The Federal Deposit Insurance Corporation stood its ground in a submission to a House Financial Services Subcommittee hearing on Friday, insisting that covered bonds remain subject to its resolution powers and arguing that proposed legislation could imply a guarantee for the asset class – a claim vigorously denied by witnesses.

The FDIC said that any legislation “must preserve the flexibility that current law provides to the FDIC in resolving failed banks” and that “any legislation that fails to preserve these important receivership authorities would make the FDIC the de facto guarantor of covered bonds and the de facto insurer of covered bonds investors”.

Witnesses at the hearing denied that the US Covered Bond Act of 2011 (HR 940), introduced by Republican Scott Garrett and Democrat Carolyn Maloney last week, would do this.

“HR940 does not provide an explicit federal guarantee of covered bonds issued under the provisions of this bill,” said Bert Ely, a financial institutions and monetary policy consultant. “Further, no provision in HR 940 even suggests an implicit federal guarantee of covered bonds.”

Scott Stengel, partner at King & Spalding, speaking on behalf of the US Covered Bond Council, said that the FDIC’s desire to control all aspects of resolution were the result of its set-up.

“Our regulatory system is balkanised,” he said. “Unlike most other countries that have one or two regulators focused on banks during their lives and then the resolution, we’ve divided that up in the US and so we have an institution, the FDIC, that is focused solely on resolution, solely on the grave for banks.

“And I think that that creates an institutional bias that is built in as a matter of statute.”

And Tim Skeet, board member of the International Capital Market Association, said that – contrary to claims made by fellow witness Stephen Andrews, president and CEO of the Bank of Alameda, a community bank – European covered bonds did not require government support.

“There are no implicit guarantees,” he said. “What there is – and we mustn’t confuse the two things – there’s explicit legislation, and there is good supervision provided by arms of the state.

“But that is not the same as any form of guarantees – nor do the investors factor that in.”

FDIC: solid foundation or immovable obstacle?

The FDIC further claimed in its statement that covered bond legislation that would, in its opinion, create a guarantee is unnecessary.

“Before the crisis, the FDIC worked closely with Washington Mutual Bank and Bank of America when they launched the first US covered bond programmes in 2006,” it said.” As a result of our efforts, the banks were able to issue covered bonds at a competitive price.

“The 2008 Statement of Policy adopted by the FDIC’s Board of Directors addressed questions from the marketplace about how covered bonds would be treated in the receivership of an issuing bank. The market’s reaction to this Statement was very positive, and most commentators stated that it provided a solid foundation for the covered bond market.”

But Ralph Daloisio, chair of the American Securitization Forum board of directors, contradicted this.

“Without the right kind of legislation, there will be no US covered bond market,” he said. “Earlier attempts in 2006 by Washington Mutual and Bank of America remain the only isolated cases of US covered bond issuance. The financial crisis highlighted the weakness in the contractual legal framework under which those covered bonds were issued, and discouraged investor participation.

“The Treasury Department and the FDIC collaborated in July 2008 to set policy and guidelines to promote the development of US covered bonds, but not one dollar of issuance followed. It should be clear by now that a US covered bond market can only be seeded by a specific enabling act of legislation, which has, at its cornerstone, a dedicated legal framework for the treatment of covered bonds in the event the issuer becomes insolvent.”

Daloisio said that the FDIC’s position in particular had been an obstacle.

“Current FDIC insolvency authorities afford the FDIC actions adverse to investor interests, including the authority to liquidate the cover pool at a loss to investors,” he said. “Covered bond-holders need legal certainty that the insolvency of the issuer will not result in a market liquidation of the cover pool and an early return of their investments at par value or less. Accordingly, legislation is required to curb FDIC authorities over covered bonds in order to bring those authorities in line with the legal frameworks in use elsewhere around the world.

“The systemic benefits of enabling banks and non-banks to issue covered bonds under a legislated framework would appear to vastly outweigh the concerns,” he added, “such as the fear that covered bonds could increase the risk of loss to the FDIC’s Deposit Insurance Fund, and therefore to the US taxpayer.”

Andrews wraps himself in the flag

Bank of Alameda’s Andrews argued that while covered bonds might benefit big banks, they would damage the interests of community banks. He depicted himself as defending the interests of the little guy – even if Daloisio had highlighted the pension funds, mutual funds and insurance company members of the ASF that he represented.

“To cut to the chase, I’m going to speak to you today as a community banker,” he said, in his opening remarks. “A banker. Not a capital market individual who’s interested in his investors.”

And at the end of his opening statement, Andrews claimed that strict eligibility criteria for covered bonds were a cause of low home ownership rates in Europe, something out of line with US culture.

“I want my children, my grandchildren to have ownership,” he said. “I want them to be able to chase the American dream.

ICMA’s Skeet countered this, by arguing that small banks in Europe have benefited from covered bond issuance alongside big banks, citing the example of SpareBank 1 Boligkreditt.

“In Europe we do have much smaller financial institutions that have been able to tap into the covered bond market,” he said. “For instance, in Norway we have a lot of very small, regional savings banks that have collectively come together and have successfully competed, including a transaction that came to the US market late last year from a Norwegian bank that represented the interests of many smaller savings banks from around Norway, and that actually proves that you can have through the covered bond instrument the ability for the smaller institutions to compete and get the same pricing terms as the larger institutions.”

Better late than never

Maloney, the bill’s co-sponsor, arrived late and while her statement, read by a clerk, said that she was interested in covered bond as an alternative to securitisation, it said she had several questions she wanted answering, which carried a note of scepticism.

“From what I have learned so far, I do not believe that covered bonds could constitute a full replacement for the Government Sponsored Enterprises, for example,” said her statement, citing a Fitch report purportedly putting bank capacity to issue covered bonds at 11% of outstanding Fannie Mae and Freddie Mac mortgage securitisations outstanding.

“I’m also interested in learning more,” she added, “about the concerns of regulators, particularly whether covered bonds present risk to the FDIC when they try to resolve failed institutions. Given the new resolution responsibilities provided to the FDIC under the Dodd Frank Act, we must ensure that their ability to protect the DIF is protected.”

However, on arriving shortly afterwards she sounded more positive about Garrett’s proposals.

“I’m very pleased to support him in his latest effort on covered bonds, that have been so successful in Europe,” she said, before going on to add: “In the way it has been drafted now, it would be no government guarantee, but has the promise of really providing liquidity to our markets and helping.”

Garrett gave no indication at the hearing of what the next steps for covered bond legislation might be.