Covered Bond Act in US

April, 2010: To add liquidity and to develop a robust capital market through new and innovative solutions, Rep. Scott Garrett, R-N.J., introduced the U.S. Covered Bond Act, 2010 with Rep. Paul E. Kanjorski, D-Pa., and Financial Services Committee Ranking Member Spencer Bachus, R-Ala. The Act is similar lines to the European covered bonds.

Covered bonds have been a major source of liquidity for many European nations’ mortgage markets. The Covered Bond Act, establishes the regulatory oversight of covered bond programs, subjects covered bonds to appropriate securities regulations by federal regulators and provides several provisions in case of default and insolvency of covered bond.The Act includes the following:

Covered Bonds have been defined as senior recourse debt obligation that has an original term to maturity of not less than 1 year, issued by an eligible issuer and secured by a perfected security interest in a cover pool of assets which is owned directly or indirectly by the issuer of the obligation. Is not a deposit as defined under section 3 of the Foreign Deposit Insurance Act.

Procedure:

·         The covered bond regulator sets up the covered bond regulatory oversight program

·         The covered bond program is approved by the regulator. The regulator being the Secretary of the Treasury or any other officer of the Department of Treasury as may be authorized by the Secretary in this regard.

·         Before approving the covered bond program the regulator has to consult the primary Federal regulator.

·         Covered Bond regulator shall maintain a covered bond registry for all approved programs

.The eligible assets are:

• Residential Mortgage Asset Class which include first-lien mortgages secured by 1 to 4 family residential property, mortgage loans insured under the National Housing Act, loans guaranteed, insured or made under Chapter 37 of Title 38 of the United States Code and residential mortgage-based securities ("RMBS") of the same asset class.
• Home Equity Asset Class would include home equity loans secured by 1-to-4 family residential property and asset-backed securities ("ABS") of the same asset class.
• Commercial Mortgage Asset Class would include commercial mortgage loans and commercial mortgage-backed securities ("CMBS") of the same asset class.
• Public Sector Asset Class would include investment-grade securities issued by one or more states or municipalities, loans made to one or more states or municipalities and loans, securities or other obligations that are insured or guaranteed, in full or substantially in full, by the full faith and credit of the United States.
• Auto Asset Class would include auto loans or leases and ABS of the same asset class.
• Student Loan Asset Class would include student loans (whether or not such loans are guaranteed) and ABS of the same asset class.
• Credit or Charge Card Asset Class would include credit or charge card loans and ABS of the same asset class.
• Small Business Asset Class would include loans made under a program established by the Small Business Administration (whether or not such loans are guaranteed) and ABS of the same asset class.

Salient features of the covered bond program:

·         In a cover pool there will not be more than one eligible asset class

·         For each covered bond program there is a need to establish minimum over collateralization requirement from time to time based on credit, collection and interest rate risk; established by the covered bond regulator

·         The covered bond issuer will have to appoint an indenture trustee (unaffiliated entity) to monitor the cover pool.

·         The cover pool securing the covered bonds shall have to satisfy an asset coverage test. This test is to be conducted every month by the issuer and the test would measure whether the assets in the cover pool satisfy the minimum collateralization requirements. The results of the monthly test are to be disclosed to the primary Federal regulator, if any, covered bond regulator and the bondholders.

·         In case the covered bond fails to satisfy the asset coverage test and the failure is not cured within the time specified in the transaction documents; it would amount to default and would result in the creation of an estate. The issuer shall submit the schedule of the eligible assets and substitute assets to the indenture trustee on monthly basis

Creation of estate in case of event of default: The estate created shall be not be taxable as a separate entity and no assets and liabilities shall be a taxable event  

1.      In case of default and before issuer enters conservatorship, receivership, liquidating agency or estate in bankruptcy

• All the applicable assets of the cover pool shall be released to and held by such estate, free from any right, title, claim of the issuer, conservator, liquidating agent, receiver or bankruptcy trustee of the issuer
• In case the assets of the cover pool are inadequate to fulfill the obligations, the bondholders will have claim against the issuer for the deficiency with respect to such covered bond or related obligation
• The issuer shall have the residual interest in the estate (if any)
• Covered bond regulator shall act as the trustee of the estate and appoint and administer one or more servicer or administrators of the pool. The administrator will:

o   Collect, realize the assets of the pool

o   Borrow, procure funds for the benefit of the estate

o   Invest or use the proceeds for making payments for the covered bonds

o   Provide liquidity support if need be

• Fees of the servicer, administrator is paid from the estate as approved by the covered bond regulator

2.      Default on conservatorship, receivership, liquidating agency or estate in bankruptcy:

• In case FDIC is the conservator/ receiver, the Corporation shall have the right to transfer the cover pool along with the covered bonds and related obligation secured by such a pool to another eligible issuer that meets all the conditions and requirements specified in the transaction document, within 15 days from the date for such appointment. The transferee shall become fully liable for the covered bonds upon such transfer
• In case no transfer takes place within 15 days an estate shall be automatically created. In such a case the issuer will continue to service the pool for 120 days from the date of creation of the estate for a fair market value fee

Before this present Act, in 2008, FDIC had issued the first formal guidance on covered bonds, the "Final Covered Bond Policy Statement" later, in the same year, the Department of the Treasury published "Best Practices Guide for US Residential Covered Bonds." This Act is the legislative follow-up to Garrett’s original legislation, The Equal Treatment for Covered Bonds Act, which was first introduced in 2008. The Covered Bond Act, 2010 has been welcomed by the industry players and is hoping to be the alternative investment solution for the markets 

[Reported by: Nidhi Bothra]

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