A covered bond bill introduced by a bipartisan group of Senators last week is very similar to legislation passed by the House Financial Services Committee in June, according to US lawyers, with the omission of tax provisions and a lack of concessions to FDIC concerns suggesting strategic thinking on behalf of the bill’s sponsors.

Democrat Kay Hagan and Republican Bob Corker last Wednesday (9 November) introduced the United States Covered Bond Act of 2011 in the Senate with the support of Democrat Chuck Schumer and Republican Mike Crapo, which means that for the first time since legislation was first introduced into the House in 2008 covered bond legislation is in both houses of Congress. Republican Congressman Scott Garrett has put forward five covered bond legislative proposals in the House, with the latest (HR 940) – sponsored with Democrat Carolyn Maloney – passed by the House Financial Services Committee (HFSC) in June.

Howard Goldwasser, partner at K&L Gates, said that the Hagan-Corker act is remarkably similar to its namesake in the House, and that this was to be welcomed.

“There are some differences between the pieces of legislation,” he said, “but I think that the important point is that, for the time being, those differences are fairly inconsequential.

“The guts of both the House and Senate bills are very similar, and I think that this is positive from the perspective of those in the industry that would like the bill to be able to move forward pretty quickly – it means they can be harmonised more expeditiously.”

Jerry Marlatt, senior of counsel at Morrison & Foerster, says that although there are four main differences between the Senate legislation and Garrett’s bill, they are not substantive in the sense of having an effect on the core purpose of the Hagan-Corker act.

Lawton Camp, partner at Allen & Overy, said that the key differences between the Hagan-Corker legislation and Garrett’s latest bill are the inclusion of broker-dealers and insurance companies as potential issuers, and the ability of the covered bond regulator and a majority of covered bondholders to replace the asset monitor.

Other differences are that the Senate bill omits tax provisions included in the legislation passed by the HFSC and that covered bond issuers that are not subject to the jurisdiction of a federal banking agency will be regulated by the Federal Reserve rather than Treasury, as foreseen by HR 940.

Marlatt said that the elimination of the tax provisions appears to be a strategic decision designed to avoid having the bill assigned to the Senate finance committee in addition to the banking committee, in contrast to the situation in the House of Representatives where HR 940 is with the Ways & Means committee, which has tax jurisdiction.

“It’s still stuck there, which, I think, is part of what influenced the decision taken with respect to the Senate bill,” he said. “We understand that the concerns the Ways & Means committee has with the bill are purely technical and my guess is that the Senators’ thinking is that if the technical issues can be resolved in the House they would be resolved in a way that would also be satisfactory to the Senate.”

Goldwasser assessed the absence of tax provisions in a similar way, attributing it to procedural considerations made by the Senate bill’s sponsors.

“I would think that the Senate bill doesn’t include tax provisions simply to avoid having it get bogged down in multiple Senate committees,” he said, “but my expectation is that those points will get addressed as the bill moves forward through the legislative process.”

Fitch last Thursday (10 November) said that the Senate legislation “generally sticks closely” to the House legislation aside from expanding the definition of eligible issuers and changing the proposed regulator for certain issuers, and that its view of the likely impact of the new legislation on ratings of US covered bonds had not changed despite such changes.

“We said when the House legislation was presented in March that we would expect to give some credit for the role of the US regulators in setting guidelines and monitoring risks,” it said. “However, this is likely to be less than in other jurisdictions where the widespread use of covered bonds means regulators have an interest and a track record in ensuring the safety of the product.”

It noted that neither the Senate nor House legislative proposals have spelled out details about regulation, such as how programmes will be monitored and the administration process following an issuer default.

The rating agency also said that the Senate bill’s proposed expansion of the list of eligible issuers raises some questions, such as whether broker-dealers wold use covered bonds to refinance assets that they buy rather than originate themselves.

Rui Pereira, managing director and head of US RMBS at Fitch, told The Covered Bond Report that allowing broker-dealers and insurance companies to issue covered bonds is a departure from the traditional application of covered bonds in Europe, and raises some concerns about how underlying assets are sourced and how issuance will be regulated.

He said it is positive that another covered bond bill has emerged from Congress, although there was still much to do.

“It’s another small positive step,” he said.

Limited concessions to FDIC

With the Federal Deposit Insurance Corporation seen as the main obstacle to passing covered bond legislation as it has been presented so far, the Senate bill contains few to no concessions to the FDIC, according to lawyers.

Clifford Chance lawyers said that in shifting regulation of covered bond issuers not subject to the jurisdiction of a federal banking agency from the Treasury to the Federal Reserve Board the Senate bill responds to an FDIC concern.

“This change addresses the FDIC’s concern that in all cases the covered bond regulator should be a prudential regulator (which is not a role of the Treasury),” they said, “although it presents the possibility that a funding programme of, for example, a State-regulated insurance company could be regulated by the Federal Reserve Board, which generally oversees banks and banking entities.”

A covered bond analyst said he was surprised by the absence of “pro-FDIC” concessions given discouraging comments he had heard about the strength of the FDIC’s lobbying in the Senate, while Morrison & Foerster’s Marlatt said the Senate bill does not contain provisions beyond those in the House legislation to address the FDIC’s concerns.

“I think it is a bargaining strategy,” he said, “to put the bill on the table and start from there rather than adding provisions to address some of the FDIC’s concerns and the FDIC pushing it further from there.”

Goldwasser noted that the Hagan-Corker act grants the FDIC a one year period to transfer a covered bond programme to another eligible issuer in the event of receivership or conservatorship, compared with the 180 day period that was included in the original version of the latest House bill, although this was amended to provide for a one year period as part of the June HFSC vote.

“The Senate bill continues to offer to the FDIC the concept of mandatory residual interest in the cover-pool estate,” he said, “with an obligation on the estate to maximise the value of the residual interest so that the estate would be obligated to not simply look out for repaying the bondholders, but to try to get maximum value out of the cover pool itself – something that would inevitably accrue to the benefit of the FDIC and the deposit insurance fund.”

What next?

The timeline for next steps on either the House or Senate legislation appears complex, with a range of aspects cited as relevant to the speed with which the bills might move ahead, if at all. These include the bipartisan backing of the Senate bill, the language chosen to promote it, proponents’ ability to keep it separate from a broader debate on the future of housing finance and the role of government sponsored entities (GSEs) in the US, and election cycle politics.

Some market participants are downbeat on the bill’s future, believing it will be mired in the GSE debate and delayed by deficit reduction talks on Capitol Hill. A US lawyer said that “the FDIC is apparently doing everything it can to kill the bill”.

Others passed on a more positive take, despite noting that rapid action on the bill was unlikely.

“With the Senate bill, for the first time there is some slightly increased optimism that even if we don’t get the legislation before the election cycle there is a pretty good chance of getting it forthwith after the election, in early 2013 with possibility of issuance that year,” said one lawyer.

A hearing on the Senate bill in the upper chamber’s banking committee is seen by several market participants as the most likely next step, with Marlatt noting that with four Senators behind the Hagan-Corker act it is embarking on a law-making journey with the support of a much bigger portion of the banking finance committee than Garrett’s bill had in the HFSC.

The Senate Committee on Banking, Housing and Urban Affairs comprises 22 Senators, 12 of whom are Democrat and 10 Republican. The HFSC is much larger, with 61 members.

He noted that deliberations by a Joint Select Committee on Deficit Reduction, also known as the supercommittee, are likely to demand much of the Senate’s and House of Representatives’ focus in the coming months, and that this could delay action on either legislation until the second quarter of 2012.

“There is a lot left to be done, but it is an important step forward,” he said.

Thinking ahead: foreign issuance under US framework

In a client memorandum on the Hagan-Corker act Clifford Chance lawyers considered the possible implications of the Senate bill on issuance by foreign banks under the framework proposed for the act.

Lewis Cohen, a US-based partner at Clifford Chance focusing on covered bonds, told The Covered Bond Report that the definition of an eligible issuer under the Senate bill throws up the question of disparate treatment of foreign and domestic issuers under the legislation.

“We wanted to bring out our strong hunch that no-one even began to think about how non-US issuers would be treated under this legislation,” he said, “highlighting the potentially disparate treatment of foreign banks under the proposed legislation because certain foreign entities may actually be considered bank holding companies for these purposes, and thus able to issue using the US statute.”

Cohen said that, while foreign banks may be able to issue under a covered bond framework in their home jurisdiction, with both the Senate and House bills being fairly flexible on asset classes, a foreign bank may have sufficient US assets to utilise US legislation.

“How realistic that is from a market demand point of view is a different point and will have to be seen as this plays out,” he added.

In the memorandum Clifford Chance’s lawyers noted that the bill defines an eligible issuer as, among other things, any bank holding company, any insured depository institution, and any subsidiary of such entities, but said that despite foreign banking organisations with operating branches or agencies in the US being treated as bank holding companies under the US Bank Holding Company Act, they technically are not bank holding companies.

Clifford Chance senior associate Philip Angeloff, specialising in financial services regulation, noted for the memorandum that “only foreign banking organisations that control a bank subsidiary in the United States are ‘bank holding companies’ within the meaning of that term under relevant banking laws.

He added: “The language of the draft bill may be interpreted more broadly in implementing regulations, but as drafted it suggests that foreign banks that do not operate bank subsidiaries in the United States may not be ‘eligible issuers’.”

Accordingly, foreign banks that operate branches but not bank subsidiaries in the United States may not be able to issue covered bonds under the proposed legislation through their US branches.