Thursday, November 10, 2011

Bi-Partisan Senate Legislation Would Establish Covered Bond Market in US

Senators Kay R. Hagan (D-NC) and Bob Corker (R-TN) have introduced legislation establishing a US covered bond market to add liquidity to the capital markets and provide a stable source of private capital. The United States Covered Bond Act (S 1835) would provide a legislative framework that expands funding options for U.S. financial institutions. The Act is co-sponsored by Senators Chuck Schumer (D-NY) and Mike Crapo (R-ID). The U.S. lags behind its global peers in the development of a covered bond market because we lack a legislative framework for issuers and investors,” said Senator Hagan, a member of the Banking Committee. With a legislative framework in place, she added, U.S. financial institutions will have a powerful tool that can be used to fund loans to small businesses and households.

Covered bonds can be another stable source of private capital, providing additional lending to businesses and families,” said Senator Corker, also a member of the Banking Committee. He noted that covered bonds can provide U.S. financial institutions an important new tool for achieving stable, long-term financing from private capital markets. Financial institutions in 30 countries, including Germany, the UK, and Canada, already issue covered bonds. At the end of 2009, the total outstanding volume of covered bonds reached €2.4 trillion and this year foreign banks have issued $32 billion of covered bond to U.S. dollar investors.

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.

In June, the House Financial Services Committee approved H.R. 940, the U.S. Covered Bond Act, by a wide bi-partisan vote of 45-7, to facilitate a covered bond market in the U.S. The House companion measure is sponsored by Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, and Rep. Carolyn Maloney (D-NY), Ranking Member on the Subcommittee on Financial Institutions.

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.