Senate Committee on Banking, Housing, and Urban Affairs
Covered Bonds: Potential Uses and Regulatory Issues
September 15, 2010
Members Present:
Chris Dodd (D-CT), Jack Reed (D-RI), Jeff Merkley (D-OR), Richard Shelby (R-AL), Bob Corker (R-TN)
Witnesses:
Panel 1
Honorable Scott Garrett, New Jersey
Panel 2
Ms. Julie L. Williams, First Senior Deputy Comptroller and Chief Counsel, Office of the Comptroller of the Currency
Mr. Michael H. Krimminger, Deputy to the Chairman, Federal Deposit Insurance Corporation
Mr. Scott A. Stengel, Partner, Orrick, Herrington & Sutcliffe LLP, on behalf of the U.S. Covered Bond Council, Securities Industry and Financial Markets Association
Kenneth A. Snowden, Professor, University of North Carolina at Greensboro
Mr. Ric Campo, CEO, Camden Property Trust, on behalf of National Multi-Housing Council
Opening Statements:
Dodd: We want to learn more about covered bonds to see if they can help with financial growth and the broader economy. We generally mean a debt security issued by a bank and backed by cash flows. They provide an additional option to the two dominant funding mechanisms currently. These assets remain on a bank’s balance sheet. It is important for Congress to look at alternative means to stimulate the economy.
Shelby: Examining the use of covered bonds is a positive first step in the direction of continuing to find ways to improve the economy. However, some things that work in other countries do not work the same way in our economy. Covered bonds have been tried here before and haven’t had much success. We need to conduct our own analysis.
Highlights from Witness Testimony (Panel 1):
Garrett: We need to increase private investment in our capital markets. Establishing this U.S. covered bond market will achieve this. Covered bonds will ensure longer, more stable liquidity in the markets. The House Financial Services Committee marked up legislation before the recess, and I hope we can pass it in the next few weeks. A regulatory regime needs to put into place to ensure proper oversight of covered bonds. I believe we have to do this right now. We hear daily about liquidity concerns in the marketplace. Billions of U.S. investment dollars are moving overseas. This is private capital that could be invested here in the U.S. We are missing out on this opportunity. Covered bonds will help to solve some of our funding needs.
Questions and Answers:
Corker: What kind of compromises did you have to make in the markup of H.R. 5823, the United States Covered Bond Act of 2010? Garrett: One was with respect to asset classes. We agreed to reign in the broad approach to asset classes and to allow regulators some degree of flexibility.
Highlights from Witness Testimony (Panel 2):
Williams: Covered bonds are a promising funding option for financial institutions. They could be a new source for lending and an alternative source for liquidity. They could provide a funding source that is longer and more stable. They might require less capital. They may attract types of investors that might not otherwise invest in bank debt. A complex set of factors will determine how attractive they are compared to other alternatives. Capital requirements could constrain the advantages of covered bonds. The legal framework will be a key factor in whether they flourish, and various legislative efforts have emerged recently regarding the elements of a regulatory regime. We support a framework with federal regulators operating under a set of uniform standards. We suggest a new covered bond program start with a relatively conservative class. Standards should include minimum eligibility requirements for asset class and others. How a U.S. legal framework resolves a default of a covered bond issuer and the role of the FDIC will critically affect the appeal of covered bonds.
Krimminger: The importance of the insurance deposit fund is one of the most important factors to consider. We urge that any legislation preserve the FDIC’s authority. The FDIC has three options. It can continue to perform under covered bonds, it could turn over the collateral to the investor, or it can terminate the program, pay the full value, and return it to the credit pool. H.R. 5823 only gives the FDIC two options. It gives investors rights that no other creditors get under U.S. law.
Stengel: There is still a need for long term, cost-effective funding that can be translated into meaningful credit. Covered bonds are an untapped yet proven resource for this. Over their history, they have been backed by a wide array of asset classes. U.S. covered bonds can stabilize the economic system and stimulate growth. They can infuse long term liquidity into the markets. They can produce less expensive and more available credit. They can add funding from a separate investor base. They can deliver funding from the private sector without implicit or explicit government guarantee. They can increase transparency and uniformity in the capital markets. They must be deep and highly liquid, and this requires legislation. We support covered bond legislation.
Snowden: Covered bonds are very popular and have a record of success in Europe. From my research, past failures of covered bonds are explained by bad timing, poor implementation, and ineffective regulation. A common failure was to transplant elements of the European system without tailoring them to fit U.S. systems. We should address these problems but not abandon the effort.
Campo: We caution that covered bonds are unlikely to provide the flexibility and other factors that would be needed to replace current mechanisms. Our concerns are about the broader issues of housing finance reform and how it affects the availability of credit. We support a careful look at covered bonds as a supplemental source of credit. For numerous reasons, it’s unlikely that they could provide the price superiority to replace current funding sources. Banks could simply replace home loans with covered bonds, which would not increase lending activity. Since so many asset classes qualify, it’s unclear whether the banks would use them to increase multifamily lending. Europe’s covered bond market came to a standstill during the global economic crisis. For all these reasons, we conclude covered bonds might augment but not replace current systems.
Questions and Answers:
Dodd: You suggest that covered bond programs could imply guarantees from federal regulators. How could this be prevented? Williams: The selection of a single covered bond regulator and depending on what entity that would be might incrementally enhance an impression that there was a government backing of the financial performance of the bond itself compared to the impression if the federal regulators were in charge of oversight. Krimminger: There should be standards being set, but to have direct oversight in order to protect investor interest certainly creates another level of oversight. Dodd: The FDIC says any covered bond legislation must preserve the current flexibility of the FDIC. Should the FDIC have this flexibility or should investors in covered bonds have more certainty? What would happen in the event of a failure of a bank that issued covered bonds? Stengel: It’s not unprecedented. Looking at the top 50 banks alone, they have over $1 trillion of assets. These lenders have much more enhanced rights. The notion that there is a dichotomy between secured and unsecured creditors is not entirely accurate. The notion today that the FDIC has unlimited flexibility is not entirely accurate. Our primary concern is a fragmentation in the market. We could be supportive of the Treasury writing the rules and then have them implemented by the prudential regulators.
Corker: The problem seems to be with the friction between the FDIC and everyone else. This is what needs to be worked out. Stengel: We could certainly create a covered bond market if they were treated like qualified financial contracts. Krimminger: The preferred option is to transfer the covered bond program to another bank if a bank fails. We need the repudiation power because in cases where we can’t transfer it, the creditors and the deposit fund should get paid. Investors should get paid but not overpaid.
Reed: If there was a covered bond program, that would require higher capital since they’re on the balance sheets. Is that correct? Williams: Yes. There would be a capital requirement that would apply. Reed: So one of the things needed would be a conscious decision of the institution to do covered bonds and to have higher capital. If the covered bond program was authorized, two consequences would be maintaining higher capital and higher assessments. So it’s not a completely win-win situation for the economy. Williams: I think that’s fair to say. There are certainly advantages and disadvantages.
Merkley: Do you anticipate banks being able to hedge their risk by purchasing insurance against the failure of the product? Stengel: Banks will hedge the assets on their balance sheet as dictated by regulatory standards, but nothing about the kind that you’re talking about is being considered at all. Williams: The assets remain on their balance sheet, so we could continue to have the same concerns about their asset liability and risk management. Krimminger: There are provisions that require replacing delinquencies over a period of time. Now when the institution closes, no one is adding to that pool, the asset pool will have diminishing value, so investors should not have the benefit of an increasing asset pool.
Dodd: A legitimate complaint is that we’ve put so much stock in home ownership and so little in home rental. You have a concern about the problems in the multifamily housing context with covered bonds. Stengel: Covered bonds will not replace securitization. They are a complement, but not a replacement. Dodd: What’s the most important thing we should keep in mind as we move forward? Williams: There’s a tradeoff here with issues that are important to the FDIC about the differences between covered bonds and what we have now and how the FDIC has traditionally viewed these situations. These issues need to be resolved. Krimminger: The concern is making sure we don’t create a super class of assets. Stengel: We need to be prudent and have cautious risk management, but we need to have some flexibility. I’m confident in the instructions from our council. Campo: It really gets down to balance. We’re talking about balance between what product is used to finance housing overall.
We know we have to finance, and we know the balance of our models need to change over time. I think covered bonds do make some sense, but we have to be careful so we aren’t crowding other parts of the market.