A discussion draft of a forthcoming covered bond bill due from Republican Congressman Scott Garrett references Federal Deposit Insurance Corporation concerns about the asset class, but contains no new concrete measures to address the regulator’s fears about subordination of depositors or taxpayer losses.

Writing on the wall for FDIC concerns?

Such FDIC concerns were cited as key to the rejection of a covered bond provision being added to the Dodd-Frank Act in June 2010 and raised in a first hearing of the Senate Banking Committee in September. And only last week Sheila Bair, while saying that the FDIC supported the covered bond market, was reported to have called for a bill that establishes good market discipline and does not leave the regulator to cover losses resulting from covered bond issuance.

However, with Dodd-Frank out of the way and the Republicans stronger in Washington since mid-term elections, there is growing hope that the concerns of the FDIC and Bair could be overridden.

The discussion draft of a forthcoming United States Covered Bond Act of 2011 resembles closely the original version of the US Covered Bond Act of 2010. Some provisions that were taken out before the bill was passed at a full hearing of the House Financial Services Committee in July have been reinserted, but observers said that little of substance has been changed.

However, the discussion draft includes a new section titled “No loss to taxpayers”.

“Taxpayers shall bear no losses from the resolution of an estate under this Act,” reads the draft. “To the extent that the Secretary and the Corporation jointly determine that the Deposit Insurance Fund incurred actual losses that are higher because the covered bond programme of an insured depositary institution was subject to resolution under this Act rather than as part of the receivership of the institution under the Federal Deposit Insurance Act (12 USC 1811 et seq), the Corporation may recover an amount equal to those losses through an increase in deposit insurance assessments on insured depositary institutions with approved covered bond programmes.”

Dechert lawyers said that it is unclear whether any time limitations would be imposed in this regard or when loss determinations and related assessments could be made.

“This provision was likely included to address concerns that the FDIC outlined in General Counsel Michael H Krimminger’s September 2010 testimony before the Senate Committee on Banking, Housing and Urban Affairs regarding covered bonds,” they said.

Although this section of the draft bill pays heed to the FDIC’s concerns, observers pointed out that it is not creating any new powers for the regulator, which in 2009 introduced new deposit insurance assessment rules that resulted in higher fees being levied for secured funding. Some believe that it would therefore not sit well in legislation.

“Rather than putting this language in this bill, it would be preferable to put a reference in this bill to the general power that the FDIC has when it makes deposit insurance assessments,” said Jerry Marlatt, senior of counsel at Morrison & Foerster. “I don’t think that we want to create the suggestion that there’s something special here, some additional burden on covered bonds that doesn’t exist for other forms of secured financing.

“Federal Home Loan Banks financing is secured. Repo financing is secured. All of those securitisations for which a bank cannot get accounting sale treatment will be secured. To single out covered bonds seems to me not the best approach.”

Since the section has little substance, it has been suggested that it is little more than a sop to the FDIC to make it easier for the regulator to compromise on its previous stance.

“From what I understand, it’s just in there to keep the FDIC happy and to point out to them that they have this power,” said one market participant. “I think the FDIC feels a little uncomfortable with where they are.

“In a sense they are holding up covered bond legislation. They are the only hold-out at the moment and – in spite of their concerns – I think they would like to see a covered bond statute.”

Other changes to the bill passed by the HFSC last summer include the reintroduction of three asset classes that were removed during the mark-up: student loans, auto loans and credit cards. A section relating to the tax treatment of covered bond estates envisaged under the bill has also returned.

The discussion draft has been circulated ahead of a hearing on Friday of the subcommittee on capital markets and government sponsored enterprises of the House Financial Services Committee, “Legislative proposals to create a covered bond market in the US”. An FDIC official is expected to be a witness at the hearing alongside Bert Ely, a financial institutions and monetary policy consultant, Tim Skeet, an International Capital Market Association board member and consultant at Amias Berman, and Scott Stengel, partner at King & Spalding.

It is not clear whether a bill based on the draft will be introduced before or after the hearing.

“My sense at the moment is that he is going to hold this hearing next Friday before he introduces a bill, so you might find some adjustment to this bill coming out of that hearing,” said Marlatt. “It’s possible he’s going to introduce it before the hearing, but I kind of get this feeling that that’s not where they are.”