Covered bonds are back on legislators’ lists of bank financing alternatives. Long an integral part of the European financial markets, covered bonds figured prominently on U.S. regulators’ radar in 2008, until the potential opportunity they offered was eclipsed by a deepening credit crisis. The FDIC issued, on July 15, 2008, the first formal guidance on covered bonds, the “Final Covered Bond Policy Statement” (the “Covered Bonds Statement”), following several months of comment on its April 23, 2008 “Interim Final Covered Bond Policy Statement” (the “Interim Covered Bond Statement”). Less than two weeks later, on July 28, 2008, the Department of the Treasury (“Treasury”) published “Best Practices Guide for US Residential Covered Bonds” (the “Covered Bond Best Practices”). Both the FDIC’s Covered Bond Statement and Treasury’s Covered Bond Best Practices focused on providing guidance for what are generally referred to as structured covered bonds rather than statutory covered bonds since both addressed covered bonds that relied on structuring and regulatory guidance rather than a statute.
The United States Covered Bond Act of 2010 (the “Covered Bond Act” or the “Act”) introduced on March 18, 2010 by Representative Scott Garrett, along with co-sponsors Representative Paul E. Kanjorski and Financial Services Committee Ranking Member Spencer Bachus, however, would provide a U.S. statutory framework for covered bonds potentially similar to that afforded certain European covered bonds and offer a financing alternative for a range of asset classes. Under the Act, the Secretary of Treasury (or other appointed officer of Treasury) would oversee the regulation of the covered bond market, including authorization to approve all covered bond programs launched in the market, following mandatory consultation with the potential issuer’s applicable federal regulator (referred to here, generally as the “Federal Bank Regulator”). Treasury’s Covered Bond Best Practices, which incorporates guidance from the FDIC’s Covered Bond Statement, may provide insight into Treasury’s covered bond regime should the Covered Bond Act be enacted. Highlights of the Covered Bond Act follow.
What covered bonds would be subject to the Act?
The Covered Bond Act would apply to and govern only a covered bond that is a senior recourse debt obligation of an “eligible issuer” that (i) has an original term of not less than one year, (ii) is secured directly or indirectly by a perfected security interest in a “cover pool” owned directly or indirectly by the issuer, (iii) is issued under a “covered bond program” that has been approved by Treasury and identified in a public register maintained by Treasury, and (iv) is not a deposit (as defined in Section 3 of the Federal Deposit Insurance Act). Notably, the Act itself would not impose a maximum maturity as the Covered Bond Statement had (30 years, increased from a maximum maturity of 10 years under the Interim Covered Bond Statement). Eligible issuers would be insured depository institutions and their subsidiaries, bank holding companies and thrift holding companies, and vehicles established solely to issue covered bonds and sponsored by one or more otherwise eligible issuers. This third category might provide options for a number of smaller banks each of which might be too small to sponsor a covered bond program on its own.
What happens on default and insolvency, conservatorship or receivership?
One of the key features of a covered bond is that, while the bond’s issuer (or sponsor, in the case of a special purpose issuer) owns the cover pool and pays interest from its general income, the covered bond is backed by an identified pool of high quality assets. Bondholders have recourse to that cover pool if the bond defaults or the issuer becomes insolvent or subject to a conservatorship or receivership (or similar proceeding); and, if the pool is inadequate to cover the issuer’s obligations on the bonds, bondholders have an unsecured claim against the issuer (or the FDIC, as conservator or receiver, or other applicable estate or party). In keeping with this typical covered bond structure, the Covered Bond Act would establish the automatic creation, by operation of law, of an estate comprised of the cover pool (the “Cover Pool Estate”) upon (i) if prior to the insolvency, conservatorship or receivership (or similar proceeding) of the issuer, a default of the covered bond and (ii) an insolvency, conservatorship or receivership (or similar proceeding) of the covered bond issuer.
Default of Covered Bonds. Upon a default on the covered bonds, the cover pool would be “automatically released to and held by [the] estate free and clear of any right, title, interest, or claim of the issuer or any conservator, receiver, liquidating agent or trustee in bankruptcy.” The issuer, however, would retain a residual interest representing a right to any surplus from the cover pool after all liabilities would have been paid in full. The Cover Pool Estate would be “fully liable” on the covered bonds and any related obligations. Notwithstanding the creation of the Cover Pool Estate, bondholders would retain claims against the issuer for any deficiency on the covered bonds or related obligations. At the election of Treasury, the issuer would be obligated to continue to service the cover pool for a maximum of 120 days after the creation of the estate in exchange for a fair market value fee. Notably, if a covered bond failed mandatory asset-coverage tests after its issuance, it would continue to be subject to the Act. Under the proposed statute, an issuer would have one month to cure its failure to meet its asset-coverage test before such failure would result in the creation of a Covered Pool Estate.
Insolvency of Covered Bond Issuers . In the event the FDIC were appointed as receiver or conservator of the issuer prior to a default under the issuer’s covered bonds, the FDIC would have the option to elect, within 15 days, to transfer any cover pool in its entirety to another eligible issuer. During such 15-day period, the FDIC would be required to satisfy all outstanding obligations of the issuer. (This is a significant difference from the FDIC’s Covered Bond Statement, which could potentially leave bondholders with no right to interest for a 10-day period.) If the FDIC were able to transfer the covered bonds (and respective cover pools), the transferee would become responsible for all outstanding obligations of the original issuer. If the FDIC were unable to transfer the covered bonds and related cover pool to an eligible issuer, a Cover Pool Estate would be automatically created with the residual interest being retained by the conservator, receiver, liquidating agent or bankruptcy estate, as applicable. As where the bonds have defaulted, if a Cover Pool Estate were created, at the election of Treasury, the issuer would be obligated to continue to service the cover pool for up to 120 days after the creation of the Cover Pool Estate, and Treasury would be authorized to act as trustee of the estate and appoint one or more servicers which would have broad powers to manage the assets of the Cover Pool Estate.
What assets are eligible for a covered bond program under the Act?
Unlike under many mortgage-backed and asset-backed securities, a covered bond’s cover pool would be a dynamic pool of assets comprised of “eligible assets” from any single “eligible asset class,” “substitute assets” and “ancillary assets.” Eligible assets would be as identified in the Act with respect to each eligible asset class and could not be delinquent more than 60 consecutive days (in the case of loans) or be rated less than the highest investment grade rating (in the case of securities). The Covered Bond Act would establish the following eight eligible asset classes:
Residential Mortgage Asset Class would include first-lien mortgages secured by 1-to-4 family residential property, mortgage loans insured under the National Housing Act, loans guaranteed, insured or made under Chapter 37 of Title 38 of the United States Code and residential mortgage-based securities (“RMBS”) of the same asset class.
Home Equity Asset Class would include home equity loans secured by 1-to-4 family residential property and asset-backed securities (“ABS”) of the same asset class.
Commercial Mortgage Asset Class would include commercial mortgage loans and commercial mortgage-backed securities (“CMBS”) of the same asset class.
Public Sector Asset Class would include investment-grade securities issued by one or more states or municipalities, loans made to one or more states or municipalities and loans, securities or other obligations that are insured or guaranteed, in full or substantially in full, by the full faith and credit of the United States.
Auto Asset Class would include auto loans or leases and ABS of the same asset class.
Student Loan Asset Class would include student loans (whether or not such loans are guaranteed) and ABS of the same asset class.
Credit or Charge Card Asset Class would include credit or charge card loans and ABS of the same asset class.
Small Business Asset Class would include loans made under a program established by the Small Business Administration (whether or not such loans are guaranteed) and ABS of the same asset class.
The ABS, CMBS or RMBS included in any eligible asset class would be required to have the highest investment grade rating and could not exceed 20 percent of the outstanding principal of the assets in a cover pool. All loans that are eligible assets would be required to be in compliance with supervisory guidance applicable at the time of their origination. At its option, Treasury would be authorized to designate additional eligible asset classes and corresponding eligible assets. Substitute assets would include cash, direct obligations of the U.S. government, obligations, with the highest investment grade credit rating, guaranteed by the U.S. government, as well as direct obligations of U.S. government corporations and U.S. government sponsored enterprises and obligations, with the highest investment grade credit ratings, guaranteed by U.S. government corporations and U.S. government sponsored enterprises. Ancillary assets would include, in each case related to other assets in the cover pool, interest rate and currency swaps, credit enhancement and liquidity arrangements, guarantees, letter-of-credit rights and other secondary obligations supporting payment or performance of an asset, and proceeds.
Over-collateralization, Monitoring and Testing. Treasury would be required to establish minimum over-collateralization requirements based on the credit, collection and interest rate risks of each eligible asset class, but not the liquidity risks associated with such class. In doing so, Treasury would be authorized to rely on established Federal Reserve over‑collateralization levels. Each covered bond issuance would be required to maintain minimum asset coverage at all times and be subject to monthly testing based on these statutory minimum levels (apparently in addition to contractual levels).
The Covered Bond Act would require an issuer to disclose over-collateralization test results to its Federal Bank Regulator, Treasury and the bondholders. Each issuer would also be required to appoint an independent trustee or asset monitor, which would, among other things, monitor a cover pool’s compliance with applicable asset-coverage tests, at least annually, and report those results to the issuer’s Federal Bank Regulator, Treasury and the bondholders. Additionally, issuers would be required to deliver to the indenture trustee, at least monthly, a schedule of eligible assets in the applicable cover pool.Disclosure and Reporting. Treasury would be required, under the Covered Bond Act, to maintain a publicly available registry of each approved covered bond program and all covered bonds issued under those programs. In addition issuers would be required to register publicly-offered covered bonds unless the bonds were exempted securities and comply with substantial disclosure requirements at issuance and while the covered bond is outstanding. Covered bonds would be permitted to be offered to the public and in private placements. Registration of covered bonds offered by a bank (or bank subsidiary) issuer, and the information required to be disclosed in connection with offering the covered bonds issued by a bank (or bank subsidiary) issuer, would be subject to securities regulations issued by the Federal Bank Regulator of that bank (or bank subsidiary) and applicable antifraud rules, but such covered bonds would be exempt from other federal securities laws. Similar provisions would apply to covered bonds offered by issuers with multiple sponsors who were banks and had the same Federal Bank Regulator. Where the covered bonds were offered to the public and not otherwise exempted securities, however, the Act would mandate that the SEC “develop a streamlined registration scheme.” Disclosure at offering would be subject to compliance with that streamlined scheme and applicable antifraud rules.