Rep. Garrett's 'Covered Bond Fact Sheet'

[Editor's note: This "Covered Bond Fact Sheet" was prepared by the office of Congressman Scott Garrett (R-NJ).  It was included with his June 16 announcement regarding the Equal Treatment for Covered Bonds Act of 2009.]
 
                             Covered Bond Fact Sheet
 
Definition of a Covered Bond  

Covered bonds are debt instruments created from high quality assets held on a bank's balance sheet. This type of bond is secured by a pool of assets (e.g. mortgages) known as a "cover pool." As a secured debt instrument, a covered bond provides funding to a depository institution that retains the assets and related credit risk on its balance sheet. Interest on the covered bond is paid to investors from the issuer's cash flows, while the cover pool serves as secured collateral. In the event of an issuer default, covered bond investors first have recourse to the cover pool. Covered bonds have historically been highly liquid and typically rated triple-A by ratings agencies as a result of the quality of the assets tied to the debt and the investor safeguards built into the structure. The holders of the bond are given additional protection in the event of the bankruptcy or insolvency of the issuing lender. Covered bonds are increasingly used in the marketplace as a funding instrument, in addition to savings deposits and mortgage-backed securities.

History of Covered Bonds

The covered-bond market has a long and extensive history in Europe, dating back to 1770 when they were first issued in Germany to finance public works projects.  Currently, 25 countries in Europe utilize the covered bond structure as a funding tool. While each country has their own laws, the Directive on Undertakings for Collective Investments in Transferable Securities (UCITS) set up guidelines for covered bonds in Europe in 1988.  

U.S. Covered Bond Issuance

The first instance of covered bond issuance in the U.S. was in 2006, when Washington Mutual entered the arena.  Bank of America followed in March 2007. 

Covered Bonds vs. Mortgage-Backed Securities ("MBS")

Covered bonds differ from mortgage-backed securities in several ways.  First, mortgages securing covered bonds remain in an issuer's balance sheet, instead of being transferred to a Special Purpose Vehicle (SPV) like MBS.  Second, pools of loans securing covered bonds are dynamic and non-performing (or prepaying loans) must be substituted out of the cover pool.  Finally, if a covered bond accelerates and repays investors at an amount less than the principal and interest owed, investors retain an unsecured claim on the issuer.

Covered Bonds vs. Unsecured Debt

Covered Bonds differ from unsecured debt because of the absence of secured collateral underlying the obligation of the issuer.  While unsecured debt investors retain an unsecured claim on the issuer in the event of issuer default, Covered bond investors possess dual recourse to both the underlying collateral of a covered bond and to the individual issuer.  Accordingly, covered bonds provide investors with additional protection on their investment compared with unsecured debt.

Need for a Covered Bonds Statute

Covered bonds as debt instruments are broad enough in scope and magnitude to warrant being authorized and codified in federal statute. The codification of this investment tool will provide greater stability and permanency for covered bonds, in addition to encouraging the use of covered bonds as an alternative to mortgage securitization. Establishing a statute will also provide for the benefit of legislative review, rather than the possibility of changing covered bond policy through a simple motion of the FDIC Board of Governors. Statutory language provides more certainty than a regulatory change, and this certainty can lower transaction costs because investors and issuers will  not be pricing for uncertainty. In addition, spreads will be narrower which will encourage more institutions to enter a covered bonds marketplace. It is the goal to provide for an environment in which the marketplace with flourish and produce increased liquidity. Furthermore, if covered bonds are not authorized by statute, contracts would be  interpreted through common contract law in the courts, not the legislature. Narrow legislative text will provide the certainty needed to provide investor confidence, leaving the details to regulation.