Thursday, June 23, 2011

House Committee Gives Bi-Partisan Approval to Legislation Creating US Covered Bond Market

The House Financial Services Committee has approved H.R. 940, the U.S. Covered Bond Act of 2011, by a bi-partisan vote of 45-7, to facilitate a covered bond market in the U.S. and add liquidity and certainty to the capital markets. Introduced by Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, and Rep. Carolyn Maloney (D-NY), Ranking Member of the Financial Services Subcommittee on Financial Institutions, the Act would create a covered bond market with appropriate protections that would level the playing field for U.S. financial institutions to better compete with their foreign counterparts. Since S 940 would amend the Internal Revenue Code and has other federal tax code implications, the measure was referred to the House Ways and Means Committee. The Obama Administration backs, in principle, efforts to create a market for covered bonds for financing mortgages that would help wean the mortgage market from government support.

The bi-partisan legislation would create a framework for U.S. covered bonds, which are securities issued by banks and backed by pools of loans that enable credit to flow more readily from the capital markets to individuals and small businesses in a way that enhances stability of the broader financial system. The Act declares any covered bond issued or guaranteed by a bank to be a security issued or guaranteed under specified securities laws, including the Securities Act and the Investment Company Act.

A critical portion of the legislation deals with an issuer’s default on its covered bond obligations, and the procedure for dealing with the covered bond program of an issuer in receivership. If an uncured default occurs on a covered bond before the issuer enters receivership, liquidation, or bankruptcy, the legislation creates an estate automatically by operation of law to be administered separately from the issuer or any later receivership or estate in bankruptcy. A separate estate must be created for each affected covered bond program. Any estate so created will generally be exempt from all securities laws, except that it would be subject to the reporting requirements established by the applicable covered bond regulator and must succeed to any requirement of the issuer to file periodic reports in respect of the covered bonds as specified in section 13(a) of the Exchange Act.

Similarly, the estate would not be treated as an entity subject to taxation separate from the owner of the residual interest for purposes of the Internal Revenue Code, including by reason of the taxable mortgage pool provisions of section 7701(i) of the Code, but instead must be treated as a disregarded entity that is owned by the owner of the residual interest for such purposes as described in applicable regulations, as in effect on the date of enactment. No transfer or assumption of any asset or liability to or by an estate or an eligible issuer would constitute an event in which gain or loss must be recognized under section 1001 of the Code.

Covered bonds have been used in Europe for centuries to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The purpose of the U.S. Covered Bond Act is to create a legislative framework for the development of a covered bond market in the U.S. This framework will enable credit to flow more readily from the capital markets to households, small businesses, and state and local governments in a way that enhances stability of the broader financial system. The core elements of the legislative framework are legal certainty for covered bond programs and supervision by federal regulators.

Currently, the US does not have the extensive statutory and oversight regulation designed to protect the interests of covered bond investors that exists in European countries. The legislation would fill this gap by establishing an oversight program that would prescribe minimum overcollateralization requirements, identify eligible asset classes for cover pools, and create a registry to enhance the transparency of covered bond programs.

Covered bonds also help to resolve some of the difficulties associated with the originate-to-distribute model. The on-balance-sheet nature of covered bonds means that the issuing banks 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, he noted, 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.

Speaking in support of the legislation, Financial Services Committee Chairman Spencer Bachus (R-Ala) said that covered bonds are an innovative source of financing that has worked well in many European countries, particularly in the aftermath of the financial crisis when many other traditional credit channels were badly disrupted. In his view, covered bonds would provide much needed liquidity in capital markets while at the same time representing a private market solution to the need for market participants to have skin in the game.

No comments: