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. 

OSFI to Reconsider 4% Limit?

According to reports in The Cover and The Covered Bond Report, Canada is considering whether to increase the 4% limit imposed on covered bond issuance. This limit was imposed by the Office of the Superintendent of Financial Institutions (OSFI) at the inception of covered bond issuance by Canadian banks in 2007 and remains unchanged today. While the limit is the most stringent currently applied in the covered bond world, Canadian banks have nevertheless been active issuers of covered bonds as can be seen by the table below.

Issued (mm)*71,60044,0374,3752,0757,4504900
Outstanding (mm)*39,60038,6134,3751,4005,1003,300

* As of January 28, 2016.

The current 4% limit is measured as the Canadian dollar equivalent amount of covered bonds outstanding divided by total assets. The table below shows the covered bond issuance capacity remaining for each Canadian covered bond issuer as of December 2015.

Total Assets (mm)**641,881856,4971,318463,309216,0901,074,208862,5324,115,835
Maximum Amount (mm)26,10033,6007,40018,2008,30043,50042,400179,700
Outstanding Amount (mm)11,60022,2005,40010,7007,30031,30020,900109,400
Used Capacity44.3%66.0%73.1%*59.0%87.8%71.6%60.9%60.9%
Remaining Amount (mm)14,50011,4002,0007,5001,00012,40021,50070,300

Source: CMHC, Covered Bond Business Supplement, September 2015.
*Note that CCDQ is subject to a different limit, which is set by Autorité des marchés financiers at EUR 5.0 billion.
** As of October 31, 2015.

In most major covered bond issuing jurisdictions there are no limits on the issuance of covered bonds. Some jurisdictions, such as the United Kingdom and the Netherlands adopted issuance limits at the inception of their covered bond issuance, but have subsequently removed fixed limits. In both jurisdictions today the issuance limit is determined on a case-by-case basis by financial authorities based on the condition of the issuer. A few jurisdictions still retain a fixed limit: Australia at 8%, Greece at 20% and New Zealand at 10%. No other country has a limit as stringent as that of Canada. See, ECBC, European Covered Bond Fact Book, 1.4 Factors Affecting Asset Encumbrance (2014) at pages 54-55.

That all other issuers of covered bonds have the benefit of more accommodating regulation of covered bond issuance limits and Canadian covered bond programs have grown for nearly ten years without evidencing any problems, suggests that OSFI may be willing to increase its 4% limit. The 4% limit increasingly appears overly restrictive.

Even under the existing tight limits on issuance, CMHC reports that covered bonds have become increasingly important as a source of funding for residential mortgage loans for Canadian banks. Covered bonds have grown from funding 5% of residential mortgage loans in early 2013 to nearly 8% by mid-2015.

With the growing use of covered bonds as a funding source for supporting mortgage loan origination, it is not surprising to see that OSFI is considering changing the current 4% limit. If OSFI were to change to limit for issuance of covered bonds to 6% or 8% or 10%, the maximum capacity of each of the issuing banks would be as follows:

6% limit (mm)38,51351,38911,00027,79912,96564,45251,752246,950
8% limit (mm)51,35068,52014,80037,06517,28785,93769,003329,267
10% limit (mm)64,18885,65018,50046,33021,609107,42186,253411,583

*This assumes that the limit set by Autorité des marchés financiers is increased comparably.

If OSFI were to raise the limit for covered bond issuance to 10% of total assets, that would create the potential for an additional C$320,683,000,000 of covered bonds outstanding based on current outstandings.

The Volcker Rule and Covered Bonds

The Volcker Rule became effective on July 21, 2015. There are two aspects to the Volcker Rule: a prohibition on proprietary trading and a limitation on sponsoring or investing in a 'covered fund.' It is this second aspect of the Volcker Rule that concerns investors in covered bonds. The Volcker Rule applies to banks in the United States, including the branches, subsidiaries and affiliates of foreign banks. Even if the investor in a covered bond is not a bank subject to the Volcker Rule, if investment in the covered bonds is subject to the Volcker Rule,the secondary market liquidity for the covered bond can be adversely affected.

If the prospectus for the covered bond does not disclose whether an investment in the covered bond is limited under the Volcker Rule, how can you determine whether the Volcker Rule applies? This can be quite a complex analysis. Fortunately, Morrison & Foerster has written a helpful article on analyzing whether a covered bond is subject to the Volcker Rule. See A user's guide to Volcker Rule complexities.

Reg AB II and Covered Bonds

Updated: 12/28/2015

The United States Securities and Exchange Commission (the “SEC”) adopted revisions to Regulation AB on August 27, 2014, after a four year process of proposals and review. Regulation AB is the rule that governs the offering disclosure and periodic reporting obligations of issuers of asset-backed securities (“ABS”).

Insofar as covered bonds are concerned, several things are clear. First, covered bonds are not included in the definition of “asset-backed security.” Item 1101 of Regulation AB provides that:

Asset-backed security means a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases.

It is clear that covered bonds are not “primarily serviced by the cash flows of a discrete pool of receivables or other financial assets.” Instead, covered bonds are senior obligations of the issuing financial institution and are expected to be repaid from the general funds of the institution. Accordingly, covered bonds should not be asset-backed securities and Regulation AB should not apply generally to covered bonds.

Second, although the Commission had proposed extending the disclosure requirements of Form SF-1 and Regulation AB to privately placed ABS, the Commission did not adopt the proposed change. The Commission stated, however, that the proposal remained outstanding.

Thus, for most issuers of covered bonds, Regulation AB II will not be applicable. Most covered bonds issued in the U.S. are issued under Rule 144A as private placements, to which Regulation AB does not currently apply. Moreover, even if the SEC were to extend Regulation AB to private placements, since covered bonds are not asset-backed securities, Regulation AB would still not apply to Rule 144A offerings of covered bonds.

For the Canadian issuers with SEC registered covered bond programs, however, there still remains the question of whether they will be required to make loan-level disclosure for the mortgage loans in their cover pools in accordance with the requirements of Regulation AB. Each of the Canadian issuers requested a no-action letter from the SEC staff to enable it to register its covered bond program. (See, e.g., the RBC no-action letter.) Each issuer stated in its letter that it would provide offering disclosure and periodic reporting in connection with its covered bond offerings consistent with the requirements of Items 1111 and 1121 of Regulation AB. These two provisions of Regulation AB have now been revised by the SEC’s amendment of Regulation AB to require disclosure of 270 data fields for each residential mortgage loan. Whether the SEC staff will extend the new loan-level disclosure requirements of revised Items 1111 and 1121 to these Canadian covered bond issuers is a question.

If the SEC decides to require the Canadian banks to disclose loan-level information for each residential mortgage loan in their cover pools in accordance with Items 1111 and 1121 of Regulation AB, this could prove troublesome. These provisions require the disclosure of information that raised concerns under U.S. consumer privacy laws. In the end, the SEC needed to obtain a letter from the Consumer Finance Protection Bureau stating that the disclosure of information as required by the SEC under Regulation AB would not result in a violation of consumer financial privacy laws. However, this protection for issuers is only protection from violation of U.S. laws. Non-U.S. issuers do not benefit from this protection if they disclose information about consumers in the issuers' home jurisdictions.

Additionally, because residential mortgage loan products are different in Canada, many of the requested fields are simply inapplicable. And the extensive disclosure required under the SEC's template would require the collection of information that Canadian banks do not currently collect in their residential mortgage business and retain in their computer systems. Modifying existing computer systems and business processes to collect and retain this information could be expensive and disruptive.

The bottom line may be that compliance with Regulation AB by foreign financial institutions is impractical. This would mean that the registered ABS market in the U.S. would be reserved for securitization of U.S. assets only.

Stay tuned.

SEC Finalizes Reg AB II

On Wednesday, August 27, 2014, the United States Securities and Exchange Commission finalized the changes to Regulation AB (commonly referred to as Reg AB II). The Commission issued a press release and a draft adopting release adopting the changes. The final version of the adopting release will be published in the Federal Register after review by the Office of Management and Budget (OMB). Regulation AB II and the related changes regulate the offering process and the disclosure and reporting requirements for asset-backed securities. Perhaps the most significant changes are (i) a requirement to file a preliminary prospectus at least three days prior to the sale of any securities and (ii) disclosure of loan-level information in machine readable form for ABS backed by residential mortgage loans, commercial mortgage loans, auto loans, auto leases, and debt securities (including resecuritizations). Updated loan-level data also must be filed periodically after issuance of the securities. The loan-level disclosure requirements come into force not later than two years after the effective date of the changes, which will be the date of the publication of the changes in the Federal Register.

The effect on covered bond issuers of these changes is still being analyzed and will be covered by a later post. However, it is clear that these changes would not be directly applicable to Rule 144A offerings of covered bonds.

See the MoFo Client Alert.

SEC Calls Reg AB II Meeting

The SEC announced today that it would hold a public meeting to consider amendments to Regulation AB on Wednesday, August 27:


Sunshine Act Meeting.

Notice is hereby given, pursuant to the provisions of the Government in the Sunshine Act, Pub. L. 94-409, that the Securities and Exchange Commission will hold an Open Meeting on Wednesday, August 27, 2014 at 10:00 a.m., in the Auditorium, Room L-002.

The subject matters of the Open Meeting will be:

  • The Commission will consider whether to adopt rules revising the disclosure, reporting and offering process for asset-backed securities.  The revisions would require asset-backed issuers to provide enhanced disclosures, including information for certain asset classes about each asset in the underlying pool in a standardized, tagged format, and revise the shelf offering process and eligibility criteria for asset-backed securities.
  • The Commission will consider whether to adopt rule amendments and new rules to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act concerning nationally recognized statistical rating organizations, providers of third-party due diligence services for asset-backed securities, and issuers and underwriters of asset-backed securities under the Securities Exchange Act of 1934.

The duty officer has determined that no earlier notice was practicable.

At times, changes in Commission priorities require alterations in the scheduling of meeting items.

For further information and to ascertain what, if any, matters have been added, deleted, or postponed, please contact:

The Office of the Secretary at (202) 551-5400.

Kevin M. O’Neill
Deputy Secretary

Dated: August 22, 2014

Although the SEC’s proposal to amend Regulation AB (hence Reg AB II) is primarily concerned with asset-backed securities, the Commission’s action will be of interest to covered bonds issuers for two reasons:

  • whether covered bonds will be defined as asset-backed securities and therefore expressly subject to Reg AB II;
  • whether Reg AB II requirements will be extended to asset-backed securities sold under Rule 144A.

Covered bonds do not fall within the current definition of asset-backed security, as the SEC has recognized in several no-action letter issued to Canadian banks. Nevertheless, in those no-action letters, the SEC has required the banks to comply with specific provisions of current Regulation AB as a condition of registering covered bonds with the SEC. If those provisions are amended, the banks could be required to comply with the provisions as amended.

However, if covered bonds are defined as asset-backed securities under Reg AB II, there may be other provisions that they would be required to comply with, including possibly the proposed requirement to issue a preliminary prospectus at least five days prior to the sale of any security.

Until now, Regulation AB has applied only to asset-backed securities registered with the SEC, and 144A covered bonds have not been subject to the regulation. The extension of Reg AB II to asset-backed securities offered under Rule 144A would therefore affect Rule 144A covered bonds if covered bonds were defined to be asset-backed securities. The extension of Reg AB II to privately placed securities sold under Rule 144A would be a major departure from prior practice. If Reg AB II is not extended to 144A securities, covered bonds could still be offered in the United States under Rule 144A without complying with Reg AB II, even if covered bonds were defined as asset-backed securities under Reg AB II.

Accordingly, the outcome of the meeting on Wednesday will be of considerable interest to covered bond issuers who currently offer or plan to offer covered bonds in the United States.

MoFo Comment Letter to Treasury on Restoring PLS Market

On August 8, Morrison & Foerster LLP filed a comment letter with the United States Department of the Treasury in response to a request for comments on the private sector development of a well-functioning private label securities (PLS) market for residential mortgage loans. The comment letter notes that perhaps the easiest way to restore private funding to residential mortgage loans in the United States is to implement a covered bond statute in the United States to enable U.S. banks to issue covered bonds. The letter notes that the conditions necessary to the establishment of a covered bod market in the United States are well advanced and that the market could be established quickly. Based on the development of the investor base in the United States, the SEC's establishment of disclosure and reporting standards, and the well-developed legislation, creation of a domestic covered bond market would appear to be low hanging fruit that Treasury should take advantage of.

EBA report on favorable capital treatment

On July 1, 2014, the European Banking Authority published a favorable opinion on the preferential capital treatment of covered bonds.  The EBA also delivered a companion report entitled EBA Report on EU Covered Bond Frameworks and Capital Treatment.  See also the press release from the EBA.  The EBA concluded that the favorable capital treatment under the capital requirements regulation (CRR) for bank investments in covered bonds was appropriate, but called for some “further qualifying criteria for their preferential treatment.”  The EBA recommended against the use of aircraft liens, residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) as cover pool assets after December 2017.  The opinion and the report were delivered to the European Commission in response to a request for advice.

With respect to favorable capital treatment the EBA said:

“Due to the good historical default/loss performance of covered bonds in the EU, the dual recourse principle embedded in covered bond frameworks whereby the covered bond holder has a claim on the issuing institution and a priority claim on the cover assets, the special public supervision for the protection of the bondholders mandated by the UCITS Directive and the existence of qualifying criteria in Article 129 of the CRR, the EBA considers the preferential risk weight treatment laid down in Article 129 of the CRR to be, in principle, an appropriate prudential treatment. “

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.