FDIC Policy Statement on Covered Bonds--in Plain English

Recently a friend sent an email asking for an explanation of what the Federal Deposit Insurance Corporation's (FDIC's) Covered Bond Policy Statement is all about—in the plainest English possible.

The Policy Statement (issued July 2008) is important to understand because in the absence of U.S. legislation on covered bonds, it comprises one of the two key official documents specifically devoted to the topic.  (The other is Treasury's Best Practices document.)

What follows is adapted from the email I put together in an attempt to explain the Policy Statement, to the best of my own understanding.

The Policy Statement's purpose

The primary purpose of the FDIC's Covered Bond Policy Statement was to clarify "how the FDIC will apply the consent requirements of section 11(e)(13)(C) of the Federal Deposit Insurance Act (FDIA)."   Basically, it deals with the scenario that arises if the FDIC takes over a failed bank that has issued covered bonds.  I'll try to summarize the scenario, the problem that results from it, and the solution that the policy statement provides.  Then I will answer some likely followup questions.

The scenario

An FDIC-insured bank issues covered bonds (either directly or through an SPV).  Then the bank runs into financial trouble and gets taken over by the FDIC.  

In that situation, the applicable law—the FDIA—allows the FDIC three options as to how to deal with the covered bond program:

(A) keep the covered bond program going as if the takeover had not occurred;

(B) put an end to the covered bond issue by paying off the bondholders in cash up to the value of the "pledged collateral" (i.e., the assets in the covered bond program's cover pool); or

(C) allow whoever has responsibility as trustee for the covered bonds to take control of the cover pool so as to liquidate it for the benefit of the bondholders.  (Note: the Policy Statement calls this trustee the "covered bond obligee.")

The problem

In effect, FDIA section 11(e)(13)(C) allows the FDIC a long delay period in which to make up its mind on which option to choose, by imposing an automatic stay.  In other words, during that period, third parties such as creditors can't enforce their legal rights, like taking possession of collateral.  Depending on whether the FDIC's takeover came in the form of a receivership or conservatorship, the delay can be 45 or 90 days—even if the FDIC stops the flow of bond payments in the meantime. 

From the standpoint of the covered bond trustee (and the bondholders), this is bad!  

The sooner the trustee can take control of the cover pool and start managing the assets, the better off the bondholders are likely to be.

The solution provided by the Policy Statement

The Policy Statement is basically an advance assurance by the FDIC that under certain specific circumstances, it will provide relief on the covered bonds sooner than the FDIA requires.  (The assurance only applies to covered bonds that meet certain specified requirements, which I will talk more about later.)

Essentially, what the FDIC promises is this:

If a situation arises where (1) we have taken over a bank that issued covered bonds; (2) we cause the bank to stop making payments on the covered bonds; (3) the covered bond trustee makes a written demand; and (4) we still don't make payments for an additional ten days—then we hereby give our consent in advance for the covered bond trustee to take control of the cover pool assets.   

Because of this assurance, the covered bond trustee can be confident in advance that if bond payments from the bank stop after an FDIC takeover, the trustee will not have to wait to take control of the assets until after the stay period ends.

There is also a related assurance for a case where the FDIC chooses to exercise option (B) above—notifying the covered bond trustee that it is "repudiating" the agreement underlying the covered bond issue—but then fails to pay the cash as required.  In that case, if the FDIC refuses to hand over the cash within ten days after giving notice of repudiation, the Policy Statement provides advance assurance that the FDIC will permit the covered bond trustee to take control of the cover pool assets (in lieu of the cash).

You will find those key assurances in section (c) of the Policy Statement.

What covered bonds qualify under the Policy Statement?

As I mentioned earlier, the FDIC's Policy Statement does not apply to all covered bonds—only to those that meet certain specific requirements.  You will find those requirements in sections (a)(1), (a)(2), and (b) of the Policy Statement.  

For example, the covered bond must have a maturity of 1 - 30 years.   There are restrictions on the type of mortgages that can be in the cover pool.  The cover pool has to consist of at least 90% mortgages—with an allowance for up to 10% of mortgage-backed securities—except that for initial collateral you can substitute cash, Treasuries, or agency securities.  Also, in order to qualify, the bank's total covered bond obligation may not exceed 4% of its total liabilities.

What if the covered bonds don't qualify?

If the covered bond issue doesn't meet the Policy Statement's requirements, the assurances in the Policy Statement don't apply, so the problem I described above still exists for those bonds.  Nothing in the Policy Statement actually restricts FDIC-insured institutions to issuing only covered bonds that qualify.

What if the issuer in question is not an FDIC-insured institution?

The Policy Statement is only an assurance by the FDIC, so it does not apply to any institutions that are not insured by the FDIC.  For example, the Policy Statement does not apply to credit unions, which are insured through a different federal agency (the National Credit Union Administration).

Beyond this, remember that a covered bond issuer does not necessarily have to be a bank or credit union at all.  For example the issuer might be a corporation.  In that case, a default by the issuer (such as in a bankruptcy situation) would bring to bear entirely different sets of laws (such as bankruptcy laws).

Mealy-mouthed disclaimers

• This attempt to summarize the FDIC's Policy Statement is not legal advice and should not be relied upon as such.

• Please bear in mind that in trying to show the big picture clearly, I have had to leave out many details.

Note to readers: If you believe I have misunderstood or badly explained anything above—or if you feel I left out something really important—please email your suggested improvements to punnetts@coveredbondinvestor.com.