The U.S. market for covered bonds may be a step closer to reality thanks to the efforts of New Jersey Congressman Scott Garrett, who introduced an amendment during the House Financial Services Committee's markup of the Financial Stability Improvement Act of 2009.
The amendment is similar to the Equal Treatment for Covered Bonds Act Garrett introduced this summer in that it aims to pave the way for the creation of a U.S. market for covered bonds at a time when many outlets for lenders, like securitization, have been shut off. The proposed legislation calls for, among other things, the Federal Deposit Insurance Act (FDIA) to be amended to treat covered bonds the same way as other FDIA-qualified financial contracts when the depository institution parties enter receivership or conservatorship.
The committee's chairman, Rep. Barney Frank (D-Mass.), requested that Garrett withdraw the amendment during the markup process, but called the Garden State's Republican congressman "a very staunch advocate of a very good idea."
Frank also stated that the housing subcommittee should hold a hearing on the issue of covered bonds, and promised Garrett "the commitment for a hearing in December and the likelihood of being able to put this in the bill in the final version," noting that the committee was already planning to hold a hearing on the Federal Housing Administration (FHA) after Thanksgiving.
Steve Adamske, a spokesman for Frank, told Invesment Dealers Digest a hearing date has not been finalized but will be announced one week in advance.
The promise of a hearing was greeted positively by advocates of the asset class, which was touted by U.S. regulators as an alternative to securitization and a possible panacea for problems in the housing market in the summer of 2008.
Covered bonds, first issued in Germany in 1770, still have not taken off in the U.S., despite a policy statement from the Federal Deposit Insurance Corp., encouraging words from then-Treasury Secretary Henry Paulson and a set of best practices from the Treasury Department.
No new covered bonds have been sold by U.S. issuers because, among other reasons, no official U.S. legislation related to the asset class has been passed.
The creation of a market for the asset class was put on the back burner in the wake of the Lehman Brothers bankruptcy and Fannie Mae and Freddie Mac receiverships, and the usually open European covered-bond market was temporarily shut during the Lehman bankruptcy aftermath.
"Even though the amendment was withdrawn, we have a positive view because of what chairman Frank said," says Sean Davy, a managing director at the Securities Industry and Financial Markets Association (SIFMA) responsible for corporate securities. "There are not enough people conversant in covered bonds and the benefits of what they have to offer, and a hearing would allow for a forum to both educate people as well as build further support. Even if something doesn't get out there within the momentum of the larger regulatory reform package, we're still several steps further along than we were six months ago."
SIFMA and the American Securitization Forum launched a U.S. covered bond council last year. The council's steering committee met for the first time on Dec. 2, 2008.
"It's a good first step, but more work needs to be done," says Tim Skeet, head of covered bonds at Bank of America Merrill Lynch. "At long last, it's put the creation of a U.S. covered-bond market back on the agenda. The need for this has become greater, and the case has become even more compelling, so we feel confident that legislators will understand the case and will be very supportive once they've had the opportunity to debate."
So far, only two U.S. issuers, Washington Mutual and Bank of America, have sold covered bonds, having done so in 2006 and 2007.
"There will be people who will want to issue it if investors can be persuaded to invest in it and buy it at an acceptable price," Skeet said. "The most important job will be to persuade investors we have a high-quality, secure asset class which will be significantly less volatile than other parts of the capital markets have been."
The rejuvenation of the European market will support the debate in the U.S. "Every asset class suffered and covered bonds were not exempt, but when it came to the recovery phase, covered bonds were the first to recover — we saw issuance right from January, with a very impressive recovery and a rapid tightening of spreads," Skeet said. "This is a positive example for us to look at, from a U.S. perspective, regarding how the asset class is capable of recovering from a period of shock."
The parameters within Garrett's amendment would also make U.S. covered bonds more attractive to issuers and investors.
"The reception in the European market for bonds issued under the proposed legislation would be considerably better than the reception the original Bank of America and Washington Mutual deals received because the structure would resemble a European covered bond," says Jerry Marlatt, senior of counsel at Morrison & Foerster and a member of its covered-bond group. "On the other hand, covered bonds are a good segue to opening up the mortgage market in the U.S. because pretty much all U.S. mortgage financing at the moment is done through Fannie, Freddie and Ginnie; the private MBS sector is virtually nonexistent. The primary liability on a covered bond is the bank, not the collateral, because the collateral pool is updated every month, so it may be a more attractive investment in this climate than RMBS."
Garrett's amendment would allow the collateral in a covered bond "to be released to an estate separate from the estate of the bank" if the issuing bank defaults or becomes insolvent, says Marlatt. "That's the same idea you find in European covered bonds, but it's the first time where that's been suggested in the U.S."
Once the separation has occurred, the collateral pool would be able to borrow from the Federal Financing Bank. Thus, the amendment "provides liquidity to the collateral pool to meet payment obligations on the covered bonds, so the bank doesn't necessarily have to sell collateral in adverse market conditions," says Marlatt. "This is something that doesn't appear in European legislation."
Another difference between U.S. and European covered bonds under Garrett's proposed framework: asset variety. "Under the amendment, the array of assets you would be able to use is much broader than you find in Europe," said Marlatt (who spoke with IDD earlier this year). "When you set up a covered-bond program you would have to restrict it to one class of assets, but you can set up more than one program, so you would be able to do covered bonds with not only commercial or residential mortgages but also car loans, student loans, credit card receivables, state and municipal obligations, etc."
Citigroup, Bank of America, Wells Fargo and JPMorgan Chase, which strongly supported Paulson's efforts in July 2008, are likely prospects for issuing new U.S. covered bonds going forward, since they "are the predominant players in the mortgage market after Fannie and Freddie," Marlatt said.
Benefits to housing aside, there is another impetus for covered-bond issuance.
According to a report issued last month by Moody’s Investors Service, banks covered by the credit rating agency will likely see $10 trillion of debt mature by the end of 2015, $7 trillion of which will mature by the end of 2012.
“If the whole banking system needs to refund liabilities in a three-to-five-year period, it’s a pretty onerous task particularly if interest rates creep up,” Davy said. “What you need is a broader mix of obligations for them to term out some of their debt, and covered bonds are a great option to do that. If you create something high-quality with a very solid framework, you can attract a bunch of new investors to support the banking system, such as those who conservatively invest now in Treasurys and agencies. That should add stability to the system.”