Alert July 29, 2008

FDIC Board Approves Final Policy Statement on Covered Bonds

The FDIC’s Board of Directors approved a final Covered Bond Policy Statement (the “Policy Statement”) designed to facilitate the “prudent and incremental development” of the US Covered Bond (as defined below) market.  The FDIC said that, although Covered Bonds are popular and widely used in Europe (more than $2 trillion of Covered Bonds issued), subject to regulatory supervision, and they are also used elsewhere outside of the US, currently there are no statutory or regulatory prohibitions in the US on the issuance of Covered Bonds by US banks.

Covered Bonds are defined by the FDIC in the Policy Statement as non-deposit, general obligation bonds issued by an FDIC-insured depository institution (an “IDI”).  Covered Bonds are secured by a pledge of mortgage loans that (as contrasted to the accounting treatment in asset securitization transactions) remain on the IDI’s balance sheet.  In addition, Covered Bonds are non-recourse obligations and, as defined in the Policy Statement, must have a term greater than one year and no more than thirty years.  Importantly, Covered Bonds are structured to provide assurance to an investor that the investor will receive timely payment of principal and interest even if the issuing IDI fails.  Investors in Covered Bonds are protected from a decline in the market value of the underlying collateral because if the loan values fall below certain pre-determined thresholds, the IDI must contribute additional performing assets to the collateral pool underlying the Covered Bonds. 

The FDIC stated that the Policy Statement is designed to provide guidance on the treatment of Covered Bonds in the case of an IDI’s failure and guidance as to when an investor in Covered Bonds issued by an IDI that has failed will be granted expedited access to the pledged collateral underlying the Covered Bonds.

The Policy Statement only applies to Covered Bond issuances made with the consent of the IDI’s primary federal regulator.  In addition, the IDI’s total Covered Bond obligation (including its obligation in the then current issuance of Covered Bonds) under the Policy Statement may not exceed 4% of the IDI’s total liabilities.  Moreover, under the Policy Statement, the collateral pool underlying the Covered Bonds must consist of: (1) perfected security interests in performing residential mortgages underwritten in accordance with existing supervisory guidance, or (2) to a limited extent, AAA-rated mortgage-backed securities backed solely by eligible mortgages (the mortgage-backed securities may not equal more than 10% of the collateral for any Covered Bond issuance).  The Policy Statement provides generally that an investor in a Covered Bond issued by a failed IDI may, after the expiration of a 10 business day period following delivery of written notice to the receiver or conservator, “exercise its contractual rights, including liquidation of properly pledged collateral by commercially reasonable and expeditions methods taking into consideration existing market conditions, provided no involvement of the receiver or conservator is required.”

The Policy Statement became effective on July 28, 2008.  On the effective date, both FRB Governor Kevin Warsh and Secretary of the Treasury Henry Paulson heralded Covered Bonds as a creative product innovation, which may be successfully exported from the European markets to the US markets and that illustrates the potential benefits of globally connected financial markets.  The Department of the Treasury also issued related guidance concerning best practices for residential Covered Bonds.