SEC Request for Comment on Asset-Level Information

On February 25, 2014, the SEC requested comment on a new proposal for disclosing asset-level information in connection with asset-backed securities.  This is a reopening of a request for comment originally made in 2010 in connection with the proposal for amending Regulation AB. Under the new disclosure proposal, the issuer of ABS would disclose asset-level information on its website rather than submitting such information to the SEC for disclosure through the SEC’s EDGAR system.  This new proposal was made in response to comments on the original proposal that raised significant privacy concerns.

The SEC proposes that issuers could restrict access to asset-level information only to investors in the related ABS and could require investors to certify that they would not “reverse engineer” downloaded data.

Under existing registration statements, the SEC does not require covered bond issuers to make asset-level information available. The no-action relief granted to Canadian covered bond issuers (see, e.g., the RBC letter) recognizes that covered bonds are not ABS, but nevertheless require disclosures regarding the cover pool assets consistent with ABS disclosure required under Regulation AB. The SEC has not committed to continue to take that position after the adoption of the amendments to Regulation AB.  Accordingly, covered bond issuers who issue into the U.S. have been waiting see whether the new Regulation AB (Reg AB II) would require disclosure of asset-level information for covered bonds.  This request for comment does not shed any light on that question.

The Case for U.S. Covered Bonds

Updated: 5/18/2015

Two U.S. banks issued covered bonds in 2006 and 2007. No U.S. banks have issued covered bonds since, due in part to the complexity of issuing structure used by U.S. banks. Legislation to implement covered bonds in the U.S. would change this. The benefits of covered bonds to both the issuing bank and to investors is set out below. These benefits would seem to provide a strong rationale for passing covered bond legislation.

The covered bond market in Europe is about $3 trillion of outstanding bonds. This suggests that covered bonds could provide a significant funding instrument for banks in the U.S. While no one expects covered bonds to provide all of the funding for residential mortgage loans in the U.S., given the historic role of the federal government in the market, covered bonds could be a significant factor. The combination of covered bonds, RMBS, FHLB loans and GNMA/FNMA/FHLMC would provide banks with improved diversity of funding.

What are covered bonds?

CB Handbook

Covered bonds are senior, secured debt of a regulated financial institution. As in typical secured debt, if the issuing bank defaults, the collateral is used to cover any shortfall in payments due by the bank on the covered bonds. With covered bonds there is the added feature that, so long as there is sufficient collateral, the covered bonds are not accelerated, but rather paid on their scheduled payment dates. If the collateral at any time is inadequate to make all scheduled payments on the covered bonds, all outstanding covered bonds are accelerated and paid pro rata from the proceeds of the collateral in the same manner as typical secured debt. For a detailed description of covered bonds, see Covered Bonds Handbook available from the Practicing Law Institute. See also the Covered Bond website at Morrison & Foerster LLP.

CB Map

Covered bonds come in differed forms, depending on the jurisdiction of the issuer. In some jurisdictions, such as Germany, the collateral is held by the issuing bank and is isolated on its balance sheet and pledged to support the bonds. In other jurisdictions, such as the U.K., the collateral is transferred to a subsidiary of the issuing bank and the subsidiary guarantees bonds issued by the bank and secures the guarantee with the collateral. (See the accompanying map of the covered bond market, provided by The Cover, for a list of jurisdictions with covered bonds.) The subsidiary, in effect, is only a security device to hold the collateral separate from the issuing bank in case of its insolvency. This two-tier arrangement is necessary in jurisdictions that do not have a special statute for covered bonds.

The collateral and any related interest rate and currency swaps are referred to as the “cover pool.” For the protection of investors, the adequacy of the assets in the cover pool to pay the covered bonds as scheduled is tested monthly. If the test is not passed, additional collateral must be added to the cover pool by the issuer.

Most often the collateral consists of residential mortgage loans, but some jurisdictions permit commercial mortgage loans, ship mortgage loans, and obligations of public sector entities.

In the single tier form, it is clear that the collateral continues to be owned by the issuing bank and is simply pledged to support the bonds. In the two-tier structure, the collateral is transferred to the subsidiary, but the bank continues to have an economic interest in the performance of the collateral. The collateral held by the subsidiary will be consolidated back onto the balance sheet of the issuing bank and losses on the collateral will be losses, on a consolidated basis, for the bank. Thus the bank continues to own the collateral as an indirect owner.

ASF 2014

Covered bonds, then, are dual recourse instruments – the holder will look first to the bank for payment and, if the bank is unable to pay, the investor will look to the collateral. Thus the creditworthiness of the bank is of primary concern to investors and the collateral is of secondary concern. See the slides presented at ASF 2014 for more detail on structure.

Investor diversity.

The investors who purchase covered bonds typically purchase sovereign debt and agency debt.  They do not typically purchase corporate bonds or ABS securities.  These investors seek investments with low risk of principal acceleration due to issuer default or insolvency.  The certainty of payment at, but not before, maturity is an important feature.  Accordingly, this is a class of investors that an issuing bank does not reach except by issuing covered bonds, providing important diversity of funding for the issuing bank.

The investor base is comprised primarily of banks, central banks and investment funds.  Banks and central banks together are often 50% to 70% of the investor base of an offering.

Excellent funding rates.

This conservative class of investors is seeking a return that exceeds that of sovereign or agency debt, but with a similar risk profile.  This permits the issuing bank to fund itself with covered bonds at very attractive rates.  In fact, other than in times of severe turmoil, covered bonds are viewed as a ‘rates’ product and not a ‘credit’ product, similar to sovereign and agency debt.

For example, TD Bank in 2012 issued $3 billion of 5 year covered bonds at mid-swaps plus 45.  RBC in 2013 issued $2 billion of 5 year covered bonds at mid-swaps plus 43. This is very attractive funding. BNS in 2014 issued €1.250 billiion of three year covered bonds at mid-swaps minus 4.

Transparent to regulators.

From a regulator’s perspective, a bank’s exposure on its covered bonds is simpler to analyze than its securitization exposure.  As the numerous recent litigation settlements by banks has shown, securitization exposes banks to the risk of significant cost that is not apparent in the financial statements or other disclosures of the banks.  JPMorgan, for example, in a single settlement with the Justice department and various State attorneys general, recently settled one set of claims for $12 billion.  The aggregate settlement amount to date in the U.S. for the banking industry in early 2014 was estimated to be around $100 billion and there is more to come.  This exposure was not apparent to regulators pre-crisis.  Securitization had been viewed by banks and regulators as a transfer of risk of the assets to investors, relieving the banks of exposure to the assets.

Covered bonds do not present this hidden risk to regulators because the assets in the cover pool remain on the balance sheet of the issuing institution.  The nature and performance of the assets is a constant audit and financial reporting item, readily apparent to the supervising agencies.  Because the issuing institution retains 100% of the risk on the assets, it has a strong incentive to monitor and maintain high origination standards.  This incentive tends to align the interests of the banks and the regulators in a way that securitization never will.

Friendly to borrowers.

Covered bonds are friendlier to borrowers than securitization. In a securitization, loans are sold to a securitization vehicle; the selling bank ceases to be a contractual party to the loans.  As a consequence, the securitization entity acquires the right to make any and all decisions with respect to granting payment rescheduling or other relief to a borrower in financial difficulty or foreclosing on property securing a loan.  Securitization entities are bound typically by a trust agreement or pooling agreement that spells out all actions the entities may take with respect to the loans.  These provisions generally do not provide for discretion to be exercised by the securitization entities to work with borrowers to avoid default and foreclosure.

The transfer of a loan to the securitization entity means that a borrower can no longer discuss with his lender alternatives that the lender might offer to avoid default.  The lender no longer has the power to effect any relief for a deserving borrower.  That power has been transferred to a securitization entity and the securitization entity is typically bound by agreements not to provide such relief.

Additionally the borrower often has difficulty determining who may have some ability to grant relief.  The borrower’s loan may have been transferred through several entities before reaching the securitization entity.  And securitization entities do not have employees.  All actions of securitization entities are performed under contract by third parties including trustees and loan servicers.  Consequently, even identifying the party that may have the power to grant relief can be hard.  And if identified, locating the appropriate person at the third party can be yet another difficult task for a borrower.

Covered bonds do not create this obfuscation.  Each loan continues to be owned by the originating lender, who retains all rights to amend the loan or the payment terms or otherwise accommodate a borrower to preserve a performing loan.  It is possible that the loan may cease to be qualified to be included in a cover pool, but in that case, the lender simply substitutes another loan for the loan being worked out.  And from the borrower’s perspective, the borrower always deals solely with the lender that the borrower originally chose to borrow from and should have little difficulty identifying who in the organization might be able to provide relief.

Analytically simpler for investors.

Covered bonds also provide simplicity for an investor.  In contrast, a securitization presents a considerably more complex investment decision.  Securitizations typically involve complex security class structures that result in complex payment provisions.  An RMBS offering may involve 20 or 25 classes of securities supported from a single pool of loans.  And the class structures and payment mechanisms and priorities are very seldom the same on consecutive offerings.  Accordingly, on each offering an investor must commit significant resources to analyzing the precise terms of the proposed investment, in addition to analyzing the performance risks of the collateral pool, which will be unique for each offering.  And finally, the risk of early or delayed principal repayment must be analyzed, which risk can be critical to assessing the value of each class of securities.

Covered bonds, on the other hand, provide a simpler challenge to the investor.  A covered bond is primarily a senior debt offering of a regulated financial institution.  The institution is usually reviewed by several investment industry credit analysts, files extensive financial statements with regulators and exchanges, and has listed common stock that has a long history of public pricing.  The institution is audited regularly by independent auditors and supervised by regulators.  Moreover the senior debt of the institution is rated by rating agencies and traded in the secondary market, providing important pricing transparency and indications of continuing credit evaluations.

Only if the issuing institution defaults on its covered bond debt does the strength of the cover pool become important.  Until then the issuing institution is bound to continually refresh the cover pool with new loans to replace delinquent, defaulted or matured loans.  At all times prior to the default of the institution, the cover pool should consist of fully performing loans.

And while the cover pool may vary over time as new loans are added to the pool, the investor’s burden of analysis is considerably simpler than in a securitization.  First, all outstanding series of covered bonds of an issuing institution are secured by the same cover pool.  New assets can be added to the cover pool only if they satisfy the eligibility criteria that are set when the covered bond program is first established.  Thus an investor analyzes the strength of the cover pool once at its first purchase of a covered bond from an issuing institution based on the eligibility criteria and can purchase subsequent offerings by conducting a simplified ‘bring down’ analysis of continuing loan performance.

Moreover, covered bonds are not tranched, so there is no complex class structure and payment mechanism or priority.  And, because covered bonds are bullet pay securities, there is no prepayment risk to analyze.  Covered bonds are primarily a payment obligation of the issuing institution, so the credit analysis is primarily an analysis of the credit worthiness of the issuing institution.  This is a risk that is publicly reviewed by other analysts and supervised by regulatory authorities.

And, finally, the risk attendant to senior debt of being written down, or possibly eliminated or converted to equity, in the insolvency of an issuing institution is not present with covered bonds because the cover pool will continue to pay the covered bonds through their maturity date independent of the outcome of the resolution of the failed issuing institution.

More on Canadian Housing Prices

The Wall Street Journal reports in its February 19, 2014 paper that the campaign to prevent a housing bubble is gaining traction. They report that many observers think the market is drastically overpriced and may be subject to t sharp correction. The article reports that housing prices have doubled since 2002 and rose 9.5% in January compared to January 2013. A chart shows average house prices in Vancouver at more than C$800,000 and in Toronto at more than C$500,000. House prices are reported to be 50% above those in the U.S. And the construction industry is reported to represent twice the percentage of the gross domestic product in Canada as in the U.S.

As noted elsewhere, however, this is not a repeat of the subprime mortgage debacle we had in the U.S. Canadian residential mortgage loans have much lower loan-to-value (LTV) ratios and are full recourse, so the borrower is unable to just turn over the keys and avoid the debt. But these comparative numbers would suggest that Canadian consumers are carrying high levels of housing related indebtedness. Small wonder that Canadian consumers are reported to have debt to asset ratios close to those of U.S. homeowners prior to the crisis. And most of that asset value is from overpriced houses. A sharp correction in housing prices would hit consumers hard.

See also, Is there a housing bubble in Canada?

More Views on Low RMBS Issuance

In a letter to the SEC dated February 14, 2014, FINRA stated that during the fourth quarter of 2013, the issuance of mortgaged-related securities declined 33 percent compared to the same period in 2012.

Fed Mortgage Role Expands

With rising rates, new mortgage loan productions has declined. WSJ reports that in November the FED bought 90% of eligible mortgage bond issuance, up from 2/3 earlier in the year, raising liquidity concerns. FNMA/FHLMC issuance fell 59% from a year earlier in November to $82.3 B.