Nicholas Pettifer
Americas editor
A likely amendment to the Financial Stability Improvement Act should encourage covered bonds in the US. If passed, the rules will offer similar features to European covered bonds legislation.
Congressman Scott Garrett detailed an amendment to the Act on November 18. Despite the fact that he immediately withdrew it, there are encouraging signs that it will pass and the plans have been well received. "The amendment is really quite good," said Jerry Marlatt, structured finance partner at Morrison & Foerster. "In some ways it is very similar to much of the legislation in Europe where, if the bank is insolvent, the protected pool of assets is set aside."
At the moment, the pool of assets in US covered bonds would only be protected by an artificially created contract structure, the enforceability of which is questionable.
Marlatt also pointed out that the Secretary of the Treasury would be the trustee of the asset pool for the benefit of the bondholders in the case of insolvency. "This is a person of responsibility at a very high level," he said.
The amendment includes a wide array of asset types that can feature in covered bond programmes. Each programme will only be allowed to focus on one type of asset, but the range under the covered bond proposals is impressive.
If an asset pool is set aside, the amendment allows the trustee to borrow funds from the Federal Financing Bank to ensure that the covered bond programme can continue. This addresses the liquidity concerns of ratings agencies and means that market risk does not have to be factored into the structuring of programmes.
"The details of the amendment are very promising," said Marlatt. "There was some genuine excitement in the covered bond community that this amendment would be included in the final bill. It could be a real vehicle for covered bonds in the US."
In June, Garrett was central to the drafting of the Equal Treatment for Covered Bonds Act. This amendment goes much further and would usurp the earlier bill. "It would lay out a detailed statutory framework to help facilitate the broader use of these funding instruments in the US," said Garrett at the Financial Services Committee's mark-up of the Financial Stability Improvement Act 2009 on November 18.
Garrett also said that while a detailed framework is common in the European countries where covered bonds flourish, "it is needed in this country to provide investors greater certainty to their exact recourse if the issuing institution fails."
Congressman Barney Frank, chairman of the Financial Services Committee, seemed to warm to the proposal instantly. But he called for a later hearing to specifically discuss the issue and asked Garrett to withdraw the amendment. "I ask that the gentleman withdraw this now with the commitment for a hearing in December and the likelihood of being able to put this in the final version [of the bill]," said Frank. The politics behind this move are unclear, especially since Garrett has been vocal in his opposition to some other amendments.
The market needs them
Earlier in the month, ratings agency Moody's had highlighted the need for US banks to issue longer term debt. It revealed that the average maturity of newly issued rated debt in the US had fallen from 7.8 years to 3.2 years over the last five years. The UK has seen a similar trend and both systems will have to face more than $2 trillion of maturing debt before the end of 2012.
Plus there are new rules making it harder to get securitisations off balance sheet. The Financial Accounting Standards Board's Financial Accounting Statements 166 and 167 come into operation on January 1, so banks are starting to reconsider covered bonds as a cheaper alternative. Due to the safety that they provide, the interest rates are much lower, saving banks money.
Washington Mutual issued the first US covered bond in 2006 and Bank of America followed suit in 2007. However, they were synthetically set up via contracts and trust arrangements. In most European countries, the assets covered by the bond are ring-fenced by legislation in the event of the issuing bank entering bankruptcy proceedings. Without that protection, US covered bonds face an expensive structuring process to factor in market risk costs.
This is because in a US bankruptcy, the pool of assets covered by the bond must be sold. A trust set up on behalf of the investors gets priority on these assets to the value of the coupon and any excess goes back to the bank. So when the structure is set up, there must be an investment contract drafted for the trust to cover the life of the bond beyond the face value of the coupon. The pool of assets is also over-collateralised to counter the depressed prices that are paid during a post-bankruptcy fire sale.
Untroubled and untested
More importantly, the synthetic US structure has not been tested, so investors are worried that the Federal Deposit Insurance Corporation (FDIC) may not honour the contracts protecting their assets during a bankruptcy. The FDIC's mandate is to protect depositors; it is less concerned with the welfare of investors.
The closest a US covered bond has come to being tested was when Washington Mutual collapsed last year. But JP Morgan came in and assumed the liabilities. The investors in the transaction's investments improved drastically overnight, but the structure remained untested.
Despite this, many believe a bank will take on the risk and issue a covered bond with or without a legislative change. But such structures would be subject to 'no action' letters from the SEC to approve them. And even from an economic perspective, not everyone is convinced: "Covered bonds are so well established in Europe that investors can get better prices there," said one in-house lawyer.
In July, France's Compagnie de Financement Foncier successfully lodged the necessary documentation to set up a 144a medium-term note programme to sell dollar denominated bonds into the US. "It is conceivable that there may be European banks selling covered bonds in the US first," said a structured finance partner. "But I still strongly believe that, with the right legislation, US banks will be able to compete."