Search Penny Hill Press

Thursday, August 19, 2010

Covered Bonds: Issues in the 111th Congress

Edward V. Murphy
Specialist in Financial Economics


Covered bonds are a relatively common method of funding mortgages in Europe, but uncommon in the United States. A covered bond is a recourse debt obligation that is secured by a pool of assets, often mortgages. The holders of the bond are given additional protection in the event of bankruptcy or insolvency of the issuing lender. Covered bonds have some features, such as pooled mortgages, that resemble securitization, but the original lenders maintain a continuing interest in the performance of the loans. Because some believe that the subprime mortgage turmoil may have been influenced by poor incentives for lenders using the securitization process, some policymakers have recommended covered bonds as an alternative for U.S. mortgage markets. Although covered bond contracts are not prohibited in the United States, some policymakers believe that legislation and agency rulemaking could facilitate the growth of a domestic covered bond market. 

In some countries, covered bonds conforming to statutorily prescribed features may receive enhanced protections or greater regulatory certainty. A statutory framework for covered bonds often includes four elements: (1) the bond is issued by (or bondholders otherwise have full recourse to) a credit institution that is subject to public supervision and regulation; (2) bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; (3) the credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times; and (4) in addition to general supervision of the issuing institution, public or other independent bodies supervise the institution's specific obligations to the covered bonds. 

Compared with securitization, covered bonds may be less susceptible to poor underwriting standards because issuers maintain risk exposure or "skin in the game," perhaps minimizing problems of the "originate to distribute" model of lending. Institutions that issue covered bonds may be less susceptible to investor panic because the status of covered bonds on their balance sheet is transparent. On the other hand, reliance on covered bonds may reduce aggregate lending because it ties up more capital than does securitization. 

Some features of American banking regulations may have to be clarified to facilitate the use of covered bonds. Covered bonds could affect potential recovery for the Federal Deposit Insurance Corporation (FDIC) when banks fail. The FDIC issued two new policy statements in 2008, Financial Institution Letter (FIL) 34-2008 and FIL 73-2008, clarifying its obligations to the holders of covered bonds if an FDIC-insured institution is placed in FDIC receivership or conservatorship. 

In the 111th Congress, Representative Garrett has introduced three versions of a bill to establish a statutory regime for covered bonds in the United States. These are H.R. 2896, H.R. 4884, and H.R. 5823. H.R. 5823, the United States Covered Bonds Act of 2010, was marked-up in the House Committee on Financial Services on July 27, 2010. H.R. 5823 designates the Office of the Comptroller of the Currency as the covered bond regulator. It establishes minimum requirements for over-collateralization, monthly reporting, and an asset coverage test. It also requires an independent monitor for the coverage pool, which would allow U.S. covered bonds to meet the international definition of a statutory framework.



Date of Report: July 29, 2010
Number of Pages: 15
Order Number: R41322
Price: $29.95

Follow us on TWITTER at http://www.twitter.com/alertsPHP or #CRSreports

Document available via e-mail as a pdf file or in paper form.
To order, e-mail Penny Hill Press or call us at 301-253-0881. Provide a Visa, MasterCard, American Express, or Discover card number, expiration date, and name on the card. Indicate whether you want e-mail or postal delivery. Phone orders are preferred and receive priority processing.