ICBA Policy Resolutions for 2013
Track I: Legislation and Regulation
- Any covered bond legislation should be crafted to ensure that community banks are not placed at a competitive disadvantage.
- Any covered bond legislation should contain provisions that ensure community banks do not become functional mortgage finance captives of their larger competitors.
- Any covered bond legislation should include provisions that maintain the Federal Deposit Insurance Corporation’s senior claim on the assets of a failed institution that has issued covered bonds.
- Any covered bond legislation should ensure that the Federal Deposit Insurance Corporation’s Deposit Insurance Fund is fully protected.
A covered bond is a corporate bond with one important enhancement: Recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. Covered bonds have been successful in Europe due in part to their implicit government guarantee and favorable capital treatment from European regulators.
For the investor, the major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's balance sheet and must be over-collateralized. Non-performing loans must be replaced to ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer. While covered bonds exist in the U.S. today, they are legally equivalent to other secured claims and have drawn limited investor interest.
Some large banks and other bond market participants are promoting covered bonds as an alternative to mortgage-backed securities. Despite their characterization as a fully private funding mechanism, as noted above evidence suggests that covered bonds enjoy an implicit government guarantee and effectively enjoy the same backing that Freddie Mac and Fannie Mae enjoyed prior to being placed in conservatorship.
During the 112th Congress, legislation on covered bonds, H.R. 940 and S. 1835, was introduced in the House and Senate. These bills would have created a regulatory oversight framework for covered bond programs. More significantly however, they would have established a process to be followed in the event of default and enhance the investor claims over the covered pool. H.R. 940 was marked up by the House Financial Services Committee but did not reach the House floor. No action took place in the Senate.
Community bank concerns with covered bonds
Likely Market Dominance of Large Banks. Covered bonds appear to be feasible only for large banks. Because the underlying mortgages (or other loans) are not sold, they remain on the issuer’s balance sheet and require a capital charge. Only large banks have the excess balance sheet capacity to make a covered bond program work. By contrast, a mortgage transferred to an MBS is sold outright. Because of the capital requirements, the covered bond market would likely remain small and would not be as liquid as the market for Fannie/Freddie MBS. Provisions would need to be made to ensure that community banks are not placed at a competitive disadvantage.
Impact on the Deposit Insurance Fund. The FDIC is concerned that covered bonds would dilute the FDIC’s claim on the assets of a failed bank. “Super priority,” combined with over-collateralization of the pool, would allow covered bond investors to recover more than other secured creditors. Resolution would be more costly because mortgages and servicing rights would have to be sold in tandem. (In an MBS, they trade separately.) This would weaken the DIF, and the FDIC is working to resolve its concerns with the legislation. Community banks pay heavily into the DIF and thus have a vested interest in ensuring the fund is fully protected and not exposed to risk due to a financial product that is not economically feasible for community banks to use.
Competition with Federal Home Loan Bank Advances. The Federal Home Loan Banks are key partners in the viability of community banks. Some in the FHLB system are concerned that large bank members would use covered bonds as an alternative to FHLB advances. If the large banks flee the system, advances are expected to become more expensive for community banks. The loss of large member advance business could force FHLBs to seek ways to significantly cut costs, negatively impacting products and services used by community bank members.
We cannot say with certainty that similar or identical legislation will be introduced in the 113th Congress, but given these issues and their potential impact on community banks, ICBA will work to protect community bank interests if the legislation moves forward.
Staff contact: David Lynch
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