On July 15, 2008, the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) adopted a final Covered Bond Policy Statement (the “Final Policy Statement”). The Final Policy Statement reflects nearly three months of comment and discussion centering on the FDIC’s interim final Policy Statement on Covered Bonds (the “Interim Policy Statement”), which was published in the Federal Register on April 23, 2008. Although the Final Policy Statement addresses some industry concerns relating to the real potential for a market in covered bonds issued by insured depository institutions (IDIs), the FDIC acknowledged at its public meeting that many comments made by industry participants will not be addressed in their favor or, alternatively, will remain issues for further examination as the covered bond market develops.
Covered bonds—full recourse obligations of IDIs secured by a pool of mortgage loans—have been popular in Europe for more than a century, but have never gained much popularity in the United States.1 The FDIC has indicated its hope that the covered bond market can become a useful tool to banks as another funding source for originating residential mortgage loans, in light of the recent credit market difficulties. However, in adopting the Final Policy Statement, the FDIC made clear that it views the U.S. covered bond market as an experiment in its infancy, and that the goal of increasing liquidity options for IDIs must be carefully weighed against the potential cost to the FDIC in the case of IDI insolvencies.
The Final Policy Statement affirmed many of the parameters set forth in the Interim Policy Statement that, if complied with, would enable holders of covered bonds to obtain control over and/or liquidate the related collateral (referred to as the “cover pool”) on an expedited basis in the case of conservatorship or receivership of the issuing IDI. Specifically, rather than having to wait 45 days (in the case of conservatorship) or 90 days (in the case of receivership),2 covered bond holders will obtain FDIC consent to access and liquidate the cover pool after only 10 days, following a monetary default on the obligation or repudiation of the transaction by the FDIC. This expedited access applies to covered bond transactions that comply with the following restrictions:
- Assets securing the covered bonds are limited to eligible mortgages and mortgage-backed securities backed by eligible mortgages. “Eligible mortgages” consist of residential mortgage loans on one-tofour family residential properties, underwritten at the fully indexed rate3 and relying on documented income in accordance with FDIC and interagency guidelines. Securities backed by eligible mortgages must be rated AAA and cannot comprise more than 10 percent of the pool. In addition, cash or cash equivalents, such as Treasury or agency securities, are permissible substitutes for the initial cover pool collateral.
- Upon issuance, all covered bond transactions must not comprise more than 4 percent of an IDI’s total liabilities.
- Each IDI must obtain the consent of its primary federal regulator prior to entering into covered bond transactions.
The hope is that expedited access to the cover pool would reduce the risk of an interrupted payment stream on the bonds, consequently reducing liquidity risk to the bondholder.4
The FDIC reported that it had received over 130 comment letters in response to the Interim Policy Statement, but responded positively to only a few. Specifically, the Final Policy Statement permits cash and cash equivalents, such as Treasury and agency securities to be included in the cover pool as a mechanism for the IDI to manage the liquidity of the pool. In addition, the Final Policy Statement clarifies that “actual damages” payable by the FDIC in the case of repudiation are calculated as the par value of the covered bonds plus accrued interest as of the date of appointment of the FDIC as conservator or receiver.5 The Final Policy Statement also extended the maturity limit for covered bond transactions from 10 years to 30 years to more closely match many of the mortgage products offered and provide IDIs with additional flexibility.
Notwithstanding these clarifications, the FDIC stated that many of the comments submitted would not be accepted or would be tabled for possible further consideration at a later date. In particular, several comments focused on whether existing mortgages and covered bond transactions would be subject to the policy. These commenters contended that the FDIC’s restrictions on “eligible mortgages” would not provide the supply of mortgages necessary to jump start a covered bond program in the near future.6 The FDIC countered that permitting “grandfathering” of existing mortgage loans or covered bond transactions, to the extent that such loans or transactions do not comply with the criteria of “eligible mortgages,” would not further the stated goal of the Final Policy Statement—to encourage responsible mortgage lending practices—and would not promote stable and resilient covered bonds.
Several industry participants advocated expanding the cover pool to include additional types of collateral, such as commercial mortgages, credit-card loans, student loans and others. In response, the FDIC stated that the volatility of certain asset classes, coupled with the FDIC’s stated goal of encouraging liquidity specifically for underwriting residential mortgage loans, did not support expanding the Final Policy Statement to encompass additional asset classes. However, the FDIC said that this provision may be reviewed and reconsidered as the U.S. covered bond market develops.
Of primary concern in several comment letters was the cap on covered bond transactions, which limits the volume of potential transactions to an amount no more than 4 percent of the IDI’s total liabilities. Many argued that this limit erects a barrier to entry for many mid size banks and, at best, severely limits the volume of issuances for larger banks. Tying the limit to an IDI’s assets or creating regulatory triggers—two mechanisms used in Europe—would more effectively open the covered bond market to U.S. issuers than a liability-based cap. Some commenters advocated eliminating any restriction altogether, arguing that limiting the volume of transactions would similarly limit the potential for any significant secondary market in the bonds.
The FDIC acknowledged these comments but, as Director John M. Reich stated, the FDIC is only “sticking a toe in the water,” and took a conservative approach to the fundamental tension between permitting an IDI to obtain additional funding and the risk of increased costs to the FDIC, as IDIs encumber assets that would otherwise be available to satisfy insured depositors. Specifically, the FDIC contended that the 4 percent limit would grant the FDIC and other regulators an opportunity “to evaluate the development of the covered bond market within the financial system of the U.S.” Furthermore, as Chairman Sheila Bair observed, a market in covered bonds would increase the costs of the FDIC without any corresponding increase in assessment revenue. However, she also indicated that these concerns may be revisited by year-end upon further assessment of the U.S. covered bond market.
It remains to be seen whether the Final Policy Statement will provide investors and IDIs with sufficient legal comfort or transactional flexibility to take advantage of the narrow window of opportunity and begin to develop a viable market for covered bonds in the United States. Given the currently volatile nature of the U.S. banking industry, it may not be realistic to expect much more from the FDIC. On the one hand, the 4 percent cap seems to undermine in large measure the two stated intentions of the Final Policy Statement—establishing a market for covered bonds in the United States comparable to the European market, and providing a meaningful liquidity source for IDIs to originate mortgage loans. The volume restrictions imposed by the 4 percent cap will do little to level the playing field for U.S. issuers against their European counterparts, particularly in light of the well-trodden regulatory regime in place in Europe. Furthermore, the 4 percent cap, as measured against an IDI’s total liabilities, will provide minimal additional liquidity to help IDIs originate mortgage loans, and certainly is no adequate substitute for the now stalled mortgage-backed securitization market on which IDIs once heavily relied. On the other hand, a failed bank with covered bonds is likely to present higher resolution costs to the FDIC. In addition, in terms of a level playing field for overall liquidity, U.S. banks have much greater access to low-cost insured deposits than do most of their European counterparts.
As all await any further input from the FDIC over the next several months, industry participants may receive further guidance from the U.S. Treasury on this topic, as Treasury Secretary Henry Paulson has publicly indicated a strong interest in the development of a covered bond market in the context of the U.S. mortgage lending market. We can only hope that any such guidance will prompt the FDIC and other regulators to take a more expansive approach to this issue and enable the U.S. covered bond market to flourish.