Co-published Covered bonds guide: US
Time for a US alternative
Jerry Marlatt and Anna Pinedo of Morrison & Foerster ask whether it is time to stop waiting for a US statute
S
even years ago, Washington Mutual issued the first covered bonds by a US financial institution. Bank of America followed shortly after with
its own covered bonds. These were structured covered bonds, not statutory covered bonds, since there was no US statute. The structure used for these covered bonds,
however, was unique and expensive. Under this structure, the banks issued bonds secured by a pool of mortgage loans to a trust (see diagram A). The trust in turn issued covered bonds to investors. Amounts paid on the secured bonds were used by the trust to make payments on the covered bonds. If the issuing bank became insolvent, the secured bonds accelerated, resulting in the full principal and accrued interest on the bonds being paid to the trust. The trust would invest the funds received in a guaranteed investment contract until needed to make payments on the covered bonds. It was uncertain under the Federal Deposit
Insurance Act what action the Federal Deposit Insurance Corporation (FDIC)
would take as receiver of an insolvent bank with outstanding covered bonds. The FDIC could (i) repudiate the secured bonds and pay principal and interest accrued up to the date of insolvency to the trust, (ii) transfer the obligation on the secured bonds and the pool of mortgage loans to an assuming bank, or (iii) permit the indenture trustee for the secured bonds to liquidate the pool of mortgage loans and pay the trust principal plus accrued interest up to the date of payment. There was no certainty under the statute which course the FDIC would choose or the timing of its actions. To deal with this uncertainty, the trust held swaps that were designed, among other things, to ensure that the covered bonds continued to be paid while the FDIC determined what course of action to take. In April 2008, as the financial crisis began
to envelop the markets, the FDIC issued its Covered Bond Policy Statement, as an interim final order, to provide some immediate guidance. The statement sought to clarify the treatment of covered bonds in
the event of the FDIC becoming the receiver of a failed issuing bank. The statement was limited to covered bonds that satisfied certain mortgage loan requirements and did not exceed 4% of the issuing bank’s liabilities. In July 2008 the FDIC issued its Final Policy Statement on Covered Bonds. In June 2008, the US Department of the
Treasury called a meeting of bankers, issuers, regulators and other participants in an effort to jump start the covered bond market in the US and to promote the development of a regulatory regime and market practices to enable the issuance of covered bonds in the country. In July 2008, the Treasury released its Best Practices for Residential Covered Bonds. This document was intended to expand on the standards for covered bonds and to complement the FDIC’s Final Policy Statement. Also in 2008, Congressman Scott Garrett
(R-NJ) introduced a bill related to covered bonds. No action was taken on the bill. When the financial crisis overtook the
markets, Washington Mutual failed and was taken over by the FDIC, as receiver. The FDIC transferred the cover pool and the obligation on the mortgage bonds to JP Morgan Chase, which continued to make payments on the bonds. Despite the success of Washington Mutual
and Bank of America with this structure, it became clear that the existing structure for issuing US covered bonds was too expensive to replicate and too complicated for investors. Unusual, securitisation-type structures became disfavoured by investors. Also, the
Diagram A: structure used by Washington Mutual and Bank of America Issuing bank Pledge of cover pool Floating rate
Mortgage bond Indenture trustee
mortgage bonds
Mortgage bond issuer Cover pool
Mortgage bond proceeds
Diagram A: the structure used by Washington Mutual and Bank of America
Mortgage bond proceeds
(solely upon acceleration of the mortgage bonds)
Income and principal from specified instruments
Pledge of floating rate mortgage bonds
Covered bond indenture trustee
Covered bond issuing trust issuer
Covered bonds
Covered bond proceeds
Covered bond investors
Specified currency covered bond rate
US dollar floating
Specified instrument provider
Covered bond swap provider
74 IFLR/July/August 2013
www.iflr.com
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