Saturday, September 11, 2010

Legislation Moving Through Congress Would Create US Covered Bond Market

Bi-partisan legislation creating a US covered bond market has been reported out to the House floor and has a good chance of being passed during the final months of the 112th Congress. The legislation is designed to enhance liquidity in the secondary markets, reduce financing pressure, and more broadly reform the mortgage-backed securitization process. The United States Covered Bond Act, HR 5823, is sponsored by Rep. Scott Garrett (R-NJ) and co-sponsored by Rep. Paul Kanjorski (D-PA), Chair of the Capital Markets Subcommittee and House Financial Services Committee Ranking Member Spencer Bachus (R-AL). The covered bond provisions narrowly missed being included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Garrett provisions were supported by Senate Banking Committee Chair Chris Dodd, who has scheduled hearings in September on the covered bond legislation.

According to Rep. Garrett, covered bonds have been used in Europe to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The legislation is a thorough framework that seeks to provide the same benefits to the U.S. market. The legislation provides for the regulatory oversight of covered bond programs, includes provisions for default and insolvency of covered bond issuers and subjects covered bonds to appropriate federal securities regulation. According to an FDIC policy statement, covered bonds originated in Europe, where they are subject to extensive regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuer. By contrast, the US does not currently have the extensive statutory and regulatory regimes designed to protect the interests of covered bond investors that exists in European countries.

Covered bonds help to resolve some of the difficulties associated with the originate-to-distribute model of securitization. The on-balance-sheet nature of covered bonds means that issuers are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

Pursuant to an amendment to HR 5823 offered by Rep. Melissa Bean (D-Il), covered bonds would be co-regulated by the SEC and the appropriate federal bank regulator. Before the Bean Amendment, the legislation housed regulation of the covered bond market solely with the OCC. The Bean Amendment also provides that, when acting as a covered bond regulator, the SEC must consult with the appropriate state regulator. The Bean Amendment also provides that, before approving any covered bond program of any eligible issuer who is an insured depository institution, the SEC or any other covered bond regulator must consult with the FDIC and confirm to the FDIC that the covered bond program is not reasonably expected to materially increase the risk of losses or actual losses to the deposit insurance fund. Similarly, before adopting regulations or issuing guidelines as part of any covered bond oversight regime, the SEC and other covered bond regulators must consult with the FDIC and confirm that the regulations or guidelines are not reasonably expected to materially increase the risk of losses or actual losses to the deposit insurance fund.

A covered bond is a secured debt instrument that provides funding to an issuer that retains residential mortgage assets and related credit risk on its balance sheet. These assets are known as the cover pool. Interest on the covered bond is paid to investors from the issuer’s cash flows, while the cover pool serves as secured collateral. Covered bonds provide dual recourse to both the cover pool and the issuer. In the event of an issuer default, covered bond investors first have recourse to the cover pool.

The Act defines a cover pool as a dynamic pool of assets comprised of eligible assets, including secured first-lien mortgage loans, any state or municipal security, and SBA guaranteed small business loans. A Managers Amendment offered during the mark up of the legislation by Rep. Kanjorski deleted student loans, auto loans, and home equity loans from the list of eligible assets, as well as, in the case of the credit or charge card asset class, any extension of credit to a person under an open-end credit plan.

The legislation also provides that any covered bond issued or guaranteed by a bank is a security under Section 3(a)(2) Securities Act, Section 3(c)(3) of the Investment Company Act, and Section 304(a)(4)(A) of the Trust Indenture Act. However, no covered bond issued or guaranteed by a bank is an asset-backed security, as defined in Section 3 of the Exchange Act.

Any estate created under the legislation will be exempt from all securities laws, except that the estate will be subject to reporting requirements established by the SEC and other covered bond regulators. The Kanjorski Managers Amendment directs the SEC and other covered bond regulators to require that such reports cannot contain any untrue statement of a material fact and cannot omit to state a material fact necessary in order to make the statements made, in light
of the circumstances under which they are made, not misleading. The estate will also succeed to any requirement of the issuer to file periodic information, documents, and reports in respect of the covered bonds as specified in Section 13(a) of the Exchange Act. Any residual interest in an estate created under the legislation will also be exempt from all securities laws.

Covered bonds differ from mortgage backed securities in several ways. First, mortgages
securing covered bonds remain on an issuer’s balance sheet, unlike mortgage backed securities.
Second, pools of loans securing covered bonds are dynamic, and non-performing or prepaying
loans must be substituted out of the cover pool. Finally, if a covered bond accelerates and repays
investors at an amount less than the principal and interest owed, investors retain an unsecured
claim on the issuer.

Covered bonds differ from unsecured debt because of the absence of secured collateral
underlying the obligation of the issuer. While unsecured debt investors retain an unsecured
claim on the issuer in the event of issuer default, covered bond investors possess dual recourse to
both the underlying collateral of a covered bond and to the individual issuer. Accordingly,
covered bonds provide investors with additional protection on their investment compared with
unsecured debt.

The Securities Industry and Financial Markets Association (SIFMA) supports HR 5823, noting that covered bonds can provide a substantial and stable source of long term private capital and liquidity to fund mortgage, public-sector, and small business loans. In doing so, covered bonds have the ability to positively impact the financial system by providing an alternative source of funding and, in turn, increase the availability of consumer credit. In SIFMA’s view, HR 5823 provides the legal framework necessary to develop a liquid and efficient covered bond market in the U.S. It also provides investors with the certainty they need to support the market and is consistent with several policy objectives including increased transparency and uniformity, and the desire for issuers to have skin in the game. Covered bonds also represent an untapped and proven resource to provide liquidity to credit markets, an essential benefit in the current constrained environment.

In a comment letter on the SEC’s proposed revisions to Regulation AB, the American Bar Association said that covered bonds have been widely touted as being able to essentially replace asset-backed securities as a key funding source. The ABA is reluctant to see this type of security encumbered by issues from the securitization industry before a United States market even has a chance to develop. A broad reading of the cash flow element of the SEC’s proposed structured finance product definition could, however, include payments received from the covered bonds’ collateral pool after a default or issuer insolvency under the covered bonds. Although the ABA does not believe that payments on covered bonds depend on the cash flow from the assets in the collateral pool, the Association urged the SEC to explicitly exclude covered bonds from the structured finance product definition.