Covered Bonds: An Update
Earlier this year, the Securities and Exchange Commission issued a “no-action letter” with respect to the issuance by a non-U.S. bank of covered bonds as publicly registered securities in the U.S. The letter paved the way for the first covered bond issuance in the U.S. registered with the SEC – a $2.5 billion issuance by Royal Bank of Canada last month. While European investors have been familiar with covered bonds since approximately the 18th century, domestic investors, potential issuers and regulators have been hesitant to embrace the covered bond concept. This recent triple A rated issuance by Royal Bank of Canada should cause those in the finance community to at least review the basics of this financing vehicle – and a good place to start would be to read the proposed “United States Covered Bond Act of 2011” (the Act), which was introduced in the U.S. House of Representatives last year in order to create a framework for the issuance of covered bonds by U.S. issuers.
Essentially, a covered bond is senior debt issued by a regulated financial institution that is additionally backed by a pool of financial assets (a cover pool) that remains on the institution’s balance sheet and is continually replenished. A key distinction between covered bonds and ordinary secured debt is that for covered bonds there is a legislatively (or sometimes contractually) established process for managing the cover pool and continuing scheduled payments on the covered bonds in the event of issuer default or insolvency, instead of liquidating the collateral and accelerating the debt.
The proposed Act includes definitions of key terms, i.e. “cover pool”, “covered bond” and “eligible asset”, and provides guidance on regulatory oversight. However, the more significant aspect of the proposed statute is its extensive language on the resolution of a default on a covered bond and/or the insolvency of a bond issuer.
Of the 48-page proposed Act, almost 25 pages are devoted to important concepts such as: (i) the creation of an estate, immediately and automatically by operation of law, upon the occurrence of an uncured default on a covered bond; (ii) the rights of the issuer of the covered bond, referred to as a residual interest, in that estate; (iii) protective consequences with respect to the covered bond in the event a conservator or receiver is appointed for the issuer; and (iv) guidelines allowing the servicer or trustee of a covered bond estate to borrow funds to provide liquidity in the case of timing mismatches among the assets and the liabilities of the estate.
While proponents of the legislation suggest that covered bonds can provide an important funding source for U.S. financial institutions in the absence of a fully functioning securitization market in the short term, and a useful source of liquidity in the long term, others (including the FDIC) have expressed concern that covered bonds could result in increased losses to the federal deposit insurance fund (and U.S. taxpayers) by removing valuable assets (i.e. the cover pools) from the receivership estates of failed institutions.
The proposed Act advanced out of the House of Representatives’ Financial Services Committee in June 2011, and some early indications of support were heard from the Senate. However, this particular version of covered bond legislation has since stalled and it remains unclear whether the current economic, political and regulatory environment in the U.S. will be conducive to further legislative efforts on this front .