[Senate Hearing 111-768]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-768
 
          COVERED BONDS: POTENTIAL USES AND REGULATORY ISSUES

=======================================================================


                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                                   ON

  EXAMINING COVERED BONDS, THEIR POTENTIAL USES, AND REGULATORY ISSUES

                               __________

                           SEPTEMBER 15, 2010

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia             JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                   Dean V. Shahinian, Senior Counsel

                 Levon Bagramian, Legislative Assistant

             Jonathan N. Miller, Professional Staff Member

                    Deborah Katz, Legislative Fellow

                Mark Oesterle, Republican Chief Counsel

              Michael Piwowar, Republican Senior Economist

             Andrew J. Olmem, Jr.,Republican Senior Counsel

            Chad Davis, Republican Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                      Brett Hewitt, Hearing Clerk

                     William Johnson, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                     WEDNESDAY, SEPTEMBER 15, 2010

                                                                   Page

Opening statement of Chairman Dodd...............................     1
    Prepared statement...........................................    33

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
    Senator Corker...............................................     4
    Senator Johnson
        Prepared statement.......................................    33

                               WITNESSES

Scott Garrett, Representative in Congress from the State of New 
  Jersey.........................................................     5
    Prepared statement...........................................    34
Julie L. Williams, First Senior Deputy Comptroller and Chief 
  Counsel, Office of the Comptroller of the Currency.............     8
    Prepared statement...........................................    35
    Responses to written questions of:
        Senator Shelby...........................................   126
        Senator Vitter...........................................   130
Michael H. Krimminger, Deputy to the Chairman, Federal Deposit 
  Insurance Corporation..........................................    10
    Prepared statement...........................................    41
    Responses to written questions of:
        Senator Shelby...........................................   131
        Senator Vitter...........................................   136
Scott A. Stengel, Partner, Orrick, Herrington and Sutcliffe LLP, 
  on behalf of the U.S. Covered Bond Council, Securities 
  Industry, and Financial Markets Association....................    12
    Prepared statement...........................................    46
    Responses to written questions of:
        Senator Shelby...........................................   137
Kenneth A. Snowden, Associate Professor of Economics, University 
  of North Carolina at Greensboro................................    13
    Prepared statement...........................................    53
Ric Campo, Chairman and Chief Executive Officer, Camden Property 
  Trust, on behalf of National Multi Housing Council and the 
  National Apartment Association.................................    15
    Prepared statement...........................................    63
    Responses to written questions of:
        Senator Shelby...........................................   194

              Additional Material Supplied for the Record

Prepared statement of the American Society of Civil Engineers....   197

                                 (iii)


          COVERED BONDS: POTENTIAL USES AND REGULATORY ISSUES

                              ----------                              


                     WEDNESDAY, SEPTEMBER 15, 2010

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:05 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. Well, good morning, everyone. The Committee 
will come to order, and let me first of all welcome all of you 
to the Committee room. It is good to see my colleagues once 
again after the August break and the rather hectic year we have 
had with all the legislative efforts. So it is pleasant to see 
everyone, and this morning we are going to have a hearing on 
covered bonds, the potential uses and regulatory issues.
    Just as background to this--and I will make a brief opening 
statement. We are waiting for Congressman Garrett to come up. 
He is the individual in our conference who raised this as an 
amendment during the conference consideration. Senator Corker 
expressed a great deal of interest in this subject matter, as 
did others, and there was some opposition to including his 
language in the bill at the time from a number of the 
regulators and others. So I was uneasy about putting something 
in where there was that much debate about the subject matter, 
but agreed to have a hearing exclusively on the subject matter, 
which we will do here today, and we have got some wonderful 
witnesses who can shed, I hope, some very worthwhile light on 
the subject matter.
    And so I am grateful to Congressman Garrett for raising the 
issue, grateful to Senator Corker for calling for us to have a 
hearing on it so we can examine the issue; and while we do not 
intend necessarily to resolve the matter in the next few days, 
it is an important subject, and this is a vehicle that is used 
by a lot of our European allies. It is a common vehicle used, 
and there are a lot of positive things about covered bonds, but 
there are some questions obviously others will have as well 
about their usage.
    So let me open with some comments. I will turn to Senator 
Shelby, and by that time, we hope Congressman Garrett can be 
here. Then we will hear his testimony and get right to our 
panel.
    Today the Committee will hear testimony on covered bonds, 
as I have indicated, a potentially significant alternative 
means for raising capital for housing finance. Covered bonds 
have been issued widely in Europe for many years, but not in 
the United States. The purpose of today's hearing is to learn 
more about covered bonds, exploring whether they could 
contribute to sustained economic growth and whether it is in 
the public interest to encourage their broader use in our own 
country.
    The hearing grew out of a discussion, as I mentioned a 
moment ago, on covered bonds that came up during the latter 
part of the Senate-House conference on the so-called ``Dodd-
Frank Act.'' I am pleased to have worked with Ranking Member 
Shelby and Senator Corker, as I have mentioned, in organizing 
this hearing. As the Banking Committee has not previously held 
a hearing on covered bonds, and the subject has raised issues 
among Federal regulators, we determined to explore the matter 
more carefully before acting.
    When speaking of covered bonds in the United States 
context, we generally mean a debt security issued by a bank and 
backed by cash-flows from mortgages or public sector loans. The 
bond is backed by the bank's promise to repay and by the assets 
pledged in collateral. Covered bonds can provide an additional 
option to the two dominant funding mechanisms in the U.S. 
marketplace, which are securitization and the traditional 
portfolio lender model, where a bank holds mortgages on the 
balance sheets and funds them with deposits.
    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 their balance 
sheet, which increase investor confidence.
    While American banks are not prohibited from issuing 
covered bonds to raise capital, few currently do so. Some 
potential investors are concerned about the treatment of 
covered bonds if the issuer goes into conservatorship or 
receivership. They believe that legislation and agency 
rulemaking are needed to provide clarity about how covered 
bonds would be regulated. Any such measures would define the 
rights and responsibilities of investors, issuers, and 
regulators. They feel that this would stimulate the growth of a 
later domestic covered-bond market.
    It is important that Congress, I think, look for 
alternative means and measures that could stimulate the 
economy. The Committee is holding today's hearing to learn more 
about this alternative and whether it could contribute to safe 
and stable and sustained economic growth.
    We are pleased to have before us experts who will provide 
testimony about the history of covered bonds, their uses and 
potential benefits, as well as their interaction with existing 
mortgage financing mechanisms. The panel also includes Federal 
regulators who can share their perspective on the regulation of 
banks that would issue covered bonds, including the impact on 
the Deposit Insurance Fund.
    On the first panel, I am pleased to welcome Congressman 
Scott Garrett. Here you made it. I am glad you got over here. I 
was going to filibuster for a while until you got here, 
something we do with some regularity around here these days. 
Welcome to the Senate side, Congressman. Nice to see you again 
as well, by the way. We spent an awful lot of time together, it 
seems, not long ago. Anyway, delighted you are here.
    Congressman Garrett has a strong interest in this area--
spoke eloquently about it during our conference with the House 
on the financial reform bill--and has introduced legislation on 
covered bonds.
    On the second panel, we will hear from Julie Williams, 
Chief Counsel and the First Senior Deputy Comptroller, Office 
of the Comptroller of the Currency; Michael Krimminger, who is 
Deputy to the Chairman of the Federal Deposit Insurance 
Corporation; Scott Stengel, on behalf of the U.S. Covered Bond 
Council; Professor Kenneth Snowden, from the University of 
North Carolina at Greensboro; and Mr. Ric Campo, on behalf of 
the National Multi Housing Council and the National Apartment 
Association.
    Last, let me just say just as what I see as kind of the 
issues, and I will just pick seven issues here that it would 
seem to me to help our panelists--I do not expect you all to 
answer every one of these, but these are the questions we 
thought were legitimate to be raised here.
    One, is legislation needed? A pretty basic question, but 
one that I think should be raised. What entities would be 
eligible to issue covered bonds? What agencies should regulate 
covered bonds? What assets would be eligible for covered bonds? 
What standards should apply to issuance, joint rulemaking, cap 
on assets held in covered bonds, limit of percentage of covered 
bonds as to total liabilities, minimum collateralization? What 
are the consequences of a failure of a covered-bond issuer or a 
bond default? And what securities disclosures would apply?
    Now, there may be more issues, but those are six or seven 
we thought were legitimate questions to be raising about this 
subject matter.
    So, with that, let me turn to Senator Shelby for his 
opening comments, and then unless my two colleagues want to be 
heard on the matter, we will go right to Congressman Garrett. 
Richard.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Mr. Chairman, I appreciate that you are fulfilling the 
commitment that you made during the financial regulation 
conference to hold this hearing. The fact is our housing 
policies have failed on a grand scale. Fannie and Freddie are 
in Federal hands, while millions of homeowners continue to 
struggle with mortgages that are underwater. Taxpayers have 
lost over $200 billion and are likely to lose billions more in 
the future. Despite this, the proponents of reform legislation 
chose to ignore many of the problems in the mortgage market, I 
believe. I believe this was a serious mistake and think this 
Committee must remain engaged in the hard work necessary to 
come up with solutions that protect taxpayers and homeowners 
alike.
    A thorough examination of the use of covered bonds I think 
is a positive first step. A covered bond, Mr. Chairman, as you 
have mentioned, is a financial instrument that merits this 
Committee's close scrutiny. When implemented under certain 
regulatory and economic circumstances, they have proved to be a 
valuable private sector tool for providing mortgage liquidity 
in certain markets.
    However, what works in some markets does not always 
translate well to our economy. Additionally, as is noted in the 
testimony of members of the second panel, and contrary to 
popular perception, covered bonds have been tried in this 
country before, and they did not achieve a high level of 
success. Nonetheless, the Committee should thoroughly study 
this unique area of mortgage finance. Only then can we conduct 
our own analysis of this particular approach and determine 
whether covered bonds should become a part of our housing 
finance landscape.
    But I believe before we proceed with the testimony, Mr. 
Chairman, I want to reiterate my belief that, notwithstanding 
the recent passage of the Dodd-Frank bill, this Committee has a 
great deal of work yet to do. Our housing finance markets have 
been crippled, and the bureaucratic structure that has been 
erected as a result of decades of ill-advised housing policies 
has only made it worse.
    Mr. Chairman, I think the American people are fed up. They 
are fed up with bailouts, excessive debt, and oversized 
Government. They are certainly fed up with an anti-State 
mentality that demands a new Federal program for every 
identifiable problem in the housing sector. Therefore, Mr. 
Chairman, I believe we must completely reevaluate our current 
approach to housing policy and find the political courage to 
make some significant changes. My hope is that this hearing is 
the beginning of that process.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Yes, Senator Corker.

                STATEMENT OF SENATOR BOB CORKER

    Senator Corker. I want to break the Corker rule and just 
very briefly say that I want to go back to comments I made last 
November or December and say that this type of hearing is 
exactly the reason that I think this is a great Committee. And 
I think at the time of conference we did not have the 
information we needed. A commitment was made by you to have 
this hearing and we are having it, and I appreciate that. And, 
again, I think it is part of the thoughtful approach that we 
have used on most issues. I know last year was a very 
tumultuous year, a lot of emotions frayed. But, Scott, I want 
to thank you for championing this issue and pressing it as you 
have. I know that you have already passed a piece of 
legislation in the House. We did not know as much as we needed 
to know about it and had some questions, and I think it is 
appropriate that we are having a hearing, and I think this is a 
first step toward addressing some of the issues that Senator 
Shelby has raised.
    So I want to thank you for having the hearing.
    Chairman Dodd. Thank you, Senator, very much.
    Jack, any comment?
    Senator Reed. For the record, Mr. Chairman, I would like to 
follow the Corker rule.
    [Laughter.]
    Senator Shelby. Now, the Corker rule is unwritten, isn't 
it, Mr. Chairman?
    Chairman Dodd. It is an unwritten, rigid rule. And I 
suspect that as this gavel may move back and forth here that 
the people are going to want to apply it with greater 
regularity.
    Senator Shelby. And the Corker rule is very much in vogue 
when we have got a full panel of members.
    Chairman Dodd. Oh, very much in vogue.
    Senator Shelby. Of members.
    Chairman Dodd. Yes, absolutely, want to talk. First of all, 
on the subject matter I am sure not a lot of them know what a 
covered bond is yet, too. That may slow them down on opening 
statements along the way.
    Anyway, Congressman, welcome to the Senate. We are anxious 
to receive your testimony.

STATEMENT OF SCOTT GARRETT, REPRESENTATIVE IN CONGRESS FROM THE 
                      STATE OF NEW JERSEY

    Mr. Garrett. Well, first of all, thank you, Chairman Dodd 
and Ranking Member Shelby. Thank you very much for inviting me 
here and for holding this hearing as well, and thank you, 
Senator Corker, for being a strong and articulate advocate for 
covered bonds as well. I appreciate your assistance on this 
very important issue.
    As our Nation continues, in essence, to recover from the 
recent financial crisis and certain credit markets remain 
locked, Congress really must--and I think the Chairman agrees--
examine new and innovative ways to encourage the return of 
private investment to our capital markets. So we must also 
consider creative ways to enable the private sector to provide 
additional consumer and commercial and public sector and other 
types of credit as well. So establishing this U.S. covered-bond 
market would further all these shared goals.
    One reason I am really particularly fascinated with covered 
bonds is the fact that they can be a purely private means of 
finance--and this is important--without any Government 
guarantees or subsidies. Many proposals to help alleviate the 
current strains in our credit markets focus on Government loans 
or guarantees. However, I believe that covered-bond legislation 
offers a way for the Government to provide additional 
certainty--and some are looking for it--to private enterprises 
and generate increased liquidity through the innovation of a 
new marketplace without, again--and this is important--putting 
the taxpayers on the hook.
    Now, there are many potential benefits for a wide variety 
of interested parties that can be derived from a U.S. covered-
bond market. I think the Chairman was touching on some of 
these.
    Consumers will experience lower loan rates because of the 
additional liquidity in the various asset classes.
    Consumers will also be able to more easily have their loans 
modified because the loans will still be on the balance sheets, 
on the books of the originating institution.
    Investors will have a new transparent and secure vehicle to 
invest in, and this will allow for additional diversification 
within their portfolios.
    And, finally, the broader financial market itself will 
benefit by having an additional, low-cost, diverse funding tool 
for all financial institutions there.
    Covered bonds will ensure more stable and longer-term 
liquidity in the credit markets, which reduces refinancing 
risks as well as exposure to sudden changes in interest rates 
and investor confidence. And they will allow U.S. financial 
institutions to compete more effectively against their global 
peers.
    In the House, we have worked in a very constructive 
bipartisan fashion to push the ball forward on comprehensive 
covered-bond legislation. I just left Chairman Kanjorski and 
Ranking Member Bachus, and I have introduced three different 
versions of covered-bonds legislation. The most recent is H.R. 
5823, the Covered Bond Act of 2010.
    Now, a week before the August recess, we successfully 
marked up this legislation and reported it out of Committee 
with a unanimous vote. It is my hope that we can pass this 
legislation out of the House over the next several weeks.
    Some have asked why we need covered-bond legislation. You 
raised seven points. Simply, to get the market off the ground 
and provide investors with the needed confidence to invest in 
the market and resolution procedures of a bond when an issuer 
fails needs to be spelled out specifically in statute. 
Otherwise, without the certainty of a legally binding process, 
there is not significant enough appetite from the investment 
community to make covered bonds cost-effective to the issuers 
to offer. Also, a regulatory regime needs to be put in place to 
ensure proper oversight of the marketplace.
    Throughout this process, there have been some people who 
have said, ``Well, let us wait and see; maybe next year with 
housing finance reform.'' But the proposal we are discussing 
today is broader than just housing finance. Covered bonds offer 
a complementary source of funding that can spur much needed 
lending to consumers, small businesses, and State and local 
governments. The reason why I have been so active in pushing 
covered bonds this year is because I believe we have to do it 
right now. We hear almost daily about the liquidity concerns 
throughout various asset classes. The House Financial Services 
Committee held a recent hearing about the lack of liquidity in 
the marketplace. The Senate just passed a bill already approved 
by the House with the intent of providing more liquidity.
    Also, we have spoken to local and State officials about the 
problems municipalities face with increased funding costs for 
their projects. The President has continuously stressed the 
need to help these segments of the economy. More importantly, 
this is something we can do, we can do it now, and we do it 
without any cost to the taxpayer.
    Another reason to move quickly on establishing a covered-
bond market in the U.S. is because billions of U.S. investment 
dollars are moving overseas and north of the border. So far in 
2010, there have been a dozen covered-bond deals issued by 
foreign banks to U.S. investors totaling over $18 billion. This 
is private capital that could have been invested here in the 
United States with the help of our legislation.
    Private industry realizes that we are currently missing out 
on an opportunity as well. Now, I have formal letters of 
support for the U.S. Covered Bond Act from the National 
Association of Realtors, the Mortgage Bankers Association, the 
ABA, the National Multifamily Housing Council, and so on.
    Now, finally, I do not want to pretend to believe that 
covered bonds are some sort of magic bullet that will help 
solve all of our funding needs. However, what I do know is 
this: that they will help solve some--some--of our funding 
needs. What I do know is that during this time of economic 
uncertainty, lack of liquidity, and rising budget deficits, 
during all this time we must consider innovative approaches to 
help attract private investments--not Government investments--
into our capital markets. I believe that this legislation can 
help us out in that regard.
    I will end where I began. I want to thank the Chairman so 
very much and the Ranking Member as well for this invitation, 
for taking up this issue, and for considering this important 
piece of legislation.
    Thank you, Senators.
    Chairman Dodd. Thank you, Congressman, very, very much, and 
I congratulate you on your efforts in the House and getting 
things moving along in this area.
    Let me turn to my colleagues if they have any questions of 
our colleague in the House. Jack, any questions at all?
    Senator Reed. No. I just want to commend the Congressman 
not only for his work here today but for his major contribution 
to the conference committee on financial reform. Thank you, 
Congressman.
    Chairman Dodd. Yes, and I should have said that as well.
    Mr. Garrett. Well, that was made more fun because of the 
Senators.
    [Laughter.]
    Chairman Dodd. I know. I know how much you like to have us 
come over to the House side.
    Mr. Garrett. We do.
    Senator Corker. I know we do not typically question, you 
know, people who are elected officials, and so I am not going 
to do that. But you might want to get some editorial comment as 
to what--I know what passed in the House was not perfect in 
your eyes. Would you share with us a couple of things that you 
think might make the bill you passed in the House more perfect?
    Mr. Garrett. How would we make the bill----
    Senator Corker. I know you had to make some compromise in 
the House that you did not really want to make. Could you share 
with us a couple of the things that you think would make the 
bill that passed in the House better if we passed it in the 
Senate?
    Mr. Garrett. Well, I will just touch on one. One aspect is 
with regard to asset classes in the legislation. Our background 
on this looks to Europe. They use this for their asset classes. 
We take a broader approach to that. And some say maybe we are 
taking too broad an approach. So we agreed to come to 
agreement, come to a compromise on that, and rein that in 
somewhat. But I think we did it in a constructive manner to 
allow the regulators some degree of flexibility going forward 
as the marketplace expands and develops and they have the 
understanding of the operation there.
    But I do believe going forward, just as I said in my 
testimony, that this really is not an issue just in the 
mortgage/housing finance situation. This can be an avenue for 
increased liquidity and increased credit and a whole slew, if 
you will, of different asset classes as well. So that is one 
area that we could take a look at.
    Senator Corker. And right now it is mortgages only. Is that 
correct?
    Mr. Garrett. Oh, no. We have limited it, but we have not 
extended it to a carte blanche avenue in the bill.
    Senator Corker. OK. Thank you, Mr. Chairman.
    Chairman Dodd. Congressman, thank you very, very much.
    Mr. Garrett. Thank you.
    Chairman Dodd. Let me invite our panel to come up and join 
us. I have already introduced, I think, the panel so I will ask 
you to come up and assume the seats in the order in which I 
introduced you.
    While our witnesses are taking their seats, the staff has 
pointed something out to me that we do not do often enough, in 
my view. In the case of Mr. Krimminger and Ms. Williams, these 
are people who have dedicated a good part if not all of their 
professional life to the service of our country. Julie Williams 
has worked for almost 30 years for the Federal Home Loan Bank, 
the OTS, and the OCC. Where are you? There you are at the end 
down there. Very fond of people who--young people with gray 
hair. I have a bias to that coloration. And Michael Krimminger 
has worked for almost 20 years as well for the Government, and 
we thank you both for your service to our country, day in and 
day out just trying to do a good job on behalf of the Nation. 
We are very fortunate to have your service, and I thank you for 
it as well.
    We will begin with you, Ms. Williams, and then I would just 
ask you all, because it is a large panel, to try and keep your 
remarks to about 5 minutes or so, so we can engage in the 
questions that all of us will have for you. And then any 
supporting documents or materials you would like for this 
Committee to have as part of this record, I will just ask 
unanimous consent that all documents that our witnesses provide 
be accepted as part of the record. Without objection, it is 
ordered.
    Ms. Williams.

STATEMENT OF JULIE L. WILLIAMS, FIRST SENIOR DEPUTY COMPTROLLER 
  AND CHIEF COUNSEL, OFFICE OF THE COMPTROLLER OF THE CURRENCY

    Ms. Williams. Thank you. Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee, my name is Julie 
Williams, and I am the Chief Counsel and First Senior Deputy 
Comptroller at the Office of the Comptroller of the Currency. 
The OCC appreciates the opportunity to testify today regarding 
the potential of covered bonds as a new funding mechanism for 
financial institutions and the issues presented in designing a 
covered-bond legislative framework.
    Covered bonds are a promising funding option for financial 
institutions. They could serve as an alternative to 
securitization and other current funding techniques and could 
be a new source of funds for lending and an alternative source 
of liquidity.
    For the banking system, covered bonds could provide a 
funding source that is longer term and more stable and 
potentially less expensive than currently available 
alternatives. The structure of covered bonds might require less 
collateral and may also accommodate a broader range of types of 
collateral than current options.
    Covered bonds also may attract types of investors that 
would not otherwise invest in bank debt. Institutions also have 
a strong incentive to maintain prudent underwriting standards 
for loans in a covered-bond collateral pool because those loans 
remain on the institution's books.
    That said, a complex combination of factors will determine 
the relative attraction of covered bonds compared to 
alternative funding sources. Because covered bonds remain on an 
institution's balance sheet, an institution must hold more 
capital than would typically be required if the assets were 
securitized. Thus, capital requirements could constrain the 
growth of covered bonds. And new accounting rules, upcoming 
changes in capital requirements, and the ``skin in the game'' 
provisions in the Dodd-Frank Act are all factors that could 
affect the relative advantages and disadvantages of covered 
bonds versus other funding alternatives.
    The legal framework for covered bonds in the U.S. also will 
be a key factor in whether covered bonds flourish, and various 
legislative efforts have emerged recently to provide enhanced 
legal certainty regarding the elements of a covered-bond regime 
in the U.S.
    My written testimony provides detail on the issues that we 
would suggest Congress consider in designing a legislative 
framework for covered bonds. We also offer some suggestions on 
how those issues could be addressed, and I will summarize those 
points.
    First, what type of entity is eligible to issue covered 
bonds? We believe that limiting eligible issuers to entities 
already subject to Federal supervision will ensure that 
dedicated financial supervisors can monitor and control the 
growth of covered-bond programs, react to emerging issues, and 
promote safe and sound programs in the institutions they 
supervise.
    Second, what agency or agencies are appropriate to regulate 
U.S. issuers and programs? We support a framework where Federal 
financial regulators operating under a single uniform set of 
standards would be designated as the covered-bond regulators 
for their respective regulated entities.
    Third, what types of assets should be eligible to 
collateralize the covered bonds? We suggest that a new covered-
bond program start with a relatively conservative scope, with 
regulators authorized to expand the eligible asset classes as 
more experience is gained with covered-bond programs.
    Fourth, what specific standards should be applicable to 
covered bonds and covered-bond issuers? These could include, 
for example, minimum eligibility criteria by asset class, 
limits on size of issuances, and overcollateralization 
standards. Here legislation could provide direction on key 
issues and charge regulators with adopting the detailed 
standards to implement those directions.
    Fifth, what are the consequences of a default of a covered-
bond issuance or the failure of a covered-bond issuer? How a 
U.S. legal framework resolves how a covered pool is treated in 
the event of a default or insolvency of a covered-bond issuer 
and the role of the FDIC will critically affect the appeal of 
covered bonds to investors.
    And, last, what reporting and securities standards should 
apply to covered bonds? We support transparency and 
availability of information to investors as important 
components of a comprehensive covered-bond regime.
    I appreciate the opportunity to appear today to discuss 
these issues. I would be happy to answer any questions. Thank 
you.
    Senator Reed [presiding]. Thank you, Ms. Williams.
    Mr. Krimminger, please.

  STATEMENT OF MICHAEL H. KRIMMINGER, DEPUTY TO THE CHAIRMAN, 
             FEDERAL DEPOSIT INSURANCE CORPORATION

    Mr. Krimminger. Good morning, Chairman Dodd and Members of 
the Committee. On behalf of the FDIC, I want to thank you for 
the opportunity to testify about covered bonds. I am Deputy for 
Policy to Chairman Bair and have had the privilege to work on 
many of the issues that we will discuss this morning.
    Early on, the FDIC recognized covered bonds as a potential 
source of bank liquidity, but one that should be balanced 
within the U.S. financial system. To do this, in 2006, the FDIC 
worked to clarify our policies with the first U.S. banks to 
issue covered bonds. Later, in mid-2008, the FDIC adopted a 
Covered Bond Statement of Policy to further solidify that 
foundation.
    However, the intervening financial crisis has prevented new 
covered bonds so far. While there is some question whether a 
legislative framework is essential, the FDIC does support 
balanced legislation. We believe legislation should embody 
three key principles.
    First, it should clarify the rights and responsibilities of 
investors, issuers, and regulators.
    Second, it should not transfer investment risk from 
covered-bond investors to the public or to the Deposit 
Insurance Fund.
    And third, it should be consistent with longstanding U.S. 
law and policy for secured creditors. In short, covered-bond 
investors should not be given rights that are unavailable to 
any other investors.
    My written statement provides a detailed explanation of 
these principles. I will concentrate today on the need to 
provide protections for the Deposit Insurance Fund and to 
preserve the priorities of U.S. laws.
    We have worked with the sponsors of H.R. 5823, the United 
States Covered Bond Act of 2010, and appreciate the evolution 
of that legislation to address some of our concerns. However, a 
few key concerns remain. Of course, we will continue to work 
with the sponsors and other members to address these continuing 
concerns with that legislation.
    I think the importance of the Deposit Insurance Fund to 
stability in our banking system is very apparent today. Key 
statutory protections for this Fund are, one, the FDIC's 
ability, or duty, I should say, to use the least costly way to 
resolve banks, and two, the ability to fulfill this duty by 
getting the best value for a failed bank's assets, such as a 
covered-bond program.
    To maintain these protections, we urge that any covered-
bond legislation preserve the FDIC's flexibility in handling 
covered bonds in receiverships. Today, the FDIC has three 
options. First, it can continue to perform under the covered 
bonds and then sell the program intact to another bank. Second, 
the FDIC can turn over the collateral to the investors. 
Finally, the FDIC can terminate the program, pay the full value 
of the bonds plus interest, and reclaim the cover pool. This 
flexibility is critical to protect the Deposit Insurance Fund. 
It allows the FDIC to effectuate the least costly resolution 
for a failed bank by recovering the best value for its assets, 
as we did when Washington Mutual failed and we sold the program 
to JPMorgan Chase.
    Unfortunately, in our view, H.R. 5823 gives the FDIC only 
two options, transfer a covered-bond program in a certain 
period of time or turn over the collateral to the investors. In 
effect, it transfers the risk of loss to the Deposit Insurance 
Fund if, as is usually the case, the cover pool is worth far 
more than the total due on the bonds.
    H.R. 5823 gives investors rights that no other creditors 
get under U.S. law, whether in bankruptcy or in FDIC 
receiverships. Under the House bill, investors get to keep all 
the cover pool, even if the full par value of their bonds plus 
interest is far less, which is usually the case. All the 
Deposit Insurance Fund would get is a, quote, ``residual 
certificate'' for any remaining value left after 10 or 20 
years. Unfortunately, the certificate is likely worth nothing.
    Longstanding U.S. law properly says a secured creditor, 
like the covered-bond investors, has a claim to keep the 
collateral only up to the amount due on the debt. H.R. 5823 
turns this on its head and makes the Deposit Insurance Fund 
bear the lost value of the collateral that exceeds the total 
due on the bonds. In effect, the proposed bill would give the 
covered-bond investors a superpriority over the Deposit 
Insurance Fund.
    I want to be clear. Contrary to what some argue, the FDIC 
is not trying to pay only the market value of the bonds, which, 
as we saw during the fall of 2008, can be dramatically 
discounted. The FDIC will support legislation that guarantees 
the investors the bond's par value plus accrued interest if we 
cannot sell the program and must terminate it. This gives the 
investor full value while preserving the FDIC's existing power 
to recapture the excess collateral value on behalf of the fund 
and the depositors. So long as investors are paid the full 
principal amount of the covered bonds and interest to the date 
of payment, there is no policy reason to protect them beyond 
that, especially through an indirect subsidy from the Deposit 
Insurance Fund.
    In effect, the super-priority could create a new class of 
investments that appear to be risk-free and can lead to a 
mispricing of the risk of covered bonds. As we have seen, 
mispricing of risk can have disastrous consequences.
    As I said before, the FDIC supports a vibrant covered-bond 
market in the U.S. and will continue to work with Congress, 
other regulators, and the industry to create one. Thank you 
again for the opportunity to testify.
    Chairman Dodd [presiding]. Thank you very, very much. I 
appreciate it very much.
    Mr. Stengel, welcome.

STATEMENT OF SCOTT A. STENGEL, PARTNER, ORRICK, HERRINGTON AND 
  SUTCLIFFE LLP, ON BEHALF OF THE U.S. COVERED BOND COUNCIL, 
     SECURITIES INDUSTRY, AND FINANCIAL MARKETS ASSOCIATION

    Mr. Stengel. Chairman Dodd, Ranking Member Shelby, and 
Members of the Committee, I am grateful for your invitation to 
testify today on the crucial role that U.S. covered bonds can 
play in stabilizing our financial system and contributing to 
our economic recovery.
    I am a partner with Orrick, Herrington and Sutcliffe and a 
member of the Steering Committee for the U.S. Covered Bond 
Council. The Council is comprised of investors, issuers, 
dealers, and other participants in the covered-bond market and 
we strive to develop policies and practices that harmonize the 
views of these different constituencies and that promote a 
vibrant market for U.S. covered bonds.
    The precarious state of our Nation's economy has become all 
too apparent. Almost 17 percent of Americans are still 
unemployed or underemployed. More than half of small business 
owners are experiencing cash-flow issues. Nearly one out of 
four homeowners is underwater on a mortgage, and a record 
percentage of commercial mortgage loans is delinquent.
    In the Council's view, sustained economic growth begins 
with a stable financial system. While the Dodd-Frank Act has 
supplied some important structural elements, there is still a 
need for long-term and cost-effective funding that is sourced 
from diverse parts of the private sector capital markets and 
that can be translated into meaningful credit for households, 
small businesses, and the public sector. We believe that 
covered bonds are an untapped but proven resource that could be 
invaluable in meeting this need. We also believe that the time 
for U.S. covered bonds is now.
    At its core, a covered bond is simply a form of high-grade 
debt that is issued by a bank or other regulated institution 
and that is secured by a dynamic cover pool of financial 
assets. What distinguishes covered bonds from other secured 
debt is a legal framework for managing and maximizing the value 
of the cover pool after the issuer's default or insolvency, and 
only if the cover pool is adequate, continuing scheduled 
payments on the covered bonds. Over the course of their 240-
year history, covered bonds have been backed by a wide array of 
asset classes that benefit from long-term, stable liquidity and 
that are significant to national economies.
    U.S. covered bonds can stabilize our financial system and 
encourage economic growth in several ways. First, with 
maturities that extend out to 10 years or more, covered bonds 
can infuse longer-term liquidity into the credit markets as a 
complement to the shorter-term funding that is supplied through 
the Federal Home Loan Banks and the securitization and repo 
markets.
    Second, by providing more cost-effective liquidity for 
lenders, covered bonds can produce less expensive and more 
available credit for consumers, small businesses, and the 
public sector.
    Third, covered bonds can add funding from a separate 
investor base that would not otherwise make this liquidity 
available through the unsecured debt or securitization markets.
    Fourth, covered bonds can deliver funding from the private 
sector even in distressed market conditions without any 
explicit or implicit Government guarantee or other taxpayer 
support.
    Fifth, because issuers continue to own the assets in their 
cover pools and have 100 percent skin in the game, incentives 
relating to loan underwriting, performance, and modifications 
are strongly aligned.
    And sixth, as a straightforward financial instrument, 
covered bonds can increase transparency and uniformity in the 
capital markets.
    To function successfully, however, a U.S. covered-bond 
market must be deep and highly liquid, and that requires the 
kind of legal certainty that only legislation can provide. 
Covered bonds developed in Europe under dedicated legislative 
frameworks and this precedent, now found in almost 30 other 
countries, has set expectations. The twin pillars of such a 
framework are, one, public supervision by a covered-bond 
regulator that can protect the interests of investors, free of 
any conflict, perhaps like the FDIC's duty to the Deposit 
Insurance Fund, and two, a separate resolution process that is 
clear and unequivocal and that is designed to avoid forced 
acceleration of covered bonds and a fire sale of the cover pool 
after the issuer's default or insolvency. These pillars, which 
afford the legal certainty required for investors to dedicate 
funds to this market, cannot be replicated by regulatory action 
like the FDIC's Covered Bond Policy Statement.
    Without action by Congress, European and other non-U.S. 
issuers will be left to fill the void. Thus far in 2010, they 
have targeted over today $19 billion in U.S. dollar covered 
bonds to investors of the United States. The result is an 
increasingly uneven playing field for U.S. institutions of all 
sizes and less available credit for families, small businesses, 
and the public sector.
    The Council, therefore, fully supports covered-bond 
legislation of the kind offered during the House-Senate 
Conference on the Dodd-Frank Act, and I want to thank Senator 
Corker and Congressman Garrett for their leadership and 
Chairman Dodd for holding this hearing. I would be pleased to 
answer any questions that Members of the Committee may have.
    Chairman Dodd. Thank you very, very much.
    Professor, Snowden, thank you.

    STATEMENT OF KENNETH A. SNOWDEN, ASSOCIATE PROFESSOR OF 
     ECONOMICS, UNIVERSITY OF NORTH CAROLINA AT GREENSBORO

    Mr. Snowden. Chairman Dodd and Members of the Committee, I 
appreciate the opportunity to testify today before the 
Committee concerning potential uses and regulation of covered 
bonds in the U.S. mortgage market. I am an economic historian 
who for the past two decades has studied the development of the 
U.S. mortgage market. The purpose of my testimony is to share 
with you some of the research I and others have done concerning 
the history of the market and the role that covered mortgage 
bonds have played within it.
    Really, one of the motivations we hear for using covered 
bonds is what I will talk about mostly today, which is that 
they are very popular and have a record of success in Europe. 
In fact, the European record of covered mortgage bond success 
stretches back over 200 years.
    My own research is completely U.S.-centric, but I became 
aware of the history of covered bond use in Europe two decades 
ago when I came across commentaries by late 19th century 
writers in the United States that complained bitterly about the 
absence of covered bonds in this country. These comments 
provided evidence that market participants in the U.S. were 
well aware of covered mortgage bonds as early as 1870, and this 
led me to question why the mechanism hadn't been implemented 
here.
    Further exploration revealed, in fact, that they had been 
introduced several times between 1870 and 1935. So at that 
point, the important question became, why did covered bonds not 
become a permanent fixture in the U.S. mortgage market after 
being introduced? My testimony briefly surveys the record to 
provide the Committee with this historical perspective as you 
consider legislation to encourage the introduction of covered 
mortgage bonds one more time.
    I divide the historical record into two parts. The first 
lies between 1870 and 1900, when covered mortgage bonds were 
introduced in the U.S. without the regulatory framework that 
was used at that time in Europe. The covered mortgage bond had 
its greatest success during this period in the Western farm 
mortgage market with companies that normally brokered whole 
mortgage loans to investors, but they began to issue bonds 
secured by mortgages instead of selling the loans outright.
    I have examined one of these companies in depth and found 
that the loans it placed behind its covered bonds were, in 
fact, riskier than the ones that it brokered. That result 
appears to contradict the generalization that underwriting 
standards are strict inside a covered mortgage bond structure. 
But in this case, the issuer could shift risk between brokerage 
and covered bonds because of ineffective regulation.
    A more obvious lesson can be drawn by the way these 
companies failed during the general farm mortgage crisis of the 
1890s. Serious malfeasance occurred throughout the covered 
mortgage bond sector during the crisis because there was no 
regulation in place to control the behavior of the mortgage 
companies after their financial capital had dissipated. These 
failures affected the reputation of covered mortgage bonds in 
the United States for decades.
    The Federal Government takes center stage in the history of 
covered mortgage bonds between 1900 and 1935. Your predecessors 
in the 63rd and 64th Congresses benefited from an extensive 
investigation of covered-bond systems in Europe before they 
created the Federal Farm Loan Bank System in 1916. The system 
was comprised of both public and private institutions and both 
relied on covered mortgage bonds as their financing.
    The privately financed Joint Stock Land Bank component of 
this system was structured and regulated just like institutions 
in Germany, and this led private farm mortgage companies in the 
United States to oppose and avoid the system because of 
restrictions on their activities that were placed by these 
German practices.
    Twenty years later, the 73rd Congress authorized the 
creation of a privately financed, federally regulated covered 
residential mortgage bond program to provide a liquid market 
for the new FHA insured mortgage loans. No private institution 
was ever chartered under this authority, and the discussion 
about introducing covered mortgage bonds to the U.S. went 
silent for decades.
    In the final section of my testimony, I provide an overview 
of the development of the institutional residential mortgage 
market over the past century to provide perspective on how the 
introduction of covered mortgage bonds at this time fits into 
its long-run pattern of development.
    I will close my remarks, however, by summarizing two 
lessons that I draw from the historical record. First, past 
failures of covered mortgage bonds in the U.S. are explained by 
a combination of bad timing, poor implementation, and 
ineffective regulation. We need to do a better job of 
incorporating covered bonds into the U.S. mortgage market 
rather than to abandon the effort.
    Second, a common failure in past attempts was to transplant 
elements of a European covered mortgage bond system without 
tailoring them to fit U.S. institutions. We need to identify 
features of the U.S. mortgage market that could be incompatible 
with European covered mortgage bond practice while, rather than 
after, regulation is being formulated.
    I thank you for your time and would be happy to answer 
questions.
    Chairman Dodd. Thank you very much, Professor.
    Mr. Campo, good to have you with us this morning.

 STATEMENT OF RIC CAMPO, CHAIRMAN AND CHIEF EXECUTIVE OFFICER, 
  CAMDEN PROPERTY TRUST, ON BEHALF OF NATIONAL MULTI HOUSING 
         COUNCIL AND THE NATIONAL APARTMENT ASSOCIATION

    Mr. Campo. Thank you, Chairman Dodd and distinguished 
Members of the Committee. I am Ric Campo, Chairman and CEO of 
Camden Property Trust, a publicly traded apartment firm. I am 
the Immediate Past Chairman of the National Multi Housing 
Council and I am testifying today on behalf of NMHC and our 
joint legislative partner, the National Apartment Association.
    We applaud the Senate Banking Committee for exploring 
alternative sources of capital to support housing. We believe 
covered bonds could indeed provide some degree of additional 
liquidity to the U.S. multifamily finance. We caution, however, 
that it is quite unlikely that covered bonds could provide the 
capacity, flexibility, or price superiority necessary to 
adequately replace any of the U.S. traditional sources of 
multifamily mortgage credit. I am hoping to provide you with 
the apartment sector's perspective based on our general credit 
needs and to share some insights into what role covered bonds 
could play in meeting those needs.
    One-third of American households rent. About 16.7 million 
households live in rental apartments. Our industry depends on a 
reliable source and sufficient capital to meet the Nation's 
rental housing demand. Currently, private mortgage lenders have 
left the market, forcing us to rely heavily on credit insured 
or guaranteed by the Federal Government, namely FHA, Fannie 
Mae, and Freddie Mac. Eighty percent of the apartment loans 
that were issued in the first 6 months of 2010 have some form 
of Government credit behind them. Therefore, our concerns are 
over the broader issue of housing finance reform and the 
unintended consequences that could reduce credit now provided 
by the GSEs.
    Since the conservatorship, the latest data shows that 
Freddie Mac's multifamily unit has generated a billion dollars 
of profits that have been used to offset the losses on their 
single-family book. Fannie Mae's numbers are similar. This is a 
strong indicator that the model for the multifamily finance 
market works pretty well.
    We support a careful look at covered bonds as a 
supplemental source of credit. The European experience 
indicates that covered bonds provide numerous benefits to 
issuers and investors. Investors earn attractive risk-adjusted 
yields on low-risk diversified securities. Financial 
institutions that issue the bonds benefit from the lower cost 
of funds and reduced risk-based capital requirements along with 
meaningful collateral substitution capabilities.
    For numerous reasons, though, it is quite unlikely that 
covered bonds could provide the capacity, flexibility, and 
pricing superiority necessary to adequately replace the U.S. 
existing sources of multifamily credit. First, it is unclear 
whether covered bonds would actually increase the amount of 
credit banks would make available to apartment firms because 
the covered-bond structure limits the issuers' lending volumes 
by requiring them to hold loans on their balance sheet and 
retain capital reserves in case of losses. It is also possible 
that banks could simply replace some of the home loan 
activities with covered bonds, which would not increase lending 
capacity. Even then, however, larger banks are anticipated to 
be more--major covered-bond issuers may choose not to issue 
covered bonds for multifamily mortgages because they already 
originate such mortgages for the GSE and CMBS market and avoid 
any balance sheet liability. Additionally, since so many asset 
classes qualify for covered bonds, it is unclear whether the 
banks would use them to increase multifamily lending.
    It is also important to understand that the European 
experience with covered bonds for multifamily properties may 
not be transferrable to the U.S. In Europe, the rental markets 
operate on a condominium model comprised of small investors 
buying individual units and renting them out. For instance, in 
the U.K., 73 percent of the rental stock is owned by mom-and-
pop operators and there is no institution investors.
    Likewise, questions remain about whether a purely private 
American covered-bond market could be a critical backstop 
capital during the periods of financial instability. Europe's 
covered-bond market came to a standstill during the global 
financial crisis, going dormant for several months after Lehman 
Brothers collapsed. Some European jurisdictions have still seen 
no issuance. In contrast, in the U.S., Fannie Mae and Freddie 
Mac continued to provide liquidity to the multifamily sector at 
a profit.
    For all these reasons, we can only conclude that the 
covered-bond market might augment but not adequately replace 
any of the components of the U.S. multifamily finance. 
Apartments are a critical component of our Nation's housing 
market and the apartment industry depends on the reliable, 
reasonably priced, and readily available supply of credit to 
meet the Nation's growing demand for rental housing. We look 
forward to the return of credit liquidity from all sources, 
including covered bonds, and welcome your efforts to increase 
the credit liquidity in the future.
    Thank you, and I look forward to your questions.
    Chairman Dodd. Thank you very, very much. We appreciate 
your testimony, as well, and all of you this morning, and I 
will ask the Clerk to kind of keep an eye on the timing here so 
we don't go over too long. There are only three or four of us 
here. Senator Merkley has joined us, as well. I will begin with 
a few questions, and then I will turn to Senator Corker and we 
will go back and forth here this morning. But I thank all of 
you again for your participation this morning.
    Let me begin, if I can, Mr. Krimminger and Ms. Williams, 
your testimony suggested covered-bond programs as now proposed 
could create the impression of implied guarantees by Federal 
bank regulators. One, do you agree this could be the case, and 
I think you implicitly have suggested that, and if so, then how 
can this be prevented?
    Ms. Williams. Mr. Chairman, the point that we noted in our 
testimony was that the selection of a single covered-bond 
regulator, and depending upon what entity that single covered-
bond regulator would be, an existing agency or even if one new 
one were created, might incrementally enhance an impression 
that there was a Government backing of the financial 
performance of the bond itself as compared with the impression 
that one would take if the Federal financial regulators were 
the covered-bond regulators for the respective institutions 
that they supervise. So that would sort of put the covered-bond 
regulator role more in the framework of oversight supervision 
of adherence to standards that the financial regulators adopt 
and then implement and apply as opposed to having a single 
agency viewed as the covered-bond regulator.
    Mr. Krimminger. I would certainly agree with Ms. Williams 
that I think there are three key factors from our view that 
could give that kind of implied, if you will, view of 
Government support. One is we certainly support the idea that 
there could be or should be standards being set, particularly 
by the Federal banking regulators or the Federal Financial 
Institutions Examination Council, which combines all the 
regulators. But to have direct oversight specifically for the 
purpose of protecting the investors' interests versus the 
safety and soundness of the financial institutions certainly 
creates another level, if you will, of Federal involvement in 
the program.
    Chairman Dodd. Would that be unique? Would that create a 
unique category, then?
    Mr. Krimminger. It would create, from our view, a unique 
category in the United States certainly, and it is very common 
in Europe. You have, for example, in the European Pfandbriefe 
example, the BaFin, which is the primary regulator in Germany 
for banks, does have the responsibility by law to provide 
specific oversight for covered bonds for the benefit of 
investors. I think that creates a conflict and creates 
certainly an implication of there being some support.
    The third part of that is in the resolution of covered-bond 
defaults, or defaults by issuers. Under the proposed regulation 
or the proposed legislation, the regulator would then be 
responsible for perhaps removing a trustee that would be used 
over the separate estate. So you have an estate leaping out, if 
you will, of the failed institution, the failed bank, depriving 
the banker receivership of collateral that benefits the Deposit 
Insurance Fund and other creditors. But, also the trustee could 
be removed by the regulator based upon the interest of the 
investors. That provides a level of oversight of the insolvency 
process for the private investors' benefit that would be 
somewhat unique under U.S. law.
    I think one last point I would make is that there are very 
great differences between the U.S. system and the European 
system. In many cases in Europe, part of the support for 
covered bonds has been the fact that banks that issue covered 
bonds are simply not closed, and certainly that is not 
consistent with the intent of the Federal Deposit Insurance Act 
and certainly the intent of the Dodd-Frank Act, that is 
certainly not an avenue we wish to go down.
    Chairman Dodd. No, that was one area there was pretty 
significant agreement, I think.
    [Laughter.]
    Chairman Dodd. Let me give Mr. Stengel a chance to respond 
to that, but let me ask you a question, if I can, Mr. Stengel, 
and then give you the opportunity to respond to what has been 
raised here. The FDIC in its testimony here this morning, and I 
am quoting them here, said any covered-bond legislation must 
preserve the flexibility that current law provides to the FDIC 
in resolving failed banks, including the options of continuing 
to perform under the covered-bond program pending a sale to 
another bank, turnover of collateral to the investors, and 
repudiation. It was on page seven of the testimony.
    The Covered Bond Council testified that having all of these 
alternatives raises uncertainty for investors, and I think it 
is a legitimate point. But should the FDIC have this 
flexibility or should investors of covered bonds have greater 
certainty and the choice here? And again, obviously, given the 
history of the FDIC and how important that has been for 
avoiding the kind of problems that created the FDIC in the 
first place here, what about what would happen in the event of 
a failure of a bank that issued covered bonds, where you might 
have that certainty if you would take the Council's point of 
view, but lack the flexibility that the FDIC would need. How do 
you answer that?
    Mr. Stengel. Well, I think in a couple of ways. First, it 
is certainly not unprecedented. I mean, looking at just some 
rough data, the top--looking at the top 50 banks alone, they 
have over $1 trillion of assets pledged either under securities 
lending or repos, and that represents over approximately 10 
percent of their assets. Now, these lenders have much more 
enhanced rights than anything in the proposal from the U.S. 
Covered Bond Council.
    So I think the notion that there is a dichotomy between 
secured creditors and unsecured creditors and there is 
uniformity among secured creditors is not entirely accurate, 
that there are, in fact, quite a few secured creditors with 
quite a lot of flexibility, and particularly those with these 
qualified financial contracts, repos, and securities loans, not 
to mention the Federal Home Loan Banks. So the notion that 
today the FDIC has unlimited flexibility, I think is just not 
entirely accurate.
    In response to the notion about the regulator, I think 
certainly the Council understands the perspectives of the 
regulators and the concern about having a single covered-bond 
regulator. Our primary concern is a fragmentation of the 
market. So, for instance, if you were to have each individual 
regulator able to write separate rules of the road for covered 
bonds, that would create a fragmented market that we don't 
think would be quite helpful.
    I think we could be supportive and would support, for 
instance, the Department of the Treasury writing the rules of 
the road and then having those implemented by the individual 
prudential regulators. That is something that seems to be a 
compromise that makes a lot of sense.
    Chairman Dodd. Do either of you other two want to comment 
on this exchange, Mr. Snowden or Mr. Campo? No?
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank all of 
you for your testimony.
    It seems to me the essence of the rub on covered bonds and 
all of these other things that we have talked about can be 
worked out pretty easily, but the essence is going to be the 
rub between the FDIC and everybody else. I mean, they have the 
ability to do whatever they wish when they resolve an 
institution today, and obviously a covered bond potentially 
eats into that flexibility. So it seems that to create a 
regimen that is going to work, that is the issue that has got 
to be--that is the rub. That is the essence of this entire 
deal.
    I will ask a couple of questions of you, Mike, but when we 
have risk-weighted sort of assessments now of institutions and 
if institutions are involved in covered bonds, couldn't you--
doesn't that actually enable the DIF to be stronger when you 
make those assessments? I mean, isn't that something that, on 
one hand, is a plus as it relates to the DIF itself?
    Mr. Krimminger. Well, certainly, Senator. The fact that now 
the assessment process is essentially assets minus net equity 
does allow us, does allow, for example, covered bonds, since 
they are on the balance sheet, to be part of the assessment 
base, whereas they weren't. I think the problem, however, is 
that the assessments would need to be extraordinarily high on 
assets if they were to cover against the loss of our ability to 
recapture the overcollateralization.
    And if I might just give one illustration, when Washington 
Mutual failed in the fall of 2008, they had one of the two 
covered-bond programs that were outstanding. At the time that 
they failed, the overcollateralization requirement by the 
rating agencies in the industry, if you will, to try to 
maintain a AAA rating, which they weren't able to maintain, was 
149-plus percent. So that is a huge amount of 
overcollateralization.
    I think all the flexibility we are seeking would simply be 
that we would pay--and this is different from our original 
statement of policy, and I want to make sure that people 
understand that--we would be, under legislation be willing to 
certainly make sure that covered-bond investors were covered to 
the full par value of their bonds plus accrued interest through 
the date of payment so that there would be--that would be the 
full amount of debt they could ever claim. And I think that 
provides the benefit that a covered-bond investor would be 
entitled to. It would give a pool of cash that could be then 
either reinvested by a trustee or through a guaranteed 
investment contract or something to pay the cash over the long 
term, which is what the investors are looking for.
    And if I might comment on the unprecedented nature of what 
would be done for covered-bond investors, I think an important 
thing here is that Mr. Stengel mentions the qualified financial 
contracts. As I noted in one of the footnotes in my testimony, 
there is some additional protection provided for qualified 
financial contracts, but even for those contracts, you are 
limited to the amount of your collateral protection by the 
amount of the actual debt due at the time the bank fails, and 
that is all we are seeking here, as well. Covered bonds simply 
are not QFCs.
    Senator Corker. So, Mr. Stengel, does the solution that Mr. 
Krimminger has offered, is that something that would create a 
viable covered-bond market?
    Mr. Stengel. We could certainly build a covered-bond 
program if covered bonds were treated like qualified financial 
contracts. So if the concept is we would like to use existing 
precedent that qualified financial contracts or something that 
are known in the United States, and the FDIC feels like the 
remedies there are more consistent with something that they are 
familiar with and would agree to, I think that that could very 
easily be done.
    I think the counterparties under qualified financial 
contracts like repos and securities loans have a number of 
enhanced rights which we did not initially recommend because of 
our intent to try to accommodate concerns that we expected from 
the FDIC. They have a higher claim for damages, in fact, that 
includes the costs of cover, which covers the reinvestment risk 
which covered-bond investors are very concerned about. So that 
would be covered under the QFC structure. They have a right to 
take more rapid remedies. So within 1 day, if the entire 
covered-bond program, and, in fact, all covered-bond programs 
of an issuer were not moved to another bank, in 1 day, the 
investors could come in and take their collateral. They have 
immunity from nearly all avoidance actions. And there are 
limits on the FDIC's ability to repudiate the contracts and 
transfer them. Again, they all have to go or none of them go.
    So I think if we were to use a QFC structure, the Covered 
Bond Council could be very supportive of that kind of approach, 
and if that is what is being proposed here, I think that we 
probably have a lot of middle ground to cover.
    Senator Corker. Since it is, in essence, a debate between 
the two of you, and I notice he disagrees, go ahead.
    Mr. Krimminger. That, as the Senator knows, that is not 
what we were proposing. I was just making the point that even 
under the QFCs, your value is limited to the amount of your 
debt. Yes, there is a cost recovered, but you don't get to keep 
your collateral for the balance of your contract.
    Senator Corker. When you were moving, say, an institution 
fails and you move the covered bond off to another institution, 
can't the FDIC sell that overcollateralization and reap some 
benefit from that? So it is not like--it is not quite like you 
said. I mean, you have a benefit there, too, do you not?
    Mr. Krimminger. Well, that is one of the three options that 
we talked about. Certainly, one of the options and the 
preferred option--we have made this very clear in our statement 
of policy, as well--is to transfer the covered-bond program 
over to another bank, which is what we did with the WaMu 
covered-bond program. There, it is part of the assets and we 
are getting the benefit of the franchise value of that program 
as a liquidity tool back to the Deposit Insurance Fund.
    The reason we need the repudiation power is that in those 
cases where we cannot transfer it, there is no interest in that 
particular program and it is heavily overcollateralized. We 
think that the Deposit Insurance Fund and the creditors should 
get the overcollateralization, not the investors. The investors 
should get paid in full, but not overpaid.
    Senator Corker. Mr. Chairman, my time is up. I know we have 
had debates in our conference rooms between the FDIC and others 
and we look forward to having the two of you in soon, so thank 
you.
    [Laughter.]
    Mr. Krimminger. Thank you, Senator.
    Chairman Dodd. Thank you very much.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    I want to follow up the thoughtful questioning of the 
Chairman and Senator Corker and just clarify in my mind a 
couple of points. One, if there was a covered-bond program, 
that would require, since these assets are on the balance 
sheets, higher capital? Would that be a general point?
    Ms. Williams. The basic point is that there would be a 
capital requirement that would apply----
    Senator Reed. Right.
    Ms. Williams. ----because it is on balance sheet.
    Senator Reed. Right.
    Ms. Williams. Yes.
    Senator Reed. And in contrast to selling the mortgages in 
the secondary market where that would----
    Ms. Williams. In contrast----
    Senator Reed. ----a bona fide real sale----
    Ms. Williams. Yes, in contrast to a sale of the mortgages 
that would be treated under the accounting standards as a sale.
    Senator Reed. So one of the things if we pursue a covered-
bond program would be there would be a conscious decision the 
institution would have to make between doing covered bonds and 
likely having higher capital. That is----
    Ms. Williams. That is definitely a factor that affects the 
attractiveness for any given issuer.
    Senator Reed. And then with respect to the FDIC, is the 
implication in your testimony that there would be a higher 
assessment because of the--if the rules were changed, in 
effect, that you would fully protect the covered bondholder in 
a failed institution, that would require a higher assessment?
    Mr. Krimminger. I think it no doubt would. We are currently 
obviously looking at our assessment structure and the risk-
based assessments generally because of the change to the 
assessment base. But certainly if the flexibility were taken 
away, we would need to seriously look at much higher 
assessments for those who issue covered bonds.
    Senator Reed. So if the covered-bond program was authorized 
in the broadest framework, as the proponents suggest, two 
likely consequences for financial institutions would be 
maintaining higher capital, which in effect probably limits 
their ability to provide more liquidity in the marketplace, and 
higher assessments. So it is not a completely win-win for the 
economy, is that fair?
    Ms. Williams. I think it is absolutely fair to say that 
there are advantages and disadvantages of covered bonds 
relative to other funding options.
    Senator Reed. And let me just again, to the point I sense 
you are making, is that in a failed institution, the FDIC is 
obligated to pay not just the par value plus accrued interest, 
but all of the interest and par value of the bond, that in some 
respects could be described as a subsidy by the Government to 
those bondholders that is not extended to other parties. Is 
that----
    Mr. Krimminger. Our view certainly, Senator, is that that 
would be--it would be certainly creating a subsidy for the 
covered bonds by the Deposit Insurance Fund, because otherwise 
that overcollateralization would come to the Deposit Insurance 
Fund now.
    Senator Reed. Right. Right. And so in some respects, and 
Mr. Stengel, and I want everyone else to comment, too, there is 
the issue of uncertainty, but there is the issue of is there a 
disguised subsidy here also because of preferential rules in 
the failed institution. Is that one reason now that these 
aren't as attractive or as used as they could be?
    Mr. Stengel. I would not characterize the covered-bond 
programs that at least the Council has proposed as involving 
any Government subsidy of any kind. It is probably important to 
remember that it is the banks, after all, that fund the Deposit 
Insurance Fund. In fact, the top four banks account for 
approximately 40 percent of the Deposit Insurance Fund, so if 
there are stakeholders here, certainly I think the 
disadvantages, and the banks are aware that it involves higher 
capital and it also involves perhaps higher deposit insurance 
assessments. The FDIC before the Dodd-Frank Act had come out 
with a particular secured liability assessment to penalize 
banks for engaging in secured lending from an insurance 
assessment standpoint.
    So I think that there is a recognition that there are costs 
and benefits. I think the message that we want to convey is 
that if we are talking about covered bonds that can be 
accelerated, we are not talking about covered bonds and we can 
put our pencils down and there will be no market. And so there 
certainly is a different treatment for covered bonds than 
normal secured debt. It is not as aggressive as the QFCs. It is 
certainly not as aggressive as the Federal Home Loan Banks. So 
it was something that we thought struck a reasonable middle 
ground in order to get the market and introduce it into the 
United States. But without those, there will be no market.
    Senator Reed. Well, let me just shift briefly, because one 
of the comparisons we have is with the Europeans who use these, 
and Professor, you have pointed out that in 1916, our 
predecessors--I don't think anyone is here from that Congress, 
but who knows----
    [Laughter.]
    Senator Reed. The Europeans, though, particularly, and I 
will express my ignorance, use very short-term nonrecourse 
mortgages for residential mortgages. Is there a difference 
between the types of mortgages that they are doing this 
routinely with that makes a difference? Maybe you might 
comment, Professor.
    Mr. Snowden. I would be happy to. Again, I am not an expert 
on contemporary European practice. Actually, in the farm 
mortgage market, one of the great advantages of covered bonds 
there were very long-term amortized loans, mortgage loans, at a 
time in the United States where farmers had to rely on 3- to 5-
year debt, rollover, and this is why farmers wanted a covered-
bond program. This is why you guys passed it--I mean, not you, 
your predecessors. Excuse me.
    [Laughter.]
    Senator Reed. Yes. We have established they are not here.
    [Laughter.]
    Mr. Snowden. Right. But if I could point out that one of 
the characteristics of these early covered-bond programs in 
Europe were they were monoline. This was their job. This was 
all they did. And I think as you think about these issues of 
insured institutions taking on this product line, one way of 
thinking about the subsidy, to me, is what would this business 
look like if it stood alone, and especially, I think, it makes 
you look at the dynamic pool aspect.
    People complain about securitization. One thing about 
securitization that is good is once you stick the loans in 
there, no matter how they perform, they stay there. In a 
dynamic pool, you are going to have--if there are any problems 
in that pool, those loans have to be pulled out. Now, this is 
what my guy did in Kansas in the 1880s. He was able to put them 
behind his covered bonds because there was no regulation of 
covered bonds and he bilked people this way.
    I think the concern--we are not in that situation today, 
obviously, but if there is any difference between underwriting 
standards in the covered-bond program and whoever else the 
deposit fund is supporting, there is going to be shifting of 
risk between those programs.
    The other thing is, when you talk about subsidy, if these 
were stand-alone businesses, these covered bonds, who would 
cure the bad loans? And that would have to be a cost of 
business.
    I will just bring up this last point, and a difference with 
Europe is at least in my time period, foreclosure was very 
rapid in Europe. These mortgage banks could take over 
foreclosed land in 15 days in some cases, which means not only 
could they cure defaults very rapidly, they were expected to. 
In the United States today, we have a problem where foreclosure 
is a long process, apart from the securitization problem. I 
mean, I understand that. But just the fact of doing it. So you 
are going to have default pools sitting there. Where will they 
sit? Who will fund those default pools, because they have to be 
pulled out from behind the secured bonds.
    Senator Reed. Thank you. My colleagues have been very 
gracious. Just one other point, and I will make it and if you 
have to correct me, please correct me. I have been told 
basically, too, that in most mortgage arrangements in Europe, 
there is personal liability, as well, so that you can't just 
sort of walk away, they take the house and you are fine. They 
come after you. And that makes a difference in terms of what 
these types of pools will look like.
    Thank you, Mr. Chairman. You are very kind.
    Chairman Dodd. Thank you very much, Senator.
    Senator Merkley.
    Senator Merkley. Thank you very much. There are many 
aspects of this strategy that are extremely appealing. One 
certainly is that rather than having a pool of securities to 
which the rights are sold to the cash-flow and then those bonds 
are remixed into a second waterfall and a third waterfall and 
so forth, but it makes it impossible, Professor, to know what 
they are buying, this is a much more direct transaction, 
potentially, and this is what I want to ask.
    Would the structure be limited to a bank having a pool of 
loans, mortgages, and as you mentioned potentially other 
products, loan products, against which they are providing the 
collateral for essentially the loan to the bank, for the bond, 
or would banks be buying other bonds that they then use as 
collateral, and then would the bonds against those pools, would 
they be able to buy those so we end up with the same 
multilayered complexity that makes it impossible to understand 
the true nature of the collateral that we have in the mortgage 
market now?
    Mr. Stengel. At least under the Council's proposal, it 
would be a single eligible asset class, which would be loans, 
backing a single issuance of covered bonds, so something much 
more straightforward. There would be the opportunity to invest 
proceeds in Treasuries and other what we call substitute 
assets, which are really cash equivalents. But the notion of 
the CDO-squared or cubed is not something that we are looking 
for.
    Senator Merkley. I am very glad to hear that. Another 
challenge we had was with rating agencies not having access to 
all the details of the specific loans themselves. Is it 
envisioned under this proposal that a rating agency would be 
involved to help establish to investors the quality of the 
underlying collateral, and would they have access to all the 
loan-level detail?
    Mr. Stengel. It is expected that covered bonds would 
receive a rating, assuming we still have that process going on 
in the wake of the Dodd-Frank Act. And so certainly as part of 
that process, rating agencies would have access to whatever 
they felt was required in order to provide the rating.
    On that point, I think it is worth noting, none of these 
programs have a trip wire on the rating. So the notion that 
they have to keep putting in good assets to maintain a rating 
which is a covenant in the documents is not required. The 
rating agencies will provide their rating and certainly, as the 
regulators have done in the past using their existing cease-
and-desist authority, and certainly all the new powers under 
the Dodd-Frank Act, have more than enough power to say, you are 
not going to put any more assets into the cover pool just to 
maintain a rating. So the rating agencies will be involved, and 
I think there are a lot of protections to make sure that that 
process does not go off the tracks.
    Senator Merkley. If we turn the clock back just a little 
bit, the pools that were utilized in the CDOs and CDO-squared, 
there was also a right to substitute failing bonds, and there 
was a--an account manager had a responsibility to do that. For 
some reason, that really didn't unfold in a manner that 
sustained the value of those pools and it all collapsed and I 
never really quite caught what went wrong in that substitution 
process.
    Mr. Stengel. In the case of CDOs, it really was--to some 
degree, they worked in the sense that they transferred the risk 
of the underlying assets to the investors. I think the issue 
was there were no good assets to bring in and substitute 
because the CDOs weren't set up to actually have an originator 
like a bank that makes loans and can put new assets into a 
pool, much like you think of any commercial lending with a 
borrowing base and that there is a revolving inventory of 
assets coming in and out. So CDOs weren't set up that way. So 
while there was a possibility of going out and bringing in new 
assets, ultimately, you were limited to the proceeds of what 
you had available to begin with and those just turned out to be 
very risky and for a lot of loss.
    Senator Merkley. So let me turn to another piece of this. 
We have had a lot of discussion in this Committee about the 
situation where firms that originate securities should be 
limited, or people had various opinions, I had the opinion they 
should be limited in their ability to buy insurance that 
exceeds the value of the bonds they are issuing, in other 
words, gamble on the failure of the very products they are 
selling to the public. That was addressed in the Merkley-Levin 
Amendment.
    Do you anticipate here that banks would be able to hedge 
their risk by purchasing insurance against the failure of the 
product, and if they were allowed to do that, would that be 
limited to the value of the product so that they are not 
actually gambling on the failure of what they are selling?
    Mr. Stengel. I think just a couple of points. You know, the 
Council, because of its unique composition, being equal 
investors, dealers, and issuers, we spent months having a very, 
very robust debate among ourselves, and we few lawyers who were 
allowed to tag along tried to proxy for regulators and the 
consumer, about how to create a benchmark covered-bond market. 
You know, there may be folks--there are a lot of smart folks 
out there and they may be able to come up with structured 
covered bonds and covered bonds that do all kinds of different 
things. But we wanted to propose legislation to the Members of 
Congress that would create a benchmark very safe and 
conservative market. So the kinds of things that certainly the 
Dodd-Frank Act was very focused on is not something at all that 
we are contemplating in the context of a covered-bond market.
    Now, banks, I am sure, will hedge the assets on their 
balance sheet, their interest rate risk, their currency risk, 
according to prudent risk management standards as dictated and 
informed by regulatory standards. But nothing of the kind that 
I think you are talking about is contemplated, at all.
    Ms. Williams. Senator, if I could just add to that and 
reinforce the last point that Mr. Stengel made, the assets 
remain on the institution's balance sheet and so we will 
continue to have the concerns that we would have as a 
supervisor with respect to effective sound asset liability risk 
management.
    Senator Merkley. I believe the--oh, please, go ahead.
    Mr. Krimminger. I am sorry to interrupt. I just wanted to 
make one comment on one point Mr. Stengel made just to make 
sure that it is clear. While there is not a trigger in the 
documents requiring it based upon rating agency action to 
replace delinquencies, there are contractual provisions that 
require replacement of delinquencies over a certain date so 
that this is a constantly refreshing pool. So there is 
constantly the requirement to put new loans in. So there is a 
benefit to the investors of having a quality pool throughout 
the time supporting a security for the general obligation of 
the bank, and our point really is that once the institution 
closes, no one is going to be adding to that pool. You are 
going to have a diminishing asset pool that is going to be of 
diminishing value.
    We just believe that the investors should not get the 
benefit of a constantly refreshing pool but then be able to 
take all the collateral after a failure as you would with a 
securitization that is off balance sheet. They should get one 
or the other, but not both.
    Senator Merkley. OK. Let me turn to a piece of the FDIC 
action in this regard, which is in 2008, a rule issued that 
limited covered bonds to, I think, 4 percent of the 
capitalization. Can you comment on that, because there is a 
concern that that type of limit would prevent development of a 
robust covered-bond market.
    Mr. Krimminger. That was a statement of policy that was 
issued by our board in July of 2008, and we had a 4-percent 
limit there in part based upon prior precedent of countries 
that had begun to introduce covered bonds, both in the United 
Kingdom and in Canada. In their early introduction of covered 
bonds, they had a 4-percent limit, as well. We were simply 
modeling on that with the expectation, which we stated up front 
in our board meeting as well as in the document, that we could 
limit as the market developed. We had talked with major issuers 
and they were of the view that 4 percent would be--was far in 
excess of their immediate plans to expand the programs they had 
as far as new issues, as well. So it was not going to be a 
constraint at the beginning of any type of covered-bond 
program. So we felt that that would be something that could be 
modified going forward.
    Senator Merkley. I want to thank you all. I am way over my 
time. I thank the indulgence of the Chair, and I appreciate 
this discussion as we think about Fannie and Freddie and how we 
make home mortgages work in America. It is very helpful.
    Chairman Dodd. Thank you, Senator.
    Let me ask a question and turn to Senator Corker for any 
questions he has. One, I would like to get Mr. Campo into this 
conversation a bit on the rental housing aspects of all of 
this, and he makes a very good point. One of the very 
legitimate complaints over the years is that we have placed so 
much stock on home ownership, which has value in my view, and 
so very little increasing the stock of rental housing in the 
country that I think we contributed in no small measure to the 
problems we have been wrestling with over the last several 
years.
    But I wonder if, Mr. Stengel, you might comment on Mr. 
Campo's testimony, his concern in the multifamily housing 
context, the problems posed by covered bonds.
    Mr. Stengel. I think Mr. Campo's point is very well taken 
in the sense that covered bonds will not replace 
securitization. Just looking at some quick figures, in 2006, 
the volume of securitization was $2.4 trillion--$2.4 trillion 
of issuance. Thus far in 2010, there is $0.4 trillion in 
issuance. And because securitization involves transferring 
these assets onto the balance sheets of investors, you are 
talking about $2 trillion--and this is just private label ABS 
and RMBS, so it doesn't include the agencies. So you are 
talking about $2 trillion of balance sheet that has been wiped 
away until the securitization market is resuscitated. So I 
think Mr. Campo's point there is very well taken, that covered 
bonds are no substitute. They are a complement, but no 
substitute for securitization.
    I do think, at least based on the views expressed by the 
Council, that commercial mortgage, including multifamily 
covered bonds are something that are being actively looked at 
by potential issuers once the market gets up and running. 
Whether those are first out of the gate, I don't know, but I 
don't think they will be relegated to the sidelines at all. I 
think they will be center in the target of possible issuers.
    Chairman Dodd. I would encourage you to look at that and 
offer those ideas, because I think, and again, I am speaking 
for myself, but I think one of the things I feel strongly--I am 
looking at my own State of Connecticut where you have got to 
have an income of $20 an hour on average to afford a two-
bedroom apartment, a rental unit. We have such a paucity of 
stock that obviously the supply and demand issues have driven 
up the cost tremendously, driving it out of the range of an 
awful lot of people who need that rental housing market to 
provide decent shelter for themselves. So to the extent we can 
increase the opportunity if the covered-bond market is going to 
be developed here that would allow for it to be used in the 
multihousing area would be important, it seems to me.
    Mr. Stengel. We completely agree, Senator.
    Chairman Dodd. And last, I wonder if you just might 
quickly, and maybe if you want, obviously, what the most 
important consideration the Committee should keep in mind in 
the issue of regulating covered bonds going forward. Why don't 
we begin with you, Ms. Williams. Tell me one or two things you 
think we ought to really keep in mind as we look at this.
    Ms. Williams. I think that the conversation this morning 
has really highlighted the central issue. There is a tradeoff 
here with issues that are important to the FDIC. The set of 
issues that they have identified center on the differences 
between covered bonds and what we have now.
    Chairman Dodd. Yes.
    Ms. Williams. And to the extent that you want to move to 
something new, you are implicitly raising issues about having 
something different from the traditional way that the FDIC has 
viewed these situations. There is very much a balance for 
policy makers, a very interesting set of issues here to 
resolve.
    What I hear the Covered Bond Council saying is that some of 
the features that are most critical to the success of having a 
robust covered-bond market in the United States are the very 
features that the FDIC has the concerns about changing.
    Chairman Dodd. Yes.
    Mr. Krimminger. I would just note that I think the key 
concerns are making sure that we don't create a super class of 
investments that can create mispriced risk and we should not 
transfer that risk on to the Deposit Insurance Fund in the case 
of a failure.
    I would note also in response to one of the comments made 
earlier that although it has been stated, and I know this is 
the argument of the Council, that a covered-bond market cannot 
develop if the FDIC has the power to repudiate, I think there 
were certainly two very large programs that were developed 
before the financial crisis where that power still remained 
with the FDIC, and we are willing certainly to clarify these 
powers further. But I think it might be a bit of a misstatement 
to say that the market cannot develop. The financial crisis has 
sort of interrupted the markets here and in Europe.
    Chairman Dodd. Mr. Stengel.
    Mr. Stengel. Mike is a friend, and we have known each other 
a long time. And I grew up in my early years as a bankruptcy 
lawyer, so I, more than most, am sympathetic to the FDIC's 
concerns and appreciate them. The netherworld of receivership 
and bankruptcy is neither glamorous nor easy, and I think the 
FDIC does excellent, excellent work and excellent public 
service.
    But the perspective is a narrow one. There is a reason we 
don't have our funeral directors and life insurance companies 
dictating every aspect of our lives. There would be no 
airplanes. There would be no deep sea research. And there 
certainly wouldn't be anybody----
    [Laughter.]
    Mr. Stengel. ----there would be nobody walking outside of 
those white lines of the crosswalks.
    Chairman Dodd. Dodd-Frank has funeral plans all through 
here----
    [Laughter.]
    Mr. Stengel. There is no life in that world and there 
certainly is no economic recovery. We do need to be very 
prudent and have cautious risk management, but we need to be 
able to breathe.
    Those two issuers that Mike referenced are on the Council 
and we have heard in no uncertain terms that there were 
programs developed, very unique structures because we have much 
more debtor-friendly insolvency laws in the United States than 
exist in Europe, so we are already starting from an investor 
standpoint with strikes against us. There was a very elegant 
and careful structure created, but it is one of a bygone era, 
one of a very frothy market which is not with us anymore and we 
don't foresee coming again.
    So I am very confident in the instructions that I have been 
given from our Council to say that without those twin pillars, 
the public supervision and the separate resolution process, we 
should shift the focus to other avenues.
    Chairman Dodd. Mr. Snowden, any comments, or Mr. Campo?
    Mr. Campo. Yes. I think it really gets down to balance, 
because what we are talking about here is the balance between 
sort of what product is used to finance housing overall. 
Between now and 2015, it is predicted by the Harvard Joint 
Center that two-thirds of the households will be renters. That 
is six million people. And what is happening right now in the 
marketplace is that the multifamily business is doing very well 
with the existing model, as evidenced by Freddie Mac making $1 
billion in profits net of charge-offs that have been used to 
fund the losses they have experienced on single family.
    So we as an industry know that we have to finance. We know 
that the balance between our financing models needs to change 
over time and it is all about sort of a balanced housing policy 
in conjunction with a balanced finance policy and I think 
covered bonds are clearly an area that make some sense, but we 
just have to be thoughtful about it where we are not crowding 
out other parts of the financial market.
    Chairman Dodd. I agree with that.
    Senator Corker.
    Senator Corker. Well, thank you, and I want to thank, even 
though Mr. Snowden and Mr. Campo, I have no questions, I want 
to thank you for the historical perspective, which is also 
always very useful, and certainly some of the rubs that you can 
create in the multifamily market by taking away resources, I 
appreciate you saying that and agree with the Chairman that 
certainly having more affordable rental stock might help in 
certainly times like right now.
    But I want to move back to the first three and say that I 
know we are not going to resolve the issue of the rub today and 
I look forward to having, seriously, both of you all in our 
conference room and trying to figure out a way to resolve that 
rub.
    But I do want to go back to something Senator Reed 
mentioned because we will be talking about just home finance, 
mortgage issues, I think, in a very focused way over the next 
year or so. The issue of personal recourse loans, I have to be 
candid, I was a fairly sophisticated borrower and was shocked 
when I got to the Senate and realized that people had no 
recourse mostly in residential loans. And I know that as we 
tried to address that during the debate on Dodd-Frank, we 
realized there were some State Constitutions around this 
country that kept there from being any recourse against home 
mortgages. I don't know how many there are. There are a 
handful. But what happened, I guess, over time is the mortgage 
industry said, look, it is just easier not to have recourse if 
some States you cannot do that.
    What impact do you think that would have, though, if 
somehow or another we were able to create a situation where 
there was personal recourse on home mortgages? What would that 
do to the durability, if you will, of the mortgage market and 
what effect do you think that would have?
    Ms. Williams. The imponderable there is to what extent that 
the existence of personal recourse would significantly affect 
default rates, and I don't know personally how to answer that 
question right now.
    Mr. Krimminger. I would just note that I think I agree with 
Ms. Williams. I think it is hard to predict exactly what the 
effects would have. I mean, obviously, there are many States in 
which there is recourse. There tends to be a very involved 
process, of course, of going through a judicial foreclosure 
process in order to retain that recourse right, so many lenders 
simply avoid the judicial foreclosure route and go through a 
more streamlined route and don't have the recourse.
    It certainly might, if there is an impact upon defaults, 
reduce the cost of mortgages to some degree, but it is really 
hard to predict because you would need to have some real 
comparisons to make any judgments about the potential risk 
impact on the mortgage lending process, either from the 
investors' or from an issuer's perspective. It is a little 
unclear at this point.
    Senator Corker. Mr. Stengel.
    Mr. Stengel. I think that is an incredibly difficult issue 
and I think it is one that not only needs to be explored in the 
economic context of default, but how individuals are living 
their lives and able to maintain a certain standard of living. 
So I think that is an extraordinarily complex part of the 
debate and might well be that be one of the options and that 
might make a lot of economic sense in whatever comes out of 
housing finance reform. But I am certainly neither edified nor 
intelligent enough to speak on it today.
    Senator Corker. Our resident historian?
    Mr. Snowden. Yes, neither edified nor----
    [Laughter.]
    Mr. Snowden. In any case, that was very well done. We do 
have a little experience of what happens. The problem with 
judicial foreclosures, they have to be fair. This is one of the 
examples, mortgage market institutions generally work very well 
for idiosyncratic risk. It is when the system gets dumped and 
you have lots of foreclosures.
    And so what has happened is in the 1930s, we had 23 States 
pass foreclosure moratoria. We just stopped the process because 
no longer can the recourse--without a fair market, you cannot 
determine what the amount of recourse ought to be. Well, the 
argument is anyway, and it is persuasive enough that we see 
that.
    So I would be--I think it would work very well on 
idiosyncratic risk. I don't think it would fix what we are 
going through right now. I think it would be very difficult to 
maintain recourse in this environment and has been.
    Senator Corker. As a practical matter, it would be tough. 
Should we--on the covered-bond market, should we--one of the 
writers gave us some input before we came today and mentioned 
that one of the problems with the House bill is there is no 
homogeneous fashion to these covered bonds. I mean, you are 
talking about cats and dogs. Should we look at that as one of 
the criteria on covered bonds, to create a slightly more 
homogeneous nature for the loans that would be in these 
covered-bond sales?
    Ms. Williams. I think that the--your starting point is 
determining what your threshold eligible asset categories would 
be, and then you certainly could specify as a direction that 
there should be some principle or desirability of the nature of 
the loans being homogeneous. I think that from the perspective 
of the issuer trying to put together a pool and determine what 
the appropriate collateralization, overcollateralization level 
would be and just the predictability of the risk, the issuers 
are going to be attracted to having loans that are of a 
homogeneous type in the covered-bond pools as opposed to having 
lots of sort of cats and dogs.
    Mr. Krimminger. If I might note, as well, we worked very 
closely with the Treasury Department in mid-2008, early 2008 on 
the development of what was viewed at that time as the gold 
standard for covered bonds. It was issued as a Treasury 
Department document in August of 2008. Obviously, we know what 
happened in September, so nothing really happened as a result 
of it.
    And one of the principles behind that gold standard was 
that if you create a very high standard for the types of 
collateral that would be in the cover pool and you create a 
homogeneous pool, particularly with some substitution rights, 
then it would give investors more confidence starting out in 
the market. Then the market could be expanded beyond that as 
the market gets more solidified.
    And despite being described a bit as the dead hand of 
insolvency, I think the FDIC is in the market on a very 
frequent basis and what we are seeing really in the marketplace 
is I think there is certainly interest in different types of 
investment vehicles, but what we are really talking about when 
you get down to the brutal facts of it is money. You know, 
different options that we are talking about are really 
affecting how much money the issuers are going to make, much 
more than how interested investors will be in the particular 
product, because there are ways of dealing with that 
acceleration risk. I think there are ways of trying to 
accommodate all of these issues, and hopefully we can work 
those out.
    Mr. Stengel. I certainly didn't mean to suggest dead hand, 
not at all.
    There is some irony, of course, in the gold standard 
because it is highlighting the fact that it should have a lot 
of high-quality assets, so I think it highlights Ms. Williams' 
comment about there is some balance here. We want risk 
retention, but we don't want a lot of high-quality loans all 
going into cover pools while bad loans stay behind. So there is 
some balance on that particular issue.
    We have viewed at least the approach to covered bonds as 
being layered, the legislative framework providing the 
foundation. As Ms. Williams suggested, more specific regulator 
descriptions about eligibility in the cover pool, if 
homogeneity is important, if a certain style of loan, a certain 
either kind of product or certain quality, and then on top of 
that, individual transactions may differ. So the legislative 
framework would be the foundation on top of that regulation 
setting a minimum standard with more specificity, and then 
within those boundaries, individual issuers could go out and do 
transactions, and I think the view of the Council, including 
the institutional investors on our Council, is that there will 
be a lot of homogeneity to begin with, and the market will 
dictate a lot of that.
    Senator Corker. Mr. Chairman, I know that you are a short-
timer and there is probably some celebratory lunch that you 
need to go to, so I will stop now----
    [Laughter.]
    Senator Corker. ----and I look forward to carrying on this 
conversation with these folks later on. But thanks for having a 
most interesting hearing at a time when nothing much else 
interesting is happening. Thank you.
    Chairman Dodd. And that lunch is with my niece, who has 
come to town.
    [Laughter.]
    Chairman Dodd. So it has come down to your family at the 
end of your career. No one else will have lunch with you.
    [Laughter.]
    Chairman Dodd. It has been a good hearing, very 
informative. And again, to both of our lead witnesses here, we 
thank you for your service. Just listening to the two of you, 
how valuable it is to have people with your background and 
knowledge, and I appreciate Mr. Stengel talking about the 
relationship you and Michael have had over the years just in 
dealing with these issues. That is a comforting note, that you 
actually talk with each other with some frequency about these 
matters, as well. So that is an encouraging sign.
    At a time when we realize the environment we are in, but I 
think it is important in an environment like this to remind in 
a public setting that we are so blessed in this country to have 
talented people who give their lives to public service, and the 
two of you have and I want to express my gratitude to you.
    The Committee will stand adjourned.
    [Whereupon, at 11:41 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
           PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
    Today, the Banking Committee will hear testimony on covered bonds, 
a potentially significant alternative means for raising capital for 
housing finance. Covered bonds have been issued widely in Europe for 
many years, but not in the United States. The purpose of today's 
hearing is to learn more about covered bonds, exploring whether they 
could contribute to sustained economic growth and whether it is in the 
public interest to encourage their broader use in the United States.
    The hearing grew out of discussions on covered bonds that came up 
during the latter part of the Senate-House conference for the Dodd-
Frank Act. I am pleased to have worked with Ranking Member Shelby and 
Senator Corker in organizing the hearing. As the Banking Committee has 
not previously held hearings on covered bonds and the subject has 
raised issues among Federal regulators, we determined to explore the 
matter more carefully before acting.
    When speaking of a covered bond in the U.S. context, we generally 
mean a debt security issued by a bank and backed by cash flows from 
mortgages or public sector loans. The bond is backed both by the bank's 
promise to repay and by the assets pledged as collateral.
    Covered bonds can provide an additional option to the two dominant 
funding mechanisms in the U.S. marketplace, which are securitization 
and the traditional portfolio lender model, where a bank holds 
mortgages on its balance sheet and funds them with deposits. 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.
    While American banks are not prohibited from issuing covered bonds 
to raise capital, few currently do so. Some potential investors are 
concerned about the treatment of covered bonds if the issuer goes into 
conservatorship or receivership. They believe that legislation and 
agency rulemaking are needed to provide clarity about how covered bonds 
would be regulated. Any such measures would define the rights and 
responsibilities of investors, issuers, and regulators. They feel that 
this would stimulate the growth of a larger domestic covered-bond 
market.
    It is important that Congress look for alternative measures that 
could stimulate the economy. The Committee is holding today's hearing 
to learn more about this alternative and whether it will contribute to 
safe, stable, and sustained economic growth.
    We are pleased to have before us experts who will provide testimony 
about the history of covered bonds, their uses and potential benefits, 
as well as their interaction with existing mortgage financing 
mechanisms. The panel also includes Federal regulators who can share 
their perspective on the regulation of banks that would issue covered 
bonds, including the impact on the Deposit Insurance Fund.
    On the first panel, I am pleased to welcome Congressman Scott 
Garrett, who has a strong interest in this area and introduced 
legislation on covered bonds. On the second panel, we will hear from 
Julie Williams, Chief Counsel and First Senior Deputy Comptroller, 
Office of the Comptroller of the Currency; Michael Krimminger, Deputy 
to the Chairman, Federal Deposit Insurance Corporation; Scott Stengel, 
on behalf of the U.S. Covered Bond Council; Professor Kenneth Snowden, 
University of North Carolina at Greensboro; and Mr. Ric Campo, on 
behalf of National Multi Hhousing Council and the National Apartment 
Association.
                                 ______
                                 
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Thank you, Mr. Chairman. While covered bonds have been used in 
Europe, they are not widely used here. I look forward to hearing from 
our witnesses regarding the potential for a covered-bond market here in 
the United States.
    In addition to various covered-bond proposals being considered by 
the Congress, it is important that we explore the many different ways 
mortgage markets are structured and their ability to maintain stability 
through the recent economic downturn. As our economy stabilizes, the 
Dodd-Frank Wall Street Reform bill is implemented and we look towards a 
new structure for the housing finance system, we will need to have 
extensive discussions about the benefits and pitfalls of any potential 
changes.
    We face a fragile housing market and our decisions should not 
exacerbate that situation. It is our responsibility to ensure that the 
regulatory structure will support a functioning housing market and 
maintain long-term, fixed-rate mortgage financing at reasonable 
interest rates. I look forward to learning from our witnesses--
specifically how covered bonds might achieve this goal, what parts of 
the banking sector have the capacity to utilize cover bonds and how 
other covered-bond markets have responded to the economic downturn.
                                 ______
                                 
           PREPARED STATEMENT OF REPRESENTATIVE SCOTT GARRETT
    Thank you, Chairman Dodd and Ranking Member Shelby, for holding 
this hearing today and inviting me to testify before you. I also want 
to thank Senator Corker for all of his hard work and advocacy on 
creating a U.S. covered-bond market.
    As our Nation continues to recover from the recent financial crisis 
and certain credit markets remain locked, Congress must examine new and 
innovative ways to encourage the return of private investment to our 
capital markets. We must also consider creative ways to enable the 
private sector to provide additional consumer, commercial, public 
sector, and other types of credit. Establishing a U.S. covered-bond 
market would further these shared policy goals.
    One reason I am particularly fascinated with covered bonds is the 
fact that they can be a purely private means of finance without 
Government guarantees or subsidies. Many proposals to help alleviate 
the current strains in our credit markets focus on Government loans or 
guarantees. However, I believe covered-bond legislation offers a way 
for the Government to provide additional certainty to private 
enterprise and generate increased liquidity through the innovation of a 
new marketplace without putting the taxpayers on the hook.
    There are many potential benefits for a wide variety of interested 
parties that can be derived from a U.S. covered-bond market:

    Consumers will experience lower loan rates because of the 
        additional liquidity in the various asset classes.

    Consumers will also be able to more easily have their loans 
        modified because the loans will still be on the balance sheet 
        of the originating institution.

    Investors will have a new transparent and secure vehicle to 
        invest in. This will allow for additional diversification 
        within their portfolios.

    And finally, the broader financial markets will benefit by 
        having an additional, low cost, diverse funding tool for 
        financial institutions.

    Covered bonds will ensure more stable and longer term liquidity in 
the credit markets, which reduces refinancing risks as well as exposure 
to sudden changes in interest rates and investor confidence. And they 
will allow U.S. financial institutions to compete more effectively 
against their global peers.
    In the House, we have worked in a very constructive bipartisan 
fashion to push the ball forward on comprehensive covered-bond 
legislation. Chairman Kanjorski, Ranking Member Bachus, and I have 
introduced three different versions of covered-bonds legislation. The 
most recent is H.R. 5823, the U.S. Covered Bond Act of 2010.
    A week before the August recess, we successfully marked up the 
legislation and reported it out of Committee by a unanimous vote. It is 
my hope that we can pass this legislation out of the House over the 
next several weeks.
    Some have asked why we need covered-bond legislation. Simply, to 
get the market off the ground and provide investors with the needed 
confidence to invest in the product, the resolution procedure of a bond 
when an issuer fails needs to be spelled out specifically in statute. 
Otherwise, without the certainty of a legally binding process, there is 
not significant enough appetite from the investor community to make 
covered bonds cost-effective for issuers to offer. Also, a regulatory 
regime needs to be put in place to ensure proper oversight of the 
marketplace.
    Throughout this process, there have been some people who have said, 
``Let's wait and do this next year with housing finance reform.'' But 
the proposal we are discussing today is broader than just housing 
finance. Covered bonds offer a complementary source of funding that can 
spur much-needed lending to consumers, small businesses, and State and 
local governments.
    The reason why I have been so active in pushing covered bonds this 
year is because I believe they could help NOW. We hear almost daily 
about the liquidity concerns throughout various asset classes. The 
House Financial Services Committee held a recent hearing about the lack 
of liquidity in the Commercial Real Estate market. The Senate just 
passed a bill already approved by the House with the intent of 
providing more liquidity to small businesses.
    Also, we have all spoken to local and State officials about the 
problems municipalities face with increased funding costs for their 
projects. The President has continuously stressed the need to help 
these segments of the economy and this legislation is one we can pass 
immediately. More importantly, this is something we can pass 
immediately at NO cost to the taxpayer.
    Another reason to move quickly on establishing a covered-bond 
market in the U.S. is because billions of U.S. investment dollars are 
moving overseas and north of the border. So far, in 2010, there have 
been a dozen covered-bond deals issued by foreign banks to U.S. 
investors totaling close to $18 billion. This is U.S. private capital 
that could be invested here and help with our consumer needs.
    Private industry realizes that we are currently missing out on an 
opportunity as well. I have formal letters of support for the U.S. 
Covered Bond Act from: the National Association of Realtors, the 
Mortgage Bankers Association, the American Bankers Association, the 
National Multifamily Housing Council, the National Apartment 
Association, the CRE Finance Council, the Real Estate Roundtable, 
SIFMA, the American Securitization Forum, the Financial Services 
Roundtable, and others.
    Now, I don't pretend to believe that covered bonds are some sort of 
magic bullet that will help solve all of our funding needs. However, 
what I do know is that during a time of economic uncertainty, lack of 
liquidity and rising budget deficits, we must consider innovative 
approaches to help attract private investment back into our capital 
markets. I believe this legislation can help us in that regard.
    I thank the Chairman and Ranking Member again for holding this 
hearing and inviting me to testify. I look forward to any questions you 
may have.
                                 ______
                                 
                PREPARED STATEMENT OF JULIE L. WILLIAMS
   First Senior Deputy Comptroller and Chief Counsel, Office of the 
                      Comptroller of the Currency
                           September 15, 2010
Introduction
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
my name is Julie Williams and I am the Chief Counsel and First Senior 
Deputy Comptroller at the Office of the Comptroller of the Currency 
(OCC). I appreciate the opportunity to testify on behalf of the OCC 
today about covered bonds, their potential uses and key issues that 
they present for policy makers.
    The OCC recognizes that covered bonds can play a role in an 
institution's overall funding strategy, offer a new source of funds for 
lending activities, and provide an alternative source of liquidity for 
financial institutions. Over the past few years, the OCC has supported 
efforts to remove obstacles to the development of this market.
    My testimony today first briefly reviews the characteristics of 
covered bonds and their pros and cons relative to other funding 
options. The second portion of my testimony focuses on a set of key 
issues that would define the essential framework for a statutory 
covered-bond program.
Part I. General Information on Covered Bonds
    Covered bonds are debt obligations issued by a financial 
institution. The bonds are backed both by the institution's promise to 
pay and by a dynamic pool of assets pledged as collateral that comprise 
what is referred to as the ``cover pool.'' The underlying assets are 
typically high quality assets, subject to various eligibility criteria 
and must be replaced by the institution should they fail to meet 
specified criteria. Investors look first to the institution to make 
payments on the bonds, but investors also have a claim against the 
cover pool that has priority over unsecured creditors of the 
institution. This is commonly referred to as the ``dual recourse'' 
feature of covered bonds. There is no single definition of a covered 
bond, however. Covered bonds have been issued using different 
transaction structures and sold with varying features in many European 
countries for centuries.
    Covered bonds may provide financial institutions, including 
depository institutions, an alternative to securitization and other 
funding options. For the banking system, covered bonds provide a 
funding source that is longer-term and more stable, and potentially 
less expensive than currently available alternatives, and may also 
require less collateral or accommodate broader types of collateral than 
current options. Because the bank retains the credit risk on the 
collateral for a covered bond, it has a strong incentive to maintain 
prudent underwriting standards for those loan assets. The structure of 
risk associated with covered bonds also may attract types of investors 
that would not otherwise invest in general bank debt.
    Covered bonds are well-established in Europe as a means for 
facilitating mortgage financing. Many European jurisdictions have a 
public supervisor specifically dedicated to set uniform standards and 
regulate covered bonds. A statutory structure for covered bonds in the 
U.S. would potentially remove one obstacle to growth of a U.S. covered-
bond market.
A. Comparison With Securitization
    Covered bonds differ from typical securitizations in ways that 
offer benefits and disadvantages. Investors may have more confidence in 
covered bonds because they are less complex and more transparent. \1\ 
As noted above, covered bonds provide investors dual recourse against 
the issuer and the cover pool, which is segregated and managed 
exclusively for the benefit of the covered bondholders. In contrast, 
securitizations in the past typically have been off balance sheet 
transactions and provide investors fewer sources of repayment.
---------------------------------------------------------------------------
     \1\ Covered bonds have no credit risk tranching as is the case 
with securitizations.
---------------------------------------------------------------------------
    The collateral underlying covered bonds is dynamic--underperforming 
or prepaid assets must be substituted with performing assets. Assets 
underlying securitizations are typically static, with the notable 
exception of credit cards. In the case of default, covered bonds are 
structured to avoid prepayment prior to maturity, whereas 
securitization investors are subject to prepayment risk in the event of 
a default on an asset held as collateral or prepayment of such assets.
    Covered-bond issuers typically have a longer-term interest in the 
performance of the assets underlying the cover pool than issuers in 
typical securitizations because of the bonds' structure and dual 
recourse features. In addition, the cover pool typically remains on the 
financial institution's balance sheet, whereas the assets backing a 
securitization usually do not. This may give investors more confidence 
in covered bonds because it creates an incentive for the institution 
issuing the covered bond to adhere to strong underwriting standards. 
This feature also may enhance the transparency of covered bonds because 
covered bonds are not structured into complex tranches.
    Covered bonds also permit issuers to lengthen the maturity profile 
of their liabilities by issuing bonds with long-dated maturities to 
support long-dated assets. This may enhance the ability of banks to 
avoid maturity mismatches in their assets and liabilities. But, 
compared to securitizations, an increased reliance on covered bonds 
also could increase maturity mismatch risks because of the difficulty 
in forecasting with certainty the actual maturity of many loan 
products. In contrast, for securitizations, banks can sell their longer 
term assets and avoid maturity mismatch risks associated with longer-
dated mortgages and other similar assets.
    Because covered bonds remain on an institution's balance sheet, the 
institution must hold more capital than in a typical securitization. 
Thus, capital requirements could constrain the growth of the covered-
bond market. New accounting rules, upcoming changes in capital rules 
that may require higher levels of capital for assets held on a bank's 
balance sheet, and the ``skin-in-the-game'' securitization provisions 
in the recent Dodd-Frank Wall Street Reform and Consumer Protection 
Act, which require forms of risk retention for securitizers of loans, 
are among the factors that may have an impact going forward on the 
relative advantages and disadvantages of covered bonds and 
securitization for financial institutions.
B. Comparison With Other Funding Options
    Covered bonds also offer a potentially less expensive and more 
liquid funding source compared to senior, unsecured debt.
    In contrast to Federal Home Loan Bank (FHLB) advances, for example, 
covered bonds offer issuers access to a potentially wider investor 
pool. Financial institutions may issue covered bonds without becoming a 
member of a FHLB. Covered bonds could offer more attractive pricing, 
transparency, and lower collateral levels than some FHLB requirements. 
The amount, type, and quality of collateral pledged to covered-bond 
issuances also may provide institutions with additional options to 
obtain funding. The extent to which there are advantages will depend 
upon details of how the U.S. covered-bond program is implemented as 
well as other regulatory developments mentioned above.
Part II. Key Issues for the Framework of a Covered-Bond Program
    The U.S. does not have a specific statutory covered-bond framework, 
although various legislative and regulatory efforts have emerged over 
the past few years, particularly in response to recent years' mortgage 
market turmoil. These proposals have included a variety of mechanisms 
for designing a U.S. covered-bond regime. The appeal of establishing a 
statutory covered-bond framework is to enable a sound and viable 
alternative funding option for financial institutions, which could 
enhance liquidity options and foster healthy competition in the funding 
markets. This needs to be done without compromising the safety and 
soundness of institutions participating in covered-bond programs.
    That said, development of such a framework for a U.S. covered-bond 
program presents complex issues for consideration by policy makers. The 
remainder of my testimony focuses on a set of key issues and explores 
considerations for how those issues could be addressed.
A. What Entities Are Eligible Issuers?
    A threshold issue in designing a statutory covered-bond program is 
determining the type of entity eligible to issue covered bonds under 
the statutory program. Limiting eligible issuers to entities subject to 
supervision by Federal financial regulators has the advantage of 
dedicated financial supervisors that can monitor and control the growth 
of covered bonds, react to emerging market issues, and generally act to 
promote safe and sound covered-bond programs by their respective 
institutions. Expanding eligible issuers beyond such a group of 
federally supervised institutions, while expanding the number of 
issuers and volume of issuances, has the disadvantage of issuers not 
being subject to the same level of oversight.
    As provided for in recent legislative proposals, an ``eligible 
issuer'' could mean any insured depository institution or any 
subsidiary; any bank or savings and loan holding company and any 
subsidiary; any nonbank financial company that is approved by the 
primary Federal financial regulator for the nonbank financial company; 
and any issuer that is sponsored by one or more eligible issuers for 
the sole purpose of issuing covered bonds on a pooled basis. Regarding 
the last category, a definition that recognizes the issuance of pooled 
covered bonds from appropriately regulated firms likely would provide 
greater access for regional and community banks to this market.
B. What Agency or Agencies Should Regulate Covered-Bond Issuers?
    Another key issue in designing a statutory covered-bond program is 
determining the agency or agencies appropriate to regulate the covered-
bond issuers and programs. One agency, multiple regulatory agencies, or 
the Department of the Treasury, are options that have been suggested at 
various times. Our suggestion is for the Federal financial regulators 
to be the covered-bond regulators for their respective institutions, 
and to implement a single, uniform set of standards that are applicable 
to all covered-bond issuers.
    While having one designated U.S. covered-bond regulator has an 
advantage of inherent uniformity with respect to all covered-bond 
issuers and programs, it has the disadvantage of not utilizing existing 
supervisory knowledge and expertise of current Federal financial 
regulators. Designation of a single covered-bond regulator, 
particularly depending on the agency chosen (or created), also might 
incrementally enhance a market misimpression of Government backing of 
the financial performance of the covered bonds themselves.
    Designating an eligible issuer's Federal financial regulator takes 
advantage of that regulator's existing knowledge of an institution's 
operations. It would also be consistent with the current regulatory 
approach which provides financial regulatory agencies with 
responsibility for supervising covered-bond programs by institutions 
under their jurisdiction.
    Recent legislative proposals have taken this approach to 
structuring a U.S. covered-bond framework, proposing that the covered-
bond regulator be an eligible issuer's Federal financial regulator. 
Thus, in the case of national banks and (going forward for Federal 
thrifts), the covered-bond regulator would be the OCC. For State-
chartered, nonmember banks and State-chartered thrifts, it would be the 
FDIC; for State-chartered member banks, the Federal Reserve Board, and 
for any other issuers, it would be the Securities and Exchange 
Commission (SEC).
    Under this framework, as discussed further in Section D below, the 
designated covered-bond regulators would jointly issue a uniform set of 
regulations establishing a covered-bond regulatory regime. The 
statutory framework could provide the covered-bond regulators with 
authority to approve covered-bond programs of their respective 
institutions, require the regulators to maintain a public registry of 
approved programs, and authorize an appropriate funding mechanism for 
the regulators' oversight of the programs.
    In determining the parameters of the programs, the regulators could 
jointly establish reasonable and objective standards for the covered-
bond programs, including eligibility standards for eligible assets, and 
other criteria as determined necessary. These considerations are 
discussed in more detail in Section D below.
C. What Types of Assets Are Eligible for Covered Bonds?
    Another important component of a statutory covered-bond program is 
the types of assets eligible to collateralize the covered bonds. 
Typically, in Europe, covered bonds are associated with high quality 
assets comprised of residential or commercial mortgage loans and 
public-sector debt. While some have advocated a broad statutory 
spectrum of U.S. asset types, including credit card, student, small 
business, and auto loans, more recent proposals have tended to narrow 
the eligible asset classes.
    One approach to the question of asset eligibility would be to start 
with a relatively conservative scope. Thus, for example, policy makers 
could decide to have the statutory framework initially authorize 
certain asset classes that typically have more homogeneous product 
terms and credit risk profiles (e.g., residential mortgages). 
Authorization also could be provided for the covered-bond regulators to 
expand the eligible classes going forward on an incremental basis as 
more experience is gained with covered-bond programs and after careful 
review of relevant considerations. Asset classes with similar 
characteristics, e.g., credit cards, would be logical first candidates 
for expansion.
D. What Standards Are Applicable to Issuances of Covered Bonds?
    The question of standards applicable to covered bonds and covered-
bond issuers has two facets: How are those standards set and what 
should the standards address?
    For policy makers, determining the standards to be prescribed in 
the statutory framework versus those to be left to regulatory 
rulemaking involves a balance of factors. Providing detailed standards 
by statute offers the legal certainty of having the standards set by 
law, but has the disadvantage of less flexibility for needed changes as 
covered bonds evolve and regulators ascertain strengths and weaknesses 
in covered-bond programs and with issuers. Also, different standards 
may be appropriate for different asset classes. For those reasons, 
policy makers may wish to direct covered-bond regulators to adopt 
standards to address particular key areas.
    As noted in Section B above, while we suggest that Federal 
financial regulators are best situated to serve as the covered-bond 
regulators for the institutions subject to their jurisdiction, we 
strongly believe that those regulators should implement a common set of 
rules. Thus, the regulators could be charged with designing the 
detailed rules that govern covered-bond programs, including any key 
areas that legislation specifically requires them to address. In order 
to avoid the risk of interagency gridlock, however, we also suggest 
that some mechanism be specified to ensure that rules are issued on a 
timely basis. One option that was considered in a recent legislative 
proposal was to provide by statute that the Treasury Department would 
issue the required rules if the covered-bond regulators failed to 
jointly adopt rules within a prescribed time.
    Various types of standards could be embodied in a covered-bond 
regulatory framework. For example, all covered bonds, by asset class, 
should have minimum eligibility criteria setting asset quality 
standards to promote the inclusion of high quality assets in the cover 
pool. Most European jurisdictions prescribe asset quality criteria for 
the assets subject to the statutory covered-bond program. Those 
standards in the U.S. could be set by statute or by the covered-bond 
regulators through rulemaking. Given the likely detail involved, 
regulatory standards seem preferable.
    It is also important to recognize that there are implications if a 
depository institution begins to use covered bonds extensively as a 
funding vehicle, as the institution may have an incentive to pledge 
stronger credit quality assets for collateral, thus giving investors 
the priority claim on the institution's best assets and leaving the 
institution, its shareholders, and ultimately, in the case of 
insolvency, the FDIC, with weaker quality assets. From this standpoint, 
regulatory or supervisory standards may be needed to address risk 
management issues similar to other funding vehicles, including an 
issuer bank's overall liquidity risk management framework and 
maintaining covered-bond programs in a manner consistent with safe and 
sound banking practices.
    Covered-bond regulators also should have the authority to impose a 
cap on the percentage of particular asset types that issuing 
institutions could use for the covered-bond program. An issuer's total 
covered-bond obligations as a percentage of the issuer's total 
liabilities also could be limited. Unrestricted growth in covered bonds 
could excessively increase the proportion of secured liabilities to 
unsecured liabilities at an institution, and thus present issues in the 
event the issuer becomes insolvent. As noted above, if the issuer is a 
depository institution, this creates concerns, notably with respect to 
potential losses to the Deposit Insurance Fund.
    Another important standard is a designated minimum amount of 
overcollateralization. Typically the collateral for covered bonds has a 
market value in excess of the face amount of the covered bonds that it 
backs, i.e., overcollateralization. Having sufficient 
overcollateralization helps to preserve the value of the covered 
bondholders' claims in the event of issuer distress, and the extent of 
overcollateralization should also affect the rate the covered-bond 
issuer must pay to investors.
    Covered-bond legislation could authorize the covered-bond 
regulators to establish minimum overcollateralization requirements for 
covered bonds backed by different eligible asset classes. As a related 
standard, legislation also could set forth a framework requiring each 
cover pool to satisfy an asset coverage test that assesses whether the 
minimum overcollateralization requirements are met, and obligates the 
issuer and an independent ``Asset Monitor'' to confirm on a periodic 
basis whether the asset coverage test is satisfied.
    Legislation also could authorize covered-bond regulators to 
establish certain types of standards viewed as the most necessary and 
prudent to start with, and then authorize regulators to adopt 
additional standards deemed appropriate for particular asset classes. 
This approach would permit covered-bond regulators to revise standards 
as more experience is gained with covered-bond programs and regulators 
obtain a fuller understanding of the relevant considerations.
E. What Are the Consequences of a Default of a Covered-Bond Issuance or 
        Failure of a Covered-Bond Issuer?
    A critical component in designing a U.S. statutory covered-bond 
program is determining the consequences of a default of a covered-bond 
issuance or the failure of a covered-bond issuer. A key advantage 
typically associated with covered bonds in Europe is their continuing 
nature despite a default on the issuance or the insolvency of the 
issuing institution. Under European special law-based frameworks, 
usually there is a specific legal framework superseding the general 
insolvency law of the country. The general premise is that if an 
issuing institution of covered bonds becomes insolvent (or goes into 
bankruptcy), the cover pool is segregated and held for the benefit of 
the covered bondholders. The covered bonds do not automatically 
accelerate when the credit institution goes insolvent, and the rights 
of the bondholders are protected.
    Without a U.S. legal framework addressing the operation and 
management of the cover pool in the event of a default or insolvency, 
U.S. covered bonds will continue to lack predictability and clarity 
compared to other jurisdictions.
    From a general standpoint, there are two distinct situations to be 
addressed: (1) a default on the covered-bond issuance before the issuer 
enters conservatorship, receivership, liquidation, or bankruptcy; and 
(2) the insolvency of the issuer institution. When considering the 
default of a covered-bond issuance, ``default'' should be clearly 
defined for this purpose, and also should clearly address what will 
happen to the cover pool and the rights of the covered bondholders if a 
default occurs.
    One legislative approach is to define the term ``uncured default'' 
to mean a default on the covered bond that has not been cured within 
the time required by the transaction documents related to the covered 
bond. In that situation, a separate estate will automatically be 
created by operation of law and will exist and be administered 
separately from the issuing institution. The separate estate is 
comprised of the applicable cover pool and assumes liability for the 
covered bonds and any related obligations secured by that cover pool. 
Consideration also might be given to authorizing the covered-bond 
regulators to establish minimum time periods for an ``uncured default'' 
in order to avoid ``hair trigger'' defaults.
    Another area for consideration is statutory provisions addressing 
the preservation of deficiency claims against the issuer; the creation 
of a residual interest that represents the right to any surplus from 
the cover pool; and the obligation of the issuer to transfer applicable 
books, records, files, and other documents to the covered-bond 
regulator or another designee. Consideration also should be given to 
provisions that provide that the covered-bond regulator may elect for 
an issuer to continue servicing the cover pool for some reasonable and 
operationally practical period of time.
    The second situation to be addressed is the potential for 
insolvency of the covered-bond issuing institution, and if the issuer 
is an insured depository institution, the FDIC's statutory role as 
conservator or receiver. Again here it is important to clarify and 
address what would happen to the cover pool and the rights of the 
bondholders.
    Similar to the default situation approach, a statutory framework 
could create a separate estate for the covered-bond program similar to 
those in certain European jurisdictions. A recent legislative proposal 
creates a structure with the following general components when the FDIC 
is appointed as conservator or receiver for an insolvent issuer:

    Creation of a separate estate and provision to the FDIC of 
        an exclusive right for 180 days to transfer the issuer's 
        covered-bond program to another eligible issuer.

    A requirement that the FDIC as conservator or receiver, 
        during the 180-day period, perform all monetary and nonmonetary 
        obligations of the issuer until the FDIC completes the transfer 
        of the covered-bond program, the FDIC elects to repudiate its 
        continuing obligations to perform, or the FDIC fails to cure a 
        default (other than the issuer's conservatorship or 
        receivership).

    If the FDIC as conservator or receiver, does not timely effect a 
transfer of the covered-bond program to another eligible issuer, 
repudiates its continuing obligations to perform, or fails to cure a 
default, then the statutory framework could provide for the automatic 
creation of a separate estate and attendant responsibilities, along the 
lines previously described.
    A comprehensive approach for covered bonds that reflects a 
consistent and predictable process across the Federal financial 
regulators would serve to provide certainty and predictability to 
investors and the marketplace in cases of default. This type of 
framework would require the covered-bond regulator to act as or appoint 
a trustee of the separate estate and to appoint and oversee a servicer 
or administrator for the cover pool held by the estate. Given the 
nature of the events triggering this aspect of the covered band 
framework, litigation by unhappy private parties could attempt to draw 
in the covered-bond regulator. We therefore urge consideration of 
limitations on actions against, and recognition of sovereign immunity 
for, the covered-bond regulator acting in its statutorily designated 
capacities.
    A further specific issue for policy makers is the appropriate 
treatment of any excess amounts from the cover pool once the covered 
bondholders have been paid in full. For example, a recent approach 
proposed that a residual interest would be created in the estate that 
represented the right to any surplus from the cover pool after the 
covered bonds and all other liabilities of the estate had been paid in 
full. The issue here is whether the FDIC, or the covered bondholders, 
receives the excess collateral.
F. What Securities Disclosure Requirements Should Apply to Covered 
        Bonds?
    The securities disclosure requirements applicable to covered bonds 
is the final issue I will highlight in this written statement. 
Requiring meaningful disclosures and making detailed information 
available about assets in a cover pool is essential to provide 
consistency and transparency across covered-bond issuances. Required 
disclosures, along with appropriate reporting, by different issuers 
should be standardized to permit comparison of current information by 
investors. This transparency and consistency are fundamental to the 
structure and discipline of covered-bond programs.
    To assure these goals, covered-bond legislation could direct the 
covered-bond regulators to adopt uniform disclosure and reporting 
standards for banks and other issuers. Those standards should cover a 
number of important areas. For example, covered-bond issuers could be 
required to provide investors detailed information about the cover pool 
at the time of issuance and on a periodic (e.g., monthly) basis 
thereafter. The issuer could be required to provide updated cover pool 
information, for instance, if more than 10 percent of the cover pool is 
substituted within a month, or more than 20 percent within a quarter. 
Issuers also could be required to provide investors the results of 
monthly Asset Coverage Tests, which typically should validate 
collateral quality and the proper level of overcollateralization. 
Similarly, the results of any reviews by an Asset Monitor could be made 
available to investors, as well as any other relevant material 
information.
    The SEC's disclosure requirements for asset-backed securities (ABS) 
under Regulation AB provide a useful starting point for developing 
disclosure and reporting requirements for covered-bond programs. 
However, because covered bonds do not present the same structural 
complexities generally possible with ABS, it is probably more 
appropriate to select from, rather than duplicate, the disclosure 
requirements of Regulation AB in the case of covered bonds. \2\ Thus, 
it would be important for policy makers to clarify that covered bonds 
are not ``asset-backed securities'' for such purposes, and to the 
extent necessary should address the application of the Federal 
securities laws to any U.S. covered-bond program.
---------------------------------------------------------------------------
     \2\ Covered bonds issued by banks do not appear to fall within the 
definition of an asset-backed security under the Federal securities 
law. However, legislation clarifying that covered bonds are not asset-
backed securities could provide certainty conducive to the development 
of covered-bond markets.
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Conclusion
    We are encouraged by the continuing interest in establishing a 
statutory structure for covered bonds in the U.S. Such a step, 
prudently structured and implemented, holds promise as an additional, 
complementary funding source for financial institutions, and a catalyst 
for sound competition among the financial product funding alternatives 
available in the U.S. A complex combination of factors will determine 
the extent to which these goals are achieved.
    I appreciate the opportunity to appear before the Committee today, 
and I would be happy to answer any questions. Thank you.
                                 ______
                                 
              PREPARED STATEMENT OF MICHAEL H. KRIMMINGER
     Deputy to the Chairman, Federal Deposit Insurance Corporation
                           September 15, 2010
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
on behalf of the Federal Deposit Insurance Corporation (FDIC), thank 
you for the opportunity to testify on the regulatory and legislative 
issues posed by covered bonds. The FDIC has long worked with the 
financial industry to establish a sound foundation for a vibrant 
covered-bond market that will provide U.S. banks with an additional 
source of liquidity. These efforts include working with the first U.S. 
banks to issue covered bonds in 2006 and the FDIC's adoption of a 
Statement of Policy in mid-2008 to clarify key issues related to 
deposit insurance and bank resolutions. With this background, we hope 
our views on the covered-bond market may be helpful for the Committee.
    The FDIC supports balanced legislation to create a sound foundation 
for covered bonds that also promotes market discipline and protects the 
Deposit Insurance Fund (DIF). In order to meet these goals, we believe 
that there are three key principles that should be followed. First, the 
rights and responsibilities of investors, issuers, and regulators 
should be clearly defined. Second, the investment risks to covered-bond 
investors should not be transferred to the public sector or to the DIF. 
Third, the legislative framework should be consistent with long-
standing U.S. law and policy, and not unduly impair the interests of 
depositors and other creditors.
    While the FDIC's existing Statement of Policy provides a sound 
foundation, a properly designed legislative and regulatory framework 
could further facilitate development of a vibrant covered-bond market. 
In doing so, however, it is important to not create a new class of 
investments that appears ``risk-free'' by providing investors with 
protections unavailable for any other investment. We have already seen 
the consequences when risks are mispriced in the market. Most 
importantly, the risks should not be transferred, implicitly or 
explicitly, to the Government or the DIF. While covered bonds can be a 
valuable tool to provide liquidity, they do carry risks that should be 
considered in fashioning any final legislation.
    Our testimony will discuss the FDIC's July 28, 2008, ``Policy 
Statement on Covered Bonds'', provide background on covered bonds and 
their potential role in the financial marketplace, and address the 
proposed legislation recently adopted by the House Financial Services 
Committee, H.R. 5823, the ``United States Covered Bond Act of 2010.''
The FDIC's Existing Policy on Covered Bonds
    Before the crisis, the FDIC worked closely with Washington Mutual 
Bank and Bank of America when they launched the first U.S. covered-bond 
programs in 2006. As a result of our efforts, the banks were able to 
issue covered bonds at a competitive price. The 2008 Statement of 
Policy later adopted by the FDIC's Board of Directors addressed 
questions from the marketplace about how covered bonds would be treated 
in the receivership of an issuing bank. The market's reaction to this 
Statement was very positive and most commentators stated that it 
provided a solid foundation for the covered-bond market. Shortly after 
the adoption of the Statement of Policy, the Department of the Treasury 
issued a companion document entitled ``Best Practices for Residential 
Covered Bonds'' to establish greater clarity and homogeneity for the 
market so that investors would have confidence in future issuances. The 
FDIC worked with the Treasury Department in developing the Best 
Practices to create a coordinated framework for the responsible and 
measured roll-out and further development of covered bonds in the U.S. 
Unfortunately, the financial crisis disrupted all forms of structured 
finance. Even during the crisis, however, the FDIC was able to sell 
Washington Mutual's covered-bond program intact to JPMorgan Chase Bank 
in a failed bank resolution--demonstrating the effectiveness of the 
process outlined in our Statement of Policy.
    Given the FDIC's existing Statement of Policy, the Treasury 
Department's companion Best Practices, and the prior successful 
covered-bond programs developed in cooperation with the FDIC, it is 
unclear that legislation is necessary to relaunch the market. At a 
minimum, the FDIC suggests that its Statement of Policy should be 
considered as a framework for any legislation in order to provide a 
sound, balanced foundation for the market.
Covered Bonds in Context
    Covered bonds are general obligation bonds of the issuer, normally 
an insured bank or thrift, with payment secured by a pledge of a pool 
of loans. During normal operations, like any general obligation 
corporate bond, investors are paid from the issuing bank's general cash 
flows, while the cover pool of loans serves simply as collateral for 
the bank's duty to pay the investors. As a result, both functionally 
and legally, the cover pool is not the source for repayment as in a 
securitization, but is simply collateral to secure payment if the 
issuing bank cannot make payment from its general cash flows.
    Another distinction between covered bonds and most securitizations 
further demonstrates that the cover pools function as collateral and 
not as sources of payment when covered bonds are not in default. In a 
covered bond, any loans and other assets in the cover pool that become 
delinquent must be replaced with performing assets. As a result, the 
collateral for the covered bond is constantly refreshed--and imposes an 
ongoing obligation on the issuing bank to produce new loans or other 
qualifying collateral to replace delinquencies. Finally, the issuer 
must always maintain more collateral in the cover pool than the 
outstanding notional or ``face'' balance of the outstanding bonds. If 
the issuing bank fails to pay on the covered bond, then the investors 
have recourse to the cover pool as secured creditors. This is precisely 
how normal collateral arrangements work in other secured transactions.
    Under the long-standing U.S. law applied to all types of secured 
transactions, secured creditors have a claim to the collateral--here 
the loans or other assets pledged to secure payment on the covered 
bond--only to the full amount of their claim for payment at the time of 
any default. They do not have a claim to any part of the value of the 
collateral that exceeds their current claim for payment. Any collateral 
or proceeds in excess of that claim for payment are returned to the 
debtor or, if it has been placed into bankruptcy or receivership, are 
used to pay the claims of unsecured creditors. If, on the other hand, 
the secured creditor's claims are greater than the value of the 
collateral, the creditor will have a secured claim up to the value of 
the collateral and an unsecured, general claim for the remaining 
balance along with other unsecured creditors.
    The same rules apply in FDIC receiverships. Secured creditors are 
fully protected under Section 11(e)(12) of the Federal Deposit 
Insurance Act (FDI Act) for the amount of their claim up to the value 
of the collateral. As a result, covered bonds provide two avenues for 
recovery--from the issuing bank and from the cover pool of collateral. 
What they do not have, under U.S. law, is a right to keep collateral in 
excess of their right to payment.
Legislation To Address Covered Bonds
    As mentioned at the outset, the FDIC supports balanced covered-bond 
legislation. We believe this legislation should embody three key 
principles. First, it should clarify the rights and responsibilities of 
investors, issuers, and regulators. Second, it should ensure that 
investment risks are not be transferred to the public sector or to the 
DIF. Third, it should remain consistent with long-standing U.S. law and 
policy for secured creditors. Unfortunately, H.R. 5823 would muddy the 
relationship between investors and regulators, transfer some of the 
investment risks to the public sector and the DIF, and provide covered-
bond investors with rights that no other creditors have in a bank 
receivership. As a result, this legislation could lead to increased 
losses in failed banks that have issued covered bonds.
    Clarifying Rights and Responsibilities--To clarify the respective 
roles of investors, issuers, and regulators, we suggest that any 
legislation establish a regulatory framework for the appropriate 
Federal regulators to jointly establish standards for covered-bond 
issuances by regulated institutions. One existing forum for setting 
such joint standards is the Federal Financial Institutions Examination 
Council, which includes the Federal regulators and a representative 
from the Conference of State Bank Supervisors. H.R. 5823 provides an 
alternative approach--by making the Federal prudential regulators the 
covered-bond regulators--which could also be workable.
    The resulting standards, like the FDIC's Statement of Policy, 
should address the key elements in covered-bond transactions and the 
safety and soundness issues that can be implicated by a bank's use of 
covered bonds. The standards should address the types of collateral, 
underwriting standards, required over-collateralization, frequency and 
content of reports on collateral and satisfaction of required 
overcollateralization, disclosure standards for performance of 
underlying loans or assets, and the rights of the investors in the 
event of default. As discussed in greater detail later, a particularly 
important element in clarification of investors' rights is the 
treatment of the covered bonds if the issuer defaults on its payments 
under the bonds. This is both critical to the investor and to the 
relative balance of risks retained by the investor or transferred to 
other parties.
    The standards setters for covered bonds should have discretion in 
expanding the use of covered bonds and categories of cover pool assets 
as sustainable markets develop and the liquidity of the instruments 
increases. The gradual expansion of cover pool categories is essential 
to ensure the quality of covered bonds and of the assets in the cover 
pools.
    Unfortunately, H.R. 5823 appears to go beyond setting standards to 
provide for detailed oversight of the covered-bond program for the 
benefit of the investors. This shift of the focus of Federal regulation 
towards protection of the investment interest of specific investors 
raises significant questions about the proper role of Federal 
regulation for individual investment programs. It must be made clear 
that the Federal regulators are not guarantors of performance by the 
issuing banks and are not responsible for ensuring that the banks do 
not breach any of the standards. The Federal Government should not 
determine the roles, responsibilities, or quality of performance of the 
issuers or be perceived as protecting the investment interests of 
specific investors. These are issues best resolved by private contracts 
based on transparent disclosures about the operations of covered-bond 
programs. It is important that the federal government is not viewed in 
any way as a guarantor of performance under the covered bonds. 
Performance should be a matter of private contract.
    In addition, H.R. 5823 would also make the Federal prudential 
regulators the appointing and supervising authority of trustees that 
would operate the separate estates of the covered bonds. This level of 
Government entanglement in what are private contractual matters could 
lead to an implied guarantee of covered bonds. An implied guarantee of 
covered bonds would put covered bonds on a near par with the Government 
sponsored enterprises--a status that should not be granted without 
strong policy reasons because of the risk that status represents for 
taxpayers.
    Legislation Should Not Increase the Potential Loss to the DIF--
Intimately related to the foregoing principle is the key issue for the 
FDIC--new covered-bond legislation should not limit the FDIC's ability 
to recover the losses the DIF incurs in resolving a failed bank. To 
protect the DIF, any covered-bond legislation must preserve the 
flexibility that current law provides to the FDIC in resolving failed 
banks--including the options of continuing to perform under the 
covered-bond program pending a sale of the program to another bank, 
turn-over of the collateral to the investors, and repudiation--a 
statutory termination of the contracts--of the covered bond obligation.
    Because there is sometimes confusion concerning the FDIC's power to 
repudiate, it requires some explanation. Repudiation is the ability of 
the FDIC to terminate (or breach) a contract and then pay statutorily 
defined damages to the other parties. In the case of covered bonds, 
repudiation allows the FDIC, as receiver for the failed issuer, to cut-
off future claims and end the obligation to replenish the cover pool 
with new assets. Under the FDI Act, the FDIC will then pay damages to 
compensate the covered-bond investors.
    covered-bond investors, as noted above, are secured creditors of 
the bank. The amount of their claim is defined by the balance or par 
value of outstanding bonds plus interest. The FDIC would support 
covered-bond legislation that clarifies the amount of repudiation 
damages to be the par value of outstanding bonds plus interest accrued 
through the date of payment. This provides a remedy that fully 
reimburses the covered-bond investors. In return, as in any other 
repudiation, the FDIC as receiver would be entitled to reclaim the 
collateral in the cover pool after payment of those damages. The FDIC 
could then sell this collateral and use the proceeds to pay part of the 
claims of the DIF (which has a claim after meeting its insurance 
obligation for insured deposits), uninsured depositors, and other 
creditors of the failed bank.
    If the FDIC does not repudiate a covered bond, it should have the 
authority to continue to perform under the covered bond until it can 
sell the program to another bank. This would not expose the investors 
to any loss, by definition, since the FDIC would meet all requirements 
of the covered-bond program, including replenishment of the cover pool 
and meeting the overcollateralization requirement. As long as the FDIC 
is performing under a covered-bond agreement, covered-bond legislation 
should not limit the time in which the FDIC has to decide how best to 
proceed.
    Any legislation that fails to preserve these important receivership 
authorities makes the FDIC the de facto guarantor of covered bonds and 
the de facto insurer of covered-bond investors. Unfortunately, H.R. 
5823 would expose the DIF to additional losses by restricting the 
FDIC's ability to maximize recoveries on failed bank operations and 
assets. This is contrary to a long-standing Congressional goal of 
preserving the DIF to help maintain confidence in the U.S. banking 
system.
    Over the past several decades, Congress has revised the laws 
governing the resolution of failed banks on several occasions. However, 
two of those revisions are crucial to today's discussion. First, 
Congress required the FDIC to use the ``least costly'' transaction for 
resolving insured depository institutions. Second, Congress created 
depositor preference, which gives depositors a priority among unsecured 
creditors. Both reforms were designed to reduce losses to the DIF.
    Unfortunately, H.R. 5823 would restrict the FDIC's current 
receivership authorities used to maximize the value of the failed 
bank's covered bonds. The bill leaves the FDIC with only two options: 
continue to perform until the covered-bond program is transferred to 
another institution within a certain timeframe; or hand over the 
collateral to a separate trustee for the covered-bond estate, in return 
for a residual certificate of questionable value. The FDIC would not 
have the authority--which it can use for any other asset class--to 
repudiate covered bonds, pay repudiation damages and take control of 
the collateral. This restriction would impair the FDIC's ability to 
accomplish the ``least costly'' resolution and could increase losses to 
the DIF by providing covered-bond investors with a superpriority that 
exceeds that provided to other secured creditors. These increased 
losses to the DIF would be borne by all of the more than 8,000 FDIC-
insured institutions, whether or not they issued covered bonds.
    Limiting the time in which the FDIC could market a covered-bond 
program to other banks will constrain the FDIC's ability to achieve 
maximum value for a program through such a transfer. Similarly, 
preventing the FDIC from using its normal repudiation power will 
prevent the FDIC from recapturing the overcollateralization in the 
covered-bond program. The ``residual certificate'' proposed in H.R. 
5823 is likely to be virtually valueless. More importantly, the 
legislation would provide the investors with control over the 
collateral until the term of the program ends, even though the FDIC 
(and any party obligated on a secured debt) normally has the ability to 
recover overcollateralization by paying the amount of the claims and 
recovering the collateral free of all liens. Providing the FDIC a 
residual certificate instead of the ability to liquidate the collateral 
itself would reduce the value to the receivership estate and would not 
result in the least costly resolution.
    So long as investors are paid the full principal amount of the 
covered bonds and interest to the date of payment, there is no policy 
reason to protect investment returns of covered-bond investors through 
an indirect subsidy from the DIF. However, some market participants 
have argued that continuing to allow the receiver to exercise its 
statutory repudiation authority would reduce investors' interest in 
U.S. covered bonds due to the reinvestment risks. This argument misses 
the mark both from the perspectives of equitable risk allocations and 
real financial risk.
    As discussed earlier, if there is reinvestment risk, it should be 
borne by private investors, not the public sector, other creditors, or 
the DIF. Covered-bond investors should receive full payment for the 
face value of their bonds plus interest. However, they should not be 
guaranteed control of the cover pool where it vastly exceeds the actual 
amount of their claims. In addition, there is no real financial risk if 
the FDIC repudiates the covered-bond transaction, pays the full value 
of the outstanding bonds, plus interest, and takes control of the cover 
pool. If that happens, it simply means that the investors' trustee has 
a pot of money to reinvest into a guaranteed investment contract--like 
an annuity--to continue to pay investors the steady stream of bond 
payments which they are seeking.
    The financial returns for the investors will not be different, in 
any meaningful way, from the return they could expect if they had been 
able to seize control of the cover pool as H.R. 5823 allows. The reason 
is that, once seized, the cover pool becomes a static pool with no new 
loans entering, but with delinquent and paid-off loans exiting. Like a 
static securitization pool, it will be a diminishing pool of collateral 
as these loans exit. In addition, like other pass-through investment 
vehicles, the amount of cash generated in any period can be highly 
variable because of delinquent or missed payments, prepayments, and 
payoffs. A mismatch will occur between the bond payment obligations and 
the remaining cash flows of the cover pool. This mismatch would result 
in early prepayment of the covered bonds to maintain parity. To the 
extent investors put in place contingent liquidity and/or credit 
support mechanisms to reduce the asset/liability mismatch, they also 
reduce the internal rate of return on the covered bonds or increase the 
cost of issuance to the financial institution. There would also be 
administrative or management fees associated with the management of the 
pool. Finally, investors of a static pool pass-through would be subject 
to default risk, which would be eliminated by the payment in full of 
the covered bonds. The net economic consequences of the early 
redemption of the covered bonds would be roughly equivalent to the cost 
of managing the assets to the covered-bond's maturity. However, by 
giving the FDIC the option to redeem the covered bonds, this cost would 
not be subsidized by the DIF.
    The protections to the insurance fund, depositors and the 
flexibility afforded the FDIC as receiver of a failed depository 
institution has become a standard that other countries want to emulate. 
The flexibility that Congress afforded the FDIC permits us to respond 
to market conditions at the time of insolvency and to achieve bank 
resolutions that protect insured depositors at the least cost to the 
DIF. This is an important public policy that we believe has served the 
Nation well and should be maintained.
    Legislation Should Not Create a ``Super-Priority'' for Covered-Bond 
Investors--Under U.S. law, secured creditors are entitled to payment of 
their claims before unsecured creditors up to the lesser of the full 
amount of their claim or the value of the collateral. We should avoid 
upsetting this settled principle of law--which is enshrined both in 
State commercial law under the Uniform Commercial Code and in Federal 
and State insolvency law in the Bankruptcy Code and the FDI Act, among 
other statutes.
    Covered bonds do offer some advantages over securitization towards 
improved underwriting. The potential for improved alignment of the 
bank's incentives toward better quality underwriting is a consequence 
of the loans remaining on the bank's balance sheet, the duty to replace 
any delinquent loans in the cover pool, and holding capital for the 
loans in the pool. However, these advantages come at a cost. The 
obligation to replace delinquent loans means that there is a continuing 
demand for new originations, which can act as a liquidity drain if 
delinquencies increase. This also means that, as poorer loans are taken 
out of the cover pool, the remaining balance sheet will consist of more 
and more delinquent loans. In a receivership, this can lead to greater 
losses to the DIF--particularly if the FDIC's options to sell the 
covered-bond transaction are restricted.
    Clearly, strong origination standards will continue to be required. 
The potential stress on issuing banks is illustrated by Washington 
Mutual Bank, which had to increase the cover pool to almost 150 percent 
overcollateralization in a failed effort to maintain high ratings for 
the transaction. This further exacerbated Washington Mutual's asset and 
liquidity problems.
    This example also illustrates another important consideration in 
covered-bond legislation--investors should not be completely shielded 
from investment risk and their risk should not be transferred to the 
public sector or to the DIF. If, as under H.R. 5823, the investors can 
seize the entire cover pool for the duration of the covered bonds 
irrespective of the degree of overcollateralization, it will provide a 
strong incentive for investors to maximize the overcollateralization. 
Naturally, this will increase pressure on the issuing bank during 
periods of stress. The ability of investors to seize the entire cover 
pool will also further reduce the loan assets available for sale by the 
FDIC in any receivership. If creditors of covered bonds are shielded 
from all risks, there is a strong possibility that covered bonds could 
lead to a mispricing of risk and distortions in the market, imperiling 
banks in the future. On the other hand, if the long-standing treatment 
of secured creditors is maintained--which would allow the FDIC to pay 
the outstanding principal and interest on the bonds and recover the 
overcollateralization--there will be very limited incentive for the 
creditors to demand increasing levels of collateral as a bank becomes 
troubled.
    The super-priority given covered-bond investors by H.R. 5823 also 
runs against the policy direction established by Congress in recent 
legislation. In 2005, Congress enacted Section 11(e)(13)(C) of the FDI 
Act, which prohibits secured creditors from exercising any rights 
against any property of a failed insured depository institution (IDI) 
without the receiver's consent for the first 90 days of a bank 
receivership. \1\ This provision prevents secured creditors from taking 
and selling bank assets at fire sale prices to the detriment of the 
receiver and the DIF. More recently, section 215 of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act mandates a study to evaluate 
whether a potential haircut on secured creditors could improve market 
discipline and reduce cost to the taxpayers. This study was prompted by 
the recognized roles that the run on secured credit and the insatiable 
demand for more collateral had in the financial crisis of 2008. In 
contrast, the unprecedented protection for one form of secured 
creditors--covered-bond investors--in H.R. 5823 runs counter to the 
policies underlying these provisions.
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     \1\ The only exception to the stay in 11(e)(13)(C) is for 
qualified financial contracts (QFCs). This exemption is based on the 
fact that performance of the derivatives markets requires prompt 
transfer or closeout of derivatives positions, thereby reducing 
potentially negative systemic effects of counterparty failures. Covered 
bonds do not meet the definitions as QFCs. Nonetheless, H.R. 5823 gives 
covered-bond investors a right to retain all collateral that not even 
secured parties with QFCs receive.
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    A further concern created by H.R. 5823 is that it could encourage 
covered-bond transactions that include ``triggers'' for early 
termination or default before a bank is closed by the regulators. Under 
H.R. 5823, a separate estate, which removes the entire cover pool from 
the bank's control, is created upon any event of default. Once created, 
the separate estate and all collateral in the cover pool would be 
outside the control of the FDIC, as receiver for the bank. The residual 
value of the pool, and all of the loans, would be outside the 
receivership and be lost for all other creditors of the failed bank. 
This additional special protection creates a strong incentive for 
covered-bond transactions to include a trigger that acts before the 
bank is placed into receivership. Since such a trigger would deprive 
the bank of the cash flows from the cover pool and signal to the market 
its imminent demise, the bank would almost inevitably suffer a 
liquidity failure. As a result, these early triggers represent another 
source of increased loss to the DIF.
    The FDIC has recommended that the receiver should have the 
authority to cure any defaults under the covered-bond transaction 
within 30 days of the appointment of the FDIC as conservator or 
receiver of an issuer. This would reduce the incentive for covered-bond 
investors to declare a default and take control of the cover pool in 
anticipation of an FDIC receivership. Providing the FDIC 30 days to 
cure a default would allow the FDIC to recapture the value of the 
overcollateralization in the program for receivership creditors, 
including uninsured depositors and the DIF. The FDIC would then have 
the same options to resolve the covered-bond transaction and maximize 
the value of this asset in the receivership.
Conclusion
    The FDIC supports a vibrant covered-bond market that would increase 
liquidity to financial institutions and enable sustainable and robust 
asset origination. However, any legislation should avoid promoting 
development of a covered-bond market by reducing market discipline and 
protection for the Deposit Insurance Fund (DIF). We believe the 
principles, described above, will ensure that covered bonds serve as a 
sustainable investment for bondholders and the financial system. We 
will continue to work with the Congress, other regulators and market 
participants on ways to create a sustainable covered-bond market in the 
U.S.
    Thank you for inviting me to appear at this hearing. I will be 
happy to answer any questions.
                                 ______
                                 
                 PREPARED STATEMENT OF SCOTT A. STENGEL
 Partner, Orrick, Herrington and Sutcliffe LLP, on behalf of the U.S. 
   Covered Bond Council, Securities Industry, and Financial Markets 
                              Association
                           September 15, 2010
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I am grateful for your invitation to testify today on the crucial role 
that U.S. covered bonds can play in stabilizing our financial system 
and contributing to our economic recovery.
    I am a partner in the Washington, DC, office of Orrick, Herrington 
& Sutcliffe LLP and a member of the Steering Committee for the U.S. 
Covered Bond Council (the Council). The Council is a collaborative 
forum comprised of investors, issuers, dealers, and other participants 
in the covered-bond market, and we strive to develop policies and 
practices that harmonize the views of these different constituencies 
and that promote a vibrant market for U.S. covered bonds. \1\
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     \1\ The U.S. Covered Bond Council is sponsored by The Securities 
Industry and Financial Markets Association (SIFMA). SIFMA brings 
together the shared interests of hundreds of securities firms, banks, 
and asset managers. SIFMA's mission is to develop policies and 
practices which strengthen financial markets and which encourage 
capital availability, job creation, and economic growth while building 
trust and confidence in the financial industry. SIFMA, with offices in 
New York and Washington, DC, is the U.S. regional member of the Global 
Financial Markets Association. For more information, please visit 
www.sifma.org.
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    The precarious state of our Nation's economy has become all too 
apparent. Weakness persists in the labor market, with almost 17 percent 
of Americans still unemployed or underemployed. More than half of 
small-business owners are experiencing cash flow issues and are 
expecting economic conditions to remain unfavorable for at least the 
next 6 months. Home prices in the United States have fallen 34 percent 
since their peak in 2006, and nearly one out of every four homeowners 
is underwater on a mortgage. The delinquency rate on loans backing 
commercial mortgage-backed securities has increased to a record 8.92 
percent, even though more loans have been modified in 2010 than in the 
prior 2 years combined. In this volatile environment, credit remains 
relatively tight for both families and small businesses, public-sector 
resources are increasingly strained, and consumers are understandably 
cautious.
    In the Council's view, sustained economic growth begins with a 
stable financial system. While the Dodd-Frank Act has supplied some 
important structural elements, there remains a considerable need for 
long-term and cost-effective funding that is sourced from diverse parts 
of the private-sector capital markets and that can be translated into 
meaningful credit for households, small businesses, and the public 
sector.
    We believe that U.S. covered bonds are an untapped but proven 
resource that could be invaluable in meeting this need. We also believe 
that, with the success of a fragile economic recovery hanging in the 
balance, the time for U.S. covered bonds is now.
    Much has been written about U.S. covered bonds in the last year, 
and because not all of the commentary has been entirely accurate, I 
want to take just a moment to describe this financial tool. At its 
core, a covered bond is simply a form of high-grade senior debt that is 
issued by a regulated financial institution and that is secured--or 
``covered''--by a dynamic cover pool of financial assets which is 
continually replenished. What distinguishes covered bonds from other 
secured debt is a legislatively or sometimes contractually prescribed 
process for managing (rather than immediately liquidating) the cover 
pool upon the issuer's default or insolvency and continuing scheduled 
(rather than accelerated) payments on the covered bonds. Over the 
course of this product's 240-year history, cover pools have included 
residential mortgage loans, commercial mortgage loans, agricultural 
loans, ship loans, and public-sector loans, and in the Council's view, 
loans for small businesses, students, automobile owners and lessors, 
and consumers using credit or charge cards also are appropriate.
    Covered bonds are an effective vehicle for infusing long-term 
liquidity into the financial system. With maturities that typically 
range from 2 to 10 years and that can extend out to 15 years or more, 
they provide a natural complement to the short-and medium-term funding 
that is available through the Federal Home Loan Banks and the 
securitization and repo markets. This kind of stable liquidity, 
moreover, allows banks to turn around and provide long-term credit to 
consumers, small businesses, and governments without being vulnerable 
to sudden changes in interest rates or investor confidence. In 
addition, by using covered bonds to more closely match the maturities 
of their assets and liabilities, financial institutions are able to 
reduce refinancing risks that can have a destabilizing influence on the 
banking system more broadly.
    Covered bonds also represent a cost-efficient form of on-balance-
sheet financing for financial institutions that, in turn, can reduce 
the cost of credit for families, small businesses, and the public 
sector. The importance of this cost efficiency cannot be overstated. 
Recent accounting changes and increased regulatory capital 
requirements, as well as continued challenges in the securitization 
market, have made lending far more expensive. Spreads on long-term 
unsecured debt, moreover, are substantially wider than the short-term 
rates that have been pushed down to historically low levels by recent 
Government initiatives, and these long-term rates could move even 
higher as the Federal Government exits those initiatives and competes 
for funding to finance its own budget deficits.
    Another benefit of covered bonds is their separate and distinct 
investor base. These investors are providing liquidity that would not 
otherwise be made available through the unsecured-debt or 
securitization markets, and as a result, covered bonds enable financial 
institutions to add another source of funding rather than merely 
cannibalize their existing sources. Such diversification, not only in 
the kind but in the supply of liquidity, is crucial to reducing 
systemic risk and securing the financial system. With a growing 
shortage of fixed-income securities of the kind that appeal to rates 
investors, moreover, covered bonds are attracting as much interest as 
ever.
    Equally important, covered bonds deliver funding from the private-
sector capital markets without any reliance on U.S. taxpayers for 
support. The ongoing debate about GSE reform is a stark reminder of how 
dependent some parts of the financial system remain on Government 
intervention. That kind of intervention not only exposes the taxpayers 
to risk but also creates dislocations in the market that inhibit the 
private-sector economy from generating a self-sustaining recovery. 
Covered bonds, which have demonstrated resilience even in distressed 
market conditions, can serve as an important bridge from an economy 
that is limping along on Government support to one that is able to 
stand and thrive on its own.
    Two other features of covered bonds bear mention. First, in 
contrast to securitization, a financial institution issuing covered 
bonds continues to own the assets in the cover pool that are pledged as 
security. This creates 100 percent ``skin in the game,'' and as a 
result, incentives relating to underwriting, asset performance, and 
loan modifications are strongly aligned. Second, the success of covered 
bonds is attributable in no small measure to their high degree of 
transparency and uniformity. As one of the most straightforward of 
financial products, covered bonds are a model of safe and sound banking 
practices.
    With covered bonds supplying long-term and cost-efficient liquidity 
from a separate private-sector investor base, the Council believes that 
credit will more effectively flow to households, small businesses, and 
State and local governments. Because covered bonds are ultimately 
constrained by the balance sheets of issuers, however, they cannot be 
called a silver bullet, and action still needs to be taken to 
resuscitate securitization and other parts of the financial markets. 
But, like some of the measures in the Dodd-Frank Act, covered bonds 
represent a critical first step--and one that, in this constrained 
credit environment, is urgently needed now.
    To function successfully, however, a U.S. covered-bond market must 
be deep and highly liquid. Covered bonds are viewed as a conservative 
and defensive investment, and just as with any other high-grade 
instrument, investors expect active bids, offers, and trades. Sporadic 
issuances, one-off transactions, cumbersome trading, and shallow supply 
and demand are incompatible with covered bonds.
    This need for a deep and liquid covered-bond market was recognized 
by the Treasury Department (Treasury) and the Federal Deposit Insurance 
Corporation (FDIC) in 2008 when they collaborated to issue, 
respectively, Best Practices for Residential Covered Bonds and a Final 
Covered Bond Policy Statement. Regulators and market participants alike 
hoped that, in the absence of a legislative framework, these regulatory 
initiatives might serve as an adequate substitute and foster the growth 
of U.S. covered bonds.
    But, during the last 2 years, it has become apparent that 
regulatory guidance alone will not suffice.
    Covered bonds were originated and developed in Europe under 
legislative frameworks that require public supervision designed to 
protect covered bondholders, and this precedent has set market 
expectations. Today, almost 30 countries across the continent of Europe 
have adopted national legislation to govern covered bonds. These 
include Germany, France, the United Kingdom, the Netherlands, Spain, 
Italy, Russia, Denmark, Ireland, Portugal, the Czech Republic, the 
Slovak Republic, Austria, Hungary, Slovenia, Switzerland, Luxembourg, 
Sweden, Finland, Norway, Poland, Latvia, Lithuania, Ukraine, Romania, 
Bulgaria, Greece, Armenia, and Turkey. Even in Canada, where financial 
institutions have been able to actively tap the covered-bond market 
because of more creditor-friendly insolvency laws and the unique nature 
of their cover pools, a legislative framework is being developed.
    Dedicated covered-bond legislation and public supervision, from the 
perspective of market participants, creates a degree of legal certainty 
that regulatory initiatives just cannot replicate. This kind of 
certainty is critical because the nature of covered bonds as a high-
grade defensive investment with limited prepayment risk has no room for 
ambiguity on the rights and remedies available at law, especially in 
the event of the issuing institution's insolvency. Investors will not 
dedicate funds to this market unless the legal regime is unequivocal 
and the risks can be identified and underwritten.
    To provide an example, if a U.S. depository institution were to 
issue covered bonds and later enter receivership under existing law, 
the FDIC has expressed the view that three options are available at its 
discretion: (1) the FDIC could continue to perform on the covered bonds 
according to their original terms, (2) the FDIC could repudiate the 
covered bonds or allow a default to occur, make a determination about 
the fair market value of the cover pool securing them, pay covered 
bondholders an amount equal to the lesser of that fair market value and 
the outstanding principal amount of the covered bonds with interest 
accrued only to the date of its appointment as receiver, and retain the 
cover pool, or (3) the FDIC could repudiate the covered bonds or allow 
a default to occur, leave covered bondholders to exercise self-help 
remedies against the cover pool, and recover from them any proceeds in 
excess of the outstanding principal amount of the covered bonds with 
interest accrued only to the date of its appointment as receiver. Any 
of these three options would be exercised against the backdrop of a 
temporary automatic stay that would last for 90 days after the FDIC's 
appointment as receiver or, at best under the Final Covered Bond Policy 
Statement, 10 business days after an uncured monetary default (though 
not an uncured nonmonetary default).
    In these circumstances, investors face a number of uncertainties: 
Which of the three options will the FDIC exercise? When will the FDIC 
make its choice? How will the FDIC calculate the fair market value of 
the cover pool, and how long will that process take? Will self-help 
remedies alone suffice, or will the FDIC instead need to be involved in 
releasing the cover pool? Will the FDIC challenge the method of 
liquidation used by the trustee for the covered bondholders? What will 
happen if the FDIC elects to perform for some period of time and then 
later repudiate, especially if the cover pool has deteriorated in the 
meantime? Legal uncertainties like these simply do not exist under the 
legislative frameworks found in Europe.
    Equally troubling to investors and other market participants is the 
fact that this optionality resides with the FDIC, which has a rather 
clear conflict of interest because of its fiduciary duty to depositors 
and the deposit-insurance fund. The conflict was recently highlighted 
by the FDIC's repeated calls for legislation that would force secured 
creditors like covered bondholders to take a haircut even if their 
claims are fully collateralized--a development which, to our knowledge, 
would be unprecedented in the history of credit. \2\
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     \2\ See, e.g., Sheila C. Bair, Chairman, Federal Deposit Insurance 
Corporation, Statement on Establishing a Framework for Systemic Risk 
Regulation before the U.S. Senate Committee on Banking, Housing, and 
Urban Affairs (July 23, 2009); Sheila C. Bair, Chairman, Federal 
Deposit Insurance Corporation, Statement on Regulatory Perspectives on 
Financial Regulatory Reform Proposals before the U.S. House Committee 
on Financial Services (July 24, 2009); Sheila C. Bair, Chairman, 
Federal Deposit Insurance Corporation, Remarks to the International 
Institute of Finance (October 4, 2009); Sheila C. Bair, Chairman, 
Federal Deposit Insurance Corporation, Statement on Systemic 
Regulation, Prudential Measures, Resolution Authority, and 
Securitization before the U.S. House Committee on Financial Services 
(October 29, 2009).
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    Although this proposal was not adopted as part of the Dodd-Frank 
Act, the FDIC's advocacy was sufficiently vigorous to prompt a wide-
ranging study on the subject. \3\
---------------------------------------------------------------------------
     \3\ See, Section 215 of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act (2010).
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    Layered on top of these concerns is the obvious incompatibility of 
a forced acceleration by the FDIC with the core nature of a covered 
bond. A sine qua non of covered bonds is the use of collections and 
other proceeds from the cover pool to continue making scheduled 
payments after the issuer's default or insolvency. If forced 
acceleration were possible, the instrument would no longer be a covered 
bond but instead would be just plain-vanilla secured debt. In addition, 
if the FDIC were to take the position that secured claims of investors 
are limited to the fair market value of the cover pool at a moment in 
time rather than to its cash flow value over time, forced acceleration 
would expose them to losses arising from short-term market volatility 
and liquidity risks that are not part of the economic bargain in the 
covered-bond market.
    For these reasons, the Council has concluded that a well-
functioning market for U.S. covered bonds cannot develop without a 
legislative framework that stays true to the distinctive features of 
traditional covered bonds. Anything less would preclude issuing 
institutions--and ultimately consumers, small businesses, and the 
public sector--from realizing the cost efficiencies that make covered 
bonds worthwhile.
    We are confident, moreover, that such a framework could be 
constructed in a way to fully protect the interests of an issuer's 
other creditors (including, in the case of a bank, the deposit-
insurance fund) as well as any conservator, receiver, or bankruptcy 
trustee. Taking a bank receivership as an example once again, we would 
support a period of up to 180 days for the FDIC to transfer an affected 
covered-bond program to another eligible issuer so long as all monetary 
and nonmonetary obligations were performed during that time. \4\ If 
such a transfer turned out to be impossible or inadvisable and the 
covered-bond program were moved to a separate estate for 
administration, we believe that the receivership's equity in that 
estate should take the form of a residual interest that the FDIC could 
sell or otherwise monetize immediately for the benefit of other 
creditors and the deposit-insurance fund. We also could support the 
holder of that equity interest being afforded consent rights over the 
selection of any servicer or administrator for the estate.
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     \4\ This would be consistent with the FDIC's existing policy on 
the treatment of secured obligations. See, Federal Deposit Insurance 
Corporation, Statement of Policy Regarding Treatment of Security 
Interests After Appointment of the Federal Deposit Insurance 
Corporation as Conservator or Receiver (March 23, 1993).
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    The absence of a legislative framework for U.S. covered bonds is 
already coming at a cost. European and other non-U.S. issuers have been 
taking advantage of favorable laws in their home countries and filling 
the vacuum. Thus far in 2010, over $18 billion in U.S.-dollar-covered 
bonds have been targeted to investors in the United States. With 
governments in Europe providing the requisite legal certainty for 
covered bonds issued by their domestic institutions, we fear that the 
playing field could grow increasingly uneven in the fierce competition 
among banks for less expensive and more stable sources of funding.
    The cost of such an outcome, of course, will be born in the end by 
families, small businesses, and governments throughout the United 
States, especially those that are dependent on banks for their 
liquidity needs. When possible, the higher funding costs will be passed 
along to them; when not, credit will be denied altogether. Neither 
result can be described as at all desirable.
    The Council, therefore, fully supports the kind of comprehensive 
covered-bond legislation that was proposed by Congressman Garrett and 
the other House conferees during the House-Senate conference on the 
Dodd-Frank Act.
    In particular, the Council endorses the following elements of a 
legislative framework for U.S. covered bonds:

    Public Supervision by a Covered-Bond Regulator--The public 
        supervision of covered-bond programs by a Federal regulator, 
        whose mission is the protection of covered bondholders, is 
        central to any legislative framework. In the European Union, 
        this feature is enshrined in Article 22(4) of the Directive on 
        Undertakings for Collective Investment in Transferable 
        Securities (the UCITS Directive). Compliance with Article 22(4) 
        is what gives covered bonds their unique status in Europe, 
        including privileged risk weighting under the EU's Capital 
        Requirements Directive and preferential treatment by the 
        European Central Bank in Eurosystem credit operations.
      We therefore support a framework that includes the following: The 
        Comptroller of the Currency or another U.S. Government agency--
        excluding the FDIC because of its conflict of interest--would 
        be appointed as the Covered-Bond Regulator, which would have as 
        its mission the protection of covered bondholders. The Covered-
        Bond Regulator, in consultation with other applicable primary 
        Federal regulators, would ensure compliance with legislative 
        requirements and would establish additional regulatory 
        requirements that are tailored to the different kinds of 
        covered-bond programs. Covered bonds would fall under the 
        legislative framework only if issued under a covered-bond 
        program that has been approved by the Covered-Bond Regulator in 
        consultation with the issuer's primary Federal regulator. The 
        Covered-Bond Regulator would maintain a public registry of 
        approved covered-bond programs.

    Eligible Issuers--Issuances by regulated financial 
        institutions is another fundamental element of covered bonds 
        that is also recognized in the UCITS Directive. In order to 
        afford competitive market access to regional and community 
        banks, however, pooled issuances by entities that have been 
        sponsored by one or more regulated institutions should be 
        permitted as well.
      We therefore support a framework that includes the following: 
        Eligible issuers of covered bonds would be comprised of (1) 
        FDIC-insured depository institutions and their subsidiaries, 
        (2) bank holding companies, savings and loan holding companies, 
        and their subsidiaries, (3) nonbank financial companies that 
        are approved by the Covered-Bond Regulator and other applicable 
        primary Federal regulators, and (4) issuing entities that are 
        sponsored by one or more eligible issuers for the sole purpose 
        of issuing covered bonds on a pooled basis.

    Covered Bonds--To ensure that covered bonds retain their 
        essential attributes as the market evolves, we support a 
        framework that includes the following: A covered bond would be 
        defined as a nondeposit senior recourse debt obligation of an 
        eligible issuer that (1) has an original term to maturity of 
        not less than 1 year, (2) is secured by a perfected security 
        interest in a cover pool which is owned directly or indirectly 
        by the issuer, and (3) is issued under a covered-bond program 
        that has been approved by the Covered-Bond Regulator.

    Cover Pool--One other indispensable feature of covered 
        bonds is a cover pool that contains performing assets and that 
        is replenished and kept sufficient at all times to fully secure 
        the claims of covered bondholders. This too receives specific 
        mention in the UCITS Directive.
      We therefore support a framework that includes the following: The 
        cover pool would be defined as a dynamic pool of assets that is 
        comprised of (1) one or more eligible assets from a single 
        eligible asset class, (2) substitute assets (such as cash and 
        cash equivalents) without limitation, and (3) ancillary assets 
        (such as swaps, credit enhancement, and liquidity arrangements) 
        without limitation. No cover pool would include eligible assets 
        from more than one eligible asset class. A loan would not 
        qualify as an eligible asset while delinquent for more than 60 
        consecutive days, and a security would not qualify as an 
        eligible asset while not of the requisite credit quality.

    Eligible Asset Classes--The real benefit of covered bonds 
        is long-term and cost-effective funding from the private sector 
        that can be converted into meaningful credit for families, 
        small businesses, and State and local governments throughout 
        the United States.
      We therefore support a framework that includes the following 
        eligible asset classes: (1) residential mortgage asset class, 
        (2) home equity asset class, (3) commercial mortgage (including 
        multifamily) asset class, (4) public sector asset class, (5) 
        auto asset class, (6) student loan asset class, (7) credit or 
        charge card asset class, (8) small business asset class, and 
        (9) other asset classes designated by the Covered-Bond 
        Regulator in consultation with other applicable primary Federal 
        regulators.

    Overcollateralization, Asset-Coverage Test, and Independent 
        Asset Monitor--Full transparency, independent monitoring, and 
        regular reporting must be among the hallmarks of U.S. covered 
        bonds.
      We therefore support a framework that includes the following: The 
        Covered-Bond Regulator would establish minimum 
        overcollateralization requirements for covered bonds backed by 
        each of the eligible asset classes based on credit, collection, 
        and interest-rate risks but not liquidity risks. Each cover 
        pool would be required at all times to satisfy an asset-
        coverage test, which would measure whether the eligible assets 
        and the substitute assets in the cover pool satisfy the minimum 
        overcollateralization requirements. Each issuer would be 
        required to perform the asset-coverage test monthly on each of 
        its cover pools and to report the results to covered 
        bondholders and applicable regulators. Each issuer also would 
        be obligated to appoint the indenture trustee for its covered 
        bonds or another unaffiliated entity as an independent asset 
        monitor, which would periodically verify the results of the 
        asset-coverage test and provide reports to covered bondholders 
        and applicable regulators.

    Separate Resolution Process for Covered-Bond Programs--Hand 
        in hand with public supervision is legal certainty on the 
        resolution of a cover pool if the issuer were to default or 
        become insolvent. A dedicated process must exist that provides 
        a clear roadmap for investors, that avoids the waste inherent 
        in a forced liquidation of collateral, and that allows the 
        cover pool to be managed and its value maximized.
      Central to this resolution process is the creation of a separate 
        estate--like the ones created under the Bankruptcy Code--for 
        any covered-bond program whose issuer has defaulted or become 
        insolvent. To ensure that timing mismatches among the assets 
        and liabilities of the estate do not unnecessarily erode the 
        cover pool's value or cause a premature default, both private-
        sector counterparties and the Federal Reserve Banks should be 
        authorized to make advances to the estate on a superpriority 
        basis for liquidity purposes only. Importantly, however, 
        advances by a Federal Reserve Bank should be prohibited if U.S. 
        taxpayers could be exposed to any credit risk whatsoever.
      Special rules also are appropriate should the FDIC be appointed 
        as conservator or receiver for an issuer before any default 
        occurs on its covered bonds. All interested parties would 
        benefit if the FDIC were able to transfer the entire covered-
        bond program to another eligible issuer, much like Washington 
        Mutual's program was conveyed to JPMorgan Chase. As a result, 
        the FDIC should be afforded a reasonable period of time (not to 
        exceed 180 days) to effect such a transfer before a separate 
        estate is created.
      In addition, neither an issuer that has defaulted nor its 
        creditors in the case of insolvency should forfeit the value of 
        surplus collateral in the cover pool. To enable this value to 
        be realized promptly by the issuer or its creditors (including 
        the FDIC and the deposit-insurance fund) without disrupting the 
        separate resolution process, a residual interest should be 
        created in the form of an exempted security that can be sold or 
        otherwise monetized immediately. Such an approach should 
        satisfy all constituencies--covered bondholders will be able to 
        rely on the separate, orderly resolution process for their 
        cover pool, and the issuer and its creditors (including the 
        FDIC and the deposit-insurance fund) will not have to wait for 
        that process to conclude before turning any surplus into cash.
      We therefore support a framework that includes the following: If 
        covered bonds default before the issuer enters conservatorship, 
        receivership, liquidation, or bankruptcy, a separate estate 
        would be created that is comprised of the applicable cover pool 
        and that assumes liability for the covered bonds and related 
        obligations. Deficiency claims against the issuer would be 
        preserved, and the issuer would receive a residual interest 
        that represents the right to any surplus from the cover pool. 
        The issuer would be obligated to release applicable books, 
        records, and files and, at the election of the Covered-Bond 
        Regulator, to continue servicing the cover pool for 120 days.
      If the FDIC were appointed as conservator or receiver for an 
        issuer before a default on its covered bonds results in the 
        creation of an estate, the FDIC would have an exclusive right 
        for up to 180 days to transfer the covered-bond program to 
        another eligible issuer. The FDIC as conservator or receiver 
        would be required during this time to perform all monetary and 
        nonmonetary obligations of the issuer under the covered-bond 
        program.
      If another conservator, receiver, liquidator, or bankruptcy 
        trustee were appointed for an issuer before a default on its 
        covered bonds results in the creation of an estate or if the 
        FDIC as conservator or receiver did not transfer a covered-bond 
        program to another eligible issuer within the allowed time, a 
        separate estate would be created that is comprised of the 
        applicable cover pool and that assumes liability for the 
        covered bonds and related obligations. The conservator, 
        receiver, liquidating agent, or bankruptcy court would be 
        required to estimate and allow any contingent deficiency claim 
        against the issuer. The conservator, receiver, liquidating 
        agent, or bankruptcy trustee would receive a residual interest 
        that represents the right to any surplus from the cover pool. 
        The conservator, receiver, liquidating agent, or bankruptcy 
        trustee would be obligated to release applicable books, 
        records, and files and, at the election of the Covered-Bond 
        Regulator, to continue servicing the cover pool for 120 days.
      The Covered-Bond Regulator would act as or appoint the trustee of 
        the estate and would be required to appoint and supervise a 
        servicer or administrator for the cover pool. The servicer or 
        administrator would be obligated to collect, realize on, and 
        otherwise manage the cover pool and to invest and use the 
        proceeds and funds received to make required payments on the 
        covered bonds and satisfy other liabilities of the estate. The 
        estate would be authorized to borrow or otherwise procure 
        funds, including from the Federal Reserve Banks. Other than to 
        compel the release of funds that are available and required to 
        be distributed, no court would be able to restrain or affect 
        the resolution of the estate except at the request of the 
        Covered-Bond Regulator.

    Securities Law Provisions--With covered-bond programs 
        subject to rigorous public supervision, investors will be well-
        protected. As a result, an expansion of existing securities-law 
        exemptions may be appropriate. Regardless, because legal 
        certainty for covered bonds is paramount, we support a 
        framework that includes at least the following: Existing 
        exemptions for securities issued or guaranteed by a bank would 
        apply equally to covered bonds issued or guaranteed by a bank. 
        Each estate would be exempt from all securities laws but would 
        succeed to any requirement of the issuer to file applicable 
        periodic reports. Each residual interest would be exempt from 
        all securities laws.

    Miscellaneous Provisions--We also support a framework that 
        includes the following conforming changes to other applicable 
        law: The Secondary Mortgage Market Enhancement Act of 1984 
        would be expanded to encompass covered bonds. Covered bonds 
        that are backed by the residential mortgage asset class, the 
        home equity asset class, or the commercial mortgage asset class 
        would be qualified mortgages for Real Estate Mortgage 
        Investment Conduits (REMICs) and, subject to regulations that 
        may be promulgated by the Secretary of the Treasury, may be 
        treated as real estate assets in the same manner as REMIC 
        regular interests. The estate would not be treated as a taxable 
        entity, and no transfer of assets or liabilities to an estate 
        would be treated as a taxable event. The acquisition of a 
        covered bond would be treated as the acquisition of a security, 
        and not as a lending transaction, for tax purposes. The 
        Secretary of the Treasury may promulgate regulations for 
        covered bonds similar to the provisions of Section 346 of the 
        Bankruptcy Code.

    In addition to these elements of a legislative framework, the 
Council also believes that U.S. covered bonds should be afforded 
favorable regulatory capital treatment like that found in Europe, 
including in the context of risk weighting and liquidity buffers.
    On behalf of the Council, I want to thank Chairman Dodd for holding 
this hearing and Senator Corker and Congressman Garrett for their 
leadership on U.S. covered bonds.
    I would be pleased to answer any questions that Members of the 
Committee may have.
                                 ______
                                 
                PREPARED STATEMENT OF KENNETH A. SNOWDEN
   Associate Professor of Economics, University of North Carolina at 
                               Greensboro
                           September 15, 2010
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I appreciate the opportunity to testify before the Committee concerning 
the potential uses and regulation of covered bonds in the U.S. mortgage 
market. I am an economic historian who for the past two decades has 
studied the development of the U.S. mortgage market. Up until 3 years 
ago my specialty was relatively obscure even among other historians, 
but crisis always seems to enhance the value of looking back. The 
purpose of my testimony is to share with you some of the research I and 
others have done concerning the history of our mortgage market and the 
role that covered mortgage bonds have played within it. The hope is 
that the historical perspective will provide useful guidance as you 
consider whether and how to incorporate regulated covered bonds into 
the U.S. mortgage market.
    Covered bonds are being recommended for the U.S. mortgage market at 
this time because they address weaknesses that we have observed over 
the past 40 years in the two funding mechanisms that have dominated the 
U.S. mortgage market for the past century. One of these systems is what 
I refer to here as the traditional portfolio lender model in which an 
intermediary holds mortgage loans on its own balance sheet and funds 
them by issuing deposits. In the other funding mechanism that is used 
extensively in the U.S., called securitization, bonds are issued 
against a pool of mortgages that has been taken off the balance sheet 
of the intermediary that originated or assembled the mortgage loan 
pool. Covered mortgage bonds differ from both of these systems in that 
the intermediary issues debt that is secured by a pool of mortgage 
loans that it holds on its own balance sheet. Investors who purchase 
covered bonds are given senior claims on the designated mortgage cover 
pool, and also have recourse to the other assets held by the 
intermediary as security for the promised payments on their bonds. As a 
result of this structure, covered mortgage bonds can reduce the risks 
of funding long-term mortgages with short-term deposits that arise in 
the traditional portfolio lender model, while providing greater 
incentives to impose strict mortgage underwriting standards than are 
found in securitization.
    Covered mortgage bonds are also being recommended at this time 
because of their popularity and record of success in Europe. The 
European record of covered mortgage bond success, in fact, stretches 
back over 200 years. Although my own research is completely U.S.-
centered, I became aware of the history of covered bond use in Europe 
two decades ago when I came across commentaries by late 19th century 
writers that complained bitterly about the absence of European-style 
covered mortgage bond programs in the U.S. These comments provided 
evidence that market participants in the U.S were well aware of covered 
mortgage bonds as early as 1870 and led me to question why the 
mechanism had not been implemented here. Further exploration revealed 
that covered mortgage bond systems actually had been introduced several 
times between 1870 and 1935. At that point the important question 
became why did covered mortgage bonds not become a permanent fixture in 
U.S. mortgage markets. It turns out that bad timing, poor 
implementation, and ineffective regulation all played roles, and my 
testimony briefly surveys that record to provide the Committee with 
this historical perspective as you consider legislation to encourage 
the introduction of covered bonds into the U.S. mortgage market one 
more time.
    The history of covered mortgage bonds in the U.S. is messy. It 
spans the farm and nonfarm residential mortgage market, State and 
Federal regulatory structures and fundamental changes in mortgage 
contract design--all during a seven-decade period which saw three 
mortgage crises, including the most severe one in the 1930s. Before 
venturing more deeply into this chronology, a brief summary of its 
highlights and the lessons that I have drawn from it will be useful.
    I divide the historical record into two parts. The first lies 
between 1870 and 1900 when covered mortgage bonds were introduced into 
the U.S. without the regulatory framework that was used in Europe. The 
covered mortgage bond had its greatest success during this period when 
western farm mortgage companies that normally brokered whole mortgage 
loans began to issue bonds secured by the mortgages instead of selling 
the loans outright. I have examined one of these companies in depth and 
found that the loans it placed behind its covered bonds were riskier 
than those that it brokered. That result appears to contradict the 
generalization that underwriting standards are strict inside a covered 
mortgage bond structure; but in this case the issuer could shift risk 
between two mortgage funding channels because of ineffective 
regulation. A more obvious lesson can be drawn from the way these 
companies failed during the general farm mortgage crisis of the 1890s. 
Serious malfeasance occurred throughout the covered mortgage bond 
sector during the crisis because there was no regulation in place to 
control the behavior of the mortgage companies after their financial 
capital dissipated. These failures affected the reputation of covered 
mortgage bond programs in the U.S. for decades.
    The Federal Government takes center stage in the history of covered 
mortgage bonds between 1900 and 1935. Your predecessors in the 63rd and 
64th Congresses benefited from an extensive investigation of covered 
mortgage bond systems in Europe before creating the Federal Farm Loan 
Bank System in 1916. This system was comprised of both public and 
private institutions, and both relied on covered bonds to fund 
mortgages. The privately financed, joint-stock land bank component 
within the system was structured and regulated just like institutions 
in Germany which led private farm mortgage companies to oppose and 
avoid the system because of the restrictions it imposed on activities 
that were standard practice in the U.S. farm mortgage market. Twenty 
years later the 73rd Congress authorized the creation of a privately 
financed, federally regulated covered residential mortgage bond program 
to provide a liquid market for the new FHA-insured mortgage loans. No 
private institution was ever chartered under this authority, and the 
discussion about introducing covered mortgage bonds to the U.S. went 
silent for decades.
    In the final section of my testimony I provide an overview of the 
development of the institutional residential mortgage market over the 
past century to provide perspective on how the introduction of covered 
mortgage bonds at this time fits into its long-run pattern of 
development. I close this introduction, however, by summarizing three 
lessons I draw from the historical record:

  1.  Past failures of covered mortgage bonds in the U.S. are explained 
        by a combination of bad timing, poor implementation, and 
        ineffective regulation. We need to do a better job of 
        incorporating covered bonds into the U.S. mortgage market, 
        rather than abandon the effort.

  2.  A common failure in past attempts was to transplant elements of 
        European covered mortgage bond systems without tailoring them 
        to fit U.S. institutions. We need to identify features of the 
        U.S. mortgage market that could be incompatible with European 
        covered mortgage bond practice while, rather than after, 
        regulation is being formulated.

  3.  Finally, history gives us a clear bottom line in this case. If it 
        had been easy to incorporate covered bonds into the U.S. 
        mortgage market, we would have already done so.
Unregulated Early Experiments With Covered Mortgage Bonds
    By the mid-1800s covered farm mortgage bonds were trading in Europe 
in broad and active secondary markets with yields as low as those on 
Government securities. These bonds were issued by mutually owned 
institutions (Landschaften) and privately owned, joint-stock mortgage 
banks in Germany, and by a national monopoly bank (the Credit Foncier) 
in France. The success of these programs attracted attention in the 
U.S. where the focus in the mortgage market during the late nineteenth 
century was on the spatial mismatch of mortgage credit between savings-
rich, eastern urban areas and rapidly growing, capital-hungry areas in 
the Midwest and Great Plains (Davis, 1965). Several innovations 
appeared between 1870 and 1900 to facilitate the movement of mortgage 
credit from east to west to arbitrage the substantial differentials in 
mortgage rates that had appeared. Among these were attempts to 
establish covered mortgage bond programs patterned after European 
models, but not subject to the same strict regulatory oversight.
    Henry Villard, who was German-born and traveled in Europe as a 
journalist, is given credit for initially advocating for the 
importation of the European mortgage system into the U.S. in the late 
1860s (Herrick and Ingalls, 1915, 1-2). Villard's attempts to establish 
a mortgage bank failed, but in 1871 Pierpont Morgan and other respected 
American and European investment bankers organized a trust under New 
York law to implement a European-style covered mortgage bond business. 
The New York board of the U.S. Mortgage Company was charged with the 
task of assembling pools of high-yielding western mortgages, while the 
European board took charge of marketing and selling the covered bonds 
in their home markets (See, Brewer, 1976). \1\ The focus on continental 
markets led the firm to adopt the norms and even some of the language 
of European systems: outstanding bonds could not exceed 20 times paid-
in capital and had to be fully secured by mortgages on improved farm 
and urban properties with low loan-to-value ratios. \2\ The company was 
incorporated as a trust which meant that its covered mortgage business 
was virtually unregulated relative to European standards. U.S. Mortgage 
issued securities successfully for 2 years, but its growth was soon cut 
short by the Panic and recession of 1873. The company never defaulted 
on its bonds, but gradually wound down its covered mortgage bond 
business because marketing western mortgage loans turned out to be too 
risky and time-consuming to command the attention and risk the 
reputation of its high-profile organizers (Brewer 1976, 380).
---------------------------------------------------------------------------
     \1\ Brewer (1976, 373-380) also examines the mortgage bond 
business of the Mercantile Trust Company of New York, a subsidiary of 
the Equitable Insurance Company.
     \2\ Brewer (1976, 363) provides a fuller description of the 
bylaws. Brewer (373-380) also examines the mortgage bond business 
during the 1870s of the Mercantile Trust Company of New York, a 
subsidiary of the Equitable Insurance Company. Mercantile acted as 
custodian and guarantor of bonds issued against mortgages that it had 
taken off of its own books. These, and similar structures discussed 
below that were issued in the 1920s are classified here as 
securitizations, not as covered bonds.
---------------------------------------------------------------------------
    Western farm mortgage companies, unlike U.S. Mortgage, were 
intimately involved in the western farm mortgage market and much more 
successful, at least at first, in establishing covered-bond programs. 
Hundreds of these mortgage companies were organized in the Midwest and 
Great Plains during the 1860s and 1870s to broker and service 
individual whole farm mortgage loans for eastern and European 
investors. In the early 1880s several of these companies began to place 
whole mortgages that they had originated into eastern trust accounts 
and to issue covered bonds, then called debentures, against this 
collateral. The innovation enjoyed immediate popularity, and by 1890 
two-thirds of the western mortgage companies that were licensed to 
operate in New York and Massachusetts were selling their own covered 
mortgage bonds. By that time the new securities were funding about one-
tenth of outstanding western farm mortgage debt.
    Investors were attracted to covered bonds because they offered less 
idiosyncratic lending risk and lower transaction costs than the 
brokered whole farm loans that the companies had been selling up to 
that time. In order to issue the bonds, however, the mortgage company 
had to issue its own debt obligations that exposed it to risk that 
brokerage did not impose. \3\ Starting a debenture program also 
entailed the costs of incorporating the company and formulating a trust 
arrangement, most often with an eastern trust company. The trustee was 
required to evaluate mortgage loans designated for the trust account 
against criteria the company itself specified--they usually required 
mortgages written for no more than 40 or 50 percent of the value of the 
encumbered property. Debentures were issued and sold only after the 
trustee had certified the collateral. The trustee was also obligated to 
take control of the assigned mortgage loans on the behalf of the 
bondholders if the company defaulted on its obligations to them.
---------------------------------------------------------------------------
     \3\ The companies sold brokered loans with recourse, but the 
promise to buy back loans was not a formal, legal obligations as the 
companies could and did suspend recourse when in distress.
---------------------------------------------------------------------------
    An interesting feature of the farm mortgage bond movement is that 
it provided investors with less information about mortgage loan quality 
than the brokered loan business it was intended to supplant. \4\ In 
this environment investors who bought covered bonds could have relied 
on three mechanisms to assure that the bonds were well-secured: the 
trust arrangement through which debentures were issued, supervision by 
State regulatory authorities, and the mortgage company's own incentive 
to uphold underwriting standards in order to protect its own financial 
and reputational capital. Regulation and trust arrangements provided no 
effective hands-on supervision, however, so investors relied most 
heavily on the mortgage company's own ``skin in the game.'' \5\ This 
helps to explain why the debenture movement did not appear until the 
1880s after some of the mortgage companies had become large enough and 
sufficiently well-capitalized in their brokerage businesses to credibly 
issue their own securities. \6\ It also explains why not all western 
mortgage companies issued debentures; I have recently found that 
debentures were most likely to be adopted, and to be used more 
intensively, by older, larger companies with strong balance sheets and 
successful records of performance as mortgage brokers.
---------------------------------------------------------------------------
     \4\ Mortgage companies assigned loans to investors and then mailed 
applications and documents for investor approval. Loans that investors 
rejected had to be reassigned to another investor.
     \5\ Regulation came too late to be effective as western mortgage 
companies operating in Connecticut, New York and Massachusetts were not 
required to report even basic financial data to investors until 1889--
years after the debenture movement began to expand rapidly. Even at 
this point the information was self-reported and the companies were not 
subject to on-sight examinations.(New York, Annual Report (1891), pp. 
15-27.) The trustees who administered debenture programs for the 
mortgage companies were also did not monitor their western lending 
operations.
     \6\ The discussion here is summarizes evidence reported in Snowden 
(2010b).
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    A second interesting feature of these covered bonds is that all of 
the companies that issued debentures continued to broker loans. 
Mortgage companies that operated these mixed brokerage-debenture 
businesses, therefore, had to allocate mortgage loans between the two 
funding channels. I recently examined how that allocation was made in 
1887 in one large and highly respected Kansas mortgage company. The 
evidence shows that the loans placed behind the covered bonds were 
smaller in size, shorter in term and riskier than those that the 
company brokered. By packaging these types of loans behind covered 
bonds the mortgage companies improved the efficiency of the 
interregional mortgage market by creating a funding mechanism for loans 
that were difficult and costly to broker. This result provides an 
interesting counterexample to the generalization that the issuer's 
``skin in the game'' in a covered-bond structure necessarily leads to 
stricter underwriting standards. It also indicates that combining a 
covered mortgage bond program with another mortgage funding channel can 
create incentives to shift risks among the two. \7\
---------------------------------------------------------------------------
     \7\ Some of the western mortgage companies placed into trust 
mortgages written to their employees on property the company had 
acquired after buying back defaulted brokered loans.
---------------------------------------------------------------------------
    A third interesting feature of the farm debenture movement is its 
spectacular failure in the 1890s. The backdrop was a general farm 
mortgage crisis that generated substantial losses for farmers, 
investors and intermediaries in the western mortgage market. It was not 
surprising, therefore, that virtually all of the mortgage companies 
that had issued covered bonds, as well as most of the brokerage-only 
operations, failed. Many investors were shocked, however, when audits 
of the failed mortgage companies by eastern regulators found evidence 
of widespread and egregious violations of the company's own trust 
agreements within their covered mortgage bond programs. \8\ The 
problem, of course, was that the incentives of the mortgage companies 
changed dramatically once the financial capital that supported their 
debenture programs had been exhausted in the broader mortgage crisis. 
Investors learned the hard way in the 1890s that the ``skin-in-the-
game'' that promotes diligence within a covered-bond structure is not 
the mortgage loans on the issuer's balance sheet, but the value of its 
capital.
---------------------------------------------------------------------------
     \8\ For accounts of similar abuses by other mortgage companies see 
New York (Annual Report (1891), pp. 16-19). Snowden (1995, pp. 279-281) 
summarizes regulators' findings and criticisms of both operating and 
failed farm mortgage debenture companies.
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Federal Sponsorship of Covered-Bond Programs
The Federal Farm Loan Bank System
    The spectacular failure of the covered-bond programs of the western 
mortgage companies was remembered for decades as a cautionary tale. It 
also left a void in the market for farm mortgages that was filled by a 
new generation of mortgage companies that relied exclusively on the old 
system of loan brokerage. The typical farm mortgage contract at the 
time was a balloon loan with a term of 3 to 5 years that the borrower 
had to renew one or more times before extinguishing the debt. Between 
1908 and 1912 a ``Rural Credits Movement'' called for Federal 
intervention into the mortgage market so that farmers in the U.S. could 
benefit from the same type of long-term, low-cost amortized mortgage 
loans that had been written for decades within European covered-bond 
systems (Herrick and Ingalls, 1915a). The movement grew strong enough 
to pressure President Taft and the Congress to create a commission to 
investigate European mortgage banking systems and to make 
recommendations for a publicly sponsored covered farm mortgage bond 
system. The commission reported back to a joint hearing before the 
Banking Subcommittees of the Senate and the House in 1914, and that 
testimony provides an exhaustive discussion of covered mortgage bond 
practices as it existed at that time in Europe (United States, 1914).
    A heated debate arose about which one of several European models 
would be most appropriate in this country--a quasi-public monopoly bank 
like the Credit Foncier, a cooperative land credit system along the 
lines of the German Landschaften, or a regulated system of private 
joint-stock mortgage banks. The compromise that took shape in the 
Federal Farm Loan Act of 1916 was a mixed model that included a 
publicly sponsored cooperative mortgage lending system alongside a 
federally chartered system of private joint-stock mortgage banks. Both 
systems were to issue covered mortgage bonds under the supervision of 
the Federal Farm Loan Bank Board.
    The public, cooperative system was two-tiered. The foundation of 
the system was locally based, voluntary cooperatives that were 
authorized to make loans to members of the association that met 
underwriting standards established by the Federal Farm Loan Board. 
These included a maximum loan-to-value ratio of 50 percent, a term of 
30 years, and full amortization with privilege to prepay. After the 
loans were made they were sent to one of twelve district Federal Land 
Banks for approval after which Federal Land Bank Bonds could be issued 
in equal amounts. The bonds were the joint liability of the Land Banks 
and the Farm Loan Associations in a structure similar to the German 
Landschaften.
    We are more interested here in the privately financed Federal 
Joint-Stock Land Banks authorized under the legislation because they 
shared several features with covered mortgage bond models being 
considered today. The joint-stock bank charter was designed to attract 
private lending agencies so that they could issue regulated covered 
mortgage bonds rather than broker or hold farm mortgage loans. To enter 
the system the owners had to satisfy the minimum capital requirement of 
$250,000 and operate under strict regulation borrowed from the German 
private mortgage bank model (Horton, et al., 1941). Each bank could 
issue bonds in a volume no greater than 15 times their capital if they 
were fully secured by long-term, amortized mortgage loans that met the 
same underwriting standards that were set for the cooperative farm loan 
associations. Examiners of the district Farm Loan Bank served as the 
pool monitors in these structures and examined and registered each loan 
that was approved as collateral. Each joint-stock bank was fully liable 
to its bondholders, and enjoyed no implicit or explicit Government 
guarantee. Private rating agencies graded the bonds of each joint-stock 
bank separately.
    The joint-stock bank system was designed to draw in existing 
private farm lenders, especially farm mortgage companies. But the 
mortgage companies, instead, ended up opposing the Federal system 
before and even after it had been passed. \9\ The companies were not 
opposed to covered mortgage bonds, but they argued that joining the 
system would force them to abandon important elements of their existing 
business because of specific requirements of the charter. These 
included a restriction to lend only in the State in which the bank was 
located and one more contiguous to it, the prohibition on selling loans 
with recourse, which would have eliminated their brokerage businesses, 
and a requirement to write only long-term amortized loans so that they 
could not deal in the standard short-term, balloon loan (Schwartz, 
1938, 21-22). The final bill contained none of the modifications 
suggested by the mortgage companies. In response they then raised 
objection to another feature of the bill--the bonds of both the Federal 
District Land Banks and the privately owned joint-stock banks were 
fully exempt from Federal taxes. The companies pursued the issue after 
the bill had passed, and their challenge regarding the 
constitutionality of the tax exemption led to legal proceedings that 
lasted until 1921 and that retarded the early growth of the system. 
\10\
---------------------------------------------------------------------------
     \9\ The opposition to the Federal Farm Bill actually led to the 
formation of the Farm Mortgage Bankers Association--the precursor to 
the modern Mortgage Bankers Association (Robins, 1916).
     \10\ O'Hara (1983) argues that the FHLB tax exemption diverted 
credit into agriculture and made it more difficult for tenant farmers 
to purchase land, one of the system's intended goals, by capitalizing 
the subsidy in higher farm land prices.
---------------------------------------------------------------------------
    Eighty-eight of the privately owned Federal Joint-Stock Land Banks 
were ultimately chartered under these provisions, most of them before 
1925. From then on the banks began to experience difficulties because 
of general distress in American agriculture, and the system was 
particularly shaken when three of the joint-stock banks entered 
receivership in 1927. Once the Depression took hold the Treasury 
provided relief so that the District Farm Land Banks could manage and 
supervise the joint-stock banks that were forced to liquidate. 
Emergency farm mortgage relief legislation that was passed in 1933 
placed the remaining joint-stock banks in liquidation and prohibited 
the establishment of any additional institutions. The six-decade 
experiment in the U.S. with privately financed, European-style covered 
farm mortgage bonds had ended.
A Covered Mortgage Bond System for the Residential Market?
    With the establishment of the Federal Farm Loan Act proposals soon 
appeared for the creation of a central residential mortgage bank. The 
discussion began in 1919, but took more than a decade to resolve. In 
1929 the Brookings Institute produced an assessment of ``First 
Mortgages in Urban Real Estate Finance'' (Gray and Terborgh, 1929). The 
report focused on the stubborn disparity in mortgage rates across 
regions despite the interregional activities of life insurance 
companies, real estate bond houses and the mortgage guarantee companies 
during the 1920s. The recommendation, therefore, was to establish a 
public, European-style central mortgage bank--similar to the Federal 
Farm Loan Bank system--that could place pools of nonfarm residential 
mortgages made by local originators behind covered mortgage bonds.
    By 1931, when President Hoover convened a conference on home 
building and ownership in the midst of the growing mortgage crisis, it 
had become clear that a liquidity facility for residential mortgage 
lenders would soon be created under one of three proposals (Jones and 
Grebler 1961, 113-114). The National Association of Real Estate 
Builders supported a Federal system of mortgage banks and joint-stock 
banks similar to the one recommended by the Brookings Institute. The 
Hoover administration favored a Federal facility that could discount 
mortgages for a wide variety of approved mortgage lenders. The U.S. 
Building and Loan League favored the most restrictive plan, a home loan 
discount bank for only its members. Its proposal was adopted when the 
Federal Home Loan Bank System was established in 1932 to serve what 
would become the modern S&L industry.
    The possibility of a federally sponsored covered-bond mortgage 
system was revisited when provisions to create the Federal Housing 
Administration and its mortgage loan insurance program were proposed in 
the National Housing Act of 1934. Although FHA loans were insured by 
the Federal Government, there was considerable doubt whether private 
lenders would be willing to invest and hold any long-term, amortized 
mortgage loan. To encourage participation in the FHA program, Title III 
of the National Housing Act authorized the FHA to charter privately 
owned facilities that could provide liquidity for FHA mortgages by 
issuing covered mortgage bonds that used the loans as collateral. This 
provision of the bill generated attracted strong objections from the 
United States Building & Loan League and life insurance companies 
(United States, 1934a and 1934b). \11\ Both groups had reason to be 
concerned about the potential entrance of a new mortgage lending 
facility, but their testimony focused as well on the unhappy events 
associated with the farm mortgage debenture debacle of the 1890s and 
the ongoing liquidation of the joint-stock farm land bank system. 
Others witnesses doubted that private capital would be forthcoming 
given that the housing sector was at the lowest point of the crisis.
---------------------------------------------------------------------------
     \11\ The FHA insurance program took up much more of the hearing 
than any testimony on the National Mortgage Association.
---------------------------------------------------------------------------
    Despite the opposition, Title III of the National Housing Act 
authorized the creation of a system of privately owned, federally 
chartered National Mortgage Associations to buy and sell FHA loans from 
mortgage originators. These associations were to be locally based 
institutions that would buy, hold and sell FHA loans (See, Jones and 
Grebler 1961, 115-119). The legislation did not limit the number or 
regional distribution of the associations, but required a minimum paid-
in capital of $5 million. The bonds issued by an association had to be 
secured by FHA-insured loans, cash or Federal Government securities, 
and the total volume of its bonds could not exceed 10 times paid-in 
capital. By 1937 not one National Mortgage Association had been 
organized despite modifications to the original legislation designed to 
attract private investors (Jones, 1961, 116).
    In order to demonstrate the viability of the proposed system the 
Federal Housing Administrator authorized the Reconstruction Finance 
Corporation to sponsor the National Mortgage Association of Washington 
in February 1938. It was soon renamed the Federal National Mortgage 
Association and its first issue of $25 million of debentures was 
heavily oversubscribed. Despite the success of this experiment, the FHA 
announced in May that it would no longer process applications for 
private National Mortgage Association charters so that not one 
privately owned institution was chartered under Title II of the 
National Housing Act. \12\ The FNMA went on, however, to create a 
secondary market for FHA loans and, somewhat later, VA guaranteed 
loans. What had been abandoned, however, were plans to create a 
federally chartered, private system of institutions that could issue 
covered residential mortgage bonds.
---------------------------------------------------------------------------
     \12\ The New York Times, May 28, 1938, reported that applications 
for new NMAs increased after FNMA's successful bond offering, but that 
with the FHA decision ``private interests planning to take advantage of 
this potential market . . . appear doomed to disappointment or at least 
considerable delay.'' p. 25. Jones and Grebler (1961, p. 115) refer to 
the NMA proposal as a ``frustrating episode.''
---------------------------------------------------------------------------
Covered Bonds and the Long-Run Development of the Market
    Although most of our experience with covered bonds took place in 
the farm mortgage market, we end by focusing on the Nation's nonfarm 
residential mortgage because it is there that the introduction of 
covered mortgage bonds in the U.S. today are most likely to affect the 
long-run development of the mortgage market. Figure 1 provides a view 
of changes in the structure of that market over the past century.
    The turmoil of the past decade pales in comparison to events in the 
residential mortgage market during the 1920s and 1930s. The volume of 
nonfarm residential mortgage debt tripled during the home building boom 
of the 1920s and financed an increase in the rate of nonfarm 
homeownership from 41 to 46 percent. The noteworthy structural change 
in the mortgage market during the decade was the rapid growth of two 
forms of privately issued real estate securities that by 1929 funded 
nearly 10 percent of Nation's outstanding residential mortgage debt. 
These innovations--single-property real estate bonds and participation 
certificates issued by mortgage guarantee companies--financed 
commercial as well as residential development in the Nation's largest 
urban areas and were primarily directed toward the individual investor 
who played a much larger role in the residential market at that time. 
Both of these securities were early forms of off-balance-sheet 
securitization and were not covered mortgage bonds. \13\
---------------------------------------------------------------------------
     \13\ See, Goetzmann and Newman (2010) and Snowden (2010a) for 
discussions of both instruments.
---------------------------------------------------------------------------
    During the 1930s the U.S. experienced record levels of nonfarm 
foreclosures, widespread distress among mortgage lenders, a collapse 
and weak recovery in homebuilding, large decreases in home values and a 
complete reversal of the gains in homeownership made during the 1920s. 
Against this backdrop the Home Owners' Loan Corporation had a sudden 
and large impact on the structure of the residential mortgage market 
(refer to Figure 1). Between 1933 and 1936 this Federal agency operated 
as both a ``bad mortgage bank'' (by purchasing distressed mortgages 
from private lenders) and a loan modification program (by refinancing 
the mortgages with long-term, high-leverage, amortized loans). In three 
short years it had refinanced mortgages on one out of every 10 owner-
occupied homes and held nearly 10 percent of the Nation's home mortgage 
debt. HOLC's lending activities ended in 1936 after which the agency 
existed another 15 years to service its mortgage portfolio. \14\
---------------------------------------------------------------------------
     \14\ HOLC is currently drawing substantial attention in the 
academic literature. See, Fishback et al. (2010), Rose (2010), and 
Courtemanche and Snowden (2010).
---------------------------------------------------------------------------
    A second striking change in market structure during the 1930s was 
the disappearance of the private securitization structures that had 
grown so rapidly during the previous decade. Although the decline in 
the share of private real estate securities looks gradual in Figure 1, 
the actual process was not. Nearly all of the real estate bond houses 
and mortgage guarantee companies that had issued real estate securities 
during the 1920s failed during the early 1930s. From this point on 
investors holding these securities went through complicated and 
protracted proceedings in order to liquidate the underlying mortgage 
assets. Some of these resolutions took more than a decade during which 
State authorities had to act as receivers and modifications of State 
and Federal law were required to help resolve conflicts among the 
parties who owned the loans. The failures of these securitization 
structures were so widespread, complex, and costly that private 
mortgage insurance and privately sponsored securitization disappeared 
entirely from the U.S. residential mortgage market for decades.
    As we have seen earlier, the prospects for a covered residential 
mortgage bond system in the U.S. also diminished severely in the 1930s. 
But traditional portfolio mortgage lenders sought and received several 
regulatory interventions during the decade that strengthened their 
mortgage lending operations. The Building & Loan industry, which had 
been the Nation's largest source of home mortgages before 1930, was 
transformed into the modern Savings & Loan sector with the creation of 
the Federal Home Loan Bank System's discounting facility in 1932, a new 
system of Federal S&L charters, and an insurance program for S&L share 
accounts. A second important development was the creation in 1934 of 
the FHA mortgage loan insurance program that was discussed above. 
Although the companion covered mortgage bond system authorized by the 
legislation never materialized, FHA loans became important to the 
lending activities of mortgage companies, commercial banks, mutual 
savings banks and life insurance companies--none of which participated 
in the FHLB system. After the Federal National Mortgage Association was 
established to serve as a dedicated secondary market facility for FHA 
loans in 1938, therefore, all of the traditional mortgage portfolio 
lenders were supported by new Federal structures.
    Traditional portfolio lenders performed well within their new 
Federal structures during the immediate post-World War II period. The 
S&L industry focused on local mortgage markets and small-scale 
builders; commercial banks and mortgage companies used FHA and VA loans 
to finance large tract builders and multifamily projects; and life 
insurance companies and mutual savings banks used insured and 
guaranteed loans to serve the interregional residential mortgage market 
through networks of closely affiliated mortgage companies. With all of 
this activity supported by the FHLB and FNMA secondary market 
facilities, the share of the Nation's residential mortgage debt that 
was held by the portfolio lenders swelled to 80 percent and financed a 
historic surge in homebuilding and homeownership during the 1950s and 
early 1960s (See, Figure 1).
    Despite the accomplishments, there were several disadvantages 
associated with relying so heavily on portfolio lenders. Strict 
regulatory boundaries, for example, limited competition and discouraged 
innovation. The more telling weakness, however, was the inability of 
portfolio lenders to profitably underwrite the risks of funding long-
term, fixed-rate mortgages when nominal interest rates, driven by 
inflation, became variable around high levels in the 1970s. 
Institutions that relied on short-run deposits were particularly 
vulnerable, but even the life insurance companies, which had been 
successful farm and residential mortgage lenders for more than a 
century, dramatically reduced their portfolio of residential mortgage 
loans. It took more than a decade, and a full-blown thrift crisis, for 
the depression-era S&L industry to do the same.
    Securitization reappeared in the U.S. in the 1970s to supplant the 
failing mortgage system that had been forged during the 1930s mortgage 
crisis. Securitization was not sponsored this time by private entities, 
as it had been in the 1920s, but by a Federal agency (Ginnie Mae) and 
federally sponsored GSEs (Fannie Mae and Freddie Mac) that had been 
carved out of the FHLB and FNMA secondary market facilities that had 
been created four decades earlier to support portfolio lenders. Agency- 
and GSE-sponsored securitization made modest inroads at first, but 
captured virtually all of the mortgage business lost by insurance 
companies and savings institutions during the 1980s.
    During this period private agencies began to repackage the cash-
flows from federally sponsored mortgage securities in order to offer 
investors other securities that offered different exposures to the 
prepayment and interest rate risks that had proven to be so troublesome 
for portfolio lenders. The trajectory and composition of securitization 
then changed in the 1990s, however, as the GSEs began to hold large 
volumes of mortgages and securities within their own portfolios, and 
private issuers began to securitize mortgage pools that contained the 
types of loans that the GSEs, at least at first, would not. We continue 
to debate the role that the GSEs played in our recent crisis, and 
changes in their structure and mission are sure to play a decisive role 
in the future development of the residential mortgage market.
    But the topic of this hearing is the potential role that covered 
bonds will play in the future, and the chronology we have just reviewed 
reveals some striking similarities between the decisions Congress faces 
now and the ones that it confronted in the 1930s. Then, like now, it 
was responding to a mortgage crisis which had brought into focus severe 
problems with the private securitization structures that had grown so 
rapidly in the previous decade. Then, like now, it considered 
establishing a covered mortgage bond market to serve as a new funding 
channel for a housing market in distress. The legislation authorizing a 
covered mortgage bond system passed in the 1930s, but the system failed 
to materialize. What followed is the pattern of development and chain 
of events that has brought us here today. I hope that recounting this 
history provides some assistance to the Committee as it helps to shape 
the next chapter.
References
Brewer, H. Peers (1975). ``Eastern Money and Western Mortgages in the 
    1870s'', Business History Review, 50, 356-380.
Courtemanche, Charles, and Kenneth Snowden (forthcoming). ``Repairing a 
    Mortgage Crisis: HOLC Lending and Its Impact on Local Housing 
    Markets'', National Bureau of Economic Research WP 16245, July 
    2010.
Davis, Lance (1965). ``The Investment Market, 1870-1914: The Evolution 
    of a National Market'', Journal of Economic History, 25 (2), 355-
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Fishback, Price, Shawn Kantor, Alfonso Flores-Lagunes, William Horrace, 
    and Jaret Treber (forthcoming). ``The Influence of the Home Owners' 
    Loan Corporation on Housing Markets During the 1930s'', Review of 
    Financial Studies, National Bureau of Economic Research WP 15824, 
    March 2010.
Frederiksen, D.M. (1894a). ``Mortgage Banking'', Journal of Political 
    Economy 2, 210-221.
Frederiksen, D.M. (1894b). ``Mortgage Banks in Germany'', Quarterly 
    Journal of Economics 9, 47-76.
Goetzmann, William N., and Frank Newman (2010). ``Securitization in the 
    1920s'', National Bureau of Economic Research WP 15650, January 
    2010.
Gray, John H., and George W. Terbough (1929). ``First Mortgages in 
    Urban Real Estate'', The Brookings Institute Pamphlet Series, 1 
    (2).
Herrick, Myron, and R. Ingalls (1915a). Rural Credits. New York: D. 
    Appleton.
Herrick, Myron, and R. Ingalls (1915b). ``How to Finance the Farmer: 
    Private Enterprise--Not Public Aid'', Ohio State Committee on Rural 
    Credits, Cincinnati.
Horton, Donald, H. Larsen, and N. Wall (1942). ``Farm Mortgage Credit 
    Facilities in the United States'', Miscellaneous Publication No. 
    478, USDA.
Jones, Oliver, and Leo Grebler (1961). ``The Secondary Mortgage 
    Market'', Los Angeles: UCLA
New York (1891-97). Annual Report of the Superintendent of Banks 
    Relative to Foreign Mortgage, Loan, or Investment Companies.
O'Hara, Maureen (1983). ``Tax Exempt Financing'', Journal of Money, 
    Credit and Banking 15, 425-441.
Palyi, Melchior (1934). ``Principles of Mortgage Banking Regulation in 
    Europe'', Journal of Business: Studies in Business Administration 
    V. 1-37.
Preston, Howard (1921). ``The Federal Farm Loan Case'', Journal of 
    Political Economy, Vol. 29, No. 6, pp. 433-454.
Rose, Jonathan (2010). ``The Incredible HOLC? Mortgage Relief During 
    the Great Depression'', Unpublished Working Paper, April.
Schwartz, Carl Herbert (1938). Financial Study of the Joint Stock Land 
    Banks. Washington, DC: Washington College Press.
Snowden, Kenneth (1995). ``Mortgage Securitization in the U.S.: 20th 
    Century Developments in Historical Perspective'', in M. Bordo and 
    R. Sylla (eds.), Anglo-American Financial Systems, New York: Irwin, 
    261-298.
Snowden, Kenneth (forthcoming). ``The Anatomy of a Residential Mortgage 
    Crisis: A Look Back to the 1930s'', in L. Mitchell and A.E. 
    Wilmarth (ed.), The Panic of 2008: Causes, Consequences and 
    Proposals for Reform. Northampton, MA, Edward Elgar Publishing. 
    National Bureau of Economic Research Working Paper #16244, July 
    2010a.
Snowden, Kenneth (forthcoming). ``Covered Farm Mortgage Bonds in the 
    Late Nineteenth Century U.S.'', Journal of Economic History. 
    National Bureau of Economic Research WP #16242, July 2010b.
United States (1914). Rural Credits Joint Hearings before the 
    Subcommittees of the Committees on Banking and Currency of the 
    Senate and of the House of Representatives, Charged with the 
    Investigation of Rural Credits, Sixty-Third Congress, Second 
    Session. Washington: GPO.
United States (1934a). National Housing Act: Hearing Before the 
    Subcommittee on Housing of the Committee on Banking and Currency, 
    House of Representatives, Seventy-Third Congress, second session, 
    on H. R. 9620. May 18, 25, 26, 28, 29, 30, 31, June 1, 2, 4, 1934. 
    Washington: GPO.
United States (1934b). National Housing Act: Hearings Before the 
    Committee on Banking and Currency, United States Senate, Seventy-
    Third Congress, second session, on S. 3603. May 16-24, 1934. 
    Washington: GPO.
    
    
                    PREPARED STATEMENT OF RIC CAMPO
Chairman and Chief Executive Officer, Camden Property Trust, on behalf 
     of National Multi Housing Council and the National Apartment 
                              Association
                           September 15, 2010
    Chairman Dodd, Ranking Member Shelby, and distinguished Members of 
the Committee, I am Ric Campo, Chairman and CEO of Camden Property 
Trust, a publicly held apartment firm.
    I am the immediate past Chairman of the National Multi Housing 
Council (NMHC) and am testifying today on behalf of NMHC and its joint 
legislative partner, the National Apartment Association (NAA).
    Camden Property Trust is an S&P 400 Company and one of the largest 
publicly traded multifamily companies in the United States. Structured 
as a Real Estate Investment Trust (REIT), our company owns, develops, 
acquires and manages multifamily residential apartment communities. We 
are headquartered in Houston, TX, and currently operate 187 properties 
containing 64,074 apartment homes. Our workforce totals nearly 1,800 
employees.
    NMHC and NAA represent the Nation's leading apartment firms. Our 
combined memberships are engaged in all aspects of the industry, 
including ownership, development, management and finance. NMHC 
represents the principal officers of the industry's largest and most 
prominent firms. NAA is the largest national federation of State and 
local apartment associations with 170 State and local affiliates 
comprised of more than 50,000 members. Together they represent just 
under 6 million apartment homes.
    We applaud the Senate Banking Committee for exploring alternative 
sources of capital to support housing. We believe that covered bonds 
could indeed provide some degree of additional liquidity to U.S. 
multifamily finance. We caution, however, that it is quite unlikely 
that covered bonds could provide the capacity, flexibility or pricing 
superiority necessary to adequately replace any of the U.S.'s 
traditional sources of multifamily mortgage credit.
    I am not here today as an expert on covered bonds. Rather, I am 
hoping to provide you with some background on the apartment sector, its 
general credit needs and to share some insights into what role covered 
bonds could play in meeting those needs.
    To understand the role or impact covered bonds might have on the 
apartment industry's access to credit, it is necessary first to have a 
broad understanding of the apartment industry's current capital 
sources--both before and during the crisis.
    One-third of American households rent, and over 14 percent of 
households--16.7 million households--live in a rental apartment 
(buildings with five or more units). Our industry's ability to meet the 
Nation's rental housing needs depends on reliable and sufficient 
sources of capital.
Multifamily Capital Markets and Industry Performance
    Since the onset of the financial meltdown, virtually all private 
mortgage lenders left the housing finance market, and the apartment 
industry has relied heavily on credit either insured or guaranteed by 
the Federal Government. Fully 8 out of 10 apartment loans issued in the 
first six months of 2010 had some form of Government credit behind 
them, namely FHA, Fannie Mae, or Freddie Mac. The FHA and Government 
Sponsored Enterprises (GSEs) are expected to account for 80-90 percent 
of the $50-$60 billion in credit provided to the apartment sector this 
year.
    Historically, however, the apartment industry has enjoyed access to 
mortgage credit from a variety of capital sources. In addition to the 
FHA and GSEs, banks and thrifts, life insurance companies, pension 
funds and the commercial mortgage-backed securities market have all 
provided significant amounts of mortgage capital to the apartment 
industry. Prior to the financial crisis, these capital sources provided 
our sector with $100-$150 billion annually, reaching as high as $225 
billion, to develop, refinance, purchase, renovate, and preserve 
apartment properties.
    These market sources have proven to be reliable and durable, with 
the exception of unique financial situations, such as the current 
economic crisis and the 1997-1998 Russian financial crisis.
    As of the first quarter of 2010, there was approximately $872 
billion in outstanding multifamily mortgage debt (See, Table 1). In 
recent years, the industry has shifted from relying on whole loans from 
banks and life insurance companies to securitized loans. Currently, 
just under half (49 percent) of outstanding multifamily capital is held 
in the secondary market (31 percent by the GSEs, 13 percent in CMBS and 
5 percent in Ginnie Mae.) Nevertheless, banks remain an important 
capital source, providing nearly one-quarter of the industry's mortgage 
capital.


    As policy makers consider the causes of, and solutions to, the 
single-family meltdown, it is important to distinguish between 
performance in the single-family sector and the multifamily sector. The 
multifamily industry did not overbuild in the housing boom.
    Table 2 below shows the stark contrast between the single-family 
housing production/bubble and resulting housing crisis and the 
relatively constant level of new production in the multifamily housing 
sector during the same period. Since the mid-1990s, the multifamily 
industry has started approximately 350,000-375,000 new units annually. 
During the same period, the single-family market almost doubled its 
production from around 1 million to 1.75 million units.


    The discipline shown by the apartment industry has translated into 
stronger portfolio performance as well. Overall loan performance in the 
$853 billion multifamily sector remains relatively healthy, with 
delinquencies and default rates only a fraction of those seen in 
single-family. The 90-day delinquency rate of multifamily loans is 
estimated to be 4.3 percent or $31 billion. Compared to the single-
family residential mortgage market where the mortgage debt outstanding 
is reported at $10.7 trillion as of March 30, 2010, and a 90-day 
delinquency rate of 9.2 percent or $984.4 billion.
    There has been some stress recorded in bank loans and CMBS, 
particularly those originated between 2006 and 2008 when more 
aggressive underwriting and higher leverage was employed. However, that 
stress is largely a result of the overall economy and the worst job 
market in 40 years and not due to oversupply.
    Many of those problematic loans were taken out to renovate and 
reposition existing properties. When property values plummeted and 
unemployment soared, those projects stalled and borrowers lost most of 
their equity. The problem is especially acute in some markets such as 
the boroughs of New York City and other major employment centers that 
have large concentrations of apartment properties.
    Nevertheless, many of these distressed loans will be resolved, and 
most apartment residents will not be affected by loan delinquencies or 
even defaults, as such situations generally result in a smooth 
transition to a new operating entity with sufficient capital to 
maintain the property.


Covered Bonds and the Multifamily Credit Market
    The current housing finance system has worked extremely well in 
providing liquidity to the apartment sector in all economic climates. 
That said, we welcome Congressional efforts to create a framework for 
covered bonds so they may serve as an additional source of capital for 
apartments. We do not believe, though, as some have suggested, that 
covered bonds can resolve the current financial crisis or prevent 
future crises that might require Government intervention.
    It is clear that covered bonds offer some advantages to issuers and 
investors. They give issuers access to lower-cost funding for mortgage 
and other asset-backed credit with more favorable risk-based capital 
requirements than whole loans held in their portfolio. For investors, 
they offer high credit quality, solid yield, low-risk and diversified 
investments. They also offer both issuer and investor the ability to 
substitute bond assets in the collateral pools if there is a problem 
with an individual loan or mortgage, thus reducing overall risk.
    My comments focus on the value of covered bonds to multifamily 
borrowers. Under the right conditions and circumstances, covered bonds 
could serve as an added credit option for our sector by augmenting 
banks' mortgage credit activity. Therefore, we support efforts to 
create the legal and regulatory oversight needed to foster the use of 
covered bonds by banks.
    For numerous reasons, though, it is quite unlikely that covered 
bonds could provide the capacity, flexibility or pricing superiority 
necessary to adequately replace the U.S.'s existing sources of 
multifamily mortgage credit.
    It is unclear whether covered bonds would actually increase the 
amount of credit banks would make available to apartment firms. The 
covered-bond structure limits issuer lending volumes by requiring them 
to hold loans on the issuer's balance sheet and retain capital reserves 
in case of losses. It is also possible that banks could simply replace 
some of their whole loans activities with covered bonds, which would 
not increase lending capacity except as it relates to how risk-based 
capital reserves are held by banks.
    Covered bonds could allow banks to compete with other credit 
sources such as life companies, thrifts, CMBS and GSEs because the loan 
term for covered bonds is longer (10-year terms) than the 5-year term 
banks typically provide. Even then, however, larger banks that are 
anticipated to be a major source of covered-bond issuance may choose 
not to issue covered loans for multifamily mortgages because many of 
these banks originate such mortgages for the GSEs or CMBS market and 
thereby avoid any balance sheet liability.
    It is also unclear to what extent banks would use covered bonds for 
multifamily lending since so many asset classes qualify for covered 
bonds. Legislation pending in the House of Representatives (H.R. 5823, 
``The United States Covered Bond Act of 2010'') would allow covered 
bonds to be used for single-family mortgages and equity loans, 
commercial and multifamily real estate mortgages, auto loans and 
leases, loans for public facilities and activities, student loans, 
small business loans and credit card and revolving credit loans to 
consumers. We question the capacity of covered bonds to meet the demand 
from all of these loan categories.
    In Europe, the majority of real estate-related covered-bond debt 
has been for public purposes and residential home mortgages. Unless 
there are allocations and diversification requirements for covered-bond 
issuers, we expect the U.S. experience would be similar, with most of 
the additional credit created by covered bonds directed to the 
residential mortgage market and other consumer and loan assets and not 
toward rental housing.
    It is also important to understand that the European experience 
with covered bonds for multifamily properties is not translatable to 
the U.S. In Europe, the rental markets operate on a condominium model 
comprised of small investors buying individual units and renting them 
out. For instance, in the United Kingdom, 73 percent of the rental 
stock is owned by ``mom-and-pop'' operators, and there is no 
institutional investment. There is little existing data or analysis 
determining to what degree European covered bonds actually finance 
commercially developed rental housing.
    In addition to these issues, it also remains unclear whether the 
covered-bond structure can become sufficiently flexible to accommodate 
broad-based, public-sector participation in the U.S. affordable-housing 
finance arena. For instance, a significant proportion of apartment 
production in recent decades has been financed through Low-Income 
Housing Tax Credit (LIHTC) equity investments and various structures of 
tax-exempt or otherwise subsidized bonded debt. These specialized loans 
may not be able to gain access to covered-bond credit capital.
    Likewise, questions remain about whether a purely private American 
covered-bond market could become a critical ``backstop'' capital source 
during periods of financial instability. While Europe's covered-bond 
market came to something of a standstill during the global financial 
crisis, in the U.S. the GSEs, Fannie Mae and Freddie Mac, remained a 
critical liquidity source in the domestic multifamily finance field. 
They have served this role during other capital market dislocations, 
including the Russian economic collapse in the late 1990s, which caused 
a collapse of the U.S. commercial mortgage conduit market, and during 
the 2001-2003 recession.
    Although the European covered-bond market remained liquid longer 
than many other wholesale funding markets, it was ultimately rendered 
dormant for several months during the last quarter of 2008. In the wake 
of Lehman Brothers' collapse in September 2008, the European covered-
bond market went without a public issuance until early 2009 and some 
jurisdictions have still not seen new issuance. The European Central 
Bank (ECB) reported earlier this year that the number of issuers has 
doubled since 2008 (from approximately 75 to 150 issuers). \1\ But this 
was fueled in large part by ECB-sponsored bond purchase programs to 
facilitate liquidity.
---------------------------------------------------------------------------
     \1\ European Central Bank Annual Report, p. 19.
---------------------------------------------------------------------------
    Despite some =60 billion ($76.6 billion) in ECB-sponsored purchase 
commitments, however, the return of liquidity appears to be limited. 
Covered bonds over the past few calendar quarters have traded at 
historically low volumes and at historically wide yield spreads over 
their relevant benchmarks.
    For all these reasons, we can only conclude that a covered-bond 
market might augment--but would not adequately replace--any of the 
active components of the U.S. multifamily finance marketplace, 
including ``conduit'' financing through mortgage-backed securities 
issued by the GSEs and private Wall Street firms, along with mortgages 
funded by life companies, banks and other balance sheet lenders.
Maintaining Credit Capacity for the Apartment Market
    The bursting of the housing bubble exposed serious flaws in our 
housing finance system. As policy makers undertake housing finance 
reform--including creating a framework for a U.S. covered-bonds 
market--we urge you to ensure that any actions taken are not done so at 
the expense of the much smaller and less understood, but vital, 
multifamily sector.
    Apartments are a critical component of the Nation's housing market, 
and our industry depends on a reliable, reasonably priced and readily 
available supply of credit to meet the Nation's growing demand for 
rental housing.
    The U.S. is on the cusp of fundamental changes in our housing 
dynamics. Changing demographics are causing a surge in rental demand 
that will continue long after the economic recovery. This includes 78 
million echo boomers entering the housing market, baby boomers 
downsizing and a dramatic decrease in the number of married couples 
with children to less than 22 percent of households.
    Between 2008 and 2015, nearly two-thirds of new households formed 
will be renters. That's 6 million new renter households. University of 
Utah Professor Arthur C. Nelson predicts that half of all new homes 
built between 2005 and 2030 will have to be rental units. The Harvard 
University Joint Center for Housing Studies estimates that we already 
have a shortage of some three million units of affordable rental 
housing.
    Our industry cannot meet the Nation's current or future housing 
needs--or refinance the approximately $200 billion in mortgage debt 
coming due over the next 2 years--without a fully functioning secondary 
mortgage market.
    For these reasons it is critically important to maintain the 
existing level of liquidity for the multifamily market, in good times 
and bad. The strong performance of the sector, thanks in large part to 
the robust capital markets supporting it, has attracted an enormous 
amount of private investment. These investors have supported the 
expansion of the industry and a marked improvement in its 
professionalism. It has made the production of millions of units of 
workforce and market-rate housing possible.
    For the past 50 years, the U.S. housing system has been the envy of 
the world in attracting private capital to meet our Nation's housing 
needs. As lawmakers look for added mortgage credit sources and redesign 
the secondary mortgage market, we urge them to retain the successful 
elements of our present system, specifically those which contributed to 
the strength of the multifamily market, and understand the inherent 
limitations of new capital sources, such as covered bonds.
Tomorrow's Housing Policy: New Principles
    I would also like to take a moment to address our national housing 
policy more broadly, as I feel that it underscores the importance of 
explicitly considering apartments in a reformed housing finance system.
    For decades, the Federal Government has pursued a ``homeownership 
at any cost'' housing policy, ignoring the growing disconnect between 
the country's housing needs and its housing policy. In the process, 
many people were enticed into houses they could not afford, which in 
turn helped fuel a housing bubble that ultimately burst and caused a 
global economic crisis.
    The Nation is now paying the price for that misguided policy and 
learning firsthand that there is such a thing as too much 
homeownership; that aggressively pushing homeownership was not only 
disastrous for the hardworking families lured into unsustainable 
ownership, but also for our local communities and our national economy.
    If there is a silver lining in this situation, it is the 
opportunity we now have to learn from our mistakes and rethink our 
housing policy. Housing our diverse Nation means having a vibrant 
rental market along with a functioning ownership market. It's time we 
adopt a balanced housing policy that doesn't measure success solely by 
how much homeownership there is.
    For many of America's most pressing challenges, from suburban 
sprawl to affordable housing, apartments are a much better solution. 
Apartments help create stronger and healthier communities by offering 
enough housing for the workers that businesses need, by reducing the 
cost of providing public services like water, sewer, and roads and by 
creating vibrant live/work/play neighborhoods.
    They will help us house our booming population without giving up 
all our green space and adding to pollution and traffic congestion. And 
they will help us reduce our greenhouse gas emissions by creating more 
compact communities that enable us to spend less time in our cars.
Elements of a Balanced Housing Policy
    NMHC and NAA have joined together to advocate for a more balanced 
housing policy, one that respects the rights of individuals to choose 
housing that best meets their financial and lifestyle needs. We urge 
policy makers at all levels of Government to work with the apartment 
industry to craft a smarter housing policy that:

    Assures that everyone has access to decent and affordable 
        housing, regardless of his or her housing choice;

    Respects the rights of individuals to choose the housing 
        that best meets their financial and lifestyle needs without 
        disadvantaging, financially or otherwise, those who choose 
        apartment living;

    Promotes healthy and livable communities by encouraging 
        responsible land use and promoting the production of all types 
        of housing;

    Recognizes that all decent housing, including apartments, 
        and all citizens, including renters, make positive economic, 
        political and social contributions to their communities; and

    Balances the expected benefits of regulations with their 
        costs to minimize the impact on housing affordability.

    In conclusion, our industry stands ready to meet the Nation's 
growing demand for rental housing. We would encourage lawmakers to 
support us in those efforts by helping to craft a more balanced housing 
policy and by ensuring that housing finance reform efforts do not have 
an adverse effect on the apartment sector given that the sector was not 
responsible for the meltdown and has a long track record of strong 
performance.
Attachment: NMHC Analysis: Credit Capacity of Covered Bonds, July 2010


















































































































        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM JULIE L. WILLIAMS

Q.1. There are many differences between the U.S and European 
housing markets, which raises the question as to whether 
covered bonds would work as well in our markets as they have in 
Europe. What do you see as the primary differences between 
European and U.S. markets that this Committee must be aware of, 
and thoroughly examine, prior to the enactment of any policies 
in this area?

A.1. In Europe, covered bonds have facilitated mortgage 
financing through the capital markets for many years. Many 
European jurisdictions have a special law-based framework with 
a public supervisor specifically dedicated to setting uniform 
standards and regulating covered bonds. While differences exist 
among jurisdictions, certain essential common features of 
covered bonds are: (1) a bond collateralized by a ``cover 
pool'' of high quality assets; (2) supervised management of the 
cover pool; (3) covered bondholders have a priority claim on 
the cover pool collateral and also have recourse to the issuing 
institution; and (4) legislation providing certainty on the 
treatment of the covered bonds in an insolvency situation. The 
covered-bond market in Europe is the traditional and long-
standing means of financing mortgages.
    In contrast, U.S. institutions have had a number of 
alternatives for obtaining mortgage financing that are not 
available in Europe, such as Government-sponsored enterprises 
(GSEs) and the Federal Home Loan Banks (FHLBs). By creating the 
GSEs, the U.S. Government facilitated and promoted home 
ownership through mortgage lending. Through the GSEs, a 
secondary market for mortgages developed in the U.S. and, with 
the implicit Government backing, the GSEs were able to access 
the capital markets to fund their purchases of qualifying 
mortgage loans. By selling loans to the GSEs, financial 
institutions could obtain funding necessary to originate new 
loans. Fundamental questions are now being considered by U.S. 
policy makers on the future and purpose of the GSEs. In 
addition, the use of private-label securitization in the U.S. 
historically has played a large role in mortgage finance.
    The FHLBs also have been a significant source of funding to 
the U.S. banking system. The FHLBs are 12 banks set up under a 
Government charter to provide support to the housing market by 
advancing funds to their member banks that make mortgages. The 
FHLB system issues debt to raise capital to provide the funding 
to loan originators. Recent developments stemming from the 
mortgage market disruption, however, are creating less 
certainty in obtaining advantageous FHLB funding, and impacting 
the availability of other historically perceived advantages, 
such as dividend payments and redemption of excess stock.
    Before enacting covered-bond legislation, the Committee 
should carefully consider and examine the policy implications 
of covered bonds on other U.S. funding options. It is possible 
that covered bonds would enhance competition in the funding 
markets. For example, the HILBs would need to remain 
competitive with collateral coverage, haircuts, and cost of 
funds. The GSEs similarly would need to keep securitization 
terms competitive. Overall, competition is generally beneficial 
in promoting innovation in product structures and terms, 
including pricing competitiveness.
    Covered bonds also present broad policy questions on issues 
related to housing finance that the Committee may wish to 
examine in more detail, including efforts to stabilize housing 
prices, increasing the availability of credit, improving 
underwriting standards, relying on the capital markets for 
housing finance and transitioning away from Government 
supported housing finance.

Q.2. In Mr. Campo's testimony he states that it is his belief 
that covered bonds will not lead to new lending, but rather 
banks would simply replace some of their whole loans activities 
with covered bonds. There also has been speculation, given the 
similarities between covered bonds and advances from the 
Federal Home Loan Banks, that a covered-bonds system simply 
would replace a portion of those advances.
    Based upon your studies and experiences, do you believe a 
properly designed covered-bonds system to be a tool that will 
allow financial institutions to shift existing activity, or do 
you see this as additional activity that will increase funding, 
and thus lending?

A.2. A properly designed system of covered bonds would both 
shift the mix of funding away from other sources of funds and 
increase funding, as well as lending. However, the impact of 
covered bonds on credit provision should not be overstated, 
since there are many factors affecting the supply and demand 
for credit. A significant portion of the observed decline in 
bank lending has been demand related; business and consumers 
have cut back on spending. Looking at unused credit lines at 
banks, it appears there is a lot of available credit that 
business and consumers are not using. But it is also clear that 
bankers have generally tightened their underwriting standards--
correcting practices that had become too lenient and responding 
to deteriorating economic and borrower conditions.
    In general, the introduction of a new funding instrument 
like covered bonds tends to reduce an institution's funding 
costs by providing an additional vehicle for financing; it 
provides enhanced flexibility for an institution to identify 
the lowest cost funding alternative at any given time as market 
conditions evolve, and thus reduces the risk-adjusted cost of 
funds for issuing institutions.
    An important consideration is whether covered bonds help to 
``complete'' markets by providing a unique benefit. To succeed 
in the market, a financing alternative cannot be redundant, 
that is it must offer one or more features or characteristics 
that cannot be replicated by investors through other 
investments already available in capital markets. Covered bonds 
issued by banks (or by similar institutions) do present a 
unique combination of effective exposure from the perspective 
of bond investors, offering investors the risk-return 
possibilities associated with exposure to banking activities, 
while simultaneously providing that exposure in a form secured 
by an identifiable pool of bank-originated assets. Thus, it is 
reasonable to expect that covered bonds would be in demand, 
and, if so, should tend to reduce the risk-adjusted cost of 
funds for issuing institutions.
    Other considerations are likely to affect this potential 
reduction in funding costs. Because the covering assets remain 
on an institution's balance sheet, the institution must hold 
more capital than in a typical securitization, and the required 
amount of capital may be even higher under upcoming changes in 
capital rules. The relative benefits of covered bonds and 
securitization may also be affected by accounting changes and 
by risk-retention provisions in the recent Dodd-Frank Wall 
Street Reform and Consumer Protection Act.
    However, if covered bonds on balance tend to reduce the 
cost of funds, they also would tend to lower the cost of, and 
increase the supply of, credit flowing from issuing 
institutions. This enhanced credit availability might be most 
prominent in the covering asset, since it would present a 
source of collateral for covered-bond issuance. However, credit 
expansion would not be limited to the covering asset alone, as 
all types of credit issued by an institution would benefit from 
an issuer's overall lower cost of funding.
    The use of covered bonds would thus bring both a shift in 
the funding mix--due to the introduction of a currently 
unavailable funding alternative that at times would be the 
lowest cost of available funding alternatives--and an overall 
increase in funding (and many types of lending) by reducing the 
risk-adjusted cost of funding.
    In addition to providing a nonredundant funding alternative 
that enhances the ``completeness'' of funding markets, covered 
bonds may provide additional benefits under current capital 
market conditions. One of the closest existing substitutes for 
covered bonds is securitization. Currently low levels of 
activity in most securitization markets leaves a sizable niche 
that covered bonds could fill. The extent of this apparent gap 
in currently available funding and investment instruments 
suggests that covered bonds might significantly boost lending: 
An important counterargument relates to capital charges. 
Because covered bonds remain on an institution's balance sheet, 
the institution must hold more capital than in a typical 
securitization. In addition, new accounting rules, upcoming 
changes in capital rules that may require higher levels of 
capital for assets held on a bank's balance sheet, and risk-
retention provisions in the recent Dodd-Frank Wall Street 
Reform and Consumer Protection Act, could constrain the growth 
of the covered-bond market.

Q.3. If simply a shift, where do you see the shift occurring 
and why do you believe it beneficial, or not, under those 
circumstances?

A.3. As noted in the response to the previous question, the 
introduction of covered bonds would lead to a shift in the 
funding mix, to the extent that covered bonds present issuers 
with a less expensive alternative to existing funding vehicles. 
This shift likely would be away from all other alternatives to 
at least some degree, but the shift is likely to be relatively 
larger for alternatives that are closer substitutes, such as 
securitization.
    However, in addition to such a shift in the mix of 
financing vehicles used by issuers, the availability of covered 
bonds as a funding alternative would also likely lead to an 
overall expansion of funding activity and credit extension by 
bond issuers.

Q.4. The implicit guarantee provided to Fannie Mae and Freddie 
Mac ultimately cost the American taxpayer hundreds of billions 
of dollars. Any changes we make to our home finance system must 
ensure that the taxpayers never again are exposed to this kind 
of a danger. If a covered-bond system was to be designed and 
enacted, what components would be essential to ensure that the 
system did not carry this same implicit guarantee?

A.4. A critical component in designing a U.S. statutory 
covered-bond program is determining the consequences of a 
default of a covered-bond issuance or the failure of a covered-
bond issuer. With respect to an issuing institution's 
insolvency, it is important that the legal framework clarify 
and specifically address what would happen to the cover pool, 
including the operation and management of the pool; the rights 
of the covered bondholders; and the responsibilities and 
obligations of the covered-bond regulator. The absence of any 
Government backing or guarantee could be affirmatively provided 
in the statutory framework creating tile resolution process.
    Covered bonds provide for payment without any implicit or 
explicit Government involvement or guarantee because of their 
``dual recourse'' feature. Covered bonds are backed by the 
issuing institution's promise to pay and by a dynamic pool of 
assets pledged as collateral, referred to as the cover pool. 
The collateral underlying this pool is actively managed to 
ensure ongoing performing assets, and segregated and managed 
for the benefit of covered bondholders. In a default or issuer 
insolvency situation, investors would look first to the 
institution to make payments on the bonds, but they also would 
have a claim against the cover pool that has priority over 
unsecured creditors. The covered bonds would not automatically 
accelerate if the issuing institution goes insolvent. If 
appropriate, issuers could be required to provide disclosures 
that covered-bond issuances are not guaranteed, insured, or 
backed by the U.S. Government.

Q.5. Many experts feel that it would be economies of scale that 
could make covered bonds a viable tool for liquidity. 
Therefore, there is some debate as to how or if community and 
regional banks would be able to participate in the covered-
bonds market.
    What is your opinion on the likelihood that covered bonds 
could be an effective tool for them and why do you believe this 
to be the case?

A.5. Similar to other funding sources, the institution's 
decision-making process should consider all costs and benefits 
of a covered-bond program relative to its potential issuance 
size. As noted in the OCC testimony, various types of standards 
could be embodied in a covered-bond regulatory framework that 
would remove obstacles to the development of this market. These 
standards and framework would naturally include compliance 
costs and burdens. For example, covered bonds should have 
minimum eligibility criteria setting asset quality standards to 
promote the inclusion of high quality assets in the cover pool. 
Requiring meaningful disclosures and making detailed 
information available about assets in a cover pool is essential 
to provide consistency and transparency across covered-bond 
issuances. Another important standard may include a designated 
minimum amount of overcollateralization and an asset coverage 
test and independent ``asset monitor'' to confirm on a periodic 
basis whether the asset coverage test is satisfied. My 
testimony notes that covered-bond regulators should have the 
authority to impose a cap in the percentage of particular asset 
types that issuing institutions could use for the covered-bond 
program. In addition, an issuer's total covered-bond 
obligations as a percentage of the issuer's total liabilities 
also could be limited.
    For a quality lender with prudent underwriting standards 
and sound risk management practices already in place, the 
incremental costs of a covered-bond program would likely be 
less. In general, the larger the issuance relative to these 
incremental costs, then the greater the potential benefit to 
the issuer.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                     FROM JULIE L. WILLIAMS

Q.1. What challenges are there to creating a resolution 
procedure in the case where an issuer fails?

A.1. The resolution procedure for the failure of a covered-bond 
issuer is a critical component in designing a U.S. statutory 
covered-bond program. Without a U.S. legal framework addressing 
the operation and management of the cover pool in the event of 
an issuer insolvency U.S. covered bonds will continue to lack 
predictability and clarity compared to other jurisdictions. 
With respect to an issuing institution's insolvency, it is 
important that the legal framework clarify and specifically 
address what would happen to the cover pool and the rights of 
the covered bondholders. In particular, if the issuer is an 
insured depository institution then consideration must be given 
to the FDIC's statutory role as conservator or receiver.
    A statutory framework could create a structure with the 
following general components when the FDIC is appointed as 
conservator or receiver for an insolvent issuer: (1) creation 
of a separate estate and provision to the FDIC of an exclusive 
right for a certain designated period of time to transfer the 
issuer's covered-bond program to another eligible issuer; and 
(2) a requirement that the FDIC as conservator or receiver, 
during the time period, perform all monetary and nonmonetary 
obligations of the issuer until the FDIC completes the transfer 
of the covered-bond program, the FDIC elects to repudiate its 
continuing obligations to perform, or the FDIC fails to cure a 
default (other than the issuer's conservatorship or 
receivership). If the FDIC as conservator or receiver, does not 
timely effect a transfer of the covered-bond program to another 
eligible issuer, repudiates its continuing obligations to 
perform, or fails to cure a default, then the statutory 
framework could provide for the automatic creation of a 
separate estate and attendant responsibilities.
    Specific challenges in creating a statutory framework 
relating to the resolution procedure include addressing the 
preservation of deficiency claims against the issuer, the 
creation of a residual interest that represents the right to 
any surplus from the cover pool, and the obligation of the 
issuer to transfer applicable books, records, files, and other 
documents to the covered-bond regulator or another designee. 
Consideration also should be given to statutory provisions 
providing that the covered-bond regulator may elect for an 
issuer to continue servicing the cover pool for some reasonable 
and operationally practical period of time, and whether the 
framework should provide for the Federal Reserve Banks or 
others to make advances to the estate. If Federal Reserve 
advances are permitted, they should be for liquidity purposes, 
and should be subject to Federal Reserve rules that limit 
credit risk exposure.
    A further specific challenge is determining the appropriate 
treatment of any excess amounts from the cover pool once the 
covered bondholders have been paid in full. For example, if a 
residual interest is created in the estate that represents the 
right to any surplus from the cover pool after the covered 
bonds and all other liabilities of the estate had been paid in 
full, should the FDIC or the covered bondholders receive the 
excess collateral?

Q.2. Who should be in charge of that resolution process?

A.2. A comprehensive approach for covered bonds that reflects a 
consistent and predictable process across the Federal financial 
regulators would serve to provide certainty and predictability 
to investors and the marketplace in cases of default and issuer 
insolvency. This type of framework would require the covered-
bond regulator to act as or appoint a trustee of the separate 
estate, and to appoint and oversee a servicer or administrator 
for the cover pool held by the estate. If the issuer is an 
insured depository institution then consideration must be given 
to the FDIC's statutory role as conservator or receiver. Given 
the nature of the events triggering resolution procedures under 
a covered-bond framework, litigation by unhappy private parties 
could attempt to draw in the covered-bond regulator. As such, 
careful consideration should be given to addressing limitations 
on actions against, and recognition of sovereign immunity for, 
the covered-bond regulator acting in its statutorily designated 
capacities.

Q.3. How can that process be structured in order to prohibit 
losses from being absorbed by the taxpayer?

A.3. By structuring the resolution process to involve the 
creation of a separate estate that would exist and be 
administered separately from the issuing institution, the legal 
framework would not involve recourse to U.S. taxpayers. Covered 
bonds do not involve a Government guarantee or subsidy, and 
payments to the covered bondholders are not insured deposits. 
The distinctive features of covered bonds, unlike other secured 
debt, include backing by both the institution's promise to pay 
and a dynamic pool of assets pledged as collateral that 
comprises the ``cover pool.'' The underlying assets are 
typically high quality assets, subject to various eligibility 
criteria and must be replaced by the institution should they 
fail to meet specified criteria. While investors look first to 
the institution to make payments on tile bonds, the investors 
also have a claim against the cover pool. In the event of 
insolvency, the separate estate is comprised of the applicable 
cover pool and assumes liability for the covered bonds and any 
related obligations secured by that cover pool.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                   FROM MICHAEL H. KRIMMINGER

Q.1. In response to questioning during the hearing you 
indicated that the FDIC would price the additional risk posed 
by covered bonds into the assessment fees the FDIC would charge 
institutions that issued covered bonds.
    Does the FDIC believe issuing covered bonds increases the 
risk of failure to an institution? If so, please describe how 
the FDIC arrived at this decision, including a description of 
any data examined as part of the analysis.

A.1. If structured correctly, covered bonds could provide 
another tool for banks to either bolster liquidity or increase 
lending. However, overreliance on any type of secured 
borrowing, including covered bonds, makes it difficult for an 
institution to borrow in other ways. Overcollateralization 
requirements can increase the difficulty. Inability to borrow 
can cause liquidity problems that may make the institution more 
prone to failure during a significant downturn in the banking 
industry.
    If a covered-bond transaction requires that an institution 
substitute good collateral for defaulting collateral, an 
increase in defaulting collateral will leave the institution 
with the defaulting loans, which will increase its risk of 
failure. With an overcollateralization requirement, either an 
increase in defaulting collateral or a decrease in the 
institution's general credit quality may trigger requirements 
for additional overcollateralization, again increasing the risk 
of failure.
    Allowing an institution to include too wide a variety of 
assets as collateral in a covered-bond program (e.g., 
collateral other than home mortgage loans) may encourage the 
institution to originate or acquire assets without proper 
underwriting and in businesses in which it has no experience, 
thus increasing the risk of an institution's failure. In 
particular, permitting derivatives or a large percentage of 
structured securities (such as collateralized debt obligations) 
as collateral can increase the risk of failure. Both 
derivatives and structured securities have been implicated in 
institution failures in recent years. Covered bonds secured by 
structured securities would be particularly risky if the 
collateral backing the structured securities were of a type not 
directly permitted as collateral for the covered bonds. This 
increased risk could come from either the collateral backing 
the structured securities itself or from a lack of knowledge 
concerning the underwriting standards for the collateral.

Q.2. Does the FDIC believe issuing covered bonds increases 
losses to the Deposit Insurance Fund (DIF), given a failure of 
an institution? If so, please describe how the FDIC arrived at 
this decision, including a description of any data examined as 
part of the analysis.

A.2. Unless covered-bond transactions are structured according 
to the principles contained in the FDIC's testimony, covered 
bonds could increase losses to the DIF. As discussed in 
response to the previous question, an improperly structured 
covered-bond transaction or overreliance on failure and the 
structured bonds or other secured financing can increase an 
institution's risk of risk of DIF losses.
    Covered bonds also can increase the DIF's losses in the 
event of an institution's failure, if the covered-bond 
transaction is not structured according to the principles 
contained in the FDIC's testimony. An increase in secured 
liabilities will increase losses to the DIF because it reduces 
the unpledged assets available for sale by the FDIC as receiver 
to repay the DIF for its insured depositor protection. As a 
result, if bondholders retain the excess collateral, this will 
further decrease the assets available for sale and thereby 
increase the losses that must be covered by the DIF. 
Specifically, if bondholders are given the option of retaining 
the collateral securing the covered bonds (rather than 
accepting payment) when an institution fails, the FDIC would 
only receive a residual certificate. As the result of its 
experience with asset securitizations and structured finance 
programs, the FDIC has discovered that it is difficult to sell 
residual certificates, even at deeply discounted prices. In 
contrast, when the FDIC pays secured creditors the secured 
value of their claim and redeems collateral after an 
institution fails, the DIF's losses are reduced.
    Moreover, because losses would be allocated first to the 
residual certificate and because the retained collateral would 
be managed by an asset manager appointed by the bondholders for 
their benefit rather than the residual holder's benefit, the 
DIF could be exposed to additional losses. To forestall these 
possibilities, the FDIC as receiver should retain the ability 
to repudiate the covered bonds, pay the bondholders the 
outstanding principal and interest up to the date of payment, 
and take control of the collateral.
    Finally, regardless of the structure of a covered-bond 
transaction, to the extent that an institution borrows on a 
secured basis rather than through unsecured, nondeposit 
borrowing, the DIF will suffer larger losses if the institution 
fails, all else equal, because of the priority of claims in a 
receivership. Secured liabilities must be paid in full before 
the FDIC receives any payment on its subrogated claim as the 
deposit insurer. Unsecured claims, on the other hand, receive 
no payment unless the FDIC has been completely reimbursed on 
its subrogated claim.

Q.3. If the FDIC prices any increased risk appropriately 
(whatever the rationale for the increase in risk) in the 
deposit insurance assessments, why would this not be sufficient 
to cover assets that would not be available to the FDIC if a 
covered-bond issuing institution were to be placed into 
receivership?

A.3. Because of the large number of insured institutions and 
because of the detailed information that institutions would 
have to provide the FDIC, the FDIC generally cannot determine 
assessment rates for an institution based on individual assets 
or liabilities and generally must rely on supervisory 
appraisals and statistical methods to price for risk. Thus, for 
example, while heavy reliance on secured borrowing will 
increase an institution's assessment rate, it would be 
difficult, and likely impossible, for supervisory appraisals or 
statistical methods to price for risk based on individual 
instances where an institution has borrowed on a secured basis, 
such as a specific covered-bond transaction. For the 100 or so 
largest institutions, the FDIC relies on a more detailed 
analysis of each institution's specific risk, but, even in 
these institutions, the FDIC cannot price for individual 
instances where an institution has borrowed on a secured basis.
    Moreover, even if the FDIC was able to fully price for risk 
based on each instance where an institution has borrowed 
through a covered-bond transaction, the resulting assessment 
rate could be prohibitively high.

Q.4. In Mr. Campo's testimony he states that it is his belief 
that covered bonds will not lead to new lending, but rather 
banks would simply replace some of their whole loans activities 
with covered bonds. There also has been speculation, given the 
similarities between covered bonds and advances from the 
Federal Home Loan Banks, that a covered-bonds system simply 
would replace a portion of those advances.
    Based upon your studies and experiences, do you believe a 
properly designed covered-bonds system to be a tool that will 
allow financial institutions to shift existing activity, or do 
you see this as additional activity that will increase funding, 
and thus lending?

A.4. Covered bonds could provide a useful alternative to 
traditional off-balance sheet funding, such as asset backed 
securitizations. However, the FDIC has not undertaken a formal 
study of this issue. The banking industry is currently highly 
liquid, thus liquidity issues are not restraining lending. In 
the future, if liquidity reverts to lower levels, covered bonds 
could have a more realistic chance of spurring lending or 
having a positive impact on banks' liquidity.

Q.5. If simply a shift, where do you see the shift occurring 
and why do you believe it beneficial, or not, under those 
circumstances?

A.5. It is difficult to isolate the effect of a single funding 
source on a bank's ability or willingness to lend. The extent 
that covered bonds would replace existing sources of liquidity, 
or will serve as a complimentary source, will depend on a wide 
variety of factors such as balance sheet capacity, accounting 
standards, investor appetite, the housing market, and the cost 
of unsecured sources of liquidity, including deposits and 
unsecured commercial paper. It is, however, reasonable to 
conclude that covered bonds are likely to substitute for other 
liquidity sources if they provide cheaper funding because the 
absolute volume of covered bonds for any institution is limited 
by its balance sheet since covered bonds are an on-balance 
sheet funding source.

Q.6. The implicit guarantee provided to Fannie Mae and Freddie 
Mac ultimately cost the American taxpayer hundreds of billions 
of dollars. Any changes we make to our home finance system must 
ensure that the taxpayers never again are exposed to this kind 
of a danger.
    If a covered-bond system was to be designed and enacted, 
what components would be essential to ensure that the system 
did not carry this same implicit guarantee?

A.6. Unlike the bailouts of both Fannie Mae and Freddie Mac, 
resolutions of failed insured depository institutions as well 
as the DIF itself are not funded by taxpayers, but by the 
banking industry.
    The FDIC would support covered-bond legislation that allows 
the receiver to essentially prepay the bonds (or repudiate) by 
paying the par value of outstanding bonds plus interest accrued 
through the date of payment. This provides a remedy that fully 
reimburses the covered-bond investors. In return, as in any 
other repudiation, the FDIC as receiver would be entitled to 
retain the collateral in the cover pool after payment of those 
damages.
    Similarly, balanced covered-bond legislation should avoid 
excessive governmental or regulatory involvement in protecting 
covered-bond investors. For this reason, the FDIC has 
recommended that legislation not have regulators enforcing 
overcollateralization or other covered-bond standards for the 
benefit of investors, rather than to preserve the safety and 
soundness of financial institutions. Similarly the FDIC has 
recommended that legislation not give regulators the duty to 
control any postdefault estate for the benefit of investors. 
Such entanglements provide a level of governmental protection 
for investors that could imply implicit guarantees--as has been 
the perception in some European covered-bond regulatory 
regimes.
    The FDIC believes that transfer of covered bonds would 
minimize the disruption in the covered-bond markets. Therefore, 
legislation should provide for the authority to continue to 
perform under the covered bond until it can sell the program to 
another bank. This would not expose the investors to any loss, 
by definition, since the FDIC would meet all requirements of 
the covered-bond program, including replenishment of the cover 
pool and overcollateralization. As long as the FDIC is 
performing under a covered-bond agreement, covered-bond 
legislation should not limit the time in which the FDIC has to 
decide how best to proceed.
    Any legislation that fails to preserve these important 
receivership authorities makes the FDIC the de facto guarantor 
of covered bonds and the de facto insurer of covered-bond 
bondholders.

Q.7. Many experts feel that it would be economies of scale that 
could make covered bonds a viable tool for liquidity. 
Therefore, there is some debate as to how or if community and 
regional banks would be able to participate in the covered-
bonds market.
    What is your opinion on the likelihood that covered bonds 
could be an effective tool for them and why do you believe this 
to be the case?

A.7. Economies of scale are needed in most existing covered-
bond models. This suggests the principal users of covered bonds 
will be the largest institutions for the foreseeable future.

Q.8. There are many differences between the U.S. and European 
housing markets, which raises the question as to whether 
covered bonds would work as well in our markets as they have in 
Europe.
    What do you see as the primary differences between European 
and U.S. markets that this Committee must be aware of, and 
thoroughly examine, prior to the enactment of any policies in 
this area?

A.8. Until the past decade, most pfandbriefes (the German form 
of covered bonds) were issued by the Landesbanks, which in turn 
were supported directly by the respective local governmental 
authorities. Even without direct support, there is significant 
indirect Government support for the European banking sector. By 
contrast, in the U.S., the Dodd-Frank Wall Street Reform and 
Consumer Protection Act aims to reduce the support given by the 
taxpayers to the banking sector.
    Assets securing European covered bonds have different terms 
and structures than U.S. assets. Residential mortgages, for 
example, in many jurisdictions, permit banks to reset interest 
rates, are of short duration (5 years), and have loan to value 
ratios that are low. Similarly, use of European models to use 
as a basis or even justification for use of other types of 
assets to secure covered bonds is not wise. For example, while 
public debt instruments have been used as collateral in 
European covered-bond programs, public debt instruments have 
very different characteristics and risks in the U.S. In 
European jurisdictions, public entities generally are not 
subject to an insolvency regime similar to Chapter 9 bankruptcy 
for local governments in the U.S. They also benefit from a fair 
amount of sovereign support and are unlikely to issue complex 
or short-term instruments such as tax anticipation notes or 
variable rate demand obligations.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                   FROM MICHAEL H. KRIMMINGER

Q.1. What challenges are there to creating a resolution 
procedure in the case where an issuer fails?

A.1. First and foremost, the flexibility of the FDIC as 
receiver in dealing with covered bonds must be maintained to 
avoid a subsidy of the covered-bond investors. That flexibility 
includes the ability to control a pool of collateral securing 
the covered bonds (the cover pool) as long as the FDIC performs 
under the covered bond. It also includes the authority to 
repudiate the covered bond (after paying par plus accrued 
interest) to maintain control of the cover pool. The Statement 
of Policy adopted by the FDIC's Board of Directors in 2008 
provides a clear guide to the treatment of covered bonds in a 
receivership. The market's reaction to this Statement was very 
positive, and most commentators at the time it was proposed 
stated that it provided a solid foundation for the covered-bond 
market. At a minimum, the FDIC suggests that its Statement of 
Policy should serve as a framework for any legislation.

Q.2. Who should be in charge of that resolution process?

A.2. As we have consistently stated, we believe that resolution 
of a covered-bond program should not be separate from the 
resolution of the entire operations of the failed institution 
itself. The FDIC should retain its current flexibility to 
maximize recovery for the benefit of depositors and all 
creditors. If, in any resolution of an issuer, the FDIC 
determines to turn over the collateral to the investors, the 
administration of the collateral should remain a matter of 
private contract.

Q.3. How can that process be structured in order to prohibit 
losses from being absorbed by the taxpayer?

A.3. As noted above, to protect taxpayers and the bank-funded 
DIF, any legislation or regulatory initiative must maintain the 
FDIC's current flexibility in dealing with covered bonds, 
whether the FDIC is acting as receiver of insured depositories 
or systemically significant financial companies. Additionally, 
regulation of covered-bond programs should not entangle the 
Federal Government in the private contracts between issuers and 
investors to such an extent that would imply a guarantee by the 
Government, as is the case in Europe.
    We believe that H.R. 5823 creates a structure of regulation 
and oversight for the benefit of the investors that could imply 
that Federal regulators are responsible for ensuring that the 
issuing banks live up to their agreements under covered bonds. 
Moreover, H.R. 5823 also would make the Federal prudential 
regulators the appointing and supervising authority of trustees 
that would operate the covered-bond separate estates. This 
level of Government entanglement in private contractual matters 
could lead to the perception or even reality of an implied 
Government guarantee of covered bonds. An implied guarantee of 
covered bonds would put covered bonds on a near par with the 
Government sponsored enterprises--a status that should not be 
granted without strong policy reasons because of the risk posed 
to taxpayers.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM SCOTT A. STENGEL

Q.1. Mr. Stengel, some experts have pointed to Fannie Mae and 
Freddie Mac as major obstacles to covered bonds establishing a 
foothold in this country.
    With that in mind, what changes do you feel would need to 
occur in any new secondary market structure to better allow for 
competition by covered bonds with the agency MBS market?

A.1. In May 2006, economists at the Federal Reserve valued the 
implicit Federal subsidy backing Fannie Mae and Freddie Mac at 
$189 billion. \1\ At the time, only two U.S. financial holding 
companies even had market capitalizations in excess of that 
amount--Citigroup at $240 billion and Bank of America 
Corporation at $220 billion.
---------------------------------------------------------------------------
     \1\ Wayne Passmore, et al., Federal Reserve Research on 
Government-Sponsored Enterprises: Presentation at the Federal Reserve 
Bank of Chicago Bank Structure Conference 11 (May 18, 2006). A copy is 
attached as Exhibit A.
---------------------------------------------------------------------------
    We can say without hyperbole, therefore, that no private-
sector security of any kind can compete on an equal footing--in 
either the primary market or the secondary market--with the 
debt securities or the mortgage-backed securities of Fannie 
Mae, Freddie Mac, or any other Government-Sponsored Enterprise 
(GSE) that enjoys an implicit full-faith-and-credit guarantee.
    Looking ahead to GSE reform, we believe that two principles 
should be observed in the context of U.S. covered bonds.
    First, with nearly every reform proposal contemplating some 
form of Federal subsidy for the secondary mortgage market, the 
legislative framework for covered bonds must optimize cost 
efficiency in order to level the playing field. This implicates 
all of the structural elements that were proposed in my written 
testimony, with a particular emphasis on the following:

    a broad range of eligible asset classes (including 
        ones that encompass consumer loans like credit-card 
        loans and auto loans),

    a separate resolution process that is unequivocal 
        and nondiscretionary, that cannot be undermined by 
        conflicts of interest (including the FDIC's inherent 
        conflict with covered-bond investors), and that permits 
        nondiscriminatory access to liquidity from the Federal 
        Reserve Banks, and

    a seamless incorporation of relevant tax and 
        securities laws.

    Such a framework, in our view, is essential to achieve 
several public-policy objectives that are crucial to financial 
stability: (1) more stable long-term liquidity, (2) less 
expensive and more available credit for consumers, small 
businesses, and the public sector, (3) diversified and additive 
funding for financial institutions, (4) private-sector capital 
with no taxpayer support, (5) more strongly aligned incentives, 
and (6) increased transparency and uniformity in the capital 
markets.
    Second, if Congress were to enact a catastrophic Federal-
guarantee program like that suggested by the Housing Policy 
Council in its reform proposal, covered bonds should be 
eligible alongside securities issued by the newly created 
mortgage-securities insurance companies. \2\ As already noted, 
private-sector securities can never be positioned to compete 
fully with those that carry either an explicit or an implicit 
Federal guarantee. While we expect traditional nonguaranteed 
covered bonds to flourish in the United States, they will be in 
their infancy when GSE reform is implemented. Uncertainty about 
the interaction of these two markets, in our view, counsels in 
favor of preserving optionality. In what will be a radically 
reshaped environment for mortgage finance, there might well be 
systemic value in covered bonds that can be guaranteed against 
catastrophic macroeconomic risk.
---------------------------------------------------------------------------
     \2\ The Future of Housing Finance: A Review of Proposals To 
Address Market Structure and Transition Before the House Committee on 
Financial Services, 111th Congress (2010) (statement of Michael J. 
Heid, Chairman, Housing Policy Council of the Financial Services 
Roundtable). A copy is attached as Exhibit B.

Q.2. In Mr. Campo's testimony he states that it is his belief 
that covered bonds will not lead to new lending, but rather 
banks would simply replace some of their whole loans activities 
with covered bonds. There also has been speculation, given the 
similarities between covered bonds and advances from the 
Federal Home Loan Banks, that a covered-bonds system simply 
would replace a portion of those advances.
    Based upon your studies and experiences, do you believe a 
properly designed covered-bonds system to be a tool that will 
allow financial institutions to shift existing activity, or do 
you see this as additional activity that will increase funding, 
and thus lending?
    If simply a shift, where do you see the shift occurring and 
why do you believe it beneficial, or not, under those 
circumstances?

A.2. Each individual decision to lend is a function of return 
on capital, business strategy, and risk management.
    Covered bonds enable financial institutions (1) to lower 
the cost of funding, which increases the return on capital, (2) 
to augment rather than cannibalize their funding sources, which 
provides the fuel for business lines to innovate and boost 
lending, and (3) to better match assets and liabilities, which 
reduces the risk of providing longer-term closed-end loans 
(like residential mortgage loans) and revolving lines of credit 
(like credit-card loans).
    As a result, we must respectfully disagree with the belief 
that covered bonds will not contribute to increased lending. 
That, in our view, is not supported by the microeconomic 
incentives that drive the business of banking or by any 
empirical data.
    We also must take issue with the premise that covered bonds 
are similar or equivalent to advances from the Federal Home 
Loan Banks (the FHLBs). First, covered bonds will fund a much 
broader range of asset classes than the FHLBs typically accept 
in the normal course of business. Second, covered bonds will 
supply fixed-rate liquidity with maturities that the FHLBs 
generally do not offer to their member institutions. For these 
reasons, we envision covered bonds as a private-sector 
complement, rather than as a substitute, for federally 
subsidized FHLB advances.
    All of this being said, we can foresee financial 
institutions reallocating a modest portion of their short- and 
medium-term funding away from existing sources and toward a 
U.S. covered-bond market that is deep and liquid. But this, in 
our view, is the very macroeconomic objective that policy 
makers are seeking to achieve. The liquidity crisis that began 
in late 2008 was exacerbated in no small part by an 
overreliance on volatile short-term borrowings to fund long-
term assets. Covered bonds will provide financial institutions 
with a cost-effective source of fixed-rate funding much farther 
out on the maturity curve than is currently feasible, which 
will lessen systemic risk in the broader financial markets and 
will bolster risk-management frameworks inside individual 
institutions.

Q.3. The implicit guarantee provided to Fannie Mae and Freddie 
Mac ultimately cost the American taxpayer hundreds of billions 
of dollars. Any changes we make to our home finance system must 
ensure that the taxpayers never again are exposed to this kind 
of a danger.
    If a covered-bond system was to be designed and enacted, 
what components would be essential to ensure that the system 
did not carry this same implicit guarantee?

A.3. The implicit Federal guarantee enjoyed by Fannie Mae, 
Freddie Mac, and the FHLBs has arisen from an extraordinarily 
unique set of components:

    Each GSE has been federally chartered with a 
        targeted public-policy purpose. \3\
---------------------------------------------------------------------------
     \3\ 12 U.S.C. 1716-1717 (Fannie Mae), 1452-1454 (Freddie Mac), 
and 1423-1430c (FHLBs).

    The U.S. Treasury has been authorized to extend 
        credit to each GSE. \4\
---------------------------------------------------------------------------
     \4\ 12 U.S.C. 1719(c) (Fannie Mae), 1455(c) (Freddie Mac), and 
1431(i) (FHLBs).

    Each GSE has been exempted from most State and 
        local income tax. \5\
---------------------------------------------------------------------------
     \5\ 12 U.S.C. 1723a(c)(2) (Fannie Mae), 1452(e) (Freddie Mac), 
and 1433 (FHLBs).

    Each GSE's debt securities and mortgage-backed 
        securities have been made eligible for open-market 
        purchases by the Federal Reserve Banks, \6\ for 
        deposits of public funds, \7\ and for investments by 
        fiduciaries. \8\
---------------------------------------------------------------------------
     \6\ 12 U.S.C. 355(2) and 12 C.F.R. 201.108(b) (Fannie Mae, 
Freddie Mac, and FHLBs).
     \7\ 12 U.S.C. 1723c (Fannie Mae), 1452(g) (Freddie Mac), and 
1435 (FHLBs).
     \8\ 12 U.S.C. 1723c (Fannie Mae), 1452(g) (Freddie Mac), and 
1435 (FHLBs); see also 15 U.S.C. 77r-1(a) (preempting any contrary 
State law in connection with the securities of Fannie Mae and Freddie 
Mac).

    Each GSE's debt securities and mortgage-backed 
        securities have been exempted from investment limits 
        that are otherwise imposed on banks, savings 
        associations, and credit unions. \9\
---------------------------------------------------------------------------
     \9\ 12 U.S.C. 24(Seventh), 335, 1464(c)(1), and 1757(7) (Fannie 
Mae, Freddie Mac, and FHLBs).

    Each GSE has been entitled to use any Federal 
        Reserve Bank as its depository, custodian, and fiscal 
        agent. \10\
---------------------------------------------------------------------------
     \10\ 12 U.S.C. 1723a(g) (Fannie Mae), 1452(d) (Freddie Mac), and 
1435 (FHLBs).

    Under the legislative framework proposed in my written 
testimony, no issuer of U.S. covered bonds could lay claim to 
any status or preference that even remotely resembles those 
afforded to the GSEs. For example, to the extent that any 
misguided inference could be drawn from a covered-bond estate 
inheriting an insolvent issuer's access to liquidity from the 
Federal Reserve Banks, we have proposed that legislation 
expressly provide that (1) no advance can be made by a Federal 
Reserve Bank for the purpose, or with the expectation, of 
absorbing credit losses on the estate's cover pool, (2) any 
advance must have a maturity that is consistent with an advance 
for liquidity only, (3) repayment of any advance must 
constitute a superpriority claim against the estate that is 
secured by a superpriority lien on the cover pool, and (4) any 
Federal Reserve Bank making an advance must promptly report to 
Congress on the circumstances giving rise to the advance, the 
terms of the advance, the nature of the cover pool securing the 
advance, and the basis for concluding that credit losses on the 
cover pool will not be absorbed by the Federal Reserve Bank.
    Some have suggested that the mere existence of a single 
covered-bond regulator could imply that covered bonds are 
backed to some degree by the U.S. Government. This, in our 
view, is a questionable proposition. After all, a single 
regulator--the Comptroller of the Currency (OCC)--supervises 
all national banks, but no one could seriously argue that the 
OCC is an implied-in-fact guarantor of their obligations. 
Similarly, the Securities and Exchange Commission regulates all 
nonexempt offers and sales of securities but certainly could 
not be perceived as insuring investors against any loss.
    Our reservation about multiple covered-bond regulators, as 
some have proposed, is rooted in a conviction that market 
fragmentation would likely doom U.S. covered bonds from the 
outset. We cannot envision a deep and liquid market developing 
if national banks, State member banks, State nonmember banks, 
bank holding companies, and other covered-bond issuers are 
operating under different regulatory frameworks. At a minimum, 
therefore, we recommend that the Secretary of the Treasury be 
directed to promulgate a single set of regulations for all 
covered-bond issuers and that each of the individual prudential 
regulators be tasked with implementing them for the issuers 
under their supervision. This, in our view, would not be ideal 
but at least would allow for the kind of uniform legal regime 
that will be critical to developing a vibrant market for U.S. 
covered bonds.
    We also are aware of the FDIC's recent assertion that the 
legislative framework proposed in my written testimony would 
give covered bondholders ``a superpriority in receivership'' 
and would result in their claims being ``essentially back-
stopped by the FDIC.'' \11\ These statements, however, were not 
substantiated and, in our view, reflect a fundamental 
misunderstanding of the proposal and existing law.
---------------------------------------------------------------------------
     \11\ Sheila C. Bair, Chairman, Federal Deposit Insurance 
Corporation, Keynote Address to the Mortgages and the Future of Housing 
Finance Symposium (Oct. 25, 2010).
---------------------------------------------------------------------------
    A superpriority claim or a superpriority lien, in the 
context of an insolvency proceeding, is one that has been 
elevated to a level of priority higher than that otherwise 
afforded by applicable law to other claims or liens (including 
administrative claims or liens). \12\
---------------------------------------------------------------------------
     \12\ See, e.g., 11 U.S.C. 364(c) and (d) (in a bankruptcy case, 
authorizing postpetition loans ``with priority over any or all 
administrative expenses'' and ``secured by a senior or equal lien on 
property of the estate that is subject to a lien''); 12 U.S.C. 
4617(i)(11) (for a limited-life regulated entity created by the 
Federal Housing Finance Agency with respect to Fannie Mae, Freddie Mac, 
or an FHLB, authorizing loans ``with priority over any or all of the 
obligations of the limited-life regulated entity'' and ``secured by a 
senior or equal lien on property of the limited-life regulated entity 
that is subject to a lien (other than mortgages that collateralize the 
mortgage-backed securities issued or guaranteed by an enterprise)''); 
Section 210(b)(2) of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (2010) (``In the event that the [FDIC], as receiver for 
a covered financial company, is unable to obtain unsecured credit for 
the covered financial company from commercial sources, the Corporation 
as receiver may obtain credit or incur debt on the part of the covered 
financial company, which shall have priority over any or all 
administrative expenses of the receiver under paragraph (1)(A).''); 
Section 210(h)(16) of the Dodd-Frank Act (for a bridge financial 
company created by the FDIC with respect to a covered financial 
company, authorizing loans ``with priority over any or all of the 
obligations of the bridge financial company'' and ``secured by a senior 
or equal lien on property of the bridge financial company that is 
subject to a lien'').
---------------------------------------------------------------------------
    Nothing in our proposed legislative framework, including 
the treatment of any claim or lien of a covered bondholder, 
would change the priority scheme in a conservatorship or 
receivership of the issuing institution. Both before and after 
the insolvency proceeding, investors would benefit from a 
first-priority lien on the issuer's cover pool to secure their 
claims under the covered bonds--just like any other secured 
creditor--and at no time would they be entitled to a lien 
(superpriority or otherwise) on any of the issuer's other 
assets. In addition, to the extent that the cover pool proves 
insufficient to satisfy their claims in full, covered 
bondholders would fall in line alongside all other general 
unsecured creditors without any enhanced priority or preference 
of any kind. This treatment stands in stark contrast, for 
example, to the superpriority claims and liens that can arise 
in connection with postinsolvency financing arrangements \13\ 
and to the springing priority of an FHLB's ``super lien'' on 
all of a member institution's property. \14\
---------------------------------------------------------------------------
     \13\ See, the authorities cited in note 12.
     \14\ 12 U.S.C. 1430(e) (``Notwithstanding any other provision of 
law, any security interest granted to a Federal Home Loan Bank by any 
member of any Federal Home Loan Bank or any affiliate of any such 
member shall be entitled to priority over the claims and rights of any 
party (including any receiver, conservator, trustee, or similar party 
having rights of a lien creditor) other than claims and rights that--
(1) would be entitled to priority under otherwise applicable law; and 
(2) are held by actual bona fide purchasers for value or by actual 
secured parties that are secured by actual perfected security 
interests.''); see also 12 U.S.C. 1821(d)(5)(D) (precluding the FDIC 
from disallowing any claim asserted by an FHLB) and 1821(e)(14) 
(exempting FHLB advances from the FDIC's authority to disallow or 
repudiate contracts).
---------------------------------------------------------------------------
    What our legislative proposal would affect is the FDIC's 
power to compel an acceleration of the covered bonds and to pay 
only ``actual direct compensatory damages . . . determined as 
of the date of the appointment of the conservator or 
receiver.'' \15\ Because a sine qua non of covered bonds is 
their limited risk of prepayment, they instead would remain 
outstanding according to their original terms so long as 
collections and other proceeds from the cover pool could 
continue to fund all scheduled payments.
---------------------------------------------------------------------------
     \15\ 12 U.S.C. 1821(e)(1) and (3).
---------------------------------------------------------------------------
    This, however, hardly creates a backstop by the FDIC. To 
the contrary, our proposal is a more modest iteration of the 
framework that currently exists for qualified financial 
contracts (QFCs) under the Federal Deposit Insurance Act 
(FDIA). One notable similarity between them is full 
restitution, at least to the extent of the posted collateral 
(including any overcollateralization), for damages that result 
from reinvestment risk. In the context of QFCs, this is picked 
up by the counterparty's right under the FDIA to ``normal and 
reasonable costs of cover or other reasonable measures of 
damages utilized in the industries for such contract and 
agreement claims.'' \16\ Another similarity is found in 
carefully drawn limits on the FDIC's ability to repudiate or 
assign contracts or collateral. \17\ But, unlike covered 
bondholders in our proposed framework, a QFC counterparty is 
entitled to even more, including (1) a unilateral right to 
terminate, liquidate, or accelerate the QFC and to exercise 
remedies and rights of setoff under the QFC and against any 
related collateral, \18\ (2) an ability, after the business day 
following the date of the FDIC's appointment as receiver, to 
enforce ordinarily nonbinding contractual provisions that are 
triggered solely by the institution's insolvency or 
receivership (ipso facto clauses), \19\ and (3) immunity from 
all avoidance actions except for those grounded in an actual 
intent to defraud. \20\
---------------------------------------------------------------------------
     \16\ 12 U.S.C. 1821(e)(3)(C).
     \17\ 12 U.S.C. 1821(e)(9) and (11).
     \18\ 12 U.S.C. 1821(e)(8)(A) and (E).
     \19\ 12 U.S.C. 1821(e)(10)(B).
     \20\ 12 U.S.C. 1821(e)(8)(C).
---------------------------------------------------------------------------
    Still, as I noted in oral testimony during the hearing, we 
may be able to support a legislative framework for U.S. covered 
bonds that is modeled on these QFC provisions if the use of 
existing precedent would assuage even misplaced concerns.

Q.4. Many experts feel that it would be economies of scale that 
could make covered bonds a viable tool for liquidity. 
Therefore, there is some debate as to how or if community and 
regional banks would be able to participate in the covered-
bonds market.
    What is your opinion on the likelihood that covered bonds 
could be an effective tool for them and why do you believe this 
to be the case?

A.4. Covered bonds are a conservative and defensive investment 
that appeals to investors only if the secondary market is 
sufficiently deep and liquid to generate active bids, offers, 
and trades. As a result, each series of covered bonds is 
typically sized at no less than $500 million.
    To ensure that regional and community banks are able to 
access such a market on competitive terms, we have proposed 
that pooled issuances be permitted. Under this arrangement, 
several institutions would issue more modestly sized series of 
covered bonds to a statutory trust or other separate entity 
that they have collectively sponsored. This entity then would 
populate a cover pool with the multiple series that have been 
acquired and issue into the market a single series of covered 
bonds backed by all of them together.
    In this way, for example, each of 10 community banks could 
establish its own separate covered-bond program comprised of 
the commercial-mortgage loans on its balance sheet and issue 
$50 million of related covered bonds to a jointly sponsored 
trust. All 10 of these separate $50 million series of covered 
bonds then would fill a cover pool established by the trust, 
and a single $500 million series of covered bonds backed by the 
entire cover pool would be issued by the trust to investors.
    We believe that this approach, which has been used 
successfully in Europe, would open the U.S. covered-bond market 
to regional and community banks in a meaningful way. We also 
believe that the cost-effective, long-term funding that covered 
bonds can supply would be especially valuable to small- and 
middle-market institutions that historically have been limited 
to fewer and less diverse sources of liquidity.




































































































        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                         FROM RIC CAMPO

Q.1. In your testimony you described a difference in how 
European multifamily properties were built and marketed as 
compared to their U.S. counterparts.
    Could you describe further why this difference is important 
as it relates to covered bonds and multifamily properties?

A.1. NMHC/NAA Response: The basic issue for the multifamily 
industry is the limited information about covered-bond 
financing for multifamily properties that is comparable to how 
apartments are financed in the United States. The development 
and long-term financing in Europe and the United States is not 
an apples-to-apples comparison due to the fact that in Europe 
the individual rental units in a property are mortgaged, much 
like a condominium here in the United States. Therefore, there 
is no commercial real estate mortgage based on the collective 
income from the rental units and so we can not gain the needed 
understanding on the impact of covered-bond mortgage financing 
upon development trends and the needed financing needs to 
support the asset base over a long-term hold period.
    Most European countries, and in general most countries 
outside of the United States, rely on a condominium approach to 
develop and for ownership of rental housing. In Europe the 
development of rental apartment properties are typically 
financed based on presale of the units and what would be an 
end-loan/construction loan. This short term loan is made and 
secured on the capital from the presale and obligations by the 
individual unit owners. The role of covered bonds in rental 
housing is in the financing of the individual unit mortgages, 
which is more analogous to the single-family residential home 
mortgage market in the United States.

Q.2. What additional important differences do you see between 
the U.S. and European markets, as it relates to multifamily 
properties, that you would recommend this Committee carefully 
examine?

A.2. NMHC/NAA Response: We would urge the Committee to seek 
detailed information from the European Covered Bond Council 
that provides historical loan origination and performance 
information by asset class and in particular commercial real 
estate to better understand how the loans have performed and 
the extent of the use of covered-bond credit to serve the 
commercial real estate sector. It would be useful to understand 
how the issuer looks at diversification of assets, how they 
perform the underwriting associated with the commercial real 
estate and the specific underlying loan terms of the covered 
bonds associated with commercial income properties.

Q.3. In Mr. Campo's testimony he states that it is his belief 
that covered bonds will not lead to new lending, but rather 
banks would simply replace some of their whole loans activities 
with covered bonds. There also has been speculation, given the 
similarities between covered bonds and advances from the 
Federal Home Loan Banks, that a covered-bonds system simply 
would replace a portion of those advances.
    Based upon your studies and experiences, do you believe a 
properly designed covered-bonds system to be a tool that will 
allow financial institutions to shift existing activity, or do 
you see this as additional activity that will increase funding, 
and thus lending?

A.3. NMHC/NAA Response: Our view is the legislative proposal 
offered creates the opportunity for banks to issue loans, but 
there are issues related to risk-based capital, especially that 
associated with liabilities of replacement assets and funding 
the transfer in the event of financial institution failure. We 
believe that the institution failure can be addressed by the 
banking regulators, but we do not feel the covered-bond 
issuance is less risky than the whole loan execution and as 
noted the potential replacement of advances of FHLBs.
    Our conclusion is that covered-bond issuers would most 
likely transfer credit activity from whole loans to covered 
bonds rather than expanding credit in a heightened environment 
of risk management. Covered bonds do not dramatically address 
the ability to reduce risk to the issuer beyond other credit 
offerings.

Q.4. If simply a shift, where do you see the shift occurring 
and why do you believe it beneficial, or not, under those 
circumstances?

A.4. NMHC/NAA Response: The FHLB system has limited capacity to 
serve the multifamily mortgage market. We see the shift 
primarily occurring among existing bank loan activities and 
source of capital upon which they extend credit.

Q.5. The implicit guarantee provided to Fannie Mae and Freddie 
Mac ultimately cost the American taxpayer hundreds of billions 
of dollars. Any changes we make to our home finance system must 
ensure that the taxpayers never again are exposed to this kind 
of a danger.
    If a covered-bond system was to be designed and enacted, 
what components would be essential to ensure that the system 
did not carry this same implicit guarantee?

A.5. The issue of replacement of credit from Fannie Mae and 
Freddie Mac is the core issue for multifamily as it considers 
alternative credit in the market. The apartment industry is 
heavily regulated at the State and local level, it is a 
fragmented industry composed of thousands of owners large and 
small and as such relies on a variety of sources of credit from 
private sources, banks and thrifts, Wall Street conduits, 
insurance companies, FHA and Fannie Mae and Freddie Mac. Loans 
to the apartment sector must take into consideration the unique 
and individual circumstances of each property, the market, 
tenancy, ownership structure, and financing needs. Therefore it 
is very important to have a range of credit options that are 
both national and locally based.
    With the exception of Wall Street conduit loans, the credit 
sources available to the apartment sector have managed their 
lending activities well and have not contributed to the 
financial crisis. As the impacts of Dodd-Frank improve the 
oversight and risk mitigation in securities-based credit, the 
future expectation is for prudent lending to the apartment 
sector from Wall Street conduits. There is no cost to the 
taxpayer associated with the current financial crisis, as the 
losses suffered by Wall Street firms; banks, private capital, 
and even Fannie Mae or Freddie Mac were not a result of 
multifamily lending. In fact, the Fannie Mae and Freddie Mac 
multifamily programs are a model for prudent risk management 
and underwriting. Seeking a credit replacement should not be 
associated with their past lending practices in multifamily 
activities.
    Therefore, we would recommend that the covered-bond program 
use the GSE model for multifamily lending and take the policies 
and procedures used to purchase loans from the GSE lenders as a 
way to originate, service and manage risk with Government 
backing.

Q.6. Many experts feel that it would be economies of scale that 
could make covered bonds a viable tool for liquidity. 
Therefore, there is some debate as to how or if community and 
regional banks would be able to participate in the covered-
bonds market.
    What is your opinion on the likelihood that covered bonds 
could be an effective tool for them and why do you believe this 
to be the case?

A.6. The question is not an area where NMHC and NAA can offer 
relevant expertise and comment.
              Additional Material Supplied for the Record
     PREPARED STATEMENT OF THE AMERICAN SOCIETY OF CIVIL ENGINEERS
    The American Society of Civil Engineers (ASCE) \1\ would like to 
thank the Senate Banking, Housing, and Urban Affairs Committee for 
holding a hearing today on proposals to create a National 
Infrastructure Bank. The Society is pleased to present to the Committee 
our views on investing in the Nation's infrastructure. ASCE supports 
the creation and operation of a National Infrastructure Bank.
---------------------------------------------------------------------------
     \1\ ASCE was founded in 1852 and is the country's oldest national 
civil engineering organization. It represents more than 146,000 civil 
engineers individually in private practice, Government, industry, and 
academia who are dedicated to the advancement of the science and 
profession of civil engineering. ASCE is a nonprofit educational and 
professional society organized under Part 1.501(c) (3) of the Internal 
Revenue Code.
---------------------------------------------------------------------------
    ASCE's 2009 Report Card for America's Infrastructure graded the 
Nation's infrastructure a ``D'' based on 15 categories (the same 
overall grade as ASCE's 2005 Report Card), and stated that the Nation 
needs to invest approximately $2.2 trillion over the next 5 years to 
maintain the national infrastructure in a state of good repair. Even 
with the current and planned investments from Federal, State, and local 
governments in the next 5 years, the ``gap'' between the overall need 
and actual spending will exceed $1 trillion in 2014. If the Nation 
continues to under invest in infrastructure and ignores this backlog 
until systems fail, we will incur even greater costs.
    The total of all Federal spending for infrastructure as a share of 
all Federal spending has steadily declined over the past 30 years, 
according to the Congressional Budget Office. The results of years of 
under investment can be seen in traffic and airport congestion, unsafe 
bridges and dams, deteriorating roads, and aging drinking water and 
wastewater infrastructure. ASCE is concerned with this accelerated 
deterioration of America's infrastructure, with the general reduction 
in investment for the preservation and enhancement of our quality of 
life, and with the threatened decline of U.S. competitiveness in the 
global marketplace.
    As Congress is in the process of developing a comprehensive 
multiyear surface transportation authorization, and as President Obama 
rolls out the Administration's plan to invest $50 billion on the 
Nation's infrastructure, our roads, bridges, dams, and water systems 
continue to remain in a state of decline. Aging and overburdened 
infrastructure threatens the economy and quality of life for all 
Americans. However, while the problem may appear staggering, innovative 
financing such as a National Infrastructure Bank, could provide a 
fiscally prudent means to begin repairing our Nation's deteriorating 
infrastructure.
    Innovative financing techniques can greatly accelerate 
infrastructure development and can have a powerful economic stimulus 
effect. Currently, the burden of infrastructure funding is shifting 
from Federal to State and local resources to fund the growing need for 
improvements. Innovative programs in SAFETEA-LU, such as the 
establishment of the State Infrastructure Bank program, have been a 
good start, but more needs to be done to expand their scope, and new 
programs or approaches must be introduced. The Nation must develop and 
authorize innovative financing programs that not only make resources 
readily available, but also encourage the most effective and efficient 
use of those resources. Federal investment must be used to complement, 
encourage, and leverage investment from the State and local government 
levels as well as from the private sector. In addition, users of 
infrastructure must be willing to pay the appropriate price for their 
use.
    ASCE supports innovative financing programs for transportation 
projects and believes the Federal Government should make every effort 
to develop new programs or flexibility in innovative procurement 
approaches. President Obama's newly released infrastructure investment 
plan proposes the permanent creation of a national infrastructure bank, 
which could leverage private capital for projects of national and 
regional significance. This sort of proactive thinking toward 
infrastructure will allow States to come together for regional projects 
such as high speed rail and can move the Nation's infrastructure 
forward. ASCE applauds President Obama's leadership on the issue and 
believes that the Administration's investment plan has great potential 
to be a part of the solution. In particular, the President's call to 
establish a national infrastructure bank is a concept ASCE long has 
supported.
    The National Infrastructure Bank Act of 2009 would begin to address 
a problem that is rapidly approaching crisis levels. Briefly the 
legislation would establish a National Infrastructure Bank, which would 
be an independent body designed to evaluate and finance infrastructure 
projects of substantial regional and national significance. Eligible 
projects would range from mass transit systems, roads, bridges, 
drinking-water systems, and sewage treatment systems. The bill would 
begin the process of meeting the Nation's broad infrastructure needs, 
while selecting those projects which will be most beneficial.
    ASCE supports the creation and operation of a National 
Infrastructure Bank, which should leverage public funds with private 
dollars to invest in transportation, environment, energy, and 
telecommunications projects of significance. Each infrastructure system 
should have a dedicated source of revenue that is independent of the 
Federal Government's annual appropriations process. This ensures that 
the owners and managers of publicly owned treatment works and other 
systems will be able to finance improvements to their physical 
infrastructure in a systematic, long-term program that avoids the 
volatile atmosphere surrounding yearly spending authorizations.
    However, an infrastructure bank should adhere to certain key 
requirements:

    The bank should be capitalized initially by general fund 
        appropriations and should be self-sustaining after the initial 
        start-up period.

    The bank should develop financing packages for selected 
        projects which could include direct subsidies, direct loan 
        guarantees, long-term tax-credit general purpose bonds, and 
        long-term tax-credit infrastructure project specific bonds.

    The bank should not replace existing infrastructure funding 
        and financing mechanisms, but act as a supplement to leverage 
        Federal, State, local, and private infrastructure financing.

    Additionally, ASCE encourages an infrastructure bank where public 
works projects must meet the continuing needs to provide natural 
resources, industrial products, energy, food, transportation, shelter, 
and effective waste management, while at the same time protecting and 
improving environmental quality. Sustainability and resiliency must be 
an integral part of improving the Nation's infrastructure. Today's 
transportation systems, water treatment systems, and flood control 
systems must be able to withstand both current and future challenges. 
Infrastructure systems must be designed to protect the natural 
environment and withstand both natural and man-made hazards, using 
sustainable practices, to ensure that future generations can use and 
enjoy what we build today.
    Furthermore, a National Infrastructure Bank should allow States to 
make the ultimate decision on which projects receive financing from the 
Federal bank based on established priorities. The bank however, should 
retain sufficient oversight to guarantee an equitable distribution of 
funds and to ensure that all eligible projects are able to compete for 
financing on a relatively even footing.
    Without long-term financial assurance, the ability of the Federal, 
State, and local governments to do effective infrastructure investment 
planning is severely constrained. Therefore, in addition to a National 
Infrastructure Bank ASCE also supports:

    User fees (such as a motor fuel sales tax) indexed to the 
        Consumer Price Index.

    Appropriations from general treasury funds, issuance of 
        revenue bonds, and tax-exempt financing at State and local 
        levels.

    Trust funds or alternative reliable funding sources 
        established at the local, State, and regional levels, including 
        use of sales tax, impact fees, vehicle registration fees, toll 
        revenues, and mileage based user fees to be developed to 
        augment allocations from Federal trust funds, general 
        treasuries funds, and bonds.

    Public-private partnerships, State infrastructure banks, 
        bonding and other innovative financing mechanisms as 
        appropriate for the leveraging of available transportation 
        program dollars, but not in excess of, or as a means to 
        supplant user fee increases.

    The use of budgetary firewalls to eliminate the diversion 
        of user revenues for noninfrastructure purposes.

    ASCE is concerned with the accelerated deterioration of America's 
infrastructure, with the general reduction in investment for the 
preservation and enhancement of our quality of life, and with the 
United States' continued competitiveness in the global marketplace. As 
stewards of the Nation's infrastructure, civil engineers must be a 
voice in the national debate on infrastructure. ASCE has and will 
continue to support innovative financing programs that not only make 
resources readily available, but also encourage the most effective and 
efficient use of those resources. However, financing alternatives such 
as a National Infrastructure Bank, cannot replace a public commitment 
to funding. Financing by any technique does not supplant the need for 
adequate user fees or other funding sources to eventually pay for 
projects.
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