Key Points:

Momentum is building around the implementation of specific covered bonds legislation in the U.S. and, to a lesser extent, in Australia.

The global financial crisis has been a catalyst for some dramatic shifts in the global financial landscape - some commercial (such as reduced liquidity and reduced appetite for risk) and others regulatory.

For financial institutions which previously relied heavily on securitisation to attract offshore funding, the global financial crisis has proved challenging; as we all know, the securitisation market has effectively been closed for the past 12 months (although there have been signs of life more recently).

The market for covered bonds, on the other hand, has proved to be much resilient - in one particular week during September of this year, over $20 billion of covered bonds was issued throughout Europe. Australian and the U.S. financial institutions are, however, notably absent from the group of issuers currently benefiting from what has been dubbed as an "unprecedented supply frenzy". As a consequence, without support from their respective governments, financial institutions in Australia and the U.S. are at a distinct competitive disadvantage when it comes to tapping wholesale capital markets. As discussed below, this fact has not been lost on the governments of Australia or the U.S..

Although by all accounts it is still very early days, the Commonwealth Treasury appears to be considering a proposal to implement a legislative framework under which ADIs would be permitted to issue covered bonds in Australia. Coincidently (or perhaps not), the U.S. House of Representatives has also recently been giving off signals that the implementation of specific covered bond legislation may be on the horizon.

For those readers who are not familiar with covered bonds, it is fair to say that generally a covered bond is a full recourse debt security backed by a dynamic pool of assets. The key point of difference between a covered bond and a securitisation bond, therefore, is that not only does the holder or a covered bond have recourse to a pool of assets but it also has recourse to the issuing or sponsoring financial institution.

Developments in Australia

In November 2008, the House of Representatives Standing Committee on Economics recommended that "the Treasury examine the appropriateness and feasibility of allowing Australian authorised deposit-taking institutions to issue covered bonds." In July 2009, largely in response to imploding investor appetite for securitised paper and following consultation with key industry stakeholders, the Australian Securitisation Forum (the ASF) made a submission to the Commonwealth Treasurer setting out the need for a legislative framework which would permit ADIs to issue covered bonds.

The ASF submission canvasses the factors supporting the establishment of a covered bond market in Australia (currently, APRA does not permit ADIs to issue covered bonds on the basis that such an issue may constitute a breach of the depositor protection provision contained in section 13A(3) of the Banking Act 1959 and paragraph 7 of Prudential Standard APS 120 - Securitisation) and outlines the ASF's proposed legislative framework, including setting out two possible issuance structures. In particular, the ASF submission argues that a legislative framework is preferable to a contractual framework as it will provide the "greatest level of certainty to support each covered bond transaction". Reading between the lines, all other things being equal, a legislative framework should result in greater international investor support and (hopefully) tighter pricing.

Key features of the legislative framework proposed by the ASF include the following:

  • specific legislation would be enacted to govern covered bond issuance in Australia and section 13A(3) of the Banking Act would be amended;
  • APRA would be responsible for regulating and ensuring compliance with the implemented legislative framework and would be granted additional powers for this purpose. Specifically, APRA would be responsible for regulating the classes and quality of assets eligible to be included in cover pools, the limits on the volume of bonds that may be issuance by each ADI, the treatment of defaulting assets in the cover pool and hedging requirements;
  • only ADIs specifically licensed by APRA for the issuance of covered bonds would be eligible to issue; and
  • a statutory charge would be created over cover pool assets for the benefit of bond-holders.

It appears that Treasury has taken note of the House of Representatives Standing Committee on Economics' recommendation. We understand that representatives of the Treasury have met with the ASF and requested supporting information in relation to certain aspects of the ASF submission, in particular the assertion that investor preference would be for a legislative framework as opposed to a contractual framework (like the one under which UK covered bond issuance occurs).

It is further understood from the ASF that one of the key messages coming from Treasury is that its strong preference is for a model capable of facilitating issuance by all ADIs, not just by the big four. Given the size of some Australian ADIs, satisfaction of the Treasury's preference may mean adopting a multi-seller model similar to those used in Spain (ie. multi-seller cédula). Time will tell.

Developments in the U.S.

With explicit reference to flourishing European covered bond markets, and in the broader context of a prevailing lack of liquidity for U.S. financial institutions, on 18 November 2009 U.S. Republican Representative Scott Garrett proposed to the U.S. House of Representatives an amendment to the Financial Stability Improvement Act 2009. The key provisions of the Garrett amendment set out a legislative framework under which covered bonds could be issued.

According to Garrett, a statutory framework governing the issuance of covered bonds will result in certainty as to the recourse an investor will have to the issuing or sponsoring financial instruction and will thereby instil investor confidence.

Following a request from the U.S. House Financial Services Committee Chairman Barney Frank, the Garrett Amendment was withdrawn on the basis that the Committee had more pressing business. However, commentary suggests that the Garrett Amendment will be the subject of further debate in December 2009 and will eventually find its way into the final version of the bill for the Financial Stability Improvement Act 2009. Accordingly, it worth considering some of the features of Garrett's proposed legislative framework.

The statutory framework proposed by the Garrett Amendment borrows heavily from the model supported by the U.S. Treasury[1] and also seeks to codify certain policies of the Federal Deposit Insurance Corporation. Those key features are as follows:

  • specific legislation would be enacted to govern covered bond issuance in the U.S.;
  • only eligible issuers approved by the regulator would be permitted to issue covered bonds. Eligible issuers include insured depository institutions, bank holding companies and any issuing entity that is sponsored by one or more eligible issuers for the sole purpose of issuing covered bonds on a pooled basis;
  • the covered bonds must be a senior recourse debt obligation of, but not a deposit with, an eligible issuer;
  • the covered bonds must be secured by a cover pool owned by the eligible issuer. Cover pools can only include assets from a single eligible asset class as well as certain other ancillary assets and substitute assets. Eligible asset classes suggested in the Garrett Amendment include residential mortgage, commercial mortgage, public sector, auto, student loan, credit card and small business assets. In addition, a cover pool can generally contain up to 20 percent of securitised paper backed by assets of the relevant class;
  • the Secretary of Treasury will act as the regulator for covered bonds and will be required to maintain a register available to the public containing the details of each approved issuer as well as information of outstanding issuances under that issuer's program. In addition, the regulator will be required to set and periodically test over-collateralisation requirements; and
  • following default in relation to the covered bond or an insolvency or similar event in relation to the issuer, the cover pool shall be sequestered to a separate "estate" which will be fully liable for the covered bonds. In addition, holders of covered bonds will retain any claim against the issuer to the extent of any deficiency in moneys owed versus moneys recovered from the estate holding the cover pool.

Conclusions

Momentum is building around the implementation of specific covered bonds legislation in the U.S. and, to a lesser extent, in Australia. The general expectation is that any such legislation would enable financial institutions in those countries to more readily tap wholesale capital markets without support from their respective governments. Ultimately, whether the proposals put forward by the ASF and/or Garrett will be successful in prompting legislative action on covered bonds remains to be seen.