There has been a lot of discussion in the financial press and in the securities industry that covered bonds may be the next big growth area in the United States and provide a source of relief for the ailing debt markets. While the degree of utilization remains uncertain and dependent on the acceptance of the market, the emergence of covered bonds in the United States appears imminent. This alert provides background on covered bonds and explains recent regulatory developments in the industry.
What are Covered Bonds?
Covered bonds are a type of general obligation security issued by a bank and backed by an overcollateralized pool of mortgages called a “cover pool.” Interest on a covered bond is paid by the issuing bank’s cash flow and the cover pool serves as collateral for the bond. Covered bonds may be backed by quality residential or commercial mortgages and, in some instances, other high quality asset classes. Covered bonds are similar to mortgage-backed securities such as CMBS in that covered bonds are securities backed by a pool of mortgages, but are distinct in the following key ways:
- the underlying mortgages remain on the balance sheet of the issuing bank;
- the bondholders have dual recourse to both the issuing bank and the cover pool;
- the cover pool is monitored and modified based on changes in the pool and is not static akin to a REMIC trust; and
- most covered bonds are created to receive a AAA rating whereas mortgage-backed securities and collateralized debt obligations have varying rating levels.
Covered bonds are able to obtain a high rating because the pools are overcollateralized with high-quality assets and employ an independent asset monitor. The asset monitor routinely examines the cover pool to ensure that underperforming loans are removed and new qualifying loans are replaced to meet the proper level of overcollateralization. Issuing banks, therefore, need a steady stream of high-quality mortgages to swap into cover pools.
The Background of Covered Bonds
Covered bonds have been utilized in Europe for over two hundred years and are a large driver of mortgage funding there, but covered bonds have yet to be embraced by banks or investors in the United States. Only Bank of America, N.A. and Washington Mutual have issued covered bonds, with the first issuance occurring in 2006. Other large banks in the United States have hinted that they are in the process of introducing a covered bond product, but the movement toward widespread acceptance of covered bonds is in its infancy.
Although banks already have the ability to issue covered bonds in the United States, banks have not done so because they were able to move mortgages off their balance sheets through mortgage-backed securities. Now that the purchase of mortgage-backed securities has stalled, covered bonds may be one source of added liquidity. However, prospective issuers also need to assess the impact of increasing or retaining loans on their balance sheets in light of the proposed capital adequacy requirements of Basel II. In order for a covered bond market to materialize, the apprehensive investors that have withdrawn from the mortgage-backed securities market would need to find comfort in the credibility of the asset monitor and the other features that differentiate covered bonds from mortgage-backed securities.
In an effort to spur liquidity, United States policymakers have recently adopted several measures related to covered bonds. On April 23, 2008, the Federal Deposit Insurance Corporation (the “FDIC”) issued the Interim Final Policy Statement providing the first regulatory input on covered bonds. Thereafter, the FDIC accepted and evaluated over one hundred comments from interested parties. The result was the Final Covered Bond Policy Statement (the “FDIC Statement”) issued on July 15, 2008. As a compliment to the FDIC Statement, the Department of the Treasury (the “Treasury”) issued the Best Practices for Residential Covered Bonds (the “Treasury Statement”).
Both the FDIC Statement and the Treasury Statement were intended to provide guidance for banks issuing covered bonds and to promote stability to entice prospective investors. One concern of prospective investors is the treatment of the underlying collateral in the event of an insolvency of the bond issuer.
Section 11(e)(13)(C) of the Federal Deposit Insurance Act creates an automatic stay of forty-five days in the event of a conservatorship and an automatic stay of ninety days in the event of a receivership prior to the liquidation of an issuer’s assets. The FDIC Statement provides limited scenarios where covered bondholders can obtain an advance consent to the automatic stay such that bondholders could have expedited access to the pledged collateral in certain circumstances. Most notably, this automatic stay is only available to covered bonds secured by “eligible mortgages” which encompass first-lien residential mortgages and exclude commercial mortgages and other asset classes. Also, the issuing bank’s covered bond obligations may not comprise more than 4% of the total liabilities which may dampen the overall market impact of covered bonds.
While the FDIC Statement and the Treasury Statement provide more structure and clarity on certain covered bond issues, it is too early to determine if they will jump start the covered bond market. The FDIC Statement stopped short of incorporating certain recommendations industry associations and other interested parties requested during the comment period. Both agencies repeatedly and explicitly leave room for future changes as the industry develops. It is uncertain whether policymakers will eventually provide the same coverage for other asset classes and whether they will expand the coverage to have a greater impact on the credit markets.
Proponents view covered bonds as a new and additional vehicle for addressing the liquidity crisis. Even the most ardent proponents such as the Treasury agree that covered bonds are not a “magic bullet” to fix current financial woes, but instead will be one weapon in an arsenal of solutions needed to work through the problems in the financial and housing markets. The extent of the role covered bonds will play in the United States is still to be determined, but given the recent level of attention, covered bonds will be an important area to monitor in the next few months.