Moody's: Potential Credit Impact of U.S. Covered Bond Bill "Limited"

In a "Sector Comment," Moody's Investors Service has looked at the covered bond legislation currently before Congress.  It finds a possible negative consequence along with the pluses—and says "a key rating consideration" relating to liquidation risk remains unaddressed.

The bill under scrutiny is the "Equal Treatment of Covered Bonds Act of 2009" (ETCBA), which was introduced June 16 by Rep. Scott Garrett (R-NJ) and Rep. Paul E. Kanjorski (D-PA). 

The Sector Comment analysis was performed by two Moody's VPs: senior analyst Yehudah Forster (New York) and senior credit officer Massimo Catizone (London).  The points they address all relate to what would happen if a financial institution that sponsored a covered bond program became insolvent and was taken over by the FDIC.

Moody's identifies at least two strengths of the ETCBA in that scenario:

• If the FDIC chose to repudiate the covered bonds (rather than transfer the covered bond program to a solvent bank or let the covered bond trustee seize the cover pool), it would be expressly required to pay the full outstanding principal balance as an element of damages (see ETCBA §2(c)(3)). According to Moody's, under current law "the FDIC could potentially pay less than par if it believed the market value of the assets was less than the principal balance of the covered bonds"—with the deficiency becoming an unsecured claim against the estate of the insolvent sponsor bank.

• If the FDIC did not choose to repudiate or transfer the covered bond program, the covered bond trustee would be able to take over the cover pool without having to ask the FDIC's permission, because the ECTBA defines covered bonds as "qualified financial contracts" under the Federal Deposit Insurance Act (see ETCBA §2(b)(2)). As Moody's notes, this could enable the trustee to start liquidating the cover pool assets sooner than might otherwise be possible.

At the same time, Moody's points to two provisions of the ETCBA that may have the consequence of making the FDIC less likely to choose the options of transferring the covered bond program to a solvent bank or repudiating the covered bond program and paying damages.  If so, the covered bond trustee would be more likely to find itself in a position of having to liquidate the cover pool assets.

Liquidation by a covered bond trustee is not necessarily a concern if the program is set up so that liquidation and payment under the bonds can take place over an extended period of time.  In that context, Moody's and Fitch Ratings have both taken a favorable view of European covered bond programs with provisions that allow for extended maturity dates and pass-throughs in event of issuer insolvency.

The question—what Moody's calls "a key rating consideration"—is whether covered bond programs could be set up in the U.S. with that kind of flexibility.

"A number of European covered bond programs allow for the servicing of the assets in the cover pool for an extended period of time following sponsor default," Moody's writes.  "It is not clear to us that applicable U.S. law, such as the Uniform Commercial Code, would allow this."

Unfortunately, the ETCBA does not specifically deal with that issue.  As a result, there is a risk that applicable law may require liquidation in full within 120 days of a sponsor bank's default in all cases.

The Sector Comment from Moody's, titled "Limited Credit Impact from Proposed U.S. Covered Bond Legislation," was extracted from a "Weekly Credit Outlook" dated August 10 and released separately this week.