Ten Political Realities Affecting U.S. Covered Bond Law Prospects

The other day I briefed a German friend on U.S. political realities affecting the prospects for enacting federal covered bond legislation that could help in establishing a market in this country.  The points I made included these:

Spencer Punnett1) The concept of covered bonds has become somewhat identified with Republicans in Washington because in 2008, covered bonds were publicized (some say promoted) by the Bush administration as a potential source of home mortgage funding here.

2) Although the U.S. Treasury Department last year released a document setting forth "best practices" for residential mortgage covered bonds — and the Federal Deposit Insurance Corporation (FDIC) published an important official policy statement — the Bush administration never proposed a comprehensive legislative covered bond framework comparable to those found in Europe.  Reportedly, some were concerned (unnecessarily, in my opinion) that such legislation might be interpreted as implying a federal guarantee of bonds issued under the legislative framework.

3) The covered bond bill introduced by Congressmen Scott Garrett (R-NJ) and Paul E. Kanjorksi (D-PA) is intended to remove some significant impediments that current law presents to development of covered bonds.  It would definitely advance the ball.  However, it does not contemplate a European-style legislative framework establishing standards and rules.  Also, as Moody's Investors Service has noted, at least one significant legal impediment to covered bonds' development in the U.S. is not addressed in the bill.

4) Establishing a comprehensive legislative framework in the U.S. comparable to Germany's Pfandbrief laws would, in my view, be a big help in establishing covered bonds as a trusted, competitively-priced funding vehicle here.  I think covered bond issuers should be able to choose whether to issue under a strict legislative framework of that type or go with "structured" (i.e., purely contractual) bonds instead.  I believe that "legislative" covered bonds would soon become preferred by issuers because their higher standards and reliability would be rewarded in the marketplace.  However, unless something changes drastically, there is virtually no chance that a comprehensive legislative framework will be established here soon.  

5) The most realistic approach to covered bond laws in the U.S. probably will be incremental.  The first step would be basic legislation to remove some current impediments, so that a (structured) covered bond market can grow.  Perhaps some issuers would voluntarily adopt Pfandbrief-like standards during that period.  Then, after Americans come to appreciate the value and importance of covered bonds, a more comprehensive (but optional) legislative framework might be possible.  That sequence would be somewhat analogous to what happened in the UK.

6) Given the current Democratic majority in Congress, no covered bond bill of any kind has a chance without Democratic leadership support.  Although one of the cosponsors of the Garrett-Kanjorski bill is a Democrat, wider leadership support would be needed for it to move forward.

7) In general, Democrats in Washington have not shown much interest in covered bonds.  One reason for this is that overall, members of the Democratic leadership traditionally have focused on homeownership affordability issues —putting home mortgage funding within reach of as many Americans as possible.  Because of covered bonds' emphasis on high loan quality, some Democrats see this as funding for the well-to-do. They are wary of changing the funding system in any way that might make mortgages more expensive.  Personally, I believe covered bonds could help strengthen the American funding system in a way that would ultimately benefit all types of borrowers, but that is probably not the current perception.

8) Of course, the Democratic Party historically has been seen as more supportive of strong regulatory frameworks, while the Republican Party generally is more identified with reducing government regulation.  Thus, if the Democratic leadership became convinced of covered bonds' merits, it might look more favorably at a statutory approach to covered bond funding that is closer to European models.

9) Another consideration is that covered bond legislation of any type may have little practical chance of passage without support from the Securities Industry and Financial Markets Association (SIFMA).  Although SIFMA has issued statements generally supporting the need for a covered bond bill, and reportedly has engaged in some activities behind the scenes (according to Total Securitization), so far the organization has declined to take a public position as to what elements should be included in such a bill.  

10) Perhaps the biggest "unknown" is what the federal government will decide to do with Fannie Mae and Freddie Mac.  Under the current home mortgage funding system, Fannie & Freddie are able to offer terms to lenders that make covered bonds generally noncompetitive in that arena. But Fannie & Freddie are also costing the federal government billions of dollars and exposing it to a great deal of potential liability.  The current administration has said that early 2010, it will make recommendations regarding the future role of Fannie and Freddie.  Although it seems unlikely that the government will bite the bullet and make any drastic changes, there is always the possibility that decisions will open more room for supplementary funding methods such as covered bonds.