Recently, while visiting my in-laws, I took a break from college basketball and the Daytona 500 and caught up on the latest developments in the quest for covered bond legislation in the United States. Not surprisingly, I quickly found that the quest for covered bond legislation is, well, still a quest.
We have discussed the possibility of covered bond legislation numerous times on this blog (see here, here, here, here, here, here, here and here). As you may recall, 2010 ushered in optimism for proponents of covered bond legislation, as both the House and Senate at least entertained the possibility. Representative Scott Garrett (R-NJ), who has long been a strong proponent, led the charge in the 111th Congress pushing a bill out of the House Financial Services Committee and in front of the full House for consideration. The Senate Banking, Housing and Urban Affairs Committee even went so far as to hold a hearing on the topic. Despite the attention, the elections and then other distractions took priority, and a lame-duck session came and went without further movement on the topic. However, the bells ringing in the new year also rung in a new round of this fight, as all interested parties are gearing up for yet another attempt to pass this legislation.
As Professor Kenneth Snowden noted in his testimony before the Senate (available here), the U.S. has made several abortive attempts to create covered bonds markets, from the 1870s to the 1930s. These past attempts either failed to find the right formula to attract investors or ran afoul of established regulatory authorities and market participants. We have investor demand, which is currently serviced by “Yankee issuances” from foreign issuers; U.S. investors reportedly sent $22 billion last year abroad in search of these safe assets. This time around the push for covered bonds is foundering on the FDIC’s concerns about adequate collateralization and access to the cover pool in the resolution of failed issuer banks.
The FDIC is concerned to preserve its current authority in resolving failed banks’ contracts. Currently, just as with any other issuer, when covered bond issuers are placed in receivership, the FDIC has the authority either (i) to perform and make payments on the bonds, (ii) to repudiate and pay par plus accrued interest through the date of insolvency, and reclaim the collateral, or (iii) to do nothing and let the covered bonds default. The FDIC, speaking for depositors and other creditors (also before the Senate Committee on Banking, Housing and Urban Affairs, available here), argues that it must have the option to access cover pools in receivership. So the argument goes, absent the FDIC’s current flexibility to repudiate covered bond programs and access the cover pool to maximize recoveries, recoveries will be suboptimal and losses will be transferred to the Deposit Insurance Fund and the taxpayer, and the moral hazard abounds. However, without legislation giving certainty on the FDIC’s treatment in issuer receivership, U.S. issuers cannot offer covered bonds on terms competitive with other forms of financing, including those so called Yankee issuances.
With the continued lobbying efforts of certain industry groups and the shift in the balance of power in Congress, we do not expect the push for covered bond legislation to die any time soon. We understand that Representative Garrett plans to reintroduce legislation in the House (which must first travel back through committee) and has already circulated a discussion draft to members of Congress and securitization market participants (please see this Dechert OnPoint (pdf) for a more in depth discussion). The House Capital Markets Subcommittee is keeping the ball rolling with another hearing scheduled for the 11th, and covered bonds remain on the radar of the Senate Banking, Housing and Urban Affairs Committee. Even the Obama Administration (pdf) has given a nod to working with Congress to explore covered bond legislation in the context of GSE reform. We will be looking for signs of bigger and better things to come.
If our legislators and regulators can make haste, slowly of course, toward integrating covered bonds into our financial system, U.S. issuers may have an opportunity to tap into investor demand and give the European issuers a run for those Yankee dollars, and I may have the opportunity (or privilege) to visit my in-laws and watch college basketball and NASCAR without interruption… unless, of course, I’m working on a covered bond transaction.
By Stewart McQueen and John Bumgarner
