Covered Bonds Amendment - Interview with Jerry Marlatt

Congressman Scott Garrett (R-NJ) recently made headlines in the covered bond world when he proposed an amendment to the Financial Stability Improvement Act of 2009 — currently pending in the House of Representatives — on the topic of covered bonds.  In contrast to legislation Garrett introduced earlier in this term (the Equal Treatment of Covered Bonds Act), the proposed amendment would establish a comprehensive statutory framework governing covered bonds in the U.S.

Jerry MarlattExperts including attorney Jerry Marlatt, senior of counsel at Morrison & Foerster, see this move as a potential game-changer in the push to establish covered bonds as a new source of funding in the U.S. economy.

Still little-known here, covered bonds function in Europe as a supplemental alternative to securitization, playing a significant role in real estate and public sector financing.   Covered bonds differ from financial products such as mortgage-backed securities because they are dual recourse:  the issuing bank remains directly "on the hook" to bondholders, who can also look for payment to a pool of assets that secures the bond (the "cover pool") if the issuer becomes insolvent.   Moreover, unlike loans packaged into a securitization, the cover pool is dynamic: if the loan assets deteriorate for any reason, more loans must be added to the pool in order to keep up the required quality.

Currently there is no federal law specifically governing covered bonds in the U.S., which many say has hindered their development in this country.   In Europe, covered bond statutes are the norm, with Germany's Pfandbrief Act often considered the "gold standard."  (Pfandbrief means "covered bond" in German.)

Garrett's proposed amendment to the Financial Stability Act would fill this breach.  Several features are especially noteworthy.  If enacted, the legislation would (among other things):

• Designate the Secretary of the Treasury as the "covered bond regulator" and require ongoing oversight;

• Set forth detailed requirements governing the type and quality of assets allowed in the cover pools;

• Provide for covered bonds that could offer funding for several asset classes that are not presently included in European statutory frameworks;

• Specify that in the event that an issuing bank for a covered bond became insolvent, control of the cover pool would automatically pass to an estate for the benefit of bondholders, with the Secretary of the Treasury serving as trustee.

In a recent interview (adapted below), Jerry Marlatt gave Covered Bond Investor™ a more detailed picture of what the proposed covered bond amendment would accomplish from both a business and legal standpoint.  Marlatt is a member of the Steering Committee of the U.S. Covered Bonds Council — an organization formed by the Securities Industry and Financial Markets Association (SIFMA).  He has been called a pioneer in the U.S. covered bonds field because of his role with the first covered bond issued here (by Washington Mutual in 2006; now assumed by JP Morgan). 

Looking at the U.S. funding picture as a whole, why do you believe covered bonds could be particularly useful at the present time?

Moody's Investors Service recently came out with a release analyzing the debt issuance profiles for banks in jurisdictions around the world.  In most jurisdictions, the average debt maturity for banks for newly issued debt fell from somewhere around eight years to about 4.7.  In the UK, it's 4.3 years, and in the U.S. it's 3.2 years.   That means about $1.5 trillion of U.S. bank debt needs to be replaced in the next three years.  If you're going to — as a prudent banker should — try to extend the average maturity out closer to the traditional seven or eight year range, it means you need to really be issuing ten- and twelve-year debt to pull maturities up. 

This is a natural area for covered bonds, which tend to have longer maturities.  And it's a natural also because if you're issuing debt out at ten or twelve years, the coupon in this market is going to be much higher, and with covered bonds you're going to get a much better coupon at those maturity rates.

Before turning to other asset classes, let's discuss an area where covered bonds play an important role in Europe: real estate funding.  As a practical matter, how competitive do you think the proposed legislation could make covered bonds from a financial standpoint in the U.S. housing market?

I think for loans that fit Fannie Mae's & Freddie Mac's requirements, it's almost always going to be more efficient to be selling loans, securitizing through them — because they borrow with a government guarantee.  But it should be close. 

I think what you're left with are what are called "nonconforming" loans — those that don't fit Fannie & Freddie requirements.  In that area, covered bonds should, from a financing point of view, start to become competitive with private residential mortgage-backed securities. 

But there are some unanswered questions yet.  With a covered bond, the collateral is on-balance sheet, so there's a capital charge on that collateral.  Normally with mortgage-backed securities, since you've sold the collateral, it's off-balance sheet and there's no capital charge.  So your financing has to be very efficient with a covered bond to beat that.  But in the current environment, there have been changes with the accounting rules that will make it more difficult to get assets off-balance sheet.  What happens — what capital charge will be applied in a securitization if the asset didn't go off the balance sheet — hasn't been answered yet.  So making a complete comparison between covered bonds and securitization is a little difficult to do in the current climate.

As you know, the current situation for Fannie Mae and Freddie Mac is not stable — the Treasury Department has publicly stated that it plans to reevaluate their current role.  Does this have potential implications for covered bonds?

Yes.  At some point the administration and the Congress are going to have to turn to Fannie Mae and Freddie Mac — to decide a future for them and resolve their current problems.  They currently hold something like 60% of outstanding mortgage debt in the U.S. 

Suppose you were to conclude that the appropriate role for the government is not to be the dominant player in the market but to be present in the market particularly in areas where it's really important for affordable housing goals.  If you said Fannie & Freddie should fund 30% of the market, it basically means there's three trillion dollars worth of mortgage loans you need to fund somewhere else.   If you had a ready alternative, such as covered bonds, it would give you some flexibility in how you approached Fannie & Freddie.

I don't think the administration is going to turn to Fannie & Freddie for some time yet.   So it might be really useful to get covered bond legislation in place and see how it develops - whether it really is a viable financing technique in the U.S. and might provide some relief in dealing with Fannie & Freddie. 

What about the potential use of covered bonds for commercial real estate funding under the proposed legislation? 

Given the current problems in the commercial mortgage loan market, doing a commercial mortgage-backed security (CMBS) offering is going to be difficult or impossible.  So in this market, for a bank to issue a covered bond — where the bank is carrying the burden of the collateral and is refreshing the cover pool every month — may be advantageous in attracting investors. 

There is no requirement in the proposed legislation that loans used in cover pools be new loans, so you could put old loans in — provided that they're still performing.  For those loans that are carried on-balance sheet by the banks and not securitized, this could be an important additional alternative for financing them.

How would you compare the potential investor base for covered bonds to the investors for mortgage-backed securities?

They are two very different investor bases.  If somebody buys RMBS [residential mortgage-backed securities], they're taking convexity risk on the pool — that is, a prepayment risk.  You never know when your investment is going to pay back for sure because mortgage loans can be repaid at any time.   And you're taking 100% collateral risk.  Whereas with a covered bond you know exactly when it's going to pay back.  And you're only secondarily taking a collateral risk, because you're primarily looking to banks — and the collateral pool is updated every month, so if you ever have to rely on the collateral you start with a nice, fresh collateral pool.   So a very different type of investor, a very conservative investor — and you could see where diversification of funding between the two investor groups could be an important benefit for issuers.

One of the unusual features of the proposed legislation is that it would provide for covered bonds backed by credit card receivables, student loans, auto loans, small business loans, or home equity loans.   Are you aware of any other covered bond statutes that have provisions for such asset classes?

No, not statutory schemes.  But you may recall the $1 billion covered bond offering by Souh Korea's Kookmin Bank, in the spring of this year, that was about half credit card receivables.   Of course, that covered bond was structured by contract rather than issued under a covered bond statute.

How much of an impact do you think covered bonds could make in funding these alternative asset classes within the U.S.?

I'm going to talk around that point, because I'm not sure I can answer it directly for you.   The existing three trillion dollar covered bond market in Europe is mostly for residential mortgage loans and secondarily, for public sector obligations.   A market of that size provides a pretty strong incentive, sooner or later, for U.S. banks to issue covered bonds for real estate funding just to get to a different funding base.  Diversification is important.  And with the market already there, it's just tempting to do that.

With auto loans and credit cards, which are newer areas for covered bonds, that's a different story.   But it certainly might be appealing from a bank's point of view.  That is, if I set up a program for mortgages, I can do a similar program for auto loans — once the program is up and I'm already administering it, from an internal operational point of view there's going to be some efficiency in setting up similar programs for other asset types. 

And from an investor's point of view, if you're buying mortgage-related covered bonds, you could see where you might buy auto loan covered bonds.  They're dual recourse, the cover pool refreshes, auto loans historically have had great constant default rates — they're a very predicable asset.  That might be a pretty attractive covered bond.

Do you think these nontraditional asset classes will be controversial in the European covered bond community, since the laws there do not provide for them?

I guess the answer is maybe.  But under this legislation, if you're setting up a covered bond program, you can only use one type of collateral for the program.  If you wanted to do both a residential mortgage covered bond program and a credit card program, it has to be two separate programs.  So if somebody were buying a residential mortgage covered bond, they don't have to worry that you might put auto loans or student loans or credit card receivables into the cover pool in the future.  I think that should remove some of the concerns. 

What is the most important way in which the proposed legislation would help in developing a U.S. covered bond market?

The most immediate effect is that the proposed legislation would take a lot of the current cost of issuing covered bonds in this country off the table, which will make covered bonds more competitive with securitization or other types of funding.

How would the legislation reduce the costs of covered bond issuance?

First, under the current U.S. structure without a statute, the collateral pool has to be liquidated at the time an issuing bank becomes insolvent.   Since the pool assets have to be sold quickly instead of over a period of time, the prices obtained can easily suffer.  So there's a lot of overcollateralization in the pool to try to address that — and that's expensive.  For example, in the case of Washington Mutual, as the bank approached receivership, the overcollateralization of that pool exceeded 40% — and you can see where that's very expensive. 

Under the proposed legislation there is no need to liquidate the cover pool; it is set aside and administered to pay the bonds.

Secondly, in the absence of a statute, [in the event of issuer default] you have to liquidate the pool and end up with cash.  You have to put the cash somewhere.  So at the time you set up a U.S. covered bond under the current state of the law, there's a standby investment of some kind that's arranged.  You have to pay for that, to get somebody to put that investment up.  And it's not going to give you a very good yield, because the guy providing the investment doesn't know when he's going to get the money, and if he does get it, it's an enormous chunk of money coming down.  So the yield off of it is very low.  And you have to put swaps in place to deal with the yield difference.  Plus the swaps have to cover the time, the delay it takes to liquidate the pool — which could be 30 or 60 or 90 days or longer, depending on what stays are in place.   And those swaps are expensive, and they're off-market, and because they're off-market they're even more expensive. 

Under the proposed legislation there is no need to liquidate the cover pool [upon default] and, importantly, the separate collateral pool is authorized to borrow funds from the Federal Financing Bank, which addresses any liquidity needs.

Finally, under the current system you have a structure that is complicated to explain to investors, so they're going to charge you a higher yield on the covered bond. 

Under the proposed legislation, the framework for issuing covered bonds is simple and easy to explain to investors.  For European investors, the framework will look familiar because it is similar to many European covered bonds.

Note: The interview above was adapted from oral and written communications, November 19 - 27.

Related Articles:

• Text of Proposed Covered Bonds Amendment