On November 9, 2011, a group of Democrat and Republican U.S. senators introduced legislation to create a regulatory framework for an American covered bond market. Specifically, the United States Covered Bond Act of 2011 sets out the legal context for such a market and clarifies investors’ rights in the event of an issuer’s default.

By way of background, covered bonds are debt products issued by financial institutions and backed by a cover pool of assets, such as high-quality mortgages and public sector loans. Although they operate similarly to asset-backed securities, there is an important difference: if the issuer defaults the investor has preferential claim to the loans. Covered bonds are therefore seen as a safe source of funding for financial institutions.

European banks have issued covered bonds for hundreds of years, and the product has become increasingly popular in other jurisdictions in recent years. According to the bill’s sponsors, however, U.S. financial institutions have lagged behind due to the lack of a regulatory framework. Senator Hagan indicated that the proposed legislation “would level the playing field for U.S. financial institutions.”

American investors’ demand for this product is high, as such investors have funded over $37 billion of covered bonds issued by foreign financial institutions so far in 2011. Seeking to make the most of such high demand, senators in support of the bill wish to allow American institutions of all sizes to issue the debt instrument.

Not everyone is fully supportive, however. The Federal Deposit Insurance Corporation, a government entity that guarantees US bank deposits, has expressed concerns that the use of covered bonds may reduce the banks’ assets for their deposit funds.

A similar covered bond bill was passed in June by the House of Representatives Financial Services Committee, though it has not been voted on by the full House. Both bills seem to have bipartisan support, which bodes well for the timely implementation of covered bond legislation in the U.S.

In Canada, covered bonds have become a popular source of funding for domestic banks during recent years. Canada, however, also lacks a legislative framework for covered bonds.  The Department of Finance issued a consultation paper on May 11, 2011, setting out the main elements of a proposed legal framework for covered bonds.