Earlier this week, Representative Scott Garrett (R-NJ) introduced an amendment to the proposed financial reform legislation that will establish a regulatory framework for a covered bond market in the United States.  The House side of the reconciliation committee quickly passed the measure – the Senate side is now considering it.  This development is welcomed news to a banking industry that has craved a covered bond market for some time now.  For our part, we’ve been examining covered bond structures since the advent of the credit crises as our clients continued to try to devise a workable structure, so we’re very excited by this development. 

Covered bonds, which have been part of the European financing vernacular for over 200 years, function as a cross between an unsecured corporate bond and an asset-backed security.  Typically, a financial institution will issue a direct-recourse bond which is also secured by a specified pool of assets that remain on the financial institution’s balance sheet.  These are attractive to investors for many reasons, most important of which is that the investor has recourse to a specified pool of assets in the event the financial institution becomes insolvent, unlike typical unsecured corporate bonds that depend solely on the issuer’s credit.

Representative Garrett indicated last week at the CREFC conference in New York that he intended to introduce a covered bond proposal.  The proposed amendment directs the Treasury Department to establish a covered bond regulatory oversight program. (NOTE:  A link to the text of the proposed covered bond amendment is contained in this article from the Atlantic).  Under the proposed amendment, eligible issuers (which include FDIC insured depository institutions and bank holding companies) would be permitted to issue covered bonds pursuant to a covered bond program approved by the Treasury.  The issuance would be required to have an original term to maturity of at least 1 year and to be secured by a "cover pool" of eligible assets (and certain substitute or ancillary assets) from a single eligible asset class.  The eligible asset classes include, among others, residential mortgage loans, commercial mortgage loans, student loans, credit card receivables and car loans.

Although far from a done deal, the amendment seems to have some support, and we are optimistic that a regulatory framework for a covered bond market will be part of the final financial reform legislation.  A vibrant covered bond market could provide additional liquidity and financing sources to financial institutions which can only help to spur the recovery of the capital markets.  In addition, the structure of covered bonds seem to accomplish a lot of the stated goals of the financial reform legislation – particularly Congress’s desire for "skin in the game", as all of the assets in the "cover pool" will remain on the financial institution’s balance sheet.

We will continue to monitor the proposed legislation as it works its way through the reconciliation process.

Stay tuned …