Updated: 12/28/2015
The United States Securities and Exchange Commission (the “SEC”) adopted revisions to Regulation AB on August 27, 2014, after a four year process of proposals and review. Regulation AB is the rule that governs the offering disclosure and periodic reporting obligations of issuers of asset-backed securities (“ABS”).
Insofar as covered bonds are concerned, several things are clear. First, covered bonds are not included in the definition of “asset-backed security.” Item 1101 of Regulation AB provides that:
Asset-backed security means a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases.
It is clear that covered bonds are not “primarily serviced by the cash flows of a discrete pool of receivables or other financial assets.” Instead, covered bonds are senior obligations of the issuing financial institution and are expected to be repaid from the general funds of the institution. Accordingly, covered bonds should not be asset-backed securities and Regulation AB should not apply generally to covered bonds.
Use CBs to Restart the PLS Market
In the United States there is a lot of discussion about how to reduce the taxpayers’ exposure to housing finance. The conservatorships of Fannie Mae and Freddie Mac were a pointed reminder of the extent of the government’s, and the taxpayers’, role in housing finance. Additionally, after being taken into conservatorship, the GSEs were intentionally used to prevent a feared collapse of the housing market, further expanding their role.
As a result, the GSEs, together with FHA and GNMA, at one point provided more than 95% of the financing for new residential mortgage loans, and today they still finance roughly nine out of every ten new mortgage loans. At the same time, the private label securities (PLS) market, which provided significant private funding for residential mortgage loans, essentially vanished. The issuance of new PLS declined nearly 99% in the years following the crisis.
Today there is general agreement across the political spectrum that it would be desirable to restore some level of private funding for residential mortgage loans and reduce the role of the GSEs. There are also plans to reform the GSEs and refine their mission in housing finance. There is less agreement on the reform proposals.
On June 27, 2014, Treasury Secretary Jacob Lew requested comment on what steps could be take to restore a functioning PLS market. Almost uniformly the commenters voiced the need to shrink the presence of Fannie and Freddie in the market in order to make room for a PLS market. This reflected the view that under the existing authority of the GSEs, the private market would not be price competitive and would only be able to finance a small number of loans that did not qualify for financing through the GSEs under their very high loan limits.
However, the presence of the GSEs is not the only factor impeding the development of the PLS market. The regulatory landscape for securitizing mortgage loans has been altered dramatically since the crisis. Basel III imposes heavy, in some cases almost punitive, increased capital requirements on banks and most particularly for securitization exposures held by banks. The risk weighting for securitization exposures can range up to 1250% and in some cases, such as non-cash gain on sale, the capital requirements will result in a deduction from Tier 1 equity capital. Rulemaking by the Consumer Financial Protection Board exposes any holder of a mortgage loans to severe penalties for those loans not underwritten in accordance with the CFPB underwriting criteria, which are designed to protect the borrower. SEC requirements for mortgage securitization require 270 data points of information to be disclosed for every mortgage loan in a securitization, both at the time of the offering and in periodic reporting for the life of the securitization. Then there is risk retention, prohibited conflicts of interest, margin requirements for swaps, the Volcker Rule, conflicting requirements in foreign securities markets and a litany of other burdens on the PLS market.
SEC Finalizes Reg AB II
On Wednesday, August 27, 2014, the United States Securities and Exchange Commission finalized the changes to Regulation AB (commonly referred to as Reg AB II). The Commission issued a press release and a draft adopting release adopting the changes. The final version of the adopting release will be published in the Federal Register after review by the Office of Management and Budget (OMB). Regulation AB II and the related changes regulate the offering process and the disclosure and reporting requirements for asset-backed securities. Perhaps the most significant changes are (i) a requirement to file a preliminary prospectus at least three days prior to the sale of any securities and (ii) disclosure of loan-level information in machine readable form for ABS backed by residential mortgage loans, commercial mortgage loans, auto loans, auto leases, and debt securities (including resecuritizations). Updated loan-level data also must be filed periodically after issuance of the securities. The loan-level disclosure requirements come into force not later than two years after the effective date of the changes, which will be the date of the publication of the changes in the Federal Register.
The effect on covered bond issuers of these changes is still being analyzed and will be covered by a later post. However, it is clear that these changes would not be directly applicable to Rule 144A offerings of covered bonds.
See the MoFo Client Alert.
SEC Calls Reg AB II Meeting
The SEC announced today that it would hold a public meeting to consider amendments to Regulation AB on Wednesday, August 27:
SECURITIES AND EXCHANGE COMMISSION
Sunshine Act Meeting.
Notice is hereby given, pursuant to the provisions of the Government in the Sunshine Act, Pub. L. 94-409, that the Securities and Exchange Commission will hold an Open Meeting on Wednesday, August 27, 2014 at 10:00 a.m., in the Auditorium, Room L-002.
The subject matters of the Open Meeting will be:
- The Commission will consider whether to adopt rules revising the disclosure, reporting and offering process for asset-backed securities. The revisions would require asset-backed issuers to provide enhanced disclosures, including information for certain asset classes about each asset in the underlying pool in a standardized, tagged format, and revise the shelf offering process and eligibility criteria for asset-backed securities.
- The Commission will consider whether to adopt rule amendments and new rules to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act concerning nationally recognized statistical rating organizations, providers of third-party due diligence services for asset-backed securities, and issuers and underwriters of asset-backed securities under the Securities Exchange Act of 1934.
The duty officer has determined that no earlier notice was practicable.
At times, changes in Commission priorities require alterations in the scheduling of meeting items.
For further information and to ascertain what, if any, matters have been added, deleted, or postponed, please contact:
The Office of the Secretary at (202) 551-5400.
Kevin M. O’Neill
Deputy Secretary
Dated: August 22, 2014
http://www.sec.gov/news/openmeetings/2014/ssamtg082714.htm
Although the SEC’s proposal to amend Regulation AB (hence Reg AB II) is primarily concerned with asset-backed securities, the Commission’s action will be of interest to covered bonds issuers for two reasons:
- whether covered bonds will be defined as asset-backed securities and therefore expressly subject to Reg AB II;
- whether Reg AB II requirements will be extended to asset-backed securities sold under Rule 144A.
Covered bonds do not fall within the current definition of asset-backed security, as the SEC has recognized in several no-action letter issued to Canadian banks. Nevertheless, in those no-action letters, the SEC has required the banks to comply with specific provisions of current Regulation AB as a condition of registering covered bonds with the SEC. If those provisions are amended, the banks could be required to comply with the provisions as amended.
However, if covered bonds are defined as asset-backed securities under Reg AB II, there may be other provisions that they would be required to comply with, including possibly the proposed requirement to issue a preliminary prospectus at least five days prior to the sale of any security.
Until now, Regulation AB has applied only to asset-backed securities registered with the SEC, and 144A covered bonds have not been subject to the regulation. The extension of Reg AB II to asset-backed securities offered under Rule 144A would therefore affect Rule 144A covered bonds if covered bonds were defined to be asset-backed securities. The extension of Reg AB II to privately placed securities sold under Rule 144A would be a major departure from prior practice. If Reg AB II is not extended to 144A securities, covered bonds could still be offered in the United States under Rule 144A without complying with Reg AB II, even if covered bonds were defined as asset-backed securities under Reg AB II.
Accordingly, the outcome of the meeting on Wednesday will be of considerable interest to covered bond issuers who currently offer or plan to offer covered bonds in the United States.
BNS Files U.S. Prospectus
BNS initially filed its registration statement for its legislative covered bond program on Form F-3 with the SEC on May 31, 2013. That registration was declared effective on September 9, 2013. However, BNS did not file a prospectus under the registration statement with the SEC until today, August 20, 2014. In the interim, BNS filed a prospectus with the UKLA and offered covered bonds in Europe on March 26, 2014. Now, with the filing of a prospectus with the SEC, BNS is ready to offer covered bonds in the U.S.
Year to date, the U.S. covered bond market has been very quiet. Only two issuers have brought bonds to market for a total of $3 billion: Westpac Banking Corp. on May 14 and Commonwealth Bank of Australia on June 14, both privately placed offerings. So far, no registered covered bonds have been issued in the U.S. in 2014.
Comment Letter to Treasury on Restoring PLS Market
On August 8, Morrison & Foerster LLP filed a comment letter with the United States Department of the Treasury in response to a request for comments on the private sector development of a well-functioning private label securities (PLS) market for residential mortgage loans. The comment letter notes that perhaps the easiest way to restore private funding to residential mortgage loans in the United States is to implement a covered bond statute in the United States to enable U.S. banks to issue covered bonds. The letter notes that the conditions necessary to the establishment of a covered bod market in the United States are well advanced and that the market could be established quickly. Based on the development of the investor base in the United States, the SEC’s establishment of disclosure and reporting standards, and the well-developed legislation, creation of a domestic covered bond market would appear to be low hanging fruit that Treasury should take advantage of.
Moody’s expects lower predictability of government support for Canadian banks; changes banking system outlook to negative
On July 8, Moody’s followed up on its June 11 announcement regarding risk related to a “bail-in” regime in Canada with an announcement of the change to “outlook negative” in Global Credit Research. Additionally, Moody’s notes that “high household indebtedness and elevated housing prices remain key risks to banking system stability in Canada”. Further, Moody’s states that “growth sought by the banks has led them to diversify into riskier businesses and geographies which dilute their strong domestic credit profiles and represent a growing risk to the Canadian system’s stability”.
EBA report on favorable capital treatment
On July 1, 2014, the European Banking Authority published a favorable opinion on the preferential capital treatment of covered bonds. The EBA also delivered a companion report entitled EBA Report on EU Covered Bond Frameworks and Capital Treatment. See also the press release from the EBA. The EBA concluded that the favorable capital treatment under the capital requirements regulation (CRR) for bank investments in covered bonds was appropriate, but called for some “further qualifying criteria for their preferential treatment.” The EBA recommended against the use of aircraft liens, residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) as cover pool assets after December 2017. The opinion and the report were delivered to the European Commission in response to a request for advice.
With respect to favorable capital treatment the EBA said:
“Due to the good historical default/loss performance of covered bonds in the EU, the dual recourse principle embedded in covered bond frameworks whereby the covered bond holder has a claim on the issuing institution and a priority claim on the cover assets, the special public supervision for the protection of the bondholders mandated by the UCITS Directive and the existence of qualifying criteria in Article 129 of the CRR, the EBA considers the preferential risk weight treatment laid down in Article 129 of the CRR to be, in principle, an appropriate prudential treatment. “
Treasury trying to encourage private funding
Speaking in Washington on June 26 before the Making Homes Affordable Five Year Anniversary Summit, U.S. Secretary of the Treasury, Jacob Lew, gave a speech in which he addressed the need for housing finance reform. He also noted almost a complete absence of a private label securities market almost six years after the crisis and a need to restore private funding to the residential mortgage market. He noted that a series of questions was posted to the Treasury website seeking comment by August 8, 2014 on recommendations for reviving the private label securities market.
Neither Secretary Lew’s speech nor the posted questions mention covered bonds. Clearly covered bond legislation for the United States should be considered by the Treasury. The legislation introduced in 2011 by Representative Garrett, H.R. 940, passed the House Financial Services Committee by a very strong bi-partisan vote of 44-7. Passage of covered bond legislation should be easily achievable with Treasury backing and covered bonds could provide an important channel of private funding for the mortgage market. After all, covered bonds provide funding for about €3 trillion in the European market and the domestic U.S. market for covered bonds issued by foreign has shown healthy growth.
Moody’s: Canadian Banks on Outlook Negative
On June 11, 2014, Moody’s Investors Service changed the outlook of the seven largest Canadian banks from stable to negative and confirmed each of their long-term ratings. Moody’s stated that the action was taken in response to previously announced plans of the Canadian government to implement a “bail-in” regime for Canada. In Moody’s view, the balance of risks for senior debt holders and uninsured depositors of Canadian banks “has shifted to the downside.”
This rating action by Moddy’s has not affected the rating of any outstanding covered bonds issued by the banks. The current long-term ratings of the banks by Moody’s range from Aa3 to Aa1.