Originally published May 28, 2008
Keywords: FDIC, interim policy statement, covered bonds, Federal Deposit Insurance Corporation, FDIC, insured depositary institution, IDI, conservatorship, receivership, issuer, capital markets, Bank of America, Washington Mutual, mortgage bonds, mortgage bond default, eligible mortgages
An interim final policy statement1 issued on April 23, 2008, indicates how the Federal Deposit Insurance Corporation (FDIC) will treat covered bonds issued by an insured depositary institution (IDI) in a conservatorship or receivership of the issuer. The policy statement provides "guidance to facilitate the prudent and incremental development of the U.S. covered bond market while the FDIC, and other regulators, evaluate the benefits and risks of these products in the U.S. mortgage market." 2
While covered bonds have a long history in Europe, they are a newcomer to the U.S. capital markets, with only two U.S. issuers to date (Bank of America and Washington Mutual) and an initial issuance in 2006.3 Covered bonds are full-recourse obligations of the issuing IDI, secured by collateral (most often mortgage loans) that remains on the IDI's balance sheet. What distinguishes them from typical U.S. secured debt is that they are meant to provide investors with uninterrupted access to the collateral, notwithstanding the insolvency of the issuer. From an investor's point of view, covered bonds combine some of the best aspects of both traditional corporate bonds and asset-backed securities: a yield that is higher than government or agency bonds; bullet maturities with little prepayment or acceleration risk; and recourse to both a regulated financial institution and a high quality pool of collateral.
The insolvency regime for U.S. IDIs does not permit investors in covered bonds to enjoy all of the benefits available under some European legal systems. However, a structure has been devised that provides some of those benefits. As described by the FDIC:
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In the covered bond transactions initiated in the U.S.
to date, an IDI sells mortgage bonds, secured by
mortgages, to a trust or similar entity
(''special purpose
vehicle'' or
''SPV''). The pledged
mortgages remain on the IDI's balance sheet,
securing the IDI's obligation to make payments
on the debt, and the SPV sells covered bonds, secured
by the mortgage bonds, to investors. In the event of a
default by the IDI, the mortgage bond trustee takes
possession of the pledged mortgages and continues to
make payments to the SPV to service the covered
bonds.4
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The U.S. covered bond structure described above was meant, among other things, to reduce acceleration risk relating to insolvency of the issuing IDI or a mortgage bond default. Unfortunately, at about the time that the initial transactions using this structure were completed, Congress amended the Federal Deposit Insurance Act to add Section 11(e)(13)(C), which creates an automatic stay on certain actions for 45 days after the FDIC is appointed as conservator and 90 days after the FDIC is appointed as receiver. As a result, no party can exercise contractual rights to liquidate collateral pledged by a failed IDI during the applicable stay period without the FDIC's consent.
While market participants believe that transactions could be structured to survive these stay periods, doing so would create significant incremental transaction costs. As a result, various parties approached the FDIC asking for advance consent to the exercise of liquidation rights in covered bond transactions. The resulting interim final policy statement provides the requested advance consent, but only for specified actions and only for covered bond transactions that satisfy several requirements.
Specifically, in qualifying transactions, the FDIC has granted its prior consent to covered bond obligees to exercise their contractual rights over collateral no sooner than ten business days after either (a) a monetary default on an issuing IDI's obligation to the covered bond obligee, or (b) the effective date of the FDIC's repudiation of the covered bond obligations, as provided in a written notice by the conservator or receiver. Under the Federal Deposit Insurance Act, contracting parties cannot terminate agreements with an insolvent IDI solely on account of either the insolvency itself or the appointment of the FDIC as receiver or conservator. The policy statement does not alter this limitation or permit contracting parties to exercise remedies triggered solely by insolvency or the appointment of the FDIC as receiver or conservator.
To qualify for the advance consent:
- The issuing IDI must obtain the consent of its primary
Federal regulator prior to the issuance;
- The issuing IDI's total covered bond obligations
may not comprise more than 4 percent of its total liabilities
at the time of issuance;
- The collateral must be limited to "eligible
mortgages," except that as much as ten percent of the
collateral for any covered bond issuance or series may
consist of AAA-rated mortgage securities backed solely by
eligible mortgages; and
- The initial term of the covered bonds must be greater
than one year and no more than ten years.
"Eligible mortgages" are defined as performing mortgages on one-to-four family residential properties, underwritten at the fully indexed rate and relying on documented income in accordance with supervisory guidance governing the underwriting of residential mortgages existing at the time such covered bonds are issued.
The FDIC issued this guidance as an interim final policy statement, so the relief provided is immediately available, though the FDIC has also asked for comments and may refine the policy statement after reviewing the comments it receives. In particular, the FDIC has requested comments on two points: (a) whether the scope of the policy statement should be broadened to accommodate future innovations in the structuring of covered bonds; and (b) whether issuance of covered bonds should increase the issuing IDI's insurance assessment, either by increasing the assessment rate or by including the covered bonds in the assessment base.
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Footnotes
1. Federal Register , Vol. 73, p. 21949.
2.Federal Register , Vol. 73, p. 21950.
3. Ibid.
4. Ibid.
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