On the heels of the Administration’s recently published report to Congress outlining its objectives for reforming the housing finance market,1 new legislative action may come that would encourage the issuance of covered bonds. Secretary of the Treasury Timothy Geithner on March 1, 2011 in testimony before the House Committee on Financial Services (“Committee”) stated that the development of a legislative framework for a covered bond market should be included as part of the consideration of new means to provide mortgage credit.2 Notwithstanding earlier delays in implementing reform for this industry,3 proposals for legisla-tive action addressing covered bonds are likely to be a focal point for the Committee4 during this session of Congress. A discussion draft of a bill sponsored by Representative Scott Garrett (R-NJ), which aims to establish standards for covered bond programs and a covered bond regulatory oversight program, has been circulated to members of Congress and securitization market participants. The draft bill, if enacted in its current form, would (i) define the issuers and asset classes that would be subject to the oversight program; (ii) establish a framework for a federal regulatory oversight program for covered bonds; and (iii) implement a default and insolvency resolution process. This DechertOnPoint summarizes the February 2011 discussion draft, entitled the “United States Covered Bond Act of 2011” (the “Act”), which is expected to be introduced later this year.  

Covered Bond Act Definitions

A central component of the draft bill involves the definition of the types of programs and entities that would be subject to it. Under the draft bill, a “covered bond program” is defined as any program of an eligible issuer under which, on the security of a single cover pool, one or more series or tranches of covered bonds may be issued. Eligible issuers would include (i) any insured depository institution;5 (ii) any bank holding company; (iii) any savings and loan holding company; (iv) any non-bank financial company (as defined in the Dodd-Frank Wall Street and Consumer Protection Act (the “DFA”)) that is approved as an eligible issuer by the applicable covered bond regulator (i.e., the appropriate federal banking agency (as such term is defined under the Federal Deposit Insurance Act (“FDI Act”)) or the Board of Governors of the Federal Reserve System); and (v) any issuer that is sponsored by one or more eligible issuers for the sole purpose of issuing covered bonds on a pooled basis.6  

Additionally, the draft bill contains nine categories of eligible asset classes that are permitted to be part of a covered bond program. The eligible asset classes include residential mortgage assets, home equity assets,7 commercial mortgage assets, public sector assets, automobile assets, student loan assets, credit or charge card assets, small business assets and any other eligible asset class designated by the Secretary of the Treasury.8 Additionally, no eligible asset may be (i) a loan that has been delinquent for greater than 60 consecutive days; (ii) an asset that does not satisfy the credit quality requirements of the Act (such as the minimum overcollateralization requirements described in further detail below); or (iii) an asset that is subject to a prior perfected security interest granted in an unre-lated transaction.9

Federal Regulatory Oversight Program

The draft bill also requires that covered bonds issued by an eligible issuer under a covered bond program be approved by the applicable covered bond regulator under a regulatory regime10 to be implemented by the Secretary of the Treasury (in consultation with covered bond regulators) within 180 days of the enactment of the draft bill. All covered bonds would be subject to approval regardless of when the covered bond was issued. The draft bill provides that the oversight program must require each approved covered bond program to contain, at a minimum, the following features:  

  • A publicly available registry containing informa-tion necessary to adequately identify (i) the cov-ered bond program and the eligible issuer and (ii) all outstanding covered bonds issued under the covered bond program;  
  • A cover pool consisting of one or more eligible assets from no more than one eligible asset class;
  • A minimum level of overcollateralization (to be set by rules adopted by the Secretary of Treasury in consultation with covered bond regulators) for covered bonds backed by the applicable eligible asset class; the overcollateralization level must be based upon credit, collection and interest rate risks (excluding liquidity risks) associated with the applicable eligible asset class;11 and  
  • An undertaking to have monthly reports certifying compliance with minimum overcollateralization requirements, which must be prepared by an in-dependent unaffiliated asset monitor (which may also be the indenture trustee) to be appointed by the issuer for the covered bond program; the re-ports must be delivered to the Secretary of the Treasury, the applicable covered bond regulator, the indenture trustee and bondholders for the program.

Default and Insolvency Resolution Process

The proposed bill creates a resolution process for defaults on covered bonds both prior to and after the issuer enters conservatorship, receivership, liquidation, bankruptcy or any other insolvency proceeding. In the event of a default on a covered bond prior to the issuer’s insolvency event, the proposed bill requires that an estate separate and apart from the issuer be immedi-ately and automatically created by operation of law for each affected covered bond program.12 The proposed bill does not identify who would administer the estate. The estate would be comprised of the cover pool that secured the covered bond, which would be immediately released to and held by the estate free and clear of any right, title, interest or claim of the issuer or any conser-vator, receiver, liquidating agent or trustee in bank-ruptcy for the issuer or any other assets of the issuer. The issuer would retain the residual interest in the estate. The estate would be liable on the covered bonds and related obligations of the issuer that are secured by a perfected security interest in, or other lien on, the cover pool when the estate is created. Any holder of a covered bond or related obligation would retain a claim against the issuer for any deficiency with respect to the covered bond or related obligations. The estate would not be liable on any obligation of the issuer that were not secured by a perfected security interest in, or other lien on, the cover pool when the estate was created.

If the issuer of a covered bond was an insured deposi-tory institution placed into receivership or conservator-ship under the FDI Act or a nonbank financial institution placed into receivership under Title II of the DFA before an uncured default on the covered bond occurred, the Federal Deposit Insurance Corporation (“FDIC”), as receiver or conservator for the issuer, would have the exclusive right, during the 180-day period beginning on the date of its appointment, to transfer the cover pool in its entirety, together with all covered bonds and related obligations secured by a perfected security interest in, or other lien on, the cover pool, to another eligible issuer, which must agree to become fully liable on all covered bonds and other related obligations of the issuer secured by the cover pool. If the FDIC were to cease performance under the applicable covered bond program13 or to fail to complete a transfer to an eligible issuer within the 180-day period, or if a conservator, receiver or trustee in bankruptcy other than the FDIC was appointed for an issuer before an uncured default on a covered bond occurs, then the covered bond program would become an estate separate and apart from the defaulting issuer by operation of law. Similar to the estate created prior to an insolvency event, the estate would be comprised of the cover pool that secured the covered bond, which would be immediately released to and held by the estate free and clear of any right, title, interest or claim of the issuer or any conser-vator, receiver, liquidating agent or trustee in bank-ruptcy for the issuer or any other assets of the issuer.

The estate would be fully liable on the covered bonds and related obligations of the issuer that were secured by a perfected security interest in, or other lien on, the covered pool when the estate was created. The estate would not be liable for any obligation of the issuer that was not secured by a perfected security interest in, or other lien on, the cover pool when the estate was created. After the creation of an estate following an insolvency event, neither the issuer (whether acting as debtor in possession or in any other capacity) nor any conservator, receiver, liquidating agent or trustee in bankruptcy for the issuer or any other assets of the issuer would be able to disaffirm, repudiate or reject the obligation to turn over property or to continue servicing the cover pool.14 The residual interest in the cover pool would be held by the conservator, receiver, liquidating agent or trustee in bankruptcy for the issuer. Contingent claims for deficiencies with respect to covered bonds (such as insufficient overcollateralization) or other obligations would be allowed as a probable claim. The contingent claim would be estimated if awaiting the fixing of the claim would unduly delay the resolution of the conservatorship, receivership or bankruptcy case.

The resolution process for the Act also includes two other interesting components. The first is that any administrator or servicer of an estate created prior to or after an insolvency event would be permitted to use the cover pool to obtain liquidity for the estate (solely in the case of timing mismatches among the assets and liabilities of the estate) provided that such debt or credit extension was created on terms that (i) were fully subordinate to the interests of the beneficiaries of the estate; or (ii) had priority over (or were pari passu with) the interests of the beneficiaries of the estate, if such debt or credit extension was determined to be in the best interests of the estate and would maximize the value of the cover pool and was approved by the applicable covered bond regulator. The second compo-nent is that the Act would prevent taxpayers from incurring any losses. Specifically, if the Secretary of the Treasury and the FDIC jointly determined that the Deposit Insurance Fund incurred actual losses because the covered bond program of an insured depository institution was subject to resolution under the Act rather than as part of the receivership of the institution under the FDI Act, the FDIC would be authorized to recover an amount equal to those losses through an increase in deposit insurance assessments on insured depository institutions with approved covered bond programs. It is unclear whether any time limitations would be imposed on when loss determinations and related assessments could be made. This provision was likely included to address concerns that the FDIC outlined in General Counsel Michael H. Krimminger’s September 2010 testimony before the Senate Committee on Banking, Housing and Urban Affairs regarding covered bonds.15

Conclusion

The subject of the draft covered bond bill is one that has been the source of ongoing debate in the area of financial reform over the past couple of years. Given the importance of the issues that are sought to be ad-dressed by the draft bill, it is likely that we can expect substantial legislative and regulatory consideration and discussion of the substance of this draft bill in the near future.