Covered bond legislation is once again a hot topic on Capitol Hill. Representative Scott Garrett (R-NJ) co-sponsored the latest iteration of his proposed legislation (United States Covered Bond Act of 2010 or H.R. 5823 (pdf)) along with Representatives Kanjorski (D-NJ) and Bachus (R-AL). The House Financial Services Committee recently voted in favor of reporting H.R. 5823 to the full House of Representatives for consideration, which hopefully will be taken up for a vote this fall shortly after the August recess.

You might recall that Representative Garrett almost succeeded in getting covered bond legislation into the Fin Reg package that passed last month . Lacking one vote (pdf), and facing scrutiny from the FDIC, the language found itself on the cutting room floor when Fin Reg ingloriously exited the reconciliation process. Notwithstanding these setbacks, Garrett’s latest attempt to push this legislation through appears to have some momentum in the Senate as well—Senator Bob Corker (R. Tenn.) has asked for the Senate Banking Committee to hold hearings on the topic. In addition, H.R. 5823 has drawn the strong support of industry groups such as the Commercial Real Estate Finance Counsel, SIMFA and the American Securitization Forum.

Covered bonds function as a cross between an unsecured corporate bond and an asset-backed security, representing both a direct-recourse obligation of the financial institution that issued the bond, and an obligation secured by a specified pool of assets that remain on the financial institution’s balance sheet. They are old (like, centuries old) and safe (well, they are supposed to be). Under H.R. 5823, eligible issuers (including FDIC insured depository institutions, bank holding companies and other approved non-bank financial companies) would be permitted to issue covered bonds secured by a pre-defined set of eligible assets (such as commercial or residential mortgage loans) pursuant to an approved covered bond program.

Although H.R. 5823 (again, which is likely to continue to morph as it works its way through the House and Senate and into the Oval Office) is similar in many respects to the previously introduced versions, there is one key pragmatic difference worth highlighting—a difference that will certainly delay the establishment of a covered bond market in the United States. Representative Melissa Bean (D-Ill.) introduced an amendment in the committee process requiring multiple Federal agencies (instead of the Comptroller of the Currency as originally proposed in H.R. 5823) to jointly establish a covered bond regulatory oversight scheme. Workable? Hardly … it’s a bad idea. Given what Fin Reg has already saddled the agencies with, when will they get around to a jointly produced workable oversight scheme? I am not overly optimistic.

Aside from what H.R. 5823 provides in its current form, the more interesting debate is whether any covered bond legislation will create a robust new alternative source of capital for banks and other eligible financial institutions. With deals getting done in 2009, and several more in the pipeline before year end, it’s not at all clear that issuers will jump on the bandwagon. Although there appears to be investor appetite for covered bonds in the United States, and the structure of covered bonds accomplishes Congress’ desire for skin in the game, it’s just not clear eligible issuers will want to keep all of their skin in this game, or whether a covered bond market will provide a cheaper (or even a cost competitive) source of capital. Only time will tell, assuming H.R. 5823 ultimately becomes law. For our part, we welcome the opportunity to do new types of deals.

The good news for proponents of covered bond legislation is that both the House and the Senate seem interested, at least for now, in passing some form of covered bond legislation. We will continue to monitor this proposed legislation as it works its way through the House and the Senate.

Stay tuned…

By Stewart McQueen.