Moody’s Investors Service believes that the covered bond legislation unanimously approved by the House Financial Services Committee on July 28 will help covered bond buysiders by setting up investor-friendly procedures following an issuer default.
However, there is also a downside because the structure requires overcollaterilzation levels that will not address market value risk. The development of this market can also lead to different standards for different types of issuers, the credit rating agency said.
The bill protects investors in both existing and new transactions by creating a mechanism for transferring the cover pool following issuer default. Under the legislation, following the Federal Deposit Insurance Corp.'s (FDIC) appointment as receiver of a failed bank issuer of covered bonds, the FDIC can sell the covered bond program to a solvent issuer within 180 days, according to Moody’s. The FDIC must continue to make scheduled payments on the covered bonds during this time.
For nonbank issuers — and if the FDIC doesn’t decide to sell the program or make the scheduled payments — the bill requires the automatic transfer of the cover pool to a separate legal estate, which an administrator would manage in an orderly manner over time to make scheduled payments . The administrator would only sell assets when their natural amortization is insufficient to make scheduled payments to investors, according to the agency.
The wind-down approach avoids market value risk better than in the current system, where investors are exposed to the risk of having to liquidate the entire cover pool in the market with a short period of time following issuer default.
The bill offers protection for investors by providing protections to the administrator created to minimize disruption, protecting the administrator from lawsuits by covered bondholders. After an issuer default, investors in covered bonds with varying maturities may have divergent interest in how to administer the cover pool and some may threaten to sue the administrator and disrupt the management of the pool, according to Moody’s.
The legislation would preserve investors’ potential deficiency claims against an issuer’s estate, allowing them to make those claims in the future if the cover pool turns out to be insufficient. Without these protections, investors would have to wait for the cover pool to pay off and for a claim to materialize before filing.
The bill would require regulators to set minimum overcollateralization levels, but specifically directs them not to take into account liquidity risk, which Moody’s believes is the biggest risk facing covered bond investors in the event of an issuer default. Because the bill does not require issuers to match maturities of assets and liabilities, it fails to address the risk for investors if a sale of part of the cover pool to pay off the bonds occurs in distressed market conditions. “The bill does not standardize the industry,” Moody’s analysts stated.
Additionally, the legislation could also lead to inconsistency between the requirements for different types of institutions. The current version appoints the issuer’s primary regulator as the covered bond regulator, unlike previous versions of the proposed legislation. Different issuers will therefore have different regulators depending on their charters, and since the regulators are responsible for setting standards, this feature could lead to inconsistency between programs and reduce transparency. It could also lead to a conflict of interest since the goals of the issuer’s primary regulator may not always be aligned with covered bondholders, according to Moody’s.