WikiLeaks Document Release http://wikileaks.org/wiki/CRS-RS22925 February 2, 2009 Congressional Research Service Report RS22925 Covered Bonds: An Alternative to Securitization for Funding Mortgages Edward V. Murphy, Government and Finance Division Updated August 1, 2008 Abstract. Treasury Secretary Paulson has said that covered bonds could bring more certainty and more competition to mortgage markets. Because issuing banks do not sell mortgage assets to securitization trusts, accounting features of covered bonds may provide more readily accessible information to potential purchasers of the covered bonds and to the shareholders of the banks issuing the covered bonds. Some features of American banking regulations may have to be clarified to facilitate covered bonds. The Federal Deposit Insurance Corporation (FDIC), for example, issued a new rule clarifying its obligations to the holders of covered bonds if an FDIC-insured institution is placed in FDIC receivership or conservatorship. Order Code RS22925 Updated August 1, 2008 Covered Bonds: An Alternative to Securitization for Funding Mortgages Edward Vincent Murphy Analyst in Financial Economics Government and Finance Summary Covered bonds are a relatively common method of funding mortgages in Europe, http://wikileaks.org/wiki/CRS-RS22925 but uncommon in the United States. A covered bond is a recourse debt obligation that is secured by a pool of assets, in this case mortgages. The holders of the bond are given additional protection in the event of the bankruptcy or insolvency of the issuing lender. They 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. Treasury Secretary Paulson has said that covered bonds could bring more certainty and more competition to mortgage markets. Because issuing banks do not sell mortgage assets to securitization trusts, accounting features of covered bonds may provide more readily accessible information to potential purchasers of the covered bonds and to the shareholders of the banks issuing the covered bonds. Some features of American banking regulations may have to be clarified to facilitate covered bonds. The Federal Deposit Insurance Corporation (FDIC), for example, issued a new rule clarifying its obligations to the holders of covered bonds if an FDIC-insured institution is placed in FDIC receivership or conservatorship. This report will be updated as conditions warrant. The Equal Treatment for Covered Bonds Act of 2008, H.R. 6659, would define a covered bond as a nondeposit recourse debt with a term to maturity of at least one year and secured by specifically identified assets. H.R. 6659 also calls for rulemaking regarding covered bonds to be conducted jointly by financial regulators. In response to recent mortgage market turmoil, the Treasury Department and the Federal Deposit Insurance Corporation (FDIC) have considered rulemaking to encourage the use of covered bonds as an alternative to mortgage securitization. The volume of private-label mortgage securitizations, in which mortgages are pooled into trusts and then divided into securities for sale to investors, declined significantly following the subprime CRS-2 mortgage turmoil.1 In typical private-label securitizations, neither the original lender nor the mortgage-backed security (MBS) issuer has a continuing duty to the purchasers of the securities. It might be argued that this divorce of mortgage funding from loan origination contributed to weak underwriting standards in U.S. mortgage markets.2 Covered bonds, which are more common in Europe, especially the German Pfandbrief market, also pool mortgages, but the issuing banks continue to stand behind the performance of the loan pool. On March 13, 2008, Treasury Secretary Paulson suggested the increased use of covered bonds as one option to restore confidence in mortgage finance: Covered bonds, which allow banks to retain originated mortgage loans while accessing financial market funding, are another alternative worth considering. Covered bonds may address the current lack of liquidity in, and bring more competition to, mortgage securitization. Rule-making, not legislation, is needed to facilitate the issuance of covered bonds. Through clarification of covered bonds' status in the event of a bank-issuer's insolvency, the FDIC can reduce uncertainty and consider appropriate measures that will protect the deposit insurance fund. These http://wikileaks.org/wiki/CRS-RS22925 steps would encourage a covered bond market in the U.S.; similar changes in Europe have resulted in more covered bond activity.3 Financial Structure of Covered Bonds A covered bond is a bank-issued debt that is backed by a pool of loans, often mortgages. In finance-speak, a covered bond is thus a recourse debt obligation that is secured by a pool of assets. Unlike typical private securitizations in the United States, the bondholders' claims extend to the issuing bank's assets if the underlying mortgages default. If the underlying mortgages continue to perform but the issuing bank becomes insolvent, the bondholders retain full claim on the pooled mortgages in subsequent bankruptcy or insolvency proceedings. The bonds are covered by both the pledged mortgages and the issuing bank. Table 1 compares selected features of covered bonds to typical private securitization of U.S. mortgages. 1 Private-label securitizations refer to mortgage-backed securities that are issued by firms other than the government-sponsored enterprises, Fannie Mae and Freddie Mac. 2 CRS Report RS22722, Securitization and Federal Regulation of Mortgages for Safety and Soundness, by Edward Vincent Murphy 3 "Remarks by Secretary Henry M. Paulson Jr. on Recommendations from the President's Working Group on Financial Markets," Press Release, U.S. Department of Treasury, March 13, 2008, available at [http://www.treas.gov/press/releases/hp872.htm]. CRS-3 Table 1. Comparing the Structure of Securitization and Covered Bonds Private Securitization Covered Bonds Structure Issuer gathers mortgages (or A single bank puts its own other assets) from one or mortgages (or other assets) more banks in a pool and in a pool, sells interest in sells securities which the pool, and stands ready to represent claims on the cash cover losses if the pool does flow of the pool. not perform. Claims of bondholders Bondholders have claim Bondholders have claim against mortgage pool against mortgages in pool. against mortgages in pool. Claims of bondholders Bondholders do not have If mortgage pool exhausted, against loan originator claim against other assets of bondholders retain claim loan originators (exception against loan originator. if originator provides credit http://wikileaks.org/wiki/CRS-RS22925 enhancement). Balance sheet treatment Usually not recorded as a Usually recorded as a liability of the originator. liability of the originator. Loan originator record of Gain on sale when transfer The mortgages are not sold sale on assets to trust, subject to so no gain to record. accounting standards. Servicing the loan Originators sold the loans so No isolation of originator servicing is an independent from mortgage assets, so relationship, but originator servicing relationship can service loan under unaffected. contract. Originator bankruptcy Mortgages in the pool are Bondholders have full remote from bankruptcy of claims on mortgages in pool the loan originator. even if loan originator is in insolvency proceedings. Ratings agencies Assess only the risk of the Must assess risk of assets in assets and credit pool but also the risk of the enhancement in the issuing bank as a whole. mortgage pool. Source: Vinod Kothari, Securitization: Financial Instrument of the Future (New Jersey: John Wiley & Sons, 2006), p. 357. The structure of a covered bond may encourage transparency. Unlike a typical private securitization of U.S. mortgages, the issuing bank of a covered bond does not sell the mortgages to a pass-through trust administering the payments to the investors. Because there is no sale, the issuing bank continues to report the loans on its balance sheet. When evaluating the riskiness of a covered bond, a rating agency must account for both the quality of the underlying mortgages and the financial condition of the issuing bank that covers the bonds. CRS-4 Compared to securitization, the structure of a covered bond simplifies the relationship between mortgage pools and mortgage servicers. For a covered bond, the issuing bank continues to service the pooled loans (or contract out servicing), in the same manner as it would for loans that it has not issued as covered bonds. This preserves the issuing bank's discretion to modify loans in times of distress. In securitization, however, the discretion of servicers to modify loans can be limited by loan servicing contracts that can be difficult to adjust in changing circumstances.4 FDIC Rulemaking Affecting Covered Bonds Although the covered bond market has a long tradition in Europe, the United States has much less experience. In June 2007, Bank of America became the first U.S. depository institution to issue a domestic covered bond, with a $2 billion offering. Since then, industry specialists and policymakers have been evaluating American banking regulation to see what kinds of modifications might be required to adapt this European debt instrument to U.S. financial markets. In the United States, financial problems of banks with insured deposits are often http://wikileaks.org/wiki/CRS-RS22925 resolved through actions of the FDIC. In order to adapt covered bonds to the U.S. system, therefore, FDIC rules for resolving claims against insolvent banks that have outstanding covered bonds might have to be modified. The FDIC issued Financial Institution Letter (FIL) 34-2008, FDIC Policy Statement on Covered Bonds, on April 30, 2008. FIL 34 provides more regulatory clarity by "giving expedited access to covered bond collateral if the issuing institution fails or is placed in conservatorship and meets certain criteria." Its expressed intent is to "reduce market uncertainty and allow for evaluation of the benefits and questions about covered bonds as the market develops in the United States." The FDIC issued its policy statement for covered bonds on July 15, 2008. The policy statement defines a covered bond as a non-deposit, recourse debt obligation of an IDI [Insured depository Institution] with a term greater than one year and no more than thirty years, that is secured directly or indirectly by perfected security interests under applicable state and federal law on assets held and owned by the IDI consisting of eligible mortgages, or AAA-rated mortgage-backed securities secured by eligible mortgages if for no more than ten percent of the collateral for any covered bond issuance or series.5 The FDIC limited the covered bond policy statement only to those circumstances in which the covered bonds would comprise no more than 4% of the issuer's total liabilities. The FDIC statement did not require that issuers of covered bonds use a special purpose vehicle (SPV), which was a common financial device used in securitization. 4 CRS Report RL34386, Could Securitization Obstruct Voluntary Loan Modifications and Payment Freezes? by Edward Vincent Murphy. 5 "Covered Bond Statement," FDIC, July 15, 2008, available at [http://www.fdic.gov/news/ news/press/2008/pr08060a.html]. CRS-5 Equal Treatment for Covered Bonds Act of 2008, H.R. 6659 H.R. 6659, the Equal Treatment for Covered Bonds Act of 2008, was introduced by Congressman Garrett on July 30, 2008. The definition of a covered bond is similar to the definition used in the FDIC rulemaking. The bill defines a covered bond as a "nondeposit recourse debt obligation of an insured depository institution, with a term to maturity of at least 1 year, which is secured by specifically identified assets which are performing in accordance with the terms of the contracts which created the assets." (Section 2b.) Although similar to the FDIC definition, H.R. 6659 does not require that a covered bond be used for mortgages or for AAA-rated securities. Also, the bill does not limit the term to maturity of the assets to 30 years, which would allow covered bonds to fund 40-year mortgages. The bill also specifies the regulatory authority of federal financial regulators for covered bonds. (Section 2d). In order to be applicable to covered bonds, federal banking regulations must be jointly prescribed by the Secretary of the Treasury, the Board of Governors of the Federal Reserve System, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, and the Board of Directors of the FDIC. Of the http://wikileaks.org/wiki/CRS-RS22925 members of the Federal Financial Institutions Examinations Council, the National Credit Union Administration is absent.