Covered Bonds: An Alternative to Securitization for Funding Mortgages

Covered Bonds: An Alternative to
Securitization for Funding Mortgages
Edward Vincent Murphy
Analyst in Financial Economics
Government and Finance
Summary
Covered bonds are a relatively common method of funding mortgages in Europe,
but uncommon in the United States. A covered bond is a recourse debt obligation that
is secured by a pool of assets, in this case mortgages. The holders of the bond are given
additional protection in the event of the bankruptcy or insolvency of the issuing lender.
They have some features, such as pooled mortgages, that resemble securitization, but the
original lenders maintain a continuing interest in the performance of the loans. Because
some believe that the subprime mortgage turmoil may have been influenced by poor
incentives for lenders using the securitization process, some policymakers have
recommended covered bonds as an alternative for U.S. mortgage markets.
Treasury Secretary Paulson has said that covered bonds could bring more certainty
and more competition to mortgage markets. Because issuing banks do not sell mortgage
assets to securitization trusts, accounting features of covered bonds may provide more
readily accessible information to potential purchasers of the covered bonds and to the
shareholders of the banks issuing the covered bonds. Some features of American
banking regulations may have to be clarified to facilitate covered bonds. The Federal
Deposit Insurance Corporation (FDIC), for example, issued a new rule clarifying its
obligations to the holders of covered bonds if an FDIC-insured institution is placed in
FDIC receivership or conservatorship. This report will be updated as conditions warrant.
The Equal Treatment for Covered Bonds Act of 2008, H.R. 6659, would define a
covered bond as a nondeposit recourse debt with a term to maturity of at least one year
and secured by specifically identified assets. H.R. 6659 also calls for rulemaking
regarding covered bonds to be conducted jointly by financial regulators.
In response to recent mortgage market turmoil, the Treasury Department and the
Federal Deposit Insurance Corporation (FDIC) have considered rulemaking to encourage
the use of covered bonds as an alternative to mortgage securitization. The volume of
private-label mortgage securitizations, in which mortgages are pooled into trusts and then
divided into securities for sale to investors, declined significantly following the subprime

mortgage turmoil.¹ In typical private-label securitizations, neither the original lender nor
the mortgage-backed security (MBS) issuer has a continuing duty to the purchasers of the
securities. It might be argued that this divorce of mortgage funding from loan origination
contributed to weak underwriting standards in U.S. mortgage markets.² Covered bonds,
which are more common in Europe, especially the German Pfandbrief market, also pool
mortgages, but the issuing banks continue to stand behind the performance of the loan
pool.
On March 13, 2008, Treasury Secretary Paulson suggested the increased use of
covered bonds as one option to restore confidence in mortgage finance:
Covered bonds, which allow banks to retain originated mortgage loans while
accessing financial market funding, are another alternative worth considering.
Covered bonds may address the current lack of liquidity in, and bring more
competition to, mortgage securitization. Rule-making, not legislation, is needed to
facilitate the issuance of covered bonds. Through clarification of covered bonds’
status in the event of a bank-issuer’s insolvency, the FDIC can reduce uncertainty and
consider appropriate measures that will protect the deposit insurance fund. These
steps would encourage a covered bond market in the U.S.; similar changes in Europe³
have resulted in more covered bond activity.
Financial Structure of Covered Bonds
A covered bond is a bank-issued debt that is backed by a pool of loans, often
mortgages. In finance-speak, a covered bond is thus a recourse debt obligation that is
secured by a pool of assets. Unlike typical private securitizations in the United States, the
bondholders’ claims extend to the issuing bank’s assets if the underlying mortgages
default. If the underlying mortgages continue to perform but the issuing bank becomes
insolvent, the bondholders retain full claim on the pooled mortgages in subsequent
bankruptcy or insolvency proceedings. The bonds are covered by both the pledged
mortgages and the issuing bank. Table 1 compares selected features of covered bonds
to typical private securitization of U.S. mortgages.

¹ Private-label securitizations refer to mortgage-backed securities that are issued by firms other
than the government-sponsored enterprises, Fannie Mae and Freddie Mac.
² CRS Report RS22722, Securitization and Federal Regulation of Mortgages for Safety and
Soundness, by Edward Vincent Murphy
³ “Remarks by Secretary Henry M. Paulson Jr. on Recommendations from the President’s
Working Group on Financial Markets,” Press Release, U.S. Department of Treasury, March 13,

2008, available at [http://www.treas.gov/press/releases/hp872.htm].

Table 1. Comparing the Structure of Securitization
and Covered Bonds
Private SecuritizationCovered Bonds
StructureIssuer gathers mortgages (orA single bank puts its own
other assets) from one ormortgages (or other assets)
more banks in a pool andin a pool, sells interest in
sells securities whichthe pool, and stands ready to
represent claims on the cashcover losses if the pool does
flow of the pool.not perform.
Claims of bondholdersBondholders have claimBondholders have claim
against mortgage poolagainst mortgages in pool. against mortgages in pool.
Claims of bondholdersBondholders do not haveIf mortgage pool exhausted,
against loan originatorclaim against other assets ofbondholders retain claim
loan originators (exceptionagainst loan originator.
if originator provides credit
enhancement).
Balance sheet treatmentUsually not recorded as aUsually recorded as a
liability of the originator.liability of the originator.
Loan originator record ofGain on sale when transferThe mortgages are not sold
sale on assetsto trust, subject toso no gain to record.
accounting standards.
Servicing the loanOriginators sold the loans soNo isolation of originator
servicing is an independentfrom mortgage assets, so
relationship, but originatorservicing relationship
can service loan underunaffected.
contract.
Originator bankruptcyMortgages in the pool areBondholders have full
remote from bankruptcy ofclaims on mortgages in pool
the loan originator.even if loan originator is in
insolvency proceedings.
Ratings agenciesAssess only the risk of theMust assess risk of assets in
assets and creditpool but also the risk of the
enhancement in theissuing bank as a whole.
mortgage pool.
^Source:^Vⁱⁿ^{od K}^o^t^h^a^rⁱ^{, Secur}^itiz^{ation: Financial}^Ins^t^r^u^{ment of the Futur}^e⁽^N^ew^J^e^r^s^ey^{: J}^o^hⁿ^W^iley^&
^S^oⁿ^s^{, 2006), p. 357.}
The structure of a covered bond may encourage transparency. Unlike a typical
private securitization of U.S. mortgages, the issuing bank of a covered bond does not sell
the mortgages to a pass-through trust administering the payments to the investors.
Because there is no sale, the issuing bank continues to report the loans on its balance
sheet. When evaluating the riskiness of a covered bond, a rating agency must account for
both the quality of the underlying mortgages and the financial condition of the issuing
bank that covers the bonds.

Compared to securitization, the structure of a covered bond simplifies the
relationship between mortgage pools and mortgage servicers. For a covered bond, the
issuing bank continues to service the pooled loans (or contract out servicing), in the same
manner as it would for loans that it has not issued as covered bonds. This preserves the
issuing bank’s discretion to modify loans in times of distress. In securitization, however,
the discretion of servicers to modify loans can be limited by loan servicing contracts that
can be difficult to adjust in changing circumstances.⁴
FDIC Rulemaking Affecting Covered Bonds
Although the covered bond market has a long tradition in Europe, the United States
has much less experience. In June 2007, Bank of America became the first U.S.
depository institution to issue a domestic covered bond, with a $2 billion offering. Since
then, industry specialists and policymakers have been evaluating American banking
regulation to see what kinds of modifications might be required to adapt this European
debt instrument to U.S. financial markets.
In the United States, financial problems of banks with insured deposits are often
resolved through actions of the FDIC. In order to adapt covered bonds to the U.S. system,
therefore, FDIC rules for resolving claims against insolvent banks that have outstanding
covered bonds might have to be modified. The FDIC issued Financial Institution Letter
(FIL) 34-2008, FDIC Policy Statement on Covered Bonds, on April 30, 2008. FIL 34
provides more regulatory clarity by “giving expedited access to covered bond collateral
if the issuing institution fails or is placed in conservatorship and meets certain criteria.”
Its expressed intent is to “reduce market uncertainty and allow for evaluation of the
benefits and questions about covered bonds as the market develops in the United States.”
The FDIC issued its policy statement for covered bonds on July 15, 2008. The
policy statement defines a covered bond as
a non-deposit, recourse debt obligation of an IDI [Insured depository Institution] with
a term greater than one year and no more than thirty years, that is secured directly or
indirectly by perfected security interests under applicable state and federal law on
assets held and owned by the IDI consisting of eligible mortgages, or AAA-rated
mortgage-backed securities secured by eligible mortgages if for no more than ten⁵
percent of the collateral for any covered bond issuance or series.
The FDIC limited the covered bond policy statement only to those circumstances in which
the covered bonds would comprise no more than 4% of the issuer’s total liabilities. The
FDIC statement did not require that issuers of covered bonds use a special purpose vehicle
(SPV), which was a common financial device used in securitization.

⁴ CRS Report RL34386, Could Securitization Obstruct Voluntary Loan Modifications and
Payment Freezes? by Edward Vincent Murphy.
⁵ “Covered Bond Statement,” FDIC, July 15, 2008, available at [http://www.fdic.gov/news/
news/press/2008/pr08060a.html ].

Equal Treatment for Covered Bonds Act of 2008, H.R. 6659
H.R. 6659, the Equal Treatment for Covered Bonds Act of 2008, was introduced by
Congressman Garrett on July 30, 2008. The definition of a covered bond is similar to the
definition used in the FDIC rulemaking. The bill defines a covered bond as a “nondeposit
recourse debt obligation of an insured depository institution, with a term to maturity of
at least 1 year, which is secured by specifically identified assets which are performing in
accordance with the terms of the contracts which created the assets.” (Section 2b.)
Although similar to the FDIC definition, H.R. 6659 does not require that a covered bond
be used for mortgages or for AAA-rated securities. Also, the bill does not limit the term
to maturity of the assets to 30 years, which would allow covered bonds to fund 40-year
mortgages.
The bill also specifies the regulatory authority of federal financial regulators for
covered bonds. (Section 2d). In order to be applicable to covered bonds, federal banking
regulations must be jointly prescribed by the Secretary of the Treasury, the Board of
Governors of the Federal Reserve System, the Comptroller of the Currency, the Director
of the Office of Thrift Supervision, and the Board of Directors of the FDIC. Of the
members of the Federal Financial Institutions Examinations Council, the National Credit
Union Administration is absent.