SEC clears Royal Bank of Canada mortgage covered bond program

The Securities and Exchange Commission will allow the Royal Bank of Canada (RY) to offer covered bonds backed by residential mortgages in the U.S.

RBC qualifies to register covered bonds as a way to finance home loans outside of the securitization process, but its guarantor on the bonds did not. Morrison Foerster advised RBC on its registration.

According to a letter sent from the law firm to the SEC, the RBC limited partnership was established as the guarantor to continue making principal and interest payments in case the issuer becomes insolvent.

The SEC cleared the arrangement in a “no action” letter Friday, allowing the covered bond program to proceed.

Covered bonds are viewed as a structured finance success story in Europe, where the concept first derived. The bonds are considered a safe-haven investment and more than $164 billion in jumbo issuance appeared in the first seven months of 2011. A cover pool of mortgage loans, in which investors hold a preferential claim in the event of default, are a selling point to the bonds.

However, the bonds are expensive, considering the dual recourse structure that leaves banks liable for losses. A typical bullet repayment also tends to appeal to a separate investor base than securitization.

Moody’s Investors Service (MCO), which would be tapped to rate the RBC covered bonds, said in September it expects more U.S. banks to establish programs.

Lawmakers, led by Rep. Scott Garrett, R-N.J., continue work to establish a covered bond framework in the U.S., but a bill has only made it out of a House committee. A pair of senators attempted to move the legislation forward in March to no avail. Putting in a regulatory framework for covered bonds is viewed as a necessary step towards gaining investor trust domestically, thereby establishing robust platform. However the law does not prevent issuance. In the past, banks issued two dollar-denominated covered bond platforms, which continue to trade in the secondary market.

“The growing acceptance of covered bonds among U.S. regulators is a positive development,” said one of those lawmakers Sen. Kay Hagan, D-N.C., in a statement. “Unfortunately, until a legislative framework for covered bonds is in place in the U.S., our economy, U.S. lenders and their customers will be unable to benefit from the low cost funding that covered bonds provide. This is all the more reason for the Congress to act swiftly to pass legislation to authorize this mainstream capital markets product.”

Even though the SEC allowed the RBC deal to go through, not all American regulators are onboard for such programs based in the U.S.

In case of the issuing banks fail, the Federal Deposit Insurance Corp. would allow an entire pool to be liquidated in a short amount of time or pay the covered bond holders damages limited to the market value of those pools, likely at highly discounted prices during times of crises. The FDIC has lobbied against the Garrett legislation, arguing it should hold recourse to failed covered bond issuer assets, and not investors.

But foreign banks are continue to look for ways to expand the covered bond market in the U.S. through SEC blessings. According to a fact sheet provided by Morrison Foerster, issuers that do no use the two-tier structure to segregate the cover pool, as RBC did, would not get clearance by the SEC.

“(RBC) believes that covered bonds would provide an attractive investment alternative in the United States, and therefore believes that conducting a covered bond offering on a registered basis would greatly facilitate the introduction of the product in the United States,” according to the law firm letter to the SEC.

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