Saturday, October 02, 2010

Senate Banking Chair Sees Covered Bond Market as Alternative to Securitization

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 in conference by Senate Banking Committee Chair Chris Dodd, who recently held scheduled hearings on the covered bond legislation.

At the hearings, Senator Dodd said that covered bonds can provide an additional option to the two dominant funding mechanisms in the US marketplace, which are securitization and the traditional portfolio lender model where a bank holds mortgages on its balance sheet and funds them with deposits, said Chairman Dodd.  He added that the proponents of covered bonds point to their greater transparency, because these assets remain on a bank’s balance sheet so investors can analyze their value more easily than in the case of some other asset-backed securities. Proponents also note that issuers of covered bonds have a long term interest in the underlying loans because they keep them on the balance sheet, which increases investor confidence. Senator Dodd said that legislation and agency rulemaking on cocered bonds are needed to provide clarity about how covered bonds would be regulated.  Any legislation would define the rights and responsibilities of investors, issuers, and regulators.  Among other things, the legislation would spell out the treatment of covered bonds if the issuer goes into conservatorship or receivership.  

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.

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