Push for Covered Bonds in Financial Regulatory Reform Bill Fails

"Well, they were in, and then they were out."

That's how a Client Alert from the Morrison & Foerster law firm described the fate of the covered bond provisions that came close — very close — to inclusion in the final version of the financial service reform bill (June 25).

"The outcome: no statutory framework for covered bonds (yet).  Just one vote short."

Work by the House-Senate conference committee to arrive at the compromise bill continued until about 5:00 a.m., Congressional staffers said.  More details were hard to obtain this morning, in part because many of those involved reportedly went straight home to sleep.

In retrospect, the covered bond amendment's failure was foreshadowed by word Wednesday from House Financial Services Committee Chairman Barney Frank — who served on the conference committee — that the Treasury Department and FDIC had voiced concerns. 

Resistance from those quarters was cited by various sources as the reason why prospects for the covered bond amendment were deteriorating Thursday as the conference committee's marathon final session continued.

"Because of the crush of the Volker rule, the derivative pushout rule, the "too big to fail" resolution authority, and the other provisions of the reform bill, the covered bond language did not get the time and attention needed to get everybody's concerns on the table," Morrison & Foerster Senior of Counsel Jerry Marlatt told Covered Bond Investor™ (June 25).  

"By 4:30 in the morning it was just too late.  Too late to find solutions and too late to know if the solutions really worked.  If the concerns could have been surfaced two or three days or a week earlier, they could have been addressed."

On the bright side, Marlatt noted that "at least now the concerns have been surfaced."  But at this point, he is not optimistic that provisions governing covered bonds will find their way into law soon.

"I think it will be tough to get the Congress to refocus on covered bonds in the near future," Marlatt said.  "They have probably had enough of financial regulation for a while.  So I would not look for an early passage of a covered bond bill, but I continue to think that a bill will be adopted."

FDIC Chairman Sheila Bair is on record as having made some positive comments about covered bonds in the past, and expressing a willingness to "try and accommodate" them "in an incremental way," to gain experience before "open[ing] the door" further.  In July 2008, FDIC released its "Covered Bond Policy Statement - Final" — a document that aimed to facilitate "prudent" development of a U.S. covered bond market by specifying how it would treat such bonds in the event that an insured depository institution goes into conservatorship or receivership.

However, there have also long been concerns arising from the fact that covered bonds remain on the balance sheets of issuing banks — and the cover pools of assets are "ring-fenced" to protect investors.  As early as December 2008, a senior economist at the Federal Reserve Bank of Chicago wrote an article setting up two hypothetical bank portfolios in order to illustrate a scenario where a bank's use of covered bonds could increase the FDIC's losses in the event of insolvency.

Treasury Secretary Timothy Geithner has made few public comments about covered bonds.  In response to a question on the topic in a Congressional hearing on revamping the U.S. housing finance system, he went only so far as to say that "looking at the covered bond model will be an important part of the agenda." 

Geithner's apparent reserve on the issue contrasts with the stance of his predecessor, former Treasury Secretary Henry Paulson, who in 2008 actively promoted covered bonds as a potential supplemental source of U.S. home mortgage financing.  In January 2009, Paulson also made a positive remark about the possibility of "dedicated covered bond legislation," saying that it "could be helpful to establishing this market, and should be considered in the context of broader housing finance reforms."

Ironically, the House-Senate conference committee rejected the covered bond amendment on the same day that Canadian Imperial Bank of Commerce (CIBC) launched its second U.S. dollar-denominated covered bond — thus financing another US $1.25 billion worth of Canadian residential mortgages through an issue aimed primarily at big U.S. institutional investors.

U.S. covered bond legislation "would tend to put U.S. banks on a more equal footing with Canadian and European banks who have been financing foreign mortgage loans in the private U.S. market on the basis of the statutory or regulatory structures applicable in their home jurisdictions to the issuance of covered bonds," Marlatt wrote while the covered bond amendment was still under consideration (June 24).