Volcker Rule

The Volcker Rule implements Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The rule was finalized by the federal banking agencies and the CFTC and the SEC in December and curtails bank securities trading and investment in trading vehicles like hedge funds, private equity funds and securities arbitrage vehicles, which are referred to as covered funds.  Securities underwriting and marketmaking should be largely unaffected.  Banks will be unable to do some forms of securitizations, including many securities repackagings.

But all of this should have little impact on covered bonds.  The classic legislative covered bond is issued in a single tier structure directly from the bank.  The bank as an issuer would not be a covered fund, so Volcker would not be a consideration. The two-tier structure, used for example in Canada and the UK, utilizes an SPV to hold the cover pool and issue a guarantee.  The SPV is not a bank and therefore must be analyzed under the Volcker rule to determine if it is a covered fund. The Rule provides an express exemption from the covered fund definition for covered bonds issued by foreign banks.  Domestic US banks could use the exemption for wholly owned subsidiaries if the two-tier structure were used by US banks to issue covered bonds.  In addition, the SPV in the two-tier structure can often rely on an Investment Company Act exemption other than 3(c)(1) or 3(c)(7) – usually Section 3(c)(5) or Rule 3a-7. Use of the single tier structure by US banks would require legislation.

An investment in covered bonds by a bank should be unaffected because covered bonds should not be characterized as an ‘ownership interest’ in a covered fund. Covered bonds have none of the characteristics of control or right to profits that are necessary for an ownership interest.

Pass-Through Covered Bonds

The latest development in the covered bond world has been the adoption of pass-through covered bond structures (see also the prospectus).  In pass-through covered bond structures, if the issuing bank becomes insolvent the principal payments from the assets in the cover pool are passed through to holder of the covered bonds on each payment date; i.e., outstanding principal on the bonds is amortized as payments are received.  This amortization feature is very familiar to investors in RMBS and FNMA/FHLMC pass-through certificates.  Although pass-through covered bonds have initially been issued in Europe, such bonds may be welcomed in the US as well.  There is clearly a large investor base in the US market that is familiar with amortization and may find such a feature attractive since it recovers quicker an investment in a covered bond issued by a bank that subsequently fails.

On the issuer side, the amortization feature in covered bonds permits lower over-collateralization levels in cover pool, which is particularly attractive to cover pools consisting of lower quality collateral.

It will be interesting to see how the US market reacts to this development.

CBs as HQLA

Should covered bonds qualify as high quality liquid assets for the liquidity coverage ratio under the recent proposal from the U.S. banking agencies? After all, covered bonds qualify as HQLA for the LCR under the proposal in Europe, although it is still under debate whether they should qualify as Level 1 or Level 2 assets. The U.S. banking agencies are more conservative in qualifying Level 1 assets, permitting only direct U.S. government risk and certain foreign sovereigns and multilateral organizations. Thus, bonds from FNMA and FHLMC qualify as Level 2A assets under the U.S. proposal, but the release states that covered bonds represent unacceptable interconnectedness and wrong way risk among financial institutions.

That view, however, seems to misperceive covered bonds. While investors will purchase covered bonds primarily on the rating of the bank, the ultimate risk of default on a covered bond lies with the cover pool protecting the bonds. The risk in covered bonds, therefore, is not a risk of financial institutions in the banking system, but rather a risk connected to the housing market. That housing market risk is acceptable for FNMA and FHLMC bonds in Level 2A. There shouldn’t be a different result for covered bonds.

And the U.S. market trading data shows covered bonds being very actively traded. There are many covered bonds among the most actively traded AAA securities. Moreover, most covered bonds are eligible collateral at the ECB, which adds substantial liquidity to the secondary market for covered bonds. Covered bonds also exhibit a desireable flight to quality.  In a January 9 report, Danske Bank [reports] that in Italy, Spain and Portugal tier 1 covered bond issuers trade significantly tighter than their sovereign and in France and Belgium they trade very close to their sovereign and even through in some cases.

This would seem to be exactly the kind of instrument you want for liquid assets held for a liquidity coverage ratio.