A U.S. market for covered bonds — touted by regulators last year as a potential alternative to securitization for financing mortgages — may be a step closer to reality.

During the debate over a broad reform bill that the House Financial Services Committee passed last week, Barney Frank, the panel's chairman, called fostering a covered-bond market "a very good idea." A measure to do so could be included in the final version of the bill, which is due for a vote this week, the Massachusetts Democrat said.

A covered bond is like a mortgage-backed security in that it is secured by a specific pool of loans. However, unlike in a typical securitization, a covered bond, and the assets behind it, remain on the issuer's balance sheet. Creating a market for these bonds could free up capital at banks, allowing them to write more mortgages — particularly jumbo loans, those too large to be securitized with federal guarantees.

"Covered bonds are a good segue to opening up the mortgage market in the U.S. because pretty much all U.S. mortgage financing at the moment is done through Fannie, Freddie and Ginnie; the private MBS sector is virtually nonexistent," said Jerry Marlatt, a lawyer at Morrison & Foerster. "The primary liability on a covered bond is the bank, not the collateral, because the collateral pool is updated every month, so it may be a more attractive investment in this climate than" private mortgage-backeds.

In July 2008 the Federal Deposit Insurance Corp. removed a major obstacle to covered bond issuance by permitting holders of the securities to claim their asset as soon as 10 days after an issuing bank went into receivership. Soon thereafter the Treasury Department, under then-Secretary Henry Paulson, released a set of best practices to establish a standardized way to offer covered bonds.

But such efforts were put on the back burner after Lehman Brothers went bankrupt and Fannie Mae and Freddie Mac went into conservatorship.

During the House committee's markup of the Financial Stability Improvement Act of 2009, Rep. Scott Garrett, R-N.J., introduced an amendment to lay out a statutory framework like those found in European countries for covered bonds. Such a framework, Garrett said, would "provide investors greater certainty in regards to their exact recourse if the issuing institution fails."

Though Frank asked Garrett to withdraw the amendment, he said the housing subcommittee should hold a hearing on the issue of covered bonds, and promised Garrett "the commitment for a hearing in December and the likelihood of being able to put this in the bill in the final version."

Steve Adamske, a spokesman for Frank, said a hearing date has not been finalized but will be announced one week in advance.

"Even though the amendment was withdrawn, we have a positive view because of what Chairman Frank said," said Sean Davy, a managing director at the Securities Industry and Financial Markets Association.

"A hearing would allow for a forum to both educate people as well as build further support. Even if something doesn't get out there within the momentum of the larger regulatory reform package, we're still several steps further along than we were six months ago."

Only two U.S. issuers, Washington Mutual Inc. and Bank of America Corp., have sold covered bonds, in 2006 and 2007. (Last year regulators seized Wamu's thrift and sold it to JPMorgan Chase & Co.)

"There will be people who will want to issue it if investors can be persuaded to invest in it and buy it at an acceptable price," said Tim Skeet, the head of covered bonds at Bank of America Merrill Lynch. "The most important job will be to persuade investors we have a high-quality, secure asset class which will be significantly less volatile than other parts of the capital markets have been."

The quick recovery of the European market, which was temporarily shut after the Lehman bankruptcy, supports that case.

"Every asset class suffered and covered bonds were not exempt, but … covered bonds were the first to recover. We saw issuance right from January, with … a rapid tightening of spreads," Skeet said. "This is a positive example for us to look at, from a U.S. perspective, regarding how the asset class is capable of recovering from a period of shock."

Citigroup Inc., Bank of America, Wells Fargo & Co. and JPMorgan Chase — all of which strongly supported Paulson's efforts in July 2008 — are likely prospects for issuing covered bonds, since they "are the predominant players in the mortgage market after Fannie and Freddie," Marlatt said.

Benefits to housing aside, there is another impetus for covered bond issuance.

According to a report issued last month by Moody's Investors Service Inc., banks will likely see $10 trillion of debt mature by the end of 2015, $7 trillion of it by the end of 2012. "If the whole banking system needs to refund liabilities in a three-to-five-year period, it's a pretty onerous task particularly if interest rates creep up," Davy said. "What you need is a broader mix of obligations for them to term out some of their debt, and covered bonds are a great option to do that."

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