensure the availability of mortgage finance.  We need to make sure mortgage finance is flowing to get through the correction, but then longer term.  Number three, we need to, excuse me, enable the necessary correction to move forward as quickly as possible.  We are having a necessary housing correction.  We do not want to do anything to slow it down.  We need to get through it so that we can get housing growing again.  And then number four, minimize spillover from housing to the rest of the real economy. 

Now, covered bonds is going to fit under the second bullet there, ensuring the availability of mortgage finance.  We have taken an approach that there is no silver bullet in the housing market.  There is no one tool that is going to solve all of our problems.  We need to turn over every stone and find every incremental tool that is going to help on the margin.  So, look here, the things that we have been focused on in terms of mortgage finance to get us through the housing correction.

FHA introduced a new program last year.  It has done 350,000 refinancings in the past year.  HOPE for Homeowners.  This is the bill that the President signed that the Congress passed in July, a new refinance program.  Obviously, Fannie Mae and Freddie Mac have an enormous, important role to play, and we have taken an aggressive action to make sure they can fulfill their mission.  The home loan banks are also fulfilling their policy mission by ramping up their activity. 

Improving transparency of mortgage-backed securities.  There are a lot of reasons that we got into the mess that we are in one of which is in a private-label mortgage-backed security market there has been very poor transparency.  Very hard for investors to know what are the actual loans that are in the mortgage-backed securities?  Are they performing?  Are they delinquent?  That has been a key challenge. 

And so the American Securitization Forum has put together a task force to try to come up with detailed data -- 200 data fields on loan, by loan, by loan, and standardize it across the industry so that investors will know in new mortgage-backed securities what is in there and they can have confidence.  That is a really important factor, because we think securitization is going to come back, and it has an important role to play.  And then we have got covered bonds.  Again we do not think covered bonds are a panacea, but we think it is one more tool.  And we need to be exploring all tools to encourage mortgage finance in America.

All right, so let us look at how do banks or originators fund new mortgages.  Look at the left hand side off balance sheet.  So, let us say I am a bank and I originated a whole bunch of loans.  I could sell those loans and get them off by balance sheet.  So, I could take the loans and sell them to an investor who wants whole loans.  I could securitization them -- private-label securitization -- and sell those securities.  Again they are now off my balance sheet.  They are no longer -- I no longer have responsibility for them.  I could sell them to Fannie Mae or Freddie Mae -- GSE securitization -- or I could originate them into FHA and then it becomes a Ginnie Mae securitization.  Again it is off of my books.  I do not need capital.  I do not need any more funding for that.

On balance sheet, the alternatives are deposits.  So, I originate a bunch of loans.  I am going to hold them, but I use my deposit base from my customers to fund those mortgages.  I retain the mortgages.  Unsecured debt.  So, I originate the mortgages.  I issue debt into the capital markets.  I keep the mortgages, and I pay on that debt. 

Or federal home loan banks.  So, I originate the mortgages, and I put those mortgages to the home loan banks as advances.  I still own the mortgages -- that is collateral for the home loan banks -- and I get funding from the home loan banks.  So, you have got off balance sheet.  You have got on balance sheet.

Now, let us look at what has happened over the last several years.  This chart looks at the various sources of mortgage finance from 2002 to today.  The red at the bottom is private-label securitization.  You can see how it really ramped up '04, '05, '06, first half of '07.  The green are the GSEs, Fannie and Freddie; the blue, balance sheet lending; and the yellow, FHA.

So, in the credit crisis that we have had, securitization has really dried up.  Fannie and Freddie have raised their activity, as appropriate, fulfilling their policy role.  Balance sheets have taken on more and more loans, so banks have been looking for more sources of funding -- and FHA has really expanded their activity -- but you can see, even though these other categories have increased the overall net is a reduction in availability of mortgages.

Now look -- let us look at the home loan banks.  Again, this is an on balance sheet funding tool, so the bank retains the mortgage, but the home loan banks are funding it.  You can see how they have ramped up their activity; roughly $450 billion in '01; $850 billion or so currently.  So, they have really ramped up as a source of funding for on balance sheet finance.

So, despite this, Fannie and Freddie have ramped up their activities.  FHA has ramped up their activities.  Home loan banks have ramped up their activities.  Look at where spreads are to Treasuries for homeowners.  Prime, non-traditional -- which I think is Alt-A -- and subprime spreads are still much, much higher than they have been.  So, there is a need for more mortgage finance clearly certainly today, but even long term.

So, where are covered bonds?  Where would they fit in?  This is the same chart I showed you a minute ago.  Covered bonds are an additional source of on balance sheet financing.  I am going to walk through it in detail, and then you are going to have a very active discussion after I am done.  Again, there is no silver bullet.  It is an $11 trillion mortgage market.  Our view is there is a role for all forms of mortgage finance.  We are not picking a winner here.  We think they all have a role to play. 

So, what is a covered bond?  As I said, depository institution originates a bunch of loans.  It holds those loans in a pool.  That pool is collateral for a bond that it issues.  So, if I am the bank, I retain the credit risk.  I have to -- all of that credit risk comes to me.  And if any of those loans go delinquent, I am going to pull those out and replace them with new performing mortgages.  You as a debt investor in the covered bond, this is just collateral.  It is just security for you.  So, you would have dual recourse.  If anything were to happen to the bank, you would have recourse to the bank -- or first to the cover pool and if the cover pool is not enough then to the bank. 

So, I had never heard of a covered bond a year ago.  It took me awhile to get my head around it.  Think about an industrial company that issues secured debt secured by receivables or some other assets.  Same thing, a covered bond is just a secured debt offering where the collateral happens to be mortgages.  And again you have to maintain a high quality collateral to meet your requirements to the debt investors.

And importantly -- I am going to talk more about this in a second -- in a mortgage-backed security, the cash flow from the mortgages that are sliced and diced are what pay the interest and the principal on that security.  In a covered bond the issuer -- let us say Bank of America -- Bank of America's cash flows pay the cash flow on the covered bond not the actual mortgages themselves.  Those mortgages purely are collateral and that is an important distinction.

So, history of the covered bond market -- you probably know this -- it is roughly a $3 trillion market largely in Europe. It is a couple hundred years old; although, it really took off in the '90s.  It is used for municipal, so public sector debt, residential mortgages, commercial mortgages. 

In Europe you are going to hear a lot about this today.  A lot of European countries have what are called legislative framework.  So, it is a dedicated piece of legislation that says, "This is what a covered bond should look like.  This is what the regulatory environment is going to be.  This is what the disclosure requirements are going to be."  And it is all buttoned up nice and neat in one piece of legislation.  Some countries, including the U.S., do not have covered bond legislation.  We have what is called a structured framework where we have different pieces of law -- I am going to talk more about this -- that stitch together -- try to do the same thing. 

In the U.S., two institutions have issued covered bonds to date.  And another important distinguishing factor, we have the GSEs, and we have the home loan banks.  They do not have those in Europe.  So, we should not set expectations that covered bonds are not going to become necessarily the dominant form of mortgage finance in America because we have these other alternatives.  In Europe they do not have the GSEs or the home loan banks and so they have [inaudible] in some markets have heavily relied on covered bonds as their primary source of mortgage finance. 

So, again, let us talk through some of the difference between covered bonds and mortgage-backed securities.  I talked about the collateral -- again, let us go to the third row.  Is it a source of a capital?  A covered bond is a funding source.  So, if I own all the mortgages -- I am a bank -- I have to have capital behind those mortgages. 

Covered bonds does not solve my capital problem.  It is a funding tool, but that is true with the home loan banks too.  If I put the mortgages to the home loan banks, I still need to have capital underneath those home loan -- excuse me -- underneath those mortgages that are now placed at the home loan banks.  That is an advantage that mortgage-backed securities have is because you are selling the mortgages off your books it is no longer a use of capital, so it is important distinguishing.

Dual recourse.  Again, covered bond investors have resource to the collateral pool and to the issuer.  On secured debt they do not. 

And then acceleration and prepayment.  This is another important concept.  A lot of investors in Europe think about covered bond as what is called a rates product as opposed to a credit product.  So, if you are a fixed income rates investor, you look at this and you are making an assumption that there is no credit risk.  You are making an interest rate investment rather than thinking that I need to analyze all of -- whether or not this issue is going to go insolvent and make a credit analysis.  Similarly, with U.S. Treasuries, that is a rates product, not a credit product, because you are just making an interest rate investment not betting on the credit of the U.S. government. 

So, one of the things that rates product investors want is they do not want the bonds to accelerate.  So, that means if I am a rates investor and I invest in a 10-year bond, I want to know for the next 10 years I am going to get the coupon payments when I think I am going to get them.  I do not want the bond to accelerate and get my cash back five years early because that means I have to go find some place to put it for another five years. 

So, one of the features of the U.S. covered bonds is that there is what is called a GIC -- a guaranteed investment contract -- which means that if an issuer goes insolvent, the collateral gets either liquidated and -- that cash from that collateral goes into this contract.  It is another financial institution that is standing by to make the rest of the payments.  So, it is a structural feature that has been built in to make sure that the covered bond, if the issuer goes insolvent, continues to make the payments for the life -- the original maturity of the bond.  So, again, these are detailed -- technical details -- but these are -- end up being really important. 

As -- compare that to a mortgage-backed security.  If the loans refinance more quickly, you get your cash back quickly.  Or if a loan goes delinquent in a mortgage-backed security, your cash flow is reduced.  So, the covered bond programs have a lot of detailed features built in so that they maintain exactly the cash flows that they are supposed to over the life of the maturity.  They do not come in short, and they do not come in more quickly than you would expect.  Again, I am giving you a lot, I know, but I think it will be useful as you have your discussion this morning.

So, now let me tell you now what our approach has been to this.  We have looked at this and said, "How would we kick-start a covered bond market in the U.S.?"  We started out by reaching out to market participants around the world: investors, potential issuers, existing issuers, broker-dealers, rating agencies, law firms, anybody you can think of to solicit ideas.  What would be the key features to help kick-start a covered bond market in the U.S.?  What would you like to see if you were going to get involved in the covered bond from any of those perspectives? 

We also worked extensively with the other regulators, so in the U.S. very closely with the FDIC.  They have a very important role to play as well as the Federal Reserve, the OCC, the OTS, and the SEC, and as well as foreign governments, and foreign central banks, etcetera, especially those governments that have a lot of experience in their own markets with covered bonds to understand what has worked and what has not worked.

We have looked at -- our objective has been to try to balance structural certainty -- and I am going to explain to you what I mean by that -- with still allowing the market to innovate.  So, one of the keys is that -- as I have thought about the possibility for legislation in a covered bond, it is great if you can button everything up and say, "This is what the market should look like."  But, how do you do that in a way that does not then stifle the market from then innovating on its own and taking off in new important directions?  So, we have been trying to find that right balance as well.  And then our role as Treasury has been to try and find leadership to encourage the market to move.  And so there have been a lot of firms on their own trying to do work.  What we have tried to do is become a catalyzing force to get the market to move all at once, because if we can all move together, we have a much better shot of kick-starting this market.

So, here is what we learned from investors.  They want liquidity.  They want to know if they make this investment that they can trade it -- that there is someone on the other side.  Now, investors what liquidity today in every market and almost every market has challenges in liquidity so that is not unique to covered bonds.  But, over, and over, and over again they have been saying "liquidity" and "electronic pricing".  They want to know that they can go to a screen, press a button, and figure out what price is bond at today.  They want very high quality collateral, and they want blue chip issuers at least as a starting point for the market.  Over time you would expect to see smaller institutions, medium size institutions.  But, as a starting the investors told us, "It has got to be the blue chip names or we are not going to get going with this."

Homogeneity.  So, they do not want Bank of America's covered bond to look different than your covered bond or your covered bond.  They want to know that the structure, the template, is all the same so that they can just spend their time analyzing Bank of America or analyzing the interest rate environment.  Not spending time and saying, "Well, BOA has these three bells and whistles, and you have these two bells and whistles, you have two different bells and whistles."  Then they have to spend all sorts of time figuring out what those bells and whistles means, so homogeneity was important.

Regulatory clarity.  The FDIC has a really important role to play.  So, let me explain this to you.  You have these mortgages -- and Peter talked about this a little bit -- you have these mortgages on the balance sheet of a depository institution.  Heaven forbid that depository institution runs into trouble and goes insolvent.  Well, if they do the FDIC takes over and manages it -- either unwinds it or sells it.  How the FDIC treats that collateral and the respect they are going to have for the segregated collateral becomes very important to you as an investor so you know this collateral is really yours and you are going to get because that is what you were supposed to get.  So, the FDIC had to come in and say very clearly what they would do or would not do in such an environment, so that was really important for investors.  And we are going to talk more about that.

Issuers said, "It has got to be cost effective.  I have got alternatives.  I can go to the home loan banks.  I can fund it with my deposits, Fannie and Freddie.  This has got to be cost effective, so there needs to be investor appetite."  Issuers said, "The broker-dealers need to step up, and they need to provide training.  They need to provide research and real market support." 

And then they want flexibility.  So, the issue -- the investors want homogeneity, very high quality collateral.  The issuers want as much flexibility as possible.  We -- they want to put municipal bonds in there.  They want to put commercial mortgages in there.  Some want to put student loans in there.  But, the investors said, "No, no, no, no, no.  Keep it simple as a starting point, very high quality collateral."  So, there was a tension that we were trying to bridge.

And then the broker-dealers said, "Yes, we are happy to make this market.  There needs to be issuance volumes.  We are not going to commit resources to this if there are no deals."  And the dealers also said for their own -- excuse me -- funding needs, they need to make sure it is eligible for the tri-party repo system and that the Federal Reserve would respect covered bonds and accept them as collateral at the discount window.  Sorry, when I do not get much sleep, my [Laughter] -- it is hard to speak in the morning. 

So, what was our objective?  Providing homogeneity and clarity to the U.S. market -- I am going to talk more about legislation versus a structured framework -- want it to complement the FDIC Policy Statement.  We decided we want to start with residential mortgage collateral to keep it simple like the investors said, but to help the housing market.  And we want to encourage market participants to move at the same time.

Again, everyone was nervous when we talked to them.  Investors said, "Yes, we are interested, but only if the dealers do this and the issuers do that."  The issuers said the same thing about the other two, and the dealers said the other -- the same thing.  So, we said, "Okay, you are all interested.  Hold hands.  Let us all move forward at the same time so no one has to take the risk of going first.

Now legislative versus structured framework.  I have already talked about this.  One of the key things here -- and we have nothing against a legislative framework.  Our perspective has been we want to move fast, and we think a structured framework can be put together very quickly.  We also think just because they have legislation in Europe does not mean you have to have legislation in the U.S.  In Europe they do not have the FDIC which governs what happens in an insolvency.  We also have the Universal Commercial Code.  So, between our contracts law and clarity from the FDIC, those two things put together can provide investors the kind of legal certainty that they want in terms of what is going to happen in a covered bond.

Another key point -- just for you all to think about as you have your discussion today -- as we really pushed European investors and said, "Why is a European covered bond a rates product?"  That means no credit risk.  "Why do you look at it that way?"  When we really pushed them they said -- many of them said they would never let it fail.  Literally, the regulator that is governing the covered bond in this market or that market they would never let it fail.  Sound familiar?  So, we have to be very careful if we do go forward with covered bond legislation, which could make sense, that we design it the right way so that we do not give an implicit government guarantee to a new covered bond market.

On the right hand side, structured framework.  Again, I said FDIC has a really important role to play -- I am going to talk about the aggressive action they have taken -- combined with our contracts law we believe provides investors the certainty that they need to make these investments with no danger of an implied government guarantee.  And again, so we are open to both.  We think a structured framework can move forward very quickly and very effectively.

So, FDIC.  They have taken bold steps to try to kick-start a covered bond market.  There are two big things that investors are asking, "What are they going to do in insolvency?  How do they make their decisions?" and, "How much are they going to pay us back?"  So, the FDIC can come into a failed bank and repudiate contracts.  Say, "You know, our contract null and void.”  But then -– or they could say, “We are going to keep our contract because it makes sense for us to keep the contract.”

So, the FDIC has now come out and clarified they are going to make one of three choices.  One, they are going to continue to honor the rest of the covered bond, which you as an investor you are very happy with.  Two, they could pay off the bond in cash.  Or three, they could hand you the collateral and say, “Go ahead.  You can liquidate the collateral and take the proceeds.”  Just that clarification on their decision making was really important because a lot of investors did not understand how the FDIC goes about things, so that was really important.

Second, they had to define what the damages would be.  So, if I am the FDIC and I repudiate a contract with you, they have to pay back damages.  But, there was uncertain amount what those damages they would pay.  Are they going to pay you the full value of the bond, or are they going to pay you less that that?  They have now come out and said, assuming the collateral is there, they are going to pay back par plus accrued interest.  That was a critical point that investors wanted to hear and the FDIC has done it.  And they have reduced a stay period from 90 days to 10 days.  That means how long is the FDIC going to take to make their decisions has really reduced it, which reduces the cost of the uncertainty of that program.

Now some people have said, “Well, the FDIC could have gone further.  They could have put municipal bonds in there.  They could have put commercial mortgages in there.”  I think Peter touched on this -- they have a limitation right now that covered bonds cannot make up more than four percent of liabilities, which some people say, "That is too low."  The FDIC has said, “Look, this is a starting point.”  Over time they are going to review that four percent number and watch the market develop. So, we at Treasury are not concerned about that.  We think that is going to be a constraint.  And when you think about the feedback from investors, they said, “Keep it simple.”  And so the FDIC constraint on residential mortgages, we think, is totally appropriate in terms of kick-starting this market.  Once the market is up and running, then we should look at it –- opening it to more classes of collateral.

So, what have we done?  Aside from moving the market, we have published a best practices document that is trying to provide the homogeneity and the structure that the market participants are looking for.  So, look at the collateral -- this is consistent with the FDIC and it adds to it -- high quality mortgages, so underwritten at the fully indexed rate.  No teaser rates -- fully documented income, maximum LTV of 80 percent at origination, 20 percent limitation on -- by metro statistical areas.  So, you do not want to have -- if you are covered bond investor, you do not want all the collateral coming from Los Angeles, okay.  That is a lot of risk to you if Los Angeles has trouble, so geographic diversification is important.  No negative amortization mortgages -- so no pay Option-ARM mortgages -- minimum five percent overcollateralization. 

LTVs updated monthly.  This is an important concept.  So, let us say you put a bunch of 80 LTV loans in the cover pool and if home prices drop those LTVs climb.  Well, that does not kick all their mortgages out.  That means that the issuer has to add more mortgages to top it up to make sure that there is enough collateral.  So, we have defined some standardization around those kinds of processes and more.  There is a lot more than this on disclosure, on transparency, etcetera.  You can read about it on the Treasury Website.  So, we published a Best Practices Guide that complements the FDIC Policy Statement.  We think you put the two together and that provides the kind of clarity and certainty that the market needs to get started without overly constraining the market going forward. 

So, we have done our thing.  FDIC has done what they needed to do.  Dealers have all come together -- SIFMA created.  We encouraged them.  They were happy to do it.  U.S. Covered Bond Trader's Committee with all the major broker-dealers have come together and dedicated -– they are going to have a committed U.S. covered bond trader.  They are going to provide liquidity and trading -– they are going to provide resource -– excuse me -- research and other resources.  And then they are going to work on a Covered Bond Council.  In Europe, they got this big trade group, European Covered Bond Council.  They are now working on setting up something similar in the U.S.  Again, so the dealers are showing to investors and issuers that they are committed to this.

So, what do we need to do to kick-start the covered bond market in the U.S. in our opinion?  Regulatory clarity, FDIC has given it.  Simple homogeneous structure, standardization, high quality collateral -- we believe our Best Practices Guide provides that.  Tri-party repo eligibility -- Bank of New York, JPM have already come out and confirmed it.  Discount window eligibility -- Federal Reserve has come out and confirmed it.  Broker-dealer commitment -- SIFMA has mobilized their broker-dealers.  They are backing it.  Electronic pricing -- Bloomberg and TradeWeb are now setting up electronic screens so traders can see prices as they are updated in real time.  Strong support from institutional investors -- here are some of the institutions we have been working with who have spoken at different times in support of this.  These are the -– you know, the bluest of "blue chip" names of fixed income institutional investors in the U.S.  And then blue chip banks -- we need them to issue. 

And we had a roll out in July with the Secretary Chairwoman Bair, other regulators, where we had representatives from Bank of America, Citigroup, JPMorgan, and Wells Fargo -- kind of the four biggest blue chip names -- who have all said “yes” they want to be leaders in covered bonds.  So, we feel like that is the last piece of the puzzle to try to get a covered bond market going in the U.S.

So, what are our next steps?  Look, this is a tough environment in which to launch a new financial product, okay.  No question about that.  But, never has the market needed this financial product as much as we need it right now.  So, it is worth the effort of all of us, and that is why I am so happy you guys are having this session, and you are all here and there is so much interest.  Some people have said, “Well, look at Europe.  Look at the covered bond market in Europe is strained right now.  This does not work.”  There is no financial product short of a government -- U.S. Treasuries -- that is going to be immune to capital market stresses.  So, we should not say, “Covered bonds need to be perfect or it is not worth pursuing.”  We need to pursue all of these. 

Issuers are doing their work, setting up their programs, working with regulators for their necessary approvals.  We would expect to see likely issuance in months.  And dealers and investors are doing their work to be ready.  I was really encouraged when we had our big announcement how much Wall Street research started getting generated on covered bonds. 

A lot of U.S. investors do not know much about covered bonds.  So, one of the things we have already achieved is opened the eyes of investors to say, “Hey, what is this product?  I need to get smart about it.”  And that is going to help when the issuers come to market.  So, again, we are trying to move the whole market at once, and we are really optimistic that we can really kick-start this market.  That is all I have.  I would be happy to take a few questions.  Thank you very much, Peter. 

Peter J. Wallison:  Great. 

[Applause]  All right, we have some time for questions.

Male Voice:  Are your slides going to be made available?

Peter J. Wallison:  Yes, the slides will be on our Website for this conference -- if you go to AEI.org and look for this conference.  In the back -- and would you please identify yourselves and ask your question?

Yes, I am Joe Knoll from the law firm of Krooth --

Peter J. Wallison:  Wait, wait -- 

Male Voice:  I need the --

Peter J. Wallison:  -- can you wait for the --

Male Voice -- microphone.

Joseph Knoll:  My name is Joe Knoll.  I am a lawyer with the law firm of Krooth & Altman here in town.  Neel, two unrelated questions.  One would be the role of the rating agencies.  Are we trying to create investment grade paper?  And if so, are you rating the issuer rather than the collateral?  And if so, are not we in a climate of a rapidly diminishing pool of investment-grade issuers?  That would be one question.

The second unrelated question is, what are the implications of a default in the pool where you have got some back mortgage -– the issuer does not have any substitute collateral to put in, the bondholder is very happy with his bond receiving his payments every month, he does not want them yanked.  What happens in that instance?

Neel Kashkari:  So, let me do -– I will do the second one first.  So, it is a dynamic pool and the -– any issuer who is going to issue a covered bond, I think, is going to have to be an active mortgage originator.  Because you are right, if a loan goes more than 60 days delinquent, they have to pull it out and replace it with a new mortgage.  And there is some substitution flexibility, so you could do cash, or treasuries, or agency mortgages, I think, up to 10 percent just to help you bridge any timing issues.  If you do not have enough mortgages available this week, you could put in cash to top it off to meet your requirements.  But, I do not think a covered bond would work if you were just –- you originate 1,000 loans and you are never going to originate any more loans, I do not think a covered bond is a good tool for that type of an issuer.  Does that make sense?

Joseph Knoll:  I am just curious what would happen if they just do not do them?

Neel Kashkari:  Well, then I think if they just do not replace the mortgages the bond will default.  It will accelerate and they will have to pay it back because they will be in violation of their covenants.  So, it is a contractual arrangement.  If you are investor, you want to know that the issuer is living up to their obligations and this is -– these are the terms of the investment that you have both made at the start.  So, if for some reason they sell -– they do not meet their collateral requirements the bond would accelerate.

So, number two, rating agencies -– obviously, in fixed income markets rating agencies have an important role to play.  Each rating agency has been publishing on covered bonds.  Each has their own approach.  Each looks at both the credit quality of the issuer as well as the credit quality of the collateral because both end up being important.  Because as an investor, your first recourse is the collateral pool, and if that comes up short, your next recourse is to the issuer, as well as the likelihood that the issuer goes insolvent, determines how likely you are going to need that collateral.  So, they both have very important roles to play and all the major rating agencies have published and are publishing their approaches to that problem.

Alex J. Pollock:  Neel, could we just add, the rating agencies are very accustomed rating covered bonds because they rate lots of European bonds already.

Neel Kashkari:  That is right.

Peter J. Wallison:  Okay, next question.  Allen [phonetic], would you hold on let us wait for the mike.  All the way up in front, second in, in the second row.  And identify yourself --

Allen Elowitz:  Hi, I am Allen Elowitz [phonetic] of Visia B [sounds like].  I have to say -- and please do not take this the wrong way -- but I get very, very uncomfortable when I see the government trying to promote financial market innovation.  The last industry that needs government help in innovating is the financial sector.  We lead the world in financial innovation.  And if there was a real value we really need here, it was, there’s no question in my mind that financial markets are not –

Allen Elowitz:  Is this censorship?  Is this -- [Laughter]

Allen Elowitz:  There’s no question on my mind that financial markets on their own would have long ago since figured out how to do this and they would have done it. So, I have to say that I have a lot of discomfort with having financial market innovation being pushed by the government.  That is number one. 

Number two, there are all sorts of differences between the way the Europeans run the covered bond market and the way you proposed a structure in this country and most differences are significant.  For example, the European bonds, as I understand it, are substantially more overcollateralized than what you are proposing.  How do you deal with that? 

Secondly, other than Danes, the Europeans all deal with the adjustable-rate mortgages.  They have prepayment penalties, all sorts of other things.  You can assure constant maturity if you have prepayment penalties built into the mortgages.  So, there are tremendous structural differences between housing finance in Europe and housing finance in the United States.  And it is not clear to me that your proposal on the covered bonds, in fact, assimilates and is consistent with these differences.

Third, despite your concern over creating systemic risk and having the government on the hook, as long as the issuers are depositories that are insured by the FDIC, and the fact that the government is insuring all this stuff because we are taking collateral off the balance sheets of insured depositories that could be used to make depositors whole, that makes me uncomfortable. 

And lastly, the presumption here is somehow that investors cannot deal with the prepayment risk associated with mortgage-backed securities.  For the life of me, I have seen no inability on the part of the financial markets to absorb mortgage-backed securities at a prepayment risk.  Those investors are compensated for that -- by that -- for that risk with a higher yield. 

So, you have not made the case, for me, as to why the government should be innovating rather than the major plays in the financial market.  You have not demonstrated the overwhelming need here.  You have not demonstrated how it reconciles with the difference between our market and the European market.  You have not demonstrated how it makes sure that taxpayers are not on the hook.  And lastly, you have not demonstrated a need in terms of the market's ability to absorb mortgage-backed securities and the prepayment risk. 

But, other than that, how did you enjoy the play, Mrs. Lincoln? [Laughter]

Neel Kashkari:  I was waiting for the question.  [Laughter] Also --

Peter J. Wallison:  Can you come and get the mike?

Neel Kashkari:  I will say the -- please -- [Laughter] [Applause] No, just kidding. 

I will say the following, on the point of the market --government's role -- you know, I was a -– I am a free market Republican.  And one of the observations I will make, for the first -– for the last year, one of the things I have been doing at Treasury is working with all the servicers and the counselors and getting them to mobilize in HOPE Now.  Markets are strained right now and it is hard to just say -- as much as I would like to believe, "Just let them free and everyone is going to work out their own problems." 

We are under a lot of pressure right now.  All of us are feeling a lot of pressure.  And a lot of people have come to us and said, “Thank you for taking a leadership on covered bonds because we are interested in this.  We did not know everybody else was interested.  And by Treasury providing -– with working with the FDIC and the other regulators -- providing leadership, a lot of people have now come to the table and said, 'Yes, we really want to do this.'"  And so I think it maybe would have happened anyway.  Maybe it is going to happen faster because we are trying to get people to hold hands and do it at the same time.  And it is not going to be perfect.  We are going to learn from this and the market is going to innovative.

In terms of -– I am not going to answer all your questions.  We can talk off line -- in terms of the mortgage-backed securities and prepayment, the key is they are different classes of investors.  So, there are investors who want prepayment risk, who like prepayment risk, and who want to pay for prepayment risk.  There are other investors, who are traditionally these rates investors I talked about, who do not want it. 

And what we are trying to do is open housing finance to another category of investors who currently do not invest in housing finance, because we want to bring –- tap all the pools of capital to housing finance.  So, it is tapping another capital pool, not trying to force that into one that already exists. 

Other questions?

Peter J. Wallison:  In the back.  Can you wait for the mike, please, and identify yourself?  Thanks.

Katherine Gleason:  Hi, I am Katherine Gleason, FDIC.  And I want to know which types of financial institutions besides insured depository institutions do you think would be interested in this market?  And are you at all worried about concentration that would create systemic risk?

Neel Kashkari:  So, it is a good question on who is interested.  I mean, to date most of the interest we have received has been from depository institutions.  And I am trying to think of a big balance sheet lender who is not a depository institution, right, because it has to be a balance sheet lender because they are going to keep the loans on their balance sheet.  So, it is hard for me to imagine non-depository institutions, but I cannot say that it is impossible, but that is who has reached out to us.

In terms of, I guess, just the largest institutions, we hope -- just -- investors have told us they want to start with the biggest blue chip names because that is who they are most comfortable in the current environment.  Our intention is that this product develops, and becomes fruitful, and that smaller institutions can tap it, and midsize and smaller banks can tap it. 

And, in fact, one of the things that is in our Best Practices Guide, it talks about the concept that some markets in Europe explore where multiple small depository institutions could pool their collateral into one bigger collateral pool to then issue a common covered bond off of that.  And so that is the kind of market innovation we would like to see happen.  We do not think it is realistic to start there, but we would love to see it happen over time if the market thinks it makes sense.

Peter J. Wallison:  Other questions.  Wait for the mike.  Bill.  And identify yourself please for all those who --

William Coleman, Jr.:  I am Bill --

Peter J. Wallison:  -- do not already know you.

William Coleman, Jr.:  -- Coleman, and I am a partner at O'Melveny & Myers.  Assuming that I wanted to buy a house for $400,000, I put down $100,000, so I got to get a $300,000 mortgage.  I go in this deal and everything works perfectly.  How much has the lender made on the deal?

Neel Kashkari:  Well, it is hard for me to answer that question because I do not know what the interest -- I mean we would have to do the detailed math.  I do not know --

William Coleman, Jr.:  Well, but all I am saying --

Neel Kashkari:  -- what the --

William Coleman, Jr.:  -- is that we -- in society, as I understand it, there are only either three of four major banks: Chase, Bank of America, and perhaps Citicorp, you know, and they are getting into different businesses.  And it seems to me that what they want to do -- of course they all want to serve the public -- but they want the big deals.  And they are not going to say, "We make enough money on this."  And if we went back to where we had many more small banks throughout the country, I think this is a perfect program. 

But, if you are really recognizing today where the big banks are in bigger deals, rightfully making more money, serving the public better, I just do not see how this fits in where you make enough money to make it worthwhile.

Neel Kashkari:  Well, I mean -- I could let Greg speak -- I mean the big balance sheet lenders have -- they have many, many business lines, and mortgage finance is a big business for them.  And so even though each individual mortgage may not be big in terms of dollars, when you add up their big mortgage businesses they end up -- can be very profitable especially today.  The quality of the mortgages that are being written today, very high quality underwriting standards, significant down payments, if -- they are very good, very profitable mortgage origination businesses today. 

But, we agree completely.  We do not want to see concentration just in the big four banks.  All we were saying is that investors told us they wanted to see deals from the biggest banks to get smart, get going.  That would pave the way for the midsize and smaller banks to then follow.  We think that they should all be in the business.  And again we want to encourage all sources of mortgage finance right now to get through the housing correction and longer term.

Peter J. Wallison:  One more question -- and I have a question actually for you, Neel, and that is why are you focusing only on depository institutions?  Why not other kinds of balance sheet lenders -- and there are plenty -- that are not depository institutions?  Why is that not part of your program?

Neel Kashkari:  Well, it is just -- I guess it is two things.  One is, it is just a starting point.  So, this is who has been reaching out to us saying, "We would like to see help in kick-starting a covered bond market."  So, we started with where there was the most interest.  And I do not -- again, we do not want to rule out anything longer term.  Again we want to tap all sources of capital.  And I think working with the FDIC, obviously, they have domain over the depository institutions, and so it was useful for us to start there from a regulatory perspective and because that is where the interest was.

Peter J. Wallison:  Was there any requirement and when you started talking about marketing these things that you needed depository institutions to make this thing go?

Neel Kashkari:  No.

Peter J. Wallison:  Did not think so.  Okay.  I guess we have time for two more questions.  Is that --

Neel Kashkari:  All right.

Peter J. Wallison:  -- all right with you?

Neel Kashkari:  Yes, we can have two more and then I have got to run.

Peter J. Wallison:  Right here.  Wait for the mike, Meena.

Meena Thiravangadem:  Meena Thiravangadem [phonetic] with Dow Jones Newswires.  How binding is Treasury's Best Practices Guide and what happens to someone who says, "Ah, good suggestions, but I do not want to follow them."

Neel Kashkari:  So, it is not binding and that was intentional because we were trying to provide a starting point for the market.  If we did something binding and hard, what we were afraid of is -- you know, a year from now the market may figure out, "Hey, it should be a little different and it could be better."  And we did not want this document to constrain them.  So, what this is a Best Practices Guide.  We are encouraging and we hope that the market participants will find it as a useful starting point.  If the investors and the issuers say, "No, there is a better idea," God bless them.

Peter J. Wallison:  Okay.  And one more question in the back in the red.  Pat.

Patricia Callahan:  Pat Callahan with the American Association of Small Property Owners.  We represent the consumer perspective.  And I was wondering how are you going to be addressing to preserve the integrity of the underlying asset?  It seems like the whole program that you had was good.  I mean, but it did not go far enough.  It really did not cause the modification -- loan modifications, I think, would have prevented a lot of the downslide. 

What we were very pleased about was to see when FDIC took over one of the major banks, the first thing they did was send out massive loan logs.  And so anyway that was the problem I wanted to say was, what do you think you should do?  Because everyone seems to forget how do you then, when things are going a little bit soft, how do you probably bridge -- I do not want to say bridge long -- but bridge actions to make sure that the loan does not go completely sour?

Neel Kashkari:  Sure.  Well, so that is -- what you raised is a very important issue that is not unique to covered bonds.  It is just, "How do we deal with the different mortgages and mortgage delinquencies?"  And that is -- if you think back to the first bullet on my first slide "Avoiding Preventable Foreclosures" where we have said -- and as we have analyzed it -- foreclosures are elevated, but we are trying to avoid the foreclosures that we can avoid.  If someone bought a house that they cannot possibly afford there is really no way to avoid that foreclosure unfortunately.  And it is sad, but it is kind of reality.  And so we have -- our approach has been to mobilize the entire industry in working with the counselors to get to homeowners, to get them to pick up the phone, do repayment plans or do modifications where there is a possibility -- you know where the homeowner is in the right house, but the wrong mortgage, we like to say, where you have the fundamental -- you have the willingness.  You want to keep your home and have the basic ability to do so. 

And if you look at the data, I think it is over two million loans have been modified or repayment plan over the course of the past year.  We are on a pace of 200,000 a month.  And when I talk to counselors, the most important question I ask them, I say, "Look -- answer me this, are you seeing homeowners who want to keep their home and who, in your experience, have the basic financial capacity to do so?  Are they getting foreclosed on?"  And most of the time they say, "No." 

There are cases where people are falling through the cracks, and we are working really hard to try to reach every single one.  We believe that most of the people who have the basic financial capability to keep their home are reaching out -- if they are reaching out, they are getting the help that they need, so that is not unique to covered bonds.

Patricia Callahan:  Have you looked at the Ohio foreclosure redemption program which is done by Eugene -- Justice Moyer?

Neel Kashkari:  We have -- I cannot speak to Ohio specifically.  We have surveyed all of the states at different times, and they all had different innovative programs, and we have incorporated some of the things we have learned from different states.  So, I cannot tell you about Ohio specifically.  Some of my colleagues back in the office I am sure have.  But, again, we want all ideas, and we have a necessary correction, and we are working our way through it.  Thank you very much.  I really appreciate --

Peter J. Wallison:  Thank you, Neel.

Neel Kashkari:  -- your time.  [Applause] 

Peter J. Wallison:  Okay.  Before I introduce the next speaker, I just want to note that we have a gap up here on the panel.  You have probably noticed this.  The FDIC's representative, Jason Cave, is not here.  But, there is another representative FDIC, David Wall.  David, can you identify yourself?  David --

David Wall:  [Inaudible]

Peter J. Wallison:  -- would you take Jason's place?

David Wall:  It is probably not possible to do that actually.  [Laughter] I can do that physically.

Peter J. Wallison:  Thank you very much.  And he will be in turn in Jason's turn.  Jason could not make it.

Our next speaker is Scott Garrett, Republican of New Jersey, who has represented New Jersey's fifth congressional district in the House of Representatives since 2002.  The reason Scott is here is because he is the originator of some legislation that would enable covered bonds.  And the question, I think, that is raised by the legislation and by what Scott is doing is whether you can have an effective covered bond system -- whether there will be confidence in the market about the structure of the system without legislation.  Scott's legislation is comprehensive and could be very helpful if adopted.  But, I thought is was very important that we get before all of you and before the audience elsewhere the question of whether we ought to do this by legislation or simply as it is now structured through FDIC regulation.

Scott serves on the House Financial Services and Budget Committees and is a member of the Financial Services Subcommittees on Capital Markets, Insurance, and Government Sponsored Enterprises; Financial Institutions and Consumer Credit; and Housing and Community Opportunity.  He is one of the most innovative members of Congress, as this legislation suggests, and he has quite a bit of experience in legislating in financial matters because before coming to Congress, he was a member of the New Jersey General Assembly and was chairman there of the Banking and Insurance Committee.  There is more in his background that is in your folders, but let us give a warm welcome to Scott Garrett.  [Applause]

Scott Garrett:  Good morning, and thank you for that introduction.  Good morning, everyone.

Audience:  Good morning.

Scott Garrett:  Wow.  Boy.  It is good to be here with you.  Thank you, Peter, for the opportunity.  That was -- I found Neel's presentation totally thorough and fascinating.  Now you have me.  [Laughter] But, thank you, and appreciate AEI for hosting this forum today because it is, I believe, an important and timely topic dealing with covered bonds.

When I was invited to speak here, it was roughly, I guess, a little over a month ago.  And at that time, of course, the financial landscape in the country was markedly different than where we are right now.  Of course, since my invitation to come on over here, you have seen basically the nationalization of the GSEs, the takeover of AIG, of course, the merging with Merrill Lynch, and then, of course, you have Lehman Brothers at the end of that.

We just has a press conference yesterday and Jeb Hensarling, my colleague, made comment of that as well and made note that out of all of those, I guess Lehman Brothers probably had the worst lobbyist up here on the Capitol Hill then considering how they all turned out. 

Of all the problems that I see -- and I am worried most about what has happened over the month -- you know we see all that Bank of America did and right now they are Bank of America.  If things keep on going the way they are they may get the Hamiltonesque [phonetic].  They will be the bank of America, the only bank of America, [Laughter] the last lender out there.  Actually the lender of last resort right now is the Federal Reserve.  The federal government may actually end up being the only lender out there.

The problem that we have right now with everything that is going on on the Hill, and at the Treasury, and in the White House is worrisome to me.  The Treasury bailout of the Federal Reserve -- you know things are getting bad when the agency of the Federal Reserve that is doing all of the bailouts has to be bailed out themselves by the Treasury.  There have been so many bailouts out there -- this is just a side note on the covered bonds issue -- they -- you -- there was somebody who tried to keep track of it, why we got here or how we got here -- just two days ago I dropped in a piece of legislation -- a separate piece of legislation -- to create what we call a House Select Committee on bailouts. 

And the purpose of this -- this is a bipartisan piece of legislation that we dropped in and we already have 50 or so signatures on it and going upwards -- is to investigate the actions of -- in essence what brought us to this point over the years and then to try to give us a handle on what actions should be taken to prevent it in the future.  Hopefully, in the near future, we can overcome our current financial woes.  And if you saw the articles in the paper that near future may be only five days away -- or about six days away next Wednesday if Barney Frank has the hearing on the next bailout. 

Today, although I would like to briefly discuss one of the ways we can possibly and that is, of course, covered bonds.  I will outline some of the positive aspects, I believe, that covered bonds can bring to the market, details of the covered bond legislation that I recently introduced, and why it is necessary on a statutory framework -- and appreciate your comments and questions as well -- and also I will close on the political landscape and how that may either promote or hinder the moving forward of any legislation in the House.

To begin with, as I said -- and Peter the title of this conference is "Can Covered Bonds Compete with Fannie and Freddie?" -- the short answer to that is a definite maybe.  If the proper legislative framework is put in place allowing for a bond marketplace to fully truly flourish in the country, I do believe that covered bonds can offer an extremely valuable form of financing that could provide an alternative for a portion of the pie, if you will, to the current mortgage securitization model.

However, we all know that Fannie and Freddie are now virtually impossible to compete with unless you have -- of course, you have the competition -- also has the explicit backing of the federal government and also they have millions, and millions, and millions of dollars of campaign contributions, and also charitable contributions, and also the ability to issue manipulated or zero financial statements and still be listed on the New York Stock Exchange.  [Laughter]  If all of those things happen then you have an even playing field.  I think it is important to note from the outset that while covered bonds can provide a useful alternative to Fannie and Freddie, I seriously do doubt that their ability to replace -- totally replace -- Fannie and Freddie. 

In last Sunday's Washington Post there was an article and that article chronicled the history of congressional oversight -- or maybe the lack thereof -- dating back to the GSEs to 1992.  It mentions that former Banking Committee Chairman, Jim Leach, expressed concern that Congress was creating, at that time, a weak regulator and that the companies were changing from "being agencies of the public at-large to money machines for the stockholding few.  Leading the charge against such strong regulation, then as now, was none other than a current distinguished Financial Service Committee Chairman Barney Frank."  That article went on to describe in detail how time after time and again and again the two companies fought off increased regulations from a combination of well placed financial contributions, strong-arm lobbying tactics that have reached almost legendary status here in Capitol Hill. 

Former Capital Chairman -- Markets Chairman, Richard Baker, noted, "The political arrogance exhibited in their heyday there has never been before or since a private entity that exerted that kind of political power."  And we saw, even in light of that, former Fannie CEO, Frank Raines, told investors in 1999, "We manage our political risk with the same intensity that we manage our credit and interest rate risk." 

I am sure you have all ready recently as well over the last decade that Fannie and Freddie have spent over $170 million on lobbying on members of Congress.  At last count there was something like 142 lobbyists on retainer.  That is really a lot of people watching out for their interest -- their political interest -- and ensuring that they retain that preferred government status [sounds like].  Also, Fannie and Freddie have several different ways of passing vast sums along to their Congressional stalwarts.  Over the last 11 years, the executives of the companies have contributed over $16 million to members of the Congress by local action committees.  And the oft overlooked, but equally important Fannie and Freddie contribution, are their charitable contributions and they, of course, provide an additional avenue for members to receive millions in funds into their respective district.

So, while their lobbying has currently been suspended due to the recent actions by the Federal Housing Agency, Jim Lockhart, I would suggest that you should not expect our friends there to be any less loud in the debate that will continue to rage over the coming months and years when Congress begins now to reexamine how to reshape or reconstitute these companies.  No entity as politically entrenched as Fannie and Freddie will ever simply just disappear overnight and therefore allow these other entities to be able to grow unencumbered.

Unfortunately, it is likely the Treasury's recent actions will allow them to stay afloat while the Democrat controlled Congress plans its next move.  I already sent -- seen comments by Chairman Frank and Senate Majority Leader Reid saying that they feel that Fannie and Freddie serve a valuable mission and that they should simply be restructured in the same they were before in that business should continue as normal. 

That despite the fact that we saw a little while ago in the paper, Freddie Mac's CEO -- former CEO, Richard Syron -- acknowledged the Herculean task of serving two masters in the current structure that they have, saying that balancing the dual task of serving the public while creating profits for investors makes that job almost impossible.  I also believe that too many members of Congress have pocketed too much money, quite frankly, from the GSEs to ever let them exist in another structure.

So, I prefer the approach -- that is why I come here today -- that Mr. Wallison opined in The Wall Street Journal and Op-Ed just a week ago that GSEs should be put into a receivership.  I believe that then, if they were to be unwound, and broken into smaller entities, and privatized severing that link between the federal government and the institutions that would lead the way to strengthen our hand to be able to go forward in the covered bond situation.

I had even scheduled, come to think of it, a meeting -- today is Friday -- I just got -- scheduled meeting.  It was yesterday -- Wednesday -- to this end actually with the White House because it -- as you know, the Treasury has moved to basically allow them to continue on as they are.  We had scheduled a meeting on Wednesday with the White House to basically say -- to try to convince them that they need to act now with regard to the GSEs and not put this off to the next administration and the next Congress.  Unfortunately, I guess, with AIG coming down the pike and what have you that meeting was canceled and -- I cannot say postponed because we have not heard back from the White House as a new date yet.

So, historically, the backing of the government provided for Fannie and Freddie has provided and protected investors at the expense of taxpayers creating so called socialized losses and private profits.  And the goals of increasing low and moderate housing while laudable should be applauded, but it cannot be achieved while we are also trying to increase the wealth of the shareholders.

So, to covered bonds.  To help restore our nation's mortgage market there is a need for additional liquidity, as already been indicated, and it is covered bonds is the way to go.  Covered bonds simply are one investment tools that can provide an alternative mortgage securitization.  As indicated already, it has been used in various formats and in Europe for centuries.  As Neel mentioned, covered bonds are debt instruments for high quality assets, and I will not go into detail since Neel gave you a thorough backing on that. 

I do want to give pundit applauds to those people who have already stepped out on this and that, of course, first and foremost goes to Treasury Secretary Paulson, and also to Neel, and also to the FDIC Chairman Sheila Bear for all of the work that they have already done to date in essentially laying the groundwork out there for covered bonds in the marketplace.  Secretary Paulson recently noted covered bonds "is a way to increase the availability and lower the cost of mortgages in financing to accelerate the return to a normal market."  So, I think it serves them well that they have done this, and serves the American public well, and I can appreciate the fact that I have had opportunity to talk to all of them on this matter.

Just as Neel said, and I was glad to hear it, that he said this was something difficult even for someone of his intellect to wrap his mind and -- around.  Likewise, even more so for myself.  This is a topic that I have just began to work with I guess six or seven months ago.  It was over six months ago.  I have been working now with stakeholders as well as other interested parties on this proposal that I will be laying out for you.  And it was in July of '01, I guess, that I introduced HR 6659.  It is called the “Equal Treatment of Covered Bonds Act”.  So, what I would like to do is just take a second and outline exactly what my legislation would accomplish, explain what the structure of the bill does in the manner, in a proposed, and an overview of why it is necessary briefly. 

As I say, I began this process back in February, I guess it was, of this year in our office.  I was -- it was even before any of these others situations were occurring.  That is actually before Bear Stearns all came down in March and what have you.  Even then of course -- even before we saw the current lack of liquidity on nation's mortgage markets.  And being a conservative, it is hard sometimes to be in a position where you are not simply there saying, "Just let the free market prevail."  Sometimes you want to be a conservative and say, "Let us champion a particular program or cause and be out there in favor of something as to simply being opposed to everything out there."  So, being involved here with covered bonds gives us, as a conservative, an idea -- a road to do just that. 

And contemplating how to craft the legislation to help facilitate such a marketplace, the market participants, financial experts, and I met and tried to come up with a way.  And after examining both the European models and some of the ideas that you were discussing as well, I finally decided on the course of action that we would take in this legislation.

Instead of following, for example, the U.K. model, which is creating a detailed and expansive statutory framework.  Instead what we did was draft a bill that would make a number of smaller changes -- and I call them tweaks -- and amend the current law and do so simply in a way that would help to clear up several of the ambiguities and provide investors with certainty needed to convince them to participate in the U.S. covered bond market.  Legislation itself can be broken down into five parts, and I will run through them real quick.  First, it amends the Federal Deposit Act to provide the same treatment for covered bonds as for other qualified financial contracts.  Second, it defines a covered bond as a non-deposit recourse debt obligation of an insured depository institution.  Third, it allows for a minimum term of maturity for a covered bond of at least one year, and it does not set a maximum term for that bond.  Fourthly, it adds a clause ensuring that a bank failure will not impair the value of the covered bond.  Neel talked about that a little bit.  Finally, it provides for a joint rulemaking authority.  It goes to the Secretary of Treasury.  It goes to the Federal Reserve.  It goes to the Office of the Controller.  It goes to the OTS as well and, of course, to the FDIC.

Now, why it is necessary?  Well, we have heard some of it already.  I decided that amending the Federal Deposit Insurance Act and putting covered bonds under qualified financial contracts, what you would do there would provide possible investors the certainty and the assurance needed to guarantee them that a covered bond marketplace would be fully utilized.  Other types of qualified financial contracts would include security contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements.  These type of agreements that I just listed typically receive special legal protection in the event of a bank failure.  So, this treatment will provide investors more certainty that if the issuer of a covered bond does not fail, it is more likely that the failure will be a -- well, basically a non-event in the eyes of the investor.  So, in defining a covered bond as a non-deposit recourse debt obligation of an insured depository institution, which the bill does, second point, the legislation basically codifies what the FDIC has already put in the rule.  But, this is important in clarifying that the investor has recourse on the specific assets or mortgage being used to secure the debt and statutorily.  The investor also has an unsecure claim on the issuing bank.

One specific difference between my legislation and the FDIC Final Policy Statement is the provision regarding the term of maturity for the covered bond.  While the minimum term which is set at one year in both rule and legislation are the same, the FDIC caps the term of maturity for 30 years while this legislation does not place any limit at all. 

I was pleased to see the fact that they changed their time after taking in all the comments and everything that they had.  Their original proposal was to have a term of 10 years and that was extended out to 30 years.  Our legislation would just go one step further.  But -- and the reason we go one step further is that with constant changing of the market conditions that we see here going on, I do not see the necessity, quite honestly, of putting a limit on what these institutions can do in the private market.

Now another section of the bill seeks to make clear that a failure to the bank would be a non-event in the eyes of the investor.  The FDIC Policy Statement allows the FDIC to put a stay on for 10 days.  It originally was 90 days.  And during this time the value of the mortgage collateral would be -- could possibly be unfairly impacted -- negatively impacted.  That is why we put in 6659 specifies that if there is an appointment of a conservator or a receiver their direct compensation to the investor would be four points: the outstanding principal of the covered bond, all interest that has been accrued on the covered bond that has not been paid yet, and thirdly, the cost of any charges related to the establishment of the GIC, and fourthly the cost of any insured legal charges.  So, this provision in statute, in law, would ensure that the value covered bond is not negatively affected at all by the discretion actions of the FDIC.

Next, the legislation also provides for joint rulemaking authority, as I pointed out, to all the different banking regulators: the FDIC, the Federal Reserve, the OTC, and the OTS, and the Department of the Treasury.  See, while the FDIC is the agencies that would be in charge of, obviously, the Deposit Insurance Fund, we thought that is important to have all the regulators at the table when making the rules, so the concerns and needs of each segment of the banking industry would be represented.

Next, what -- why it is important to do this bill, and as a bill -- as a statute -- as opposed to regulation, let us look at this way.  While the FDIC put a great amount of work in the issuance and solicitation of comments from all corners of the financial sectors, I still believe that in certain ways the Policy Statement is too restrictive and prevents us from recognizing the full potential of a covered bond marketplace here in the United States. 

For example, as Neel pointed out, the Final Policy Statement limits a covered bond aggregate to no more than four percent of the institution's total liabilities and, I believe, that is perhaps unnecessarily low and my legislation does not include a specific amount for the issuer.  Other U.S. bank regulators have expressed concern over this low limit as well. 

Europe has a covered bond marketplace that is roughly $3 trillion in size and their limit is around 20 percent on the issuer's liabilities.  So, in order for a covered bond market to take off here, this number we thought should be increased.

The FDIC also has very prescriptive -- prescriptions on the type of assets that can be included in the covered pool.  And I agree that the product should be the highest quality with all the proper underwriting.  However, I really do not see any reason to limit the -- to a very narrow sector such as the residential market. 

For example, commercial mortgages are traditionally high quality assets that can provide an excellent source of possible collateral and could be used in a covered bond transaction as well.  And so because of this, I decided that we should not specify or limit the type of assets that can be on in a covered bond pool.

So, now that I have given you a little brief explanation of the legislation structure, let me just give you a very brief talk on why it is necessary.  We have talked about this -- about the flow -- changes in the market and what have you and how the covered bonds are debt instruments, but the aspect of the -- putting it in legislation versus just doing it through the rulemaking process. 

Most of the countries that use covered bonds as their basic premier tool and Europe do so by policies that are set in law.  Covered bonds or debt instruments are broad enough in scope and magnitude, we believe, to warrant, and authorize, and codify a federal statute.  The codification of this tool will provide the greater stability and permanency for the covered bond, in addition to encouraging the use of covered bonds as an alternative.  So, establishing a statute will provide for the benefit of legislator review as well, rather than the possibility of changing covered bond policy through simple motion of the FDIC Board of Governors. 

I believe that some of the specifics should be left up to the agency.  Obviously, statutory language provides more certainty than the regulatory change and this certainty can also result in lower transaction costs, the cost -- investors will not be pricing for that uncertainty.  In addition, spreads will be narrower which will encourage more institutions to enter the covered bond marketplace and it is a goal to provide an environment in which the market will flourish and produce increased liquidity.

Now, the Department of Treasury's Best Practices document highlights another benefit of a legislation framework.  It states that "a legislative framework helps the standardization covered bond market providing simplicity to the market.  This standardization will allow for a more efficient marketplace by ensuring that everyone is playing by the same rules."

Finally, the political landscape -- that is the politician here today -- and looking through the legislation to facilitate a covered bond market, we have to examine the current political realities on Capitol Hill.  And let me give you my thoughts on that.  Because covered bonds are a relatively new way of financing in the U.S., and the marketplace is really just developing here, I have to tell you that many members -- most members of Congress have not yet focused on the specifics of it all.  Even many members of my colleagues on the Financial Servicing Committee have just begun to ask questions to figure out exactly how covered bonds would work.  But, I, always the optimist, believe that we should be able to move forward on this quickly. 

And I think we are going to be able to do so in a bipartisan manner as well.  I have spoken to the Chairman and -- on this issue -- and Kanjorski as well, and also Spencer Bachus is a cosponsor of this legislation.  He has stated he supports -- strong support for going ahead with this.  And so by reaching across the aisle, I think we can move, if not in the next week, but maybe at the very beginning.

As you know, we only have something like -- one, two, three, four, five -- five days left of this legislation calendar, so it may not happen this week; although, when I wrote this, I said it may not happen this week.  But, reading today that maybe this week, this Wednesday, we may be making the largest structural changes of investment by the private -- by the public sector in the new RTC2, who knows what we could potentially actually do.  We could just throw this covered bond legislation in along with the stimulus package and everything else that will go into the Wednesday legislation and see; we may have covered bond legislation by the end of next week, so it is really fortuitous that you are all here today [Laughter].  You are all on the cutting edge.

So, again, I appreciate -- in conclusion, I just want to say that we all agree, I think, that covered bonds have a good track record in Europe and they offer an interesting alternative to the normal mortgage securitization process.  The statutory framework, I think, would be beneficial not to push the economy in this direction, but to provide that certainty -- that certainty that is not there in the rulemaking process. 

Again, appreciate AEI for giving me this opportunity and this forum.  And I thank the panel here that I look forward to hearing the great advice and debate that follows.  Thanks a lot.  [Applause]

Peter J. Wallison:  Okay, we will begin our panel discussion with Greg Baer.  We will actually be going right down the line from Greg all the way through Tim Skeet.  I will introduce them in order as they -- as their turn comes. 

Greg is the deputy general counsel of Bank of America's bank regulatory and public policy legal group.  He is responsible there for providing legal advice and counsel regarding regulatory and legislative activities for the company.

Before that, he was a partner in the Washington, D.C., law firm of WilmerHale, where he advised domestic and foreign financial institutions and represented clients before the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission. 

Many of your probably know that prior to joining WilmerHale, Greg was an assistant secretary for financial institutions at the Department of the Treasury where he coordinated Treasury policy on Gramm-Leach-Bliley and led the development of presidential initiatives on financial privacy and consumer protection. 

We are happy to have you on our panel today, Greg, and happy to learn that you are involved in the covered bond issue.  So, why do not you get started?

Greg Baer:  Thanks, Peter.  It is great to be here. I am going to try to give the issuer perspective today and then leave the rest of the panel to talk from other perspectives. 

So, basically, what we believe -- why we believe covered bonds are in the interest of Bank of America, why we also believe it is in the interest of the market and ultimately homeowners, and then from the regulatory perspective what we see as sort of the past obstacles and how we have managed to clear them. 

I was going to give a sort of broad overview of covered bonds.  I think Neel has done that admirably.  I guess I would only stress two things, which I think he stressed, but you just cannot repeat enough.  The first is I think the crucial distinction between covered bonds and mortgage-backed securities.  That is with mortgage-backed securities the investor is receiving a pass through of interest payments ultimately from homeowners with associated risks of default and prepayment. 

With a covered bond -- if we issue a covered bond, investors are looking to Bank of America to pay on that bond.  The pool of mortgage assets is relevant only in the event of our insolvency.  And that pool of assets, though, is of extraordinarily high credit quality.  Again, as he noted, this is a dynamic pool of assets where mortgages that prepay or default are removed from the pool.

As you add all that up, that reaches the second key thing to understand, which is that investors in covered bonds are a fundamentally different group of investors from investors in mortgage-backed securities.  They are covered by different desks at the investment banks, different analysts.  And potentially it opens up a whole new group of investors to fund mortgages in the United States.  I will leave more on that to Tim Skeet from the distinguished firm of Merrill Lynch, who will be talking about that later.  [Laughter]

Tim Skeet:  [Inaudible]

Greg Baer:  Every day.

So, just starting with our perspective and why we like the covered bond option.  First and foremost, it is an ability to monetize mortgage assets on our balance sheet.  Right now, we already have $100 billion of unpledged mortgage assets that potentially could qualify for inclusion in the cover pool. They also with covered bonds give us an option of offering longer term debt.  Two, three year bonds, but in Europe it has gone ten, thirty year.  So, in terms -- if you think about trying to ladder a structure of liabilities to fund mortgages that this is a very useful tool.

They are a nice complement to federal home loan bank advances, which we also use as a funding tool because they tend to be longer term and the haircuts tend to be a little lower.  And they are also a complement to securitization.  There is a clear tradeoff.  With covered bonds you keep the loans on balance sheet.  You have to hold capital in reserves against those.  But, on the other hand, you are not paying a guarantee fee.  So, depending on where the market goes on any given day or any given time, there will be a tradeoff of how much you want to use each, but we see them clearly as complementary.  Obviously, to the extent that the GSEs become smaller or less in the guarantee business, this is something that could complement that.  Those are the benefits for us.

I think from a public policy point of view, there are also benefits.  Primarily it is the fact that these mortgages remain on our balance sheet, so that means in effect we have to eat our own cooking.  We have to incur the risks and have disciplined example, in the originate-to-distribute model perhaps.

As I already explained, banks have to hold capital reserves against this which tends to yield a more stable source of lending.  And then also as we have seen recently, workouts can be difficult in the event that there are investors and servicers involved, but here since they are on our balance sheet we own them.  We have every right to work them out as we please.

I think another sort of important benefit is that as a -- I think we were discussing earlier -- these tend to have been issued only by regulated insured depository institutions.  So, again, those mortgages are subject to examination supervision by our regulator.  They are also subject to CRA.  So, there are some incidental benefits there as well. 

So, I mean, if you add it all up on a policy view, clearly covered bonds are not the answer to what ails our mortgage market, but they do seem to have important contributions in certain areas where we are experiencing problems.

So, given all this -- we actually have already done four issuances of covered bonds, not this year, but the year before in, I think, late '06 -- three issuances in Europe, one in the United States, and saw it even then as an important tool.

The problem though was -- again because of regulatory uncertainty -- this is a terrible mike -- because of regulatory uncertainty those -- that we had to structure those issuances in ways that were fairly inefficient.  And so we sought from FDIC, Treasury, and others some sort of regulatory clearing of the way that would allow us to use a more simple and easy to understand structure.  Both a less complicated structure, but also again because we are talking about rates investors, a structure that was readily understandable.

Neel has already walked you through the FDIC Policy Statement -- I am sorry, the FDIC Rule, and we will hear more about that shortly.  I will just highlight the one or two things that we thought were most significant.  The first was the shortening of the automatic stay period from 90 days to 10 days.  Again because of the uncertainty in that 80-day period, we were required to establish a structure and also pay out on a swap agreement to insure that investors continued to receive payment during that period, and that really increased our cost. 

So, ideally, as Congressman Garrett was saying, these would be qualified investment contracts and there would be a zero day, but we think 10 days is eminently workable and are very pleased that the FDIC took that step.  In fact, I should say I mean we were very pleased overall with the -- with both the speed and the thoroughness with which the FDIC devoted themself to this issue.  I think they clearly recognized this as an idea whose time has come, and they worked very well with, I think, all parties involved to make this happen.

The second issue, which is extremely technical, and I will not get into, but I think the clarification around damages being par plus accrued interest was very important to us, and I think the market as a whole and that will definitely help facilitate bank issuance.

And then there has been a lot of talk about the four percent limit that the FDIC imposed.  We think that is absolutely fine for now.  That is, I think, where the U.K. and some other countries started.  They have since increased it, and that would be fine.  But, I mean we do not think any bank should be doing all of its funding through any one mechanism.  Everyone should have an array of funding vehicles.  And so some limit on the amount you can fund yourself through covered bonds is perfectly appropriate.

Just a word or two on the Treasury best practices, which are exactly that.  As I think someone noted, it is a little odd for the private sector to go into the government and ask them to specify the terms of their deals.  But, in this case -- I think the key word Neel kept repeating was homogeneity -- that we saw real benefit in trying to develop this market for everyone to be on this -- on largely the same terms.

We actually had experience with this because the first issuer in the United States was actually WaMu.  And when we did our issuance, we replicated their structure not because we thought it was perfect and we could not improve upon it.  But, we really felt that it was important for investors to see one set of terms and be able to get comfortable with that.  So, again, we really appreciate the Treasury's actions here.  I think it has made a significant difference.

The one remaining issue we are ironing out is just the mechanism around issuance.  To date, the market has been a private placement market under Rule 144A.  We believe for this to really grow it needs to be a wider public offering.  That will get us a broader investment base.  It also qualifies covered bonds for inclusion in the indices, so we think that is very important. 

We also want to be able to issue directly out of the bank without having to use any special purpose vehicles or entities to do that.  We are currently in discussions with the SEC around Section -- what is it -- 3A2 exemption in order to try to facilitate that and hope that works out.  But, we feel all in all that there has been important and necessary work done to clear the way for a broad and liquid market here and are quite satisfied with where things are.  So, that actually brings us to the question of legislation.  And we very much appreciate the interest of the Congressman and everyone on the Hill in this budding market. 

In terms of where we stand on that, I am going to descend to a clumsy and hokey analogy.  You know, we see covered bonds right now -- if you are coming up to the car dealership, we have got sort of the base model.  The engine work is great.  There is a roomy interior, and you can drive it off the lot.  Legislation is more than the sun roof and the eight speaker stereo system, which you do not want to really wait for the factory order on that.  So, what we want to do is going ahead and drive off.  Maybe we will get those installed later some time next year, but we are perfectly happy with what we have right now in terms of our ability to issue.  That is all I have.

Peter J. Wallison:  Thank you very much, Greg.  Greg, this -- the idea of homogeneity is understandable certainly from the standpoint of trying to market something.  But, how do you react to the idea of it might stifle innovation and development about this field?  Are you suggesting that we should not have any innovation?  That we should establish one format for covered bonds and leave it that?  Or are you open and is Bank of America open to other systems?

Greg Baer:  Yes, I think generally we are open to other systems.  But, I do think if you look at the European model, their legislation is actually quite prescriptive and has really facilitated the development of this market. 

Again, I think it gets back to the second of my core points, which is when you are looking at an MBS or other sort of structured product there is a lot of analysis that goes into how does this structure work, where is the waterfall, who loses money, when, all of that.  And that is a whole group of analysts, investment bankers -- and I should let Tim hop in here at some point -- and investors. 

What we want here is to appeal to rates investors who see basically an interest product with ext