Following closely on the footsteps of the FDIC, the U.S. Treasury Department on July 28, 2008, released a “Best Practices” statement (“Statement”) providing guidance on what Treasury Secretary Henry M. Paulson, Jr. hopes will become a burgeoning market for residential mortgage loan covered bonds in the U.S. However, noting that the Statement is intended to complement the final Covered Bond Policy Statement issued by the FDIC on July 15, 2008 (“FDIC Policy Statement”), the Statement imposes additional requirements in the context of covered bond issuances without expanding the market’s scope beyond the parameters already set by the FDIC.
In particular, the Statement notes that, unlike in the context of a mortgage backed securitization transaction, the cover pool collateralizing a covered bond issuance is dynamic and requires continual management by the issuer. Issuers must replace non-performing mortgage loans on a regular basis, perform a monthly Asset Coverage Test to ensure that the bonds remain overcollateralized by at least 5%, and perform quarterly valuation tests to ensure that the maximum loan-to-value ratio for mortgages contained in the cover pool does not exceed 80%. In addition, all loans must be first-lien only, cannot include any provision for negative amortization, and cannot include any geographic concentration in excess of 20%. The Statement also reiterates the requirements for covered bonds outlined in the FDIC Policy Statement, including the requirement that covered bonds have a minimum maturity of one year and a maximum maturity of 30 years.
Issuers must provide regular disclosure to investors (on at least a monthly basis and more regularly upon the occurrence of certain triggers) concerning the cover pool’s characteristics and performance. The Statement calls attention to the regulatory regime provided by the Securities and Exchange Commission’s Regulation AB, noting that it “provides a helpful template for preparing pool level information” in this context.
Among other structural guidance, the Statement also specifies that issuers must enter into a guaranteed investment contract or other arrangement (“GIC”) in which any proceeds from cover pool assets must be invested. Upon the insolvency of the issuer, the GIC will continue to make payments on the bonds to the extent funds are available, thereby preventing an acceleration of the bonds.
On a more positive note, the Statement expressed the point that the “best practices” should not constrain the market as it develops, noting particularly that the collateral securing covered bonds may eventually expand into other asset classes. With at least four large banks ready to institute a covered bond program,1 industry participants and regulators should get their opportunity to examine the costs and benefits of a fledgling U.S. covered bond market, which hopefully will create the impetus to further broaden the regulatory landscape and, consequently, the U.S. covered bond market.
While the European covered bond market dwarfs that in the U.S., the likely U.S. issuers – banks and thrifts – have access to various other liquidity sources, many backed explicitly or implicitly by the U.S. government, that are not so readily available to European issuers. As against the U.S. alternatives – Federal Home Loan Bank advances, Federal Reserve Bank borrowings, warehouse lines of credit, and Fannie Mae and Freddie Mac purchases – covered bonds with a minimum maturity of one year may offer an important advantage in managing duration and interest rate risk. Exactly what price the market will place on this advantage will be interesting to see.