An exciting financing product has been making news as a potential supplier of liquidity to the distressed financial markets. So-called “covered bonds” have been touted by various government agencies as well as numerous financial institutions as a vehicle that may replace some of the mortgage financing that has disappeared as investors have incurred billions of dollars in losses. Simply stated, covered bonds are recourse debt obligations of an insured depository institution (IDI) which are secured directly or indirectly by a dedicated pool of mortgage loans, known as a “cover pool.” Although covered bonds are a vehicle that financial institutions can begin using immediately to raise capital, resume issuing mortgage loans to credit-worthy borrowers and help turn around the lethargic financial markets, the recent proposed changes to rating methodology for covered bonds by Standard & Poor’s (S&P) may make it more difficult to market these instruments.

Traditionally, the funds necessary for funding residential mortgage loans came from two sources: on-balance sheet debt financing and market sales. With respect to mortgages retained on an institution’s balance sheet, funding came from the cash flow of consumer deposits, the issuance of unsecured debt and pledges to the Federal Home Loan Banks (FHLBs) for cash advances. In the case of mortgages sold into the secondary markets, funding was provided by the “government sponsored enterprises” of Fannie Mae and Freddie Mac as well as from securities sold directly to third party investors.

The long-established sources of funding through market sales to investors and securitizations have been all but eliminated due to market conditions and, although sales to the government sponsored enterprises and pledges to FHLBs are still available, financing from these sources have been much more difficult to obtain. As a result, financial institutions have become more inclined to keep good mortgage loans on their balance sheets and more interested in expanding traditional sources of funding for such loans. Covered bonds can satisfy both goals of a depository institution: on-balance sheet treatment and an additional source of funding.

Covered bonds have long been popular in Europe and today serve as the primary source of mortgage loan funding as well as infrastructure financing. In contrast, only two U.S. financial institutions, Washington Mutual and Bank of America, have issued covered bonds to finance residential mortgage loans. One likely reason for their limited use in the United States to date is the uncertain regulatory environment and treatment of covered bonds in a financial institution meltdown.

Although covered bonds are similar in many ways to traditional mortgage-backed securities, there is one major difference: the loans backing a covered bond remain on the balance sheet of the issuing IDI. Because the bonds are recourse obligations of the issuing IDI, the issuer retains possession and control over the assets securing the bonds but subject to a valid and perfected security interest in the cover pool. The loans in the cover pool should meet certain criteria at all times and the issuing IDI should be required to maintain the cover pool’s credit quality throughout the life of the covered bonds. This can be accomplished by substituting loans and otherwise changing the make-up of the cover pool. By contrast, mortgage-backed securities are typically off-balance sheet transactions in which lenders sell loans to special purpose vehicles that issue bonds, thus removing the loans—and the credit risk associated with those loans— from the lenders’ balance sheets.

To mitigate an investor’s risk in an eligible cover pool, the FDIC has agreed to reduce the time periods by which it must act during a conservatorship or receivership of an IDI. In order to receive the benefit of these reduced periods of time in the event of a conservatorship or receivership of the IDI by the FDIC, the loans in a cover pool must comply with the FDIC’s Covered Bond Policy (“FDIC Policy”) pursuant to which the FDIC has established specific loan criteria. The loans must be performing loans secured by liens on one-tofour family residential properties and must be underwritten at the fully indexed rate, which is the indexed rate at the time of origination plus the margin to be in effect after the expiration of the introductory rate without regard to any applicable rate caps. Negative amortization loans are not eligible for inclusion in a cover pool. All loans in a cover pool must be underwritten based on documented income, must be in compliance with existing supervisory guidance governing the underwriting of residential mortgages, and held and owned by the IDI. In addition to qualifying loans, the IDI may include AAA-rated mortgage securities backed by loans which would otherwise qualify under the FDIC Policy so long as such mortgage-backed securities do not exceed ten percent of the cover pool, and may use substitution collateral consisting of cash and Treasury and agency securities as a means to manage the cover pool. Prior to issuing covered bonds, the IDI must obtain the consent of its primary federal regulator and limit its issuances to four percent of its total liabilities after giving effect to the issuance. The covered bonds must be secured by a perfected security interest in the cover pool and the maturity of the covered bonds may be from one year to thirty years although, in general, their maturities have ranged from two to ten years.

In addition to the criteria required by the FDIC Policy which is incorporated within the Best Practices for Residential Covered Bonds released by the U.S. Department of the Treasury (Best Practices), the Best Practices guidelines provide that a covered bond issuance and its cover pool should conform to certain standards throughout the life of the covered bond issuance. The loans in the cover pool must be current at the time of inclusion in the cover pool and replaced upon becoming more than sixty days delinquent. The mortgage loans must be secured by first liens only and have a maximum loan-to-value ratio of 80 percent at the time of inclusion in the cover pool. No more than twenty percent of any given cover pool can be within a single Metropolitan Statistical Area (a county or group of contiguous counties defined by the U.S. Office of Management and Budget for use by Federal statistical agencies in collecting, tabulating, and publishing Federal statistics). The cover pool itself must be overcollateralized by at least five percent of the outstanding principal balance of the covered bonds. In this regard, asset coverage tests must be conducted monthly to determine whether the collateral quality and levels of collateralization continues to be satisfied. The loan-to-value ratios of loans in the cover pool must be updated on a quarterly basis using nationally recognized, regional housing price indices or comparable measurement tools.

Treasury’s guidelines in the Best Practices also require certain protections for the investors as to investment of proceeds of the mortgage loans, ongoing disclosure on a monthly and quarterly basis concerning the cover pool, disclosure concerning the IDI’s own financial information, and use of an independent entity as an asset monitor and a trustee that represents the investors’ interest.

Although covered bonds can be issued directly by an IDI, in the covered bond transactions initiated in the United States to date, the issuing IDIs have used a trust or similar entity (Special Purpose Vehicle or SPV) to sell mortgage bonds secured by the IDI’s mortgage assets. The pledged mortgages remain on the IDI’s balance sheet, but are designated as security for the IDI’s obligation to make payments on the mortgage bonds. A security interest in the cover pool holding the mortgage loans is granted to the trustee. The SPV sells covered bonds, secured by the mortgage bonds, to investors. Although the use of covered bonds in the United States has never been prohibited by any statutes or regulatory requirements, regulatory agencies in the United States have been silent until recently regarding how they would be treated in the event of a conservatorship or receivership of the issuing IDI.

As discussed, the FDIC Policy sought primarily to clarify how the FDIC would treat the investors holding covered bonds, given the full recourse of the issuing IDI, in an FDIC conservatorship or receivership. If a covered bond transaction conforms to the FDIC Policy, the FDIC has agreed to consent to the exercise of specified rights and powers by a trustee on behalf of investors in covered bonds (including expedited access to the cover pool collateral) and not assert certain rights of the FDIC to which it is statutorily entitled during certain time periods after the FDIC becomes a conservator or receiver of an IDI. In general, the FDIC has reduced the time periods pursuant to which it must act to a ten business day period after certain events occur. Because investors are entitled to receive only the par value of bonds issued plus accrued interest to the date of appointment of the conservator or receiver, this reduced time period of ten business days, which may be covered by interest payment swaps, lessens an investor’s risk of interest nonpayment for the statutory time period by which the FDIC is otherwise required to act (forty-five days in a conservatorship, ninety days in a receivership).

The guidelines set forth in the Best Practices outline other recommendations with respect to the cover pool collateral, compliance testing, and capitalization of the issuing IDI. Unfortunately, these tentative first steps at regulation have been overcautious and have limited the benefits that covered bonds could provide to the financial markets. Among other things, both the FDIC Policy and the Best Practices relate only to cover pools with residential mortgage loans and exclude commercial mortgages from the pool of collateral available to covered bonds. They also limit the type and amount of mortgage securities that can be used as collateral to AAA-rated and to ten percent of any given cover pool. Further, an IDI’s aggregate covered bond obligations cannot exceed four percent of its total liabilities, even though each cover pool must at all times maintain an overcollateralization value of at least five percent of the principal balance of covered bonds outstanding and the consent of the IDI’s primary federal regulator must be obtained for the issuance of covered bonds.

There is reason to believe that notwithstanding the limitations previously discussed, these instruments will supply additional liquidity to the financial markets. Given the balance sheet retention, full recourse to the IDI’s assets, and required overcollateralization, covered bonds should help draw the more conservative investor into the real estate finance sector.

There also are reasons to believe that current governmental rules will be amended in order to extend their use to the commercial mortgage market. Although treading cautiously as they delve into the regulation of a product previously unfamiliar to them, regulators have expressed a willingness to revise or amend their policies as they observe the market unfold. The European covered bond market has widely used commercial mortgage loans and commercial mortgagebacked securities (CMBS) to secure covered bonds. Indeed, the use of commercial mortgage loans as covered bond collateral is so well-established in Europe that the European Covered Bond Council, in tables showing collateral types for its Covered Bond Fact Book, does not differentiate between residential and commercial mortgage loans but treats them as a single category. As U.S. agencies observe the development of the covered bond market they, like their European counterparts, are likely to see commercial mortgages and CMBS as viable collateral for covered bonds. Indeed there are signs that changes to the regulatory schemes in the United States may already be forthcoming. Last summer, Representative Scott Garrett (R-NJ), a member of the House Financial Services Committee, introduced legislation that would include high quality commercial mortgage loans as well as CMBS as eligible collateral in the emerging covered bond marketplace. While it remains to be seen whether or when this change would be implemented (it is not likely that anything will happen before the next administration is firmly established), it is an encouraging sign that this legislation has been introduced so early in the development of this new market.

It is important to note that while expanding the use of covered bonds should help stabilize the U.S. mortgage market, even with the addition of commercial mortgages and CMBS as collateral, most private analysts do not view the effort as a cure-all for the problems facing the mortgage market today, especially in light of the proposed rating methodology changes published by S&P for covered bonds. Specifically, based on a number of criteria, including the IDI’s own rating, asset-liability mismatch in maturities and liquidity exposure, and the maximum net stressed liquidity need, S&P will categorize individual covered bond programs into risk categories. In part, because the United States does not have specific covered bond legislation or a proven track record, S&P proposes to place covered bonds issued by U.S. IDIs in the highest risk category. Banks will have to evaluate the effect of holding the underlying loans on their balance sheets and the overall effect of the rating assigned to its covered bond program. Nevertheless, covered bonds are likely to create a powerful additional source of liquidity which offers a unique combination of stability and return.