Moody's: U.S. Covered Bond Act Would Be "Credit Positive"

A new Sector Comment from Moody's Investors Service finds that currently proposed covered bond legislation "satisfactorily address[es] the main uncertainties for U.S. covered bonds by providing predictability and clarity on how the cover pool would be treated following an issuer's insolvency" and is "credit positive overall."  But the credit agency also discusses significant remaining uncertainties in the area of over-collateralization (OC) and refinancing risk.

The Moody's Comment (released March 29) — written by VPs Yehudah Forster and Massimo Catizone — is directed to H.R. 4884, the United States Covered Bond Act of 2010.  The bill was introduced in Congress by Rep. Scott Garrett (R-NJ) on March 18 and referred to the House Financial Services Committee as well as the Committee on Ways and Means.

The uncertainty highlighted by Moody's on the topic of OC relates to Section 3(b)(3) of H.R. 4884, which states in part:

"Each cover pool securing covered bonds shall be required at all times to satisfy an asset-coverage test.  The asset-coverage test shall measure (as such term is defined by the covered bond regulator) whether the eligible assets and the substitute assets in a cover pool satisfy the minimum over-collateralization requirements established by the covered bond regulator for covered bonds backed by the applicable eligible asset class."

In this context, Moody's expresses the following concern:

"The specificity of this language leaves some uncertainty about whether any higher amount of over-collateralization committed by an issuer, such as may be demanded by the market, would be protected following an issuer insolvency or whether it could be subject to a clawback by the issuer's general insolvency estate [italics added]."

The credit agency notes that its concern on this point is magnified by the "limited criteria" specified in Section 3(b)(1) for setting minimum over-collateralization (OC) amounts in the first place.  Application of those limited criteria might result in only a "nominal level" of OC - i.e., "one that is artificially low because it would not take into account refinancing risk" (italics added).

Moody's defines refinancing risk as "the risk of having to liquidate or refinance cover pool assets in harsh or illiquid market conditions to raise cash to make payments on the covered bonds."

Also on the subject of refinancing risk, the credit agency points out that H.R. 4884 does not follow the example of European covered bond laws, which generally require portfolio level tests estimating asset-liability mismatches in cash flows and maturities.  In Moody's view, this omission could result in material differences among individual U.S. covered bond programs in their degree of exposure to refinancing risk.

This Sector Comment is Moody's third on the topic of proposed U.S. covered bond legislation.  The first (in June 2009) was on Rep. Garrett's "Equal Treatment of Covered Bonds Act of 2009," which found that the potential credit impact was "limited" and did not address "a key rating consideration" regarding liquidation risk.  The second Comment (in December 2009) was on the comprehensive covered bond framework proposed as an amendment to financial reform legislation.

Related:

• Rep. Garrett Introduces "U.S. Covered Bond Act"

• "U.S. Covered Bond Act of 2010" (text)

• "Section-By-Section Analysis" of U.S. Covered Bond Act

• Sidley Austin Update on U.S. Covered Bond Act of 2010

• "Covered Bond Legislation: Is the Fourth Time the Charm?"

• "U.S. Covered Bond Legislation Edges Forward"