The chronology of legislative attempts to enact covered bond legislation in the U.S. is well chronicled by Morrison & Forester . It seems to be an endless process. We are now beginning the sixth year of working towards covered bond legislation. What makes it so difficult you might ask? Other countries seem to adopt legislation in a couple of years. The answer to why lies in the long history of government involvement in housing finance in the U.S.

Ever since the Depression, the government has played an extensive and active role in the residential mortgage market through Fannie Mae, Ginnie Mae, Freddie Mac, FHA, FHMA, the FHLBs and a variety of other government programs and other government assistance, such as treating interest payments on residential mortgage loans as deductible for federal income tax purposes. Since the financial crisis, the government has financed about 95% of new residential mortgage loans and for a period while prices in the U.S. housing market continued to fall there was a serious concern that any reduction in government support could lead to a complete collapse in housing prices. In this environment, there was little incentive to explore private sector alternatives.

In the last year, conditions in the housing market have changed and prices have once again begun to rise. We are now entering a period when we can contemplate changing the government’s role in housing finance and how best to reduce the government’s exposure to losses, a discussion that is sure to be colored by the nearly $150 billion in losses experienced through Fannie Mae and Freddie Mac. Part of the answer will clearly involve incentives for substantial private sector participation in housing finance. A rational design would not rely on a single type of private sector mortgage financing, but rather on alternatives that are not fully correlated, so that market access to financing remains open in times of financial stress.

Covered bonds are a sensible alternative to RMBS and the GSEs. Covered bond investors tend not to buy RMBS or GSE guaranteed MBS. The advantage of a distinct investor base provides important resiliency to housing finance in difficult times as evidenced by the continued availability of covered bond financing in Europe in the aftermath of the crisis while RMBS financing has struggled to recover. Moreover, covered bonds are a relatively simple instrument and so do not present complex regulatory challenges.

Elements of Legislation

As noted elsewhere, H.R.2767 includes covered bond provisions that are similar to the provisions in bills introduced in 2011 (S.1835 and H.R.940). These bills contemplate a statutory scheme that would be familiar to many continental European investors: covered bonds would be issued in an ‘integrated structure’ with assets in the cover pool ‘ring fenced’ on the issuer’s balance sheet. Failure of the issuer would result in separately administering the cover pool to pay the outstanding covered bonds as scheduled through their maturities, very similar, for example, to the German Pfandbrief structure. See links to legislation at U.S. Legislative Links