Amendments proposed last Wednesday by Congressman Barney Frank to draft covered bond legislation would have hampered the development of a US market, Moody’s said yesterday (Monday).

While the House Financial Services Committee approved three amendments to the US Covered Bond Act of 2011 before approving the bill at a markup session, it rejected two proposed by Democrat Frank, which he said had been drafted in close co-operation with the Federal Deposit Insurance Corporation. However, they were only narrowly defeated, by 28 votes to 26.

The amendments would have allowed the FDIC to repudiate covered bonds following a bank default and would have capped maximum overcollateralisation levels and Moody’s said “both would have hurt the development of the market”.

“The repudiation power in the rejected amendment was better for investors than the FDIC’s current repudiation power because the amendment required the FDIC to pay off investors in full rather than up to the market value of the cover pool,” said the rating agency. “However, the amendment would have exposed investors to an early pay-off, which existing covered bond investors do not want.

“Furthermore, a cap on the amount of overcollateralisation would reduce the resiliency of covered bonds, preventing issuers from adding collateral to maintain the credit strength of the covered bonds if the issuer deteriorates.”

Republican Congressman Scott Garrett had made the first point in response to Frank’s amendment at the hearing last week.

“You would no longer have a covered bond marketplace,” he added. “There would not be any investors interested in the marketplace were this amendment to pass.”

Moody’s said that the three amendments that were passed would not weaken the original bill’s positive credit features.

“Although the first amendment increases the amount of time the FDIC has to transfer the covered bond programmes of a failed bank to one year from 180 days, this amendment will not increase risk for investors because the bill requires the FDIC to make timely payments during that period and satisfy all the issuer’s other obligations under the programme documents,” said the rating agency. “Although the second amendment requires regulators to set a cap on the issuance of covered bonds by an issuer relative to its assets, regulators have the flexibility to change the issuance caps over time to accommodate healthy market growth.

“Although the third amendment restricts eligibility of non-bank financial institution issuers to those regulated by the Federal Reserve, we expect the major covered bond issuers to be banks.”

Overall, Moody’s deemed the bill to have retained strong investor protection measures, and agreed that the development of an indigenous US covered bond market is contingent upon US legislation being passed.

“It is unlikely that a robust indigenous US covered bond market will develop without legislation to mitigate the acute market value risk inherent in the FDIC’s powers following a bank default,” said the rating agency. “Under the FDIC policy statement, two of the FDIC’s three options following an issuer default expose investors to acute market-value risk. The FDIC could allow a liquidation of the entire cover pool within a short time span, or it could choose to keep the cover pool and pay damages to covered bondholders equal to the lesser of par or the market value of the cover pool.

“Either scenario would acutely expose investors to prevailing market conditions at the time of issuer default. This risk is a main reason why US banks have not issued any covered bonds since 2007 even though non-US banks have issued over $45bn in US dollar denominated covered bonds since 2010 alone.”

Moody’s said that the original bill mitigated the acute market value risk by prescribing investor-friendly mechanisms for segregating the cover pool following a bank default, thereby diminishing the exposure of the cover pool to market value risk.

“For bank issuers, the bill required the FDIC to either sell the entire covered bond programme to a solvent bank within 180 days, during which time it would have to pay the covered bonds and comply with all the issuer’s other obligations under the transaction documents, or transfer the cover pool to a separate legal estate to wind down gradually,” said the rating agency. “Under the wind-down approach, the estate’s administrator would only need to sell assets if the cash generated by their natural amortisation was insufficient to make scheduled payments to investors.”