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Incoming Chair of House Capital Markets Subcommittee Wants to Reform GSEs and Create US Covered Bond Market

By Jim Hamilton

Rep. Spencer Bachus (R-AL), incoming Chair of the House Financial Services Committee, has named Rep. Scott Garrett (R-NJ) to chair the subcommittee with jurisdiction over the financial markets, the SEC, the NYSE, NASD, the SROs, and the government -sponsored enterprises, such as Fannie Mae and Freddie Mac. The Capital Markets subcommittee also has oversight of all matters related to capital markets activities such as business capital formation and venture capital, and derivative instruments.

While there will be a number of very important issues on the subcommittee?s plate during the 112th Congress, said Rep. Garrett, reforming the GSEs and the securitized secondary mortgage market will be priority number one. He also wants to reform the Securities Investor Protection Act to better protect customers of brokerage firms. The incoming Chair is also a sponsor of legislation to create a US covered bond market as part of the effort to reform the secondary market.

On December 16, 2010, Rep. Garrett introduced legislation amending the Securities Investor Protection Act to determine a customer's net equity based on the customer's last statement, to prohibit certain recoveries, and to change how trustees are appointed. The Equitable Treatment of Investors Act, HR 6531, is designed to protect ordinary investors who have already been defrauded and financially devastated from further clawbacks by the Securities Investor Protection Corporation trustee.

Upon introducing the bill in the House, Rep. Garrett said that when investors see the SIPC seal of approval they should have confidence in the account statements they receive. These ordinary investors who knew nothing about the fraud should not be held to a higher standard than the federal government, he emphasized, which in the case of the SEC missed the Madoff fraud in the first place, and in the case of the Internal Revenue Service was happy to rely on these same statements to collect taxes from the reported profits. He noted that customers of registered brokers regulated by the SEC are legally entitled to rely on their customer statements as evidence of what their broker owes them; this does not change when a broker engages in fraud. Indeed, it is there to protect customers in the event of fraud. Since customers dealing with brokers do not hold physical securities, he reasoned, there is no other way for customers to verify their holdings.

Rep. Garrett is concerned that the trustee in the Madoff case is ignoring this law and failing to provide prompt assistance to those who have been thrust into financial chaos. According to the incoming Chair, the trustee is taking positions on a wide range of issues that are contrary to the Securities Investor Protection Act, the Bankruptcy Code, and federal and state laws that are intended to protect investors against bad acts on the part of their brokers. Rep. Garrett said that the legislation is intended to clarify for the trustee and the federal bankruptcy court that Congress wants these laws to be followed. If the current law is not followed, he emphasized, no customer can ever have confidence in his or her dealings with a broker.

Reform of the GSE?s has been a special concern of Rep. Bachus (R-AL), who has vowed to make this a top priority of the 112th Congress. As part of GSE reform, and as a replacement for the mortgage securitization function that GSEs currently perform, there is growing bi-partisan effort to pass legislation creating a US covered bond market under SEC supervision. In late July, the House Financial Services Committee reported out by voice vote the US Covered Bond Act, HR 5823, which was authored by Rep. Garrett

A centerpiece of the Bachus GSE reform legislation is the establishment of a regulatory framework for a U.S. covered bond market. Covered bonds are an innovative source of private mortgage market financing which have worked well in many European countries. They are also a private market solution to the need for market participants to have "skin in the game."

A covered bond is a form of debt issued by a financial institution where a specific set of high quality assets, typically loans, are set aside into a pool for the benefit of the bondholders. The issuers of covered bonds are responsible to their bond holders for the risk posed by the underlying loan pool. For example, if the underlying loans default, bond holders can make claims against the issuer. And if the issuer becomes insolvent, bondholders retain full claim on the loan pool. Additionally, issuers of covered bonds are required to account for the risk posed by their bonds on their balance sheets.

Rep. Bachus has historically supported this type of legislation. In a letter to Senate Banking Committee Chair Chris Dodd, that he co-signed with Rep. Garrett, principal author of the covered bond legislation, the incoming House leaders said that Congress must consider creative means to enable the private sector to provide funding for additional consumer credit and alternative options for financial institutions to finance their operations. Establishing a U.S. covered bond market would further each of these shared policy goals. The letter also noted that a robust U.S. covered bond market would provide a significant source of much-needed liquidity for home mortgages, commercial real estate (including multi-family), student loans, and public sector financing.

According to Rep. Garrett, covered bonds have been used in Europe to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations? mortgage markets. The legislation is a thorough framework that seeks to provide the same benefits to the U.S. market. The legislation provides for the regulatory oversight of covered bond programs, includes provisions for default and insolvency of covered bond issuers and subjects covered bonds to appropriate federal securities regulation. According to an FDIC policy statement, covered bonds originated in Europe, where they are subject to extensive regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuer. By contrast, the US does not currently have the extensive statutory and regulatory regimes designed to protect the interests of covered bond investors that exists in European countries.

Covered bonds help to resolve some of the difficulties associated with the originate-to-distribute model of securitization. The on-balance-sheet nature of covered bonds means that issuers are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

The covered bond provisions narrowly missed being included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Garrett provisions were supported in conference by Senate Banking Committee Chair Chris Dodd, who recently held scheduled hearings on the covered bond legislation.

At the hearings, Senator Dodd said that covered bonds can provide an additional option to the two dominant funding mechanisms in the US marketplace, which are securitization and the traditional portfolio lender model where a bank holds mortgages on its balance sheet and funds them with deposits, said Chairman Dodd. He added that the proponents of covered bonds point to their greater transparency, because these assets remain on a bank?s balance sheet so investors can analyze their value more easily than in the case of some other asset-backed securities. Proponents also note that issuers of covered bonds have a long term interest in the underlying loans because they keep them on the balance sheet, which increases investor confidence.

Senator Dodd said that legislation and agency rulemaking on cocered bonds are needed to provide clarity about how covered bonds would be regulated. Any legislation would define the rights and responsibilities of investors, issuers, and regulators. Among other things, the legislation would spell out the treatment of covered bonds if the issuer goes into conservatorship or receivership.

Full post as published by Jim Hamilton's World of Securities Regulation on December 18, 2010 (boomark / email).