Regulation AB II and Canadian Covered Bonds — the end of SEC registered covered bonds?

The recent amendments to Regulation AB (commonly referred to as “Reg AB II”) were a policy response to the perceived inadequacy of securitization disclosure prior to the financial crisis and a response to a request by very large investors for extensive, detailed information about the assets in a securitization.  The adoption of the changes to Regulation AB was only possible after the SEC negotiated protection from the Consumer Financial Protection Bureau (the “CFPB”) for issuers filing the data required by the SEC.  The CFPB statement provides that an issuer filing data in accordance with the SEC rules will not be in violation of the financial privacy laws. 

The result of the amendment is a package of regulations that call for the disclosure of loan-level data that varies by asset class.  In the case of assets that are residential mortgage loans, the rules call for the disclosure of 272 data fields for each mortgage loan, including the first two digits of the postal zip code for the property. 

In a study conducted by the SEC staff prior to the adoption of the amendments, the staff calculated that disclosure of the full five digit postal zip code for a property would result in an 80% likelihood that the identity of the borrower would be discernable.  With the reduction to disclosure of only the first two digits of the postal zip code, the staff concluded that there was still a 20% likelihood that a borrower could be identified.  Thus the need for the SEC to obtain CFPB protection for issuers. 

But what has this to do with covered bonds? After all, covered bonds are not securitizations, but rather special form of secured debt.  The answer is somewhat complex. 

In 2012, Royal Bank of Canada filed a registration statement with the SEC for covered bonds.  Before filing the registration statement, however, RBC filed a request for no action relief with the SEC to enable RBC Covered Bond Guarantor Limited Partnership, the entity that would hold the cover pool of mortgage loans and guarantee the bonds issued by RBC, to register its guarantee on the same SEC Form F-3 used by RBC to issue the bonds.  Without relief, the Guarantor was ineligible to use Form F-3 as it did not have the required history of filing information with the SEC. 

The SEC granted the requested relief in May 2012 on the condition that RBC and the Guarantor agree to comply with the requirements of specific provisions of Regulation AB.  The list of provisions included Items 1111 and 1121, which were subsequently amended by Reg AB II to require the disclosure of loan-level information.  Because of Items 1111 and 1121 and because the assets in the cover pool held by the Guarantor are residential mortgage loans, RBC will be required to disclose for each offering and monthly thereafter 272 data fields of loan-level information for each loan in its cover pool if it issues SEC-registered covered bonds after November 23, 2016.  Currently there are about 350,000 loans in the RBC cover pool. 

Following the approval of the RBC registration statement by the SEC in 2012, the Bank of Nova Scotia and the Bank of Montreal each filed a no action request with the SEC to establish similar SEC-registered covered bond programs.  The requested no action relief was granted upon similar conditions and the BNS registration statement was approved in September 2013.  BMO withdrew its registration statement prior to approval by the SEC in December 2015. 

Unfortunately for the Canadian banks many of the required 272 data fields are inapplicable to Canadian residential mortgage loans.  Other fields relevant to Canadian loans would have to be added.  And unlike an RMBS transaction, many of the loans in the cover pool are not newly-originated; some of the loans will have been originated 15 or 20 years ago.  In many cases, information of the type required by the SEC was not collected when the loans were originated or if collected was not uploaded to electronic data systems; in that case the information will only be found in physical loan files scattered in offices across the country.  To the extent that the data is not collected for newly originated residential mortgage loans, company-wide systems and procedures would have to be modified in order to obtain the data – an expensive and disruptive process for such large and geographically diverse organizations. 

The fact that the 272 data fields required by the SEC are in many cases not relevant to Canadian mortgage loans is not by design.  Instead, it is the result of a very difficult rule drafting process for the SEC, particularly in the financial privacy area.  The initial rule proposal was published in 2010; the final rule was not adopted until 2014 after extensive comments and redrafting of the rule.  It was all the SEC could do to focus on US securitizations.  Had the SEC tried to address also assets and issuers in other jurisdictions, the drafting process would likely still be underway.  The only practical approach was to limit the analysis and the drafting to US securitizations if the changes were ever to be adopted. 

The result, however, has the effect of building a regulatory wall around the US.  As of the posting date, only one issuer had filed a registration statement with the SEC for securitization of residential mortgage loans, which had not been declared effective, and only a single non-US issuer had filed a registration statement for any asset type.  The additional burden created for non-US issuers is substantial, particularly for residential mortgage loans.  Each jurisdiction has its own financial privacy laws and the protection offered by the CFPB to issuers filing with the SEC does not protect non-US issuers from financial privacy laws in their home jurisdictions.  And then there is the expense and disruption of collecting the data. 

In the end, the decision to issue SEC-registered covered bonds becomes a cost-benefit analysis.  Does the lower coupon on SEC-registered covered bonds compared to 144A or Reg S covered bonds justify the expense and effort of complying with the new loan-level disclosure requirements of Regulation AB? How many offerings would be necessary over what period of time to recover the cost of the changes? Is cost recovery feasible given past levels of issuance of SEC-registered covered bonds?

None of the Canadian banks have publicly answered these questions, so at this writing it is unclear what course they will follow in connection with their US dollar covered bond offerings.  If they conclude that SEC-registered covered bonds are not cost effective, it is likely they would take the alternative of issuing US dollar covered bonds under Rule 144A.