House Financial Services Committee Chairman Barney Frank, D-Mass., recently called covered bonds "a very good idea" and promised the topic would be the subject of a housing subcommittee hearing — now scheduled for Dec. 15.

He was responding to a proposal by Rep. Scott Garrett, R-N.J., to amend a major House financial reform bill.

The draft amendment would establish a strong legislative framework for issuance of covered bonds. Both Republicans and Democrats should get behind this potential game-changer; it could significantly increase private capital funding in the U.S.

Many Americans heard of covered bonds for the first time last year when former Treasury secretary Henry Paulson noted that they constitute a $3 trillion market in Europe, with a 200-year tradition there. They are a form of on-balance-sheet funding, secured by various possible asset classes, that offers bondholders dual recourse for payment: both to the issuer (usually a bank) and to secured assets (held in the form of a separate "cover pool").

In contrast to the "originate-to-distribute" model of securitization, covered bonds require banks to keep "skin in the game" — a natural incentive to make sure their loans are sound and prudent. And unlike loan pools in securitizations, cover pools are dynamic; they can be replenished with new loans and liquid assets as needed to preserve value.

Though two U.S. financial institutions began covered bond programs before the financial crisis, covered bonds' development here has been greatly hindered by the absence of a specific legal framework. Garrett's proposal would remedy this. Among other things, his amendment would set standards for cover pools, designate the Treasury secretary as their regulator and establish important bondholder protections in case of default.

Congress could help move the U.S. economy forward on several fronts by passing covered bond legislation.

Funding for Main Street (and other) lenders. Many bankers already know that about 40% of U.S. residential mortgage debt outstanding is not securitized. Instead, it is sitting on financial institution balance sheets — a large part of it at Main Street lenders such as regional or community banks and credit unions. On-balance-sheet funding through covered bonds could free up cash for more lending without an additional capital charge for these portfolio lenders. This could be particularly useful for so-called jumbo home loans and other asset types for which funding is not available from government-sponsored enterprises.

Moreover, with the future of Fannie Mae and Freddie Mac uncertain, lenders of all sizes are justified in asking: Will GSE-subsidized funding decrease? Will the economics of Federal Home Loan Bank funding remain the same? The prudence of exploring supplemental funding sources is more obvious than ever.

In commercial real estate, an estimated 75% of recently issued loans are currently on banks' balance sheets rather than in commercial mortgage-backed securities. Covered bonds could potentially help increase liquidity in that arena, which needs it badly. Also, covered bonds could potentially fund "warehouse" lending, using cover pools where loans are placed for short periods on a flow-through basis. Other classes of debt could also enjoy new funding flexibility.

Diversification of investor base. In Europe, covered bonds are known to attract a different type of investor than securitizations. Since covered bonds historically have taken the form of longer-term bullet bonds, they typically appeal to conservative, "buy and hold" investors who are willing to give up yield in order to avoid prepayment risk and gain the protection of dual recourse. Many observers have pointed out that this diversification of investor type could benefit U.S. lenders.

Potential Federal Reserve bridge to private capital. The Fed has bought a staggering net $1 trillion worth of mortgage-backed securities in order to help support residential real estate funding. The proposed legislation could give the Fed an exit strategy for shedding those massive holdings in a disciplined way while also helping to jump-start a U.S. market for covered bonds.

Under the covered bonds amendment, the cover pool for a covered bond would be allowed to include existing AAA-rated residential MBS. The Fed could offer to sell its MBS holdings at a modest discount to banks that have retained loan portfolios on their balance sheets, provided that they then use the MBS in cover pools for covered bond funding from private investors. Special attention would of course be needed to ensure equal access to discounted MBS securities for financial institutions of all sizes.

Positive signal abroad. European Central Bank President Jean-Claude Trichet recently pointed out that, though securitizations had heavily underpriced credit risk — with "dire consequences" — covered bonds have proven safe over long periods. Though all financial instruments suffered greatly in the financial crisis, covered bonds were relatively resilient, with no defaults, and largely maintained their credit ratings. Moreover, during the course of this year covered bond issuance has rebounded, with spreads tightening almost to their pre-crisis levels. Covered bonds remain cost-efficient, with historical yields ranging from 20 to 100 basis points below unsecured bank debt.

Helping to establish this well-regarded, conservative funding source as a supplement to securitization would send a positive message to investors and governments around the world. It would show that the U.S. is serious about realigning longer-term assets on bank balance sheets with longer-term funding — putting banks on a more stable footing. And since covered bonds are widely trusted abroad, they could potentially bring in foreign investors who are now less comfortable with other instruments here.

Delivering the four benefits above through enactment of Garrett's covered bond proposal would be like hitting a home run with the bases loaded. America's bankers should make their voices heard in support.

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