Academic journal article Fordham Journal of Corporate & Financial Law

Covered Bonds: Shelter from Financial Turmoil, Exposure to the 1940 Act

Academic journal article Fordham Journal of Corporate & Financial Law

Covered Bonds: Shelter from Financial Turmoil, Exposure to the 1940 Act

Article excerpt

INTRODUCTION

The current credit crisis, a consequence of business and consumer deleveraging, has raised financial stability concerns for many major national and regional banks.1 Falling home prices, soaring mortgage defaults and an exorbitant rise in the LIBOR2 - the lending rate banks use as a benchmark to loan money - have recently made it impossible for many homeowners to refinance their mortgages to affordable levels.3 Though me Federal Reserve took drastic action to lower the lending and mortgage rates,4 many homeowners whose mortgage obligations exceeded me value of their homes simply chose to not pay their mortgages, to default, and to walk away.5 This caused great uncertainty as to the value of assets the banks have bundled up, securitized and sold to investors. As a result, banks that decided to keep some of these assets, as well as investors who hold many of those securitized loans in their portfolios, suffered steep write-downs because of depressed asset market prices.6 Such events effectively demolished the market for securitized mortgage bonds, and many financial institutions that had once participated in that market have exited with no indication of recommitting themselves to issuing those types of securities in the near term.7 Moreover, the increase in the interbank lending rate led the inversely correlated prices of banks' bonds to plummet.8 This triggered the need to recapitalize banks, which began hoarding cash and minimizing consumer lending as they realized that their very survival was at stake due to insufficient capitalization.9 Analogous to a negative feedback loop, the banks' hoarding of cash led to further increases in overnight lending rates, further decreases in asset prices, and further drops in securitized debt issuances. 10

The United States Department of the Treasury (the "Treasury"), under the guidance of then Treasury Secretary Henry Paulson,11 realized that to recapitalize, financial institutions needed to provide avenues beyond the currently dysfunctional securitization market12 to encourage investors to buy loans from the banks' books. Investors' purchases of these loans would increase asset prices and decrease mortgage rates, which would in turn incentivize new buyers to enter the devastated real estate market. 13 The Treasury has therefore decided that we must look beyond the current structure of securitized lending that lets banks divest themselves of mortgage loans. We should instead look into new issuances that help lenders make long-term loans and hold those loans on their balance sheets. 14 One possible way to lower borrowing costs and revive lending is to issue debt secured by collateral kept on the banks' books.15 This is the essential feature of a covered bond, an established financial instrument in Europe. The Treasury specifically recommended the establishment of a covered bond market in the U.S. with the goal of developing it as an alternative method for banks to issue and sell mortgage loans to investors.16

While creation of a covered bond market may alleviate stress from dysfunctional securitization markets, issuance of covered bonds must be complementary to business goals of investors and issuers alike. From the investors' standpoint, covered bonds offer recourse to the issuers' assets, thus giving investors security in the event of default.17 From the issuers' view, covered bonds attract investors - and their capital - due to characteristics such as offering a higher credit rating and recourse to the issuer's assets.18 Issuers, however, would be more reluctant to offer covered bonds if they had to comply with an additional substantial burden of compliance, such as that of the Investment Company Act of 1940 (the "1940 Act")19, without another avenue that would avoid such reporting complications.

Part I of this Note describes me European covered bond market and identifies some regulatory frameworks that allowed the covered bond to develop there into a promising financial instrument. …

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