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FDIC emerges as key theme in US covered bond story

Just one vote. That is the margin by which a statutory US covered bond framework missed being passed in a last minute attempt to tack it on to the country’s major financial reform bill in June 2010.

As a result, and despite continuing efforts to move a covered bond law through Congress, any potential issuance from US institutions remains subject to a regulatory framework that has failed to fuel the development of a home grown covered bond market. US financial institutions have been able to do little but stand by and watch as their peers in Europe, and more recently Canada, have in two waves over the past several years successfully targeted US investors with covered bonds.

But while large-scale US issuance remains elusive, it is not for want of commercial or political interest in the funding tool or efforts to establish a framework to support its development.

Covered bonds on the agenda after WaMu

Washington Mutual made the very first move when, in September 2006, it became the first US institution to launch a covered bond, a Eu4bn dual tranche issue that was followed by an inaugural deal by Bank of America, also in euros, in March 2007.

Three months later BofA became the first US bank to sell a covered bond into the US, a $2bn five year deal that pulled $4bn of demand in what looked like a flying start to a domestic covered bond market. However, the transaction remains the only home grown US covered bond so far.

Developments were hit by the onset of the financial crisis, which even heavily disrupted Europe’s mature covered bond market. But although US covered bond issuance ground to a halt, its travails were nothing compared with those of the US securitisation market, which had been poleaxed by the sub-prime crisis, with the “originate-to-distribute” model’s standing in ruins.

Thus by early 2008 government officials appeared to have understood the need to take action to help spur the growth of a covered bond market, and in particular to establish clarity around the status of covered bonds in the event of an issuer insolvency.

In a speech on 13 March 2008 setting out Recommendations from the President’s Working Group on Financial Markets, Hank Paulson, then Treasury Secretary, identified covered bonds as a source of mortgage funding that was worth investigating as an alternative to securitisation. He also spoke about the benefits of a regulatory rather than statutory approach:

“Rule-making, not legislation, is needed to facilitate the issuance of covered bonds,” he said. “Through clarification of covered bonds’ status in the event of a bank-issuer’s insolvency, the FDIC (Financial Deposit Insurance Corporation) can reduce uncertainty and consider appropriate measures that will protect the Deposit Insurance Fund.

“These steps would encourage a covered bond market in the US; similar changes in Europe have resulted in more covered bond activity.”

His pronouncement was soon followed by a flurry of activity that over a four month period yielded – in quick succession – the country’s first covered bond-specific regulations, best practice guidelines from the Treasury to build on these rules, and a first public effort to draft covered bond legislation.

FDIC, Treasury make statements of intent

The covered bond-specific regulations in question had been produced by the FDIC, and published on 15 July 2008 in the form of a final covered bond policy statement. An interim final policy statement had been released on 23 April, and a consultation around that generated some 130 written responses.

Sheila Bair

Sheila Bair, FDIC

“I believe that the underwriting standards set out in the Policy Statement will support strong, sustainable lending while at the same time give stability to the value of the covered bonds,” said Sheila Bair, chairman of the FDIC.

In an attempt to provide the clarity deemed necessary to facilitate the development of US issuance the statement set out the options available to the FDIC for the treatment of covered bonds in the event of an issuer entering into receivership or conservatorship, and the damages it would pay depending on the option it pursued.

The policy statement also exempted covered bonds from an automatic 90 day stay on payment to creditors in the event of the FDIC taking over an insolvent issuer, and reduced it to 10 days, thereby making it potentially easier and less costly to structure covered bond programmes. Other elements of the policy statement included an issuance cap of 4% of total liabilities, and definitions of a covered bond and eligible mortgages.

At the time market participants welcomed the clarity the FDIC’s statement provided, although some were disappointed that it did not go further.

“Although helpful clarity is supplied in some areas – most importantly, on the damages to which covered bondholders would be entitled in an insolvency proceeding – the FDIC has opted for dipping another toe in the water instead of making a bold move forward,” said lawyers at Orrick, Herrington & Sutcliffe.

Just under two weeks after the release of the FDIC’s policy statement the US Treasury came out with “Best Practices for Residential Covered Bonds”. Produced in conjunction with the FDIC, Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), and Securities & Exchange Commission (SEC), these non-binding guidelines were “intended to provide clarity and homogeneity to the new market,” according to the Treasury.

“It is meant to define a starting point for the US covered bond market and serve as a complement to the Federal Deposit Insurance Corporation final policy statement,” it said.

The guidelines mirrored but exceeded the scope of the FDIC’s policy statement, according to Barclays Capital analysts. For example, they specified minimum overcollateralisation of 5%, required issuance to have regulatory approval, and stipulated monthly cover pool disclosure rules.

To coincide with the Treasury’s release of its best practice guidelines the Securities Industry & Financial Markets Association (Sifma) announced the formation of a US Covered Bond Traders Committee. In December 2008 Sifma and the American Securitization Forum (ASF) set up the US Covered Bond Council to promote a US market.

Mr Covered Bond goes to Washington

Just two days after the Treasury published its best practice guidelines Congressman Scott Garrett, a Republican member of the House of Representatives, took efforts to establish a covered bond market in the US one step further by introducing the first piece of covered bond legislation, the Equal Treatment of Covered Bonds Act of 2008 (HR 6659).

Garrett welcomed Paulson’s and the FDIC’s work on establishing covered bond regulations, but emphasised the need for a legal framework.

“What is absolutely necessary is for Congress to step forward and put some of this in statute,” he said. “This will provide more certainty in the marketplace and hopefully fuel investor confidence.”

He highlighted as benefits of a legislative structure greater certainty and stability, which he said boost investors’ trust and lower issuance costs.

Scott Garrett

Republican Congressman Scott Garrett

“Investors are less familiar with the regulatory process and thus are less willing to invest in programmes that are based on regulatory structures,” said Garrett. “Narrow legislative text will provide the certainty needed to provide investor confidence, leaving the details to FDIC regulation.”

Although Garrett’s legislative proposal remained just that, failing to gain momentum – in part because of an imminent presidential election and the attendant dissolution of Congress – it served to firmly place legislation on the agenda for US covered bonds.

Amid the financial crisis interest in developing a covered bond market continued to grow, although opinions differed as to how to best pursue this goal.

At a covered bond event held by the American Enterprise Institute (AEI) four days after the collapse of Lehman Brothers, Neel Kashkari, then assistant secretary of the Treasury for International Economics & Development (he was named interim head of the government’s bailout programme soon thereafter), talked about covered bonds as a product whose time had come. He acknowledged that there was no silver bullet for the US housing and mortgage finance crisis and that the environment was not ideal for the launch of a new market, but said that covered bonds could help overcome the problems.

“Never has the market needed this financial product as much as we need it now,” he said.

However, he downplayed a need for legislation, arguing instead that a regulatory system was sufficient, allowing interested parties to “move forward quickly” while also providing investors with regulatory clarity and certainty.

Others, however, countered the notion that regulations represented the only way forward.

Alex Pollock, resident fellow at the AEI, for example, said that if covered bonds were to have a future in the US they would need to have a legislative base to protect indubitably the rights of bondholders to collateral, and that a regulatory policy was not enough as it could be changed at the whim of the regulator.

Comments made by Secretary Paulson in an address to the Economic Club of Washington in January 2009 revealed a degree of openness to the idea of a legislative covered bond framework.

“There is strong interest in developing a US covered bond market, but we will have to work through the credit crisis before a new market is likely to take hold,” he said. “Some have advocated dedicated covered bond legislation, which could be helpful to establishing this market, and should be considered in the context of broader housing finance reforms.”

By then, however, US covered bonds had faced and passed their biggest test to date in the wake of Washington Mutual’s collapse on 25 September 2008. Its programme was among assets and liabilities immediately taken on by JPMorgan, and this resulted in a multi-notch upgrade of the covered bonds, whose ratings had in the preceding months suffered sharp cuts by Fitch and Moody’s (although Standard & Poor’s had maintained a triple-A rating of the programme). The acquisition of Washington Mutual’s covered bond programme by JPMorgan and the consequent uninterrupted continuation of payments came as a relief for investors and market participants holding on to hopes of a future for US covered bonds.

Equal Treatment II, a first hearing and a new Act

On 16 June 2009, a year after his first initiative, Garrett put forward a new piece of covered bond legislation, the Equal Treatment of Covered Bonds Act of 2009 (HR 2896). This second bill was co-introduced by a Democrat, Representative Paul Kanjorski, with Republican Spencer Bachus as co-sponsor.

On 17 November 2009 Garrett filed a draft amendment to the Financial Stability Improvement Act of 2009 (the House of Representatives’ financial reform bill), withdrawing it a day later after winning a commitment from the chairman of the House Financial Services Committee (HFSC), Democrat Barney Frank, to a hearing on covered bonds. Entitled “Covered Bonds: Prospects for a US Market Going Forward”, the hearing was held on 15 December 2009. It revealed bipartisan support for the initiative to establish covered bond legislation, with Democrat and Republican committee members highlighting the contribution the asset class could make towards reviving and growing the US mortgage market without the need for costly government support.

The United States Covered Bond Act of 2010 (HR 4884), a new proposal from Garrett on 18 March 2010, was similar to his draft financial reform bill amendment, but more complete than the two Equal Treatment of Covered Bonds acts, according to law firm Morrison & Foerster.

Moody’s had earlier described Garrett’s proposed amendment as “comprehensive” and “robust”, capable of providing “very strong” protection to investors in the event of an issuer default. The main improvement, introduced first by the amendment and carried over to HR 4884, lay in the removal of the risk that a cover pool would be liquidated following an issuer’s insolvency.

Instead, the cover pool would be transferred either to a solvent institution that would assume responsibility for the obligations on the covered bonds, or to a separate legal estate that would be administered for the purpose of fulfilling all covered bond payments. The estate would be entitled to borrow from private markets in order to obtain liquidity to meet such payments, but not from the Federal Financing Bank as the 2009 amendment foresaw.

A setback, progress, then stalemate

US covered bond legislation came close to being adopted in June 2010 when provisions similar to those in Garrett’s March submission were included in a final bill intended to reconcile House and Senate versions of Congress’s major financial services reform bill (the Dodd-Frank Act). But in the early hours of 25 June the amendment in question fell short by just one vote, prompting lawyers at Morrison & Foerster to comment: “Well, they were in, and then they were out.”

Objections from the FDIC and a lack of time to address the regulator’s concerns were reportedly to blame for the defeat. However, the last minute discussions led to Democrat Senator Christopher Dodd, then chairman of the Senate Banking Committee, and Barney Frank committing to hearings in their respective houses.

(Garrett’s feelings upon hearing at 4.30am that the covered bond proposal had been rejected are best understood in the following clip, which also shows Congressmen reporting on the FDIC’s objections: Dodd-Frank climax.)

The promise of hearings by Dodd and Frank quickly began to yield fruit and when the House Financial Services Committee turned its attention to covered bonds, on 28 July, it took the important step of approving legislation, voting to send it to the full House after a markup session. The legislation in question this time was a proposal submitted by Garrett – his fifth such draft – on 22 July. (It is confusingly also called the US Covered Bond Act of 2010 and therefore usefully referred to by its code, HR 5823.)

The act was similar to its predecessor, but modified in parts to accommodate concerns raised during the June negotiations on the Dodd-Frank Act. The HFSC’s markup hearing also resulted in several amendments being accepted. One of these was to remove covered bond regulation from the responsibility of a single federal institution, and to instead allocate it to an issuer’s primary regulator.

Following the HFSC markup session it was the Senate Banking Committee’s turn to hold a hearing on covered bonds, its first, which it did on 15 September. Entitled “Covered Bonds: Potential Uses and Regulatory Issues”, the hearing exposed as the main obstacle to the passage of legislation differences of opinion between the FDIC and industry representatives about how covered bonds should be treated in the event of an issuer’s insolvency.

“The essence is going to be the rub between the FDIC and everybody else,” said Republican Senator Bob Corker during the hearing, which included as speakers or witnesses Michael Krimminger, deputy to the chairman at the FDIC, Scott Stengel, partner at Orrick, Herrington & Sutcliffe but speaking on behalf of the US Covered Bond Council, and Garrett.

Krimminger argued that any legislation should preserve the FDIC’s right to repudiate a covered bond and claim the collateral, while Stengel expressed the council’s view that the risk that covered bonds could be repudiated would render the asset class a non-starter for investors.

“The message that we want to convey is that if we’re talking about covered bonds that can be accelerated, we’re not talking about covered bonds,” said Stengel. “And we can put our pencils down, and there will be no market.”

FDIC compromise key to progress in 2011

Krimminger did, however, reveal a relaxation of the FDIC’s existing position with respect to payment of damages for repudiation. He stated that these would cover the outstanding principal plus interest through the date of payment, a position that Moody’s said marked an improvement on the existing policy of covering payments due only through the date that the FDIC became the receiver or conservator, subject to a market value cap.

The “rub” between the FDIC and proponents of existing proposals for covered bond legislation was evidenced again when the US Covered Bond Council in early November accused the FDIC of “a misunderstanding of proposed legislation and existing law”. The claim was made in a statement responding to comments made by Bair in a speech at a housing finance conference in Virginia on 25 October.

She said that the FDIC supports “balanced” covered bond legislation, but disagreed with existing proposals because these would give covered bondholders “a super-priority” in receivership that would effectively transfer credit and pre-payment risk from investors to the FDIC.

“I know this is not the intention of Congressional proponents of a covered bond market, and we want to work constructively with them to resolve this issue,” she said.

As US lawmakers find their feet in a new Congress that started on 3 January this year, the prospects for US covered bond issuance appear to hinge on their ability, if at all possible, to reconcile the FDIC’s claim to the right to repudiation with calls for legal certainty for investors and issuers.

Garrett, for one, is expected to persevere with his efforts and reintroduce covered bond legislation. He previously expressed cautious optimism that progress could be made on a legal framework in the new legislative period. This was partly because of the Republicans gaining a majority in the House following November mid-term elections, with chairmanship of the HFSC passing to Bachus (co-sponsor of the second Equal Treatment of Covered Bonds Act) and Garrett taking over as head of the subcommittee on capital markets and government-sponsored enterprises.