Co-published Covered bonds guide: US Diagram B: structure used in the UK and Canada


Mortgage loans and related security


Issuing bank Seller


Consideration Guarantor LP


Covered bond swap provider


Interest rate swap provider


Intercompany loan


Repayment of intercompany loan


Trust deed (incl. covered bond guarantee) and security agreement


Issuing bank Issuer


Bond trustee


Covered bond proceeds


Covered bonds


Payment of principal and interest


Covered bondholders


This structure has been welcome in the market and does not entail the expense and complexity of the Washington Mutual structure. It is a simple structure. The issuing bank establishes a subsidiary to which it sells the mortgage loans that will constitute the cover pool. A loan from the bank to the subsidiary provides the financing for the purchase of the loans. The bank issues covered bonds to investors, guaranteed by the subsidiary. The guarantee is secured by the pledge of the mortgage loans owned by the subsidiary. (see diagram B). If the bank fails, it will be taken into receivership by the FDIC. The subsidiary then becomes obligated under its guarantee to continue making scheduled payments on the covered bonds using proceeds from the mortgage loans. This issuance structure has now become well accepted by US investors as almost half of the $120 billion of dollar covered bonds outstanding have been issued under this structure. The legislative initiatives discussed above contemplate a direct issuance structure that is similar to many European structures. Mortgage loans in the collateral pool would be ringfenced on the balance sheet of the issuing bank and covered bonds would be issued directly to investors by the bank. Only upon the insolvency of the bank (or upon a pre-insolvency event of default) would the mortgage loans be separated from the bank and used to pay the covered bonds as scheduled. Such a structure would be


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preferable for its simplicity, but in the absence of a statute the Canadian or English structure is probably the best alternative and has the benefit of market acceptance. Whether this structure would be approved


by US regulators, particularly the FDIC, is an open question. In order for the structure to work, the FDIC would need to treat the transfer of mortgage loans to the subsidiary as a sale when the FDIC is acting as a receiver for the failed bank. Because the mortgage loans would be transferred in whole to the subsidiary, with no retained interest held by the bank, such sale treatment should be obtainable. Regulatory approval would also be needed to establish a bank subsidiary. Because the subsidiary would be engaged in the business of investing in mortgage loans, a business the bank itself is authorised to engage in, approval for establishment of the subsidiary seems likely. Such regulatory approval may be conditioned on the bank not issuing covered bonds in excess of an specific percentage of it liabilities to address any FDIC concern about excessive encumbrance of assets. The effect of this structure is to convert a


debt obligation of the issuing bank, upon its failure, into a simple securitisation with a fresh collateral pool that has no defaults at the time of the conversion. The impact on depositors and other creditors of the bank should be similar to that of the bank effecting a securitisation immediately before its failure. This structure was not used by Washington


Mutual and Bank of America to issue their covered bonds. There has been some suggestion that there was some regulatory hostility at the time to this structure. However, there has never been a definitive response from the regulators to using this structure. Moreover, in the aftermath of the financial crisis, caused at least in part by US mortgage securitisation, perhaps the regulatory response would be different today. As in the Canadian and English covered


bond programmes, if a bank were limited in the percentage of its assets that it could transfer to its subsidiary, perhaps the FDIC could be convinced that covered bonds issued under this structure would provide an attractive alternative to securitisation of mortgage loans. Securitisation comes with massive hidden contingent liabilities for breaches of representations and warranties, with inherent conflicts of interest and a mix of complicated Dodd-Frank rulemaking. By comparison, covered bonds simplify the regulators’ assessment of a bank because of improved transparency, and foster a better environment for borrowers and improved bank underwriting standards. At a time when it would be beneficial to restore a high level of private sector funding for residential mortgage loans without the risks presented by securitisation, maybe we should look at this alternative to enacting a covered bond statute, and get on with the business of financing residential housing. A statute would follow if we develop significant issuance.


IFLR/June 2013 77


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