As of yet, still, a U.S. covered bond market eludes us. Potentially a new source of funds for lending activity, a covered bond market in the U.S. would compliment the securitization market and the GSE market, enabling institutions to broaden their investor base with the dual recourse nature of covered bonds — recourse to a pool of assets that secures or “covers” the bond if the originator (usually a financial institution) becomes insolvent or otherwise fails to make payments on the covered bonds.
Without legislation to give investors certainty on how the FDIC would treat covered bonds in the event of an issuer’s insolvency, there is little hope of seeing any covered bond deals issued in the United States. Congressman Scott Garrett (R-NJ) is the author of the covered bond bill in the House but a similar bill has yet to be introduced in the Senate. On September 15, 2010, the U.S. Senate Banking, Housing and Urban Affairs Committee held a hearing on covered bonds. Congress may have a “lame duck” session after the election to take up urgent matters but it’s not likely that covered bonds will be deemed an urgent matter. If the bill is not voted on before final recess this session, the bill would need to be introduced anew in the next session of Congress in January.
There is no question that investor demand for covered bonds is there. The panelists at the SIFMA Spotlight Series on Covered Bonds earlier this week discussed the prevalence of “Yankee issuances” — issuances of covered bonds into the U.S. by issuers located in foreign countries such as Canada, France, Germany and the UK. Some serious U.S. investor cash reportedly to the tune of $20 billion has funded these issuances in 2010.
The FDIC has some issues with covered bonds that need to be resolved if this market is going to get going. The main hurdle is the FDIC’s concern with preserving its ability to recover collateral in exchange for payment of principal and interest due through the date of repudiation. Too many options for the FDIC (FDIC can make payments on the bonds, repudiate and pay par plus accrued interest through the date of insolvency, or do nothing and let the bonds default) makes the covered bond market in the U.S. untenable. If acceleration remains an option, there’s uncertainty — and we know what uncertainty means. Perhaps the reinvestment risk to investors resulting from acceleration could be mitigated through some type of enhancement feature that would preserve the maturity of the bond. Under the EU model, there is no analogous acceleration and this is putting U.S. issuers at a major disadvantage. Canada has regulator support and Canadian insolvency laws provide for secured creditors. One panelist noted that investors look first at sovereign risk, then the particular bank, then the structure and collateral, and Canada gets an A+ all around.
What’s needed is a resolution process with a clear road map to avoid forced acceleration. The FDIC argues that by requiring the transfer of the over-collateralization in a cover pool to a separate estate, the FDIC would have fewer assets to meet other obligations of a failed institution which would increase the likelihood of drawing on the deposit insurance fund and perhaps taxpayer support. But what about the Federal Home Loan Banks and counterparties to “qualified financial contracts”? Doesn’t the FDIC already face essentially the same risk with these creditors who have priority status?
At least one ratings agency links the ratings on the covered bonds to the ratings of the sponsor bank then looks at the strength of the cover pool. Risk of asset loss, market value loss and interest rate/currency risk (if not hedged through swaps) is factored in. Expected loss following an issuer default drives the rating and the current Timely Payment Indicator (TPI) right now in the U.S. sits at “Improbable”—meaning only a bank rated A-1 could get a triple-A rating. A TPI of “Probable” would allow a bank rated A-3 to get a triple-A rating. Canadian issuances have a TPI of Probable.
From legislation we don’t necessarily need details. Let the regulators handle that. Not like they’re busy with anything else right now. For example, in the legislation, a narrow list of asset classes may suffice if the regulators are granted the authority to broaden the list of asset class types as the market demands.
Kudos to SIFMA and Congressman Garrett, among others, for their work aimed at moving things along on the U.S. covered bond front. We anxiously await additional strides but are not optimistic they will be taken this year.
By Ralph Mazzeo and Laurie Nelson.