Covered bonds won't replace securitization - BofA

NEW YORK Feb 8 (Reuters) - The nascent market for U.S. covered bonds will complement, not replace, traditional mortgage securities despite the crisis in many off-balance sheet transactions, the biggest U.S. issuer said this week.

Losses in mortgage debt sold by Wall Street issuers and government-sponsored enterprises have put a spotlight on covered bonds, which also are backed by pools of assets but are perceived as less risky because the assets stay on the issuer's balance sheet.

But issuers' desire to protect their credit ratings and a lack of liquidity in covered bonds mean they will not pose serious competition for the type of mortgage securities that raised the bulk of funds for housing loans in the past decade.

Covered bonds are bank obligations, and overuse of them could hurt issuer ratings, which in turn are important for other debt funding, said Paul Baalman, a Bank of America Corp (BAC.N) structured finance executive.

"You are never going to load up on this because you have the rating agencies looking at your secured debt," Baalman said at the American Securitization Forum meeting in Las Vegas.

Bank of America, one of just two U.S. issuers, will resume issuing euro or dollar-denominated covered bonds once market volatility breaks, he said. The bank has not sold a covered bond since mid-2007 as yield spreads widened and only one issue was dollar-denominated.

Like mortgage-backed securities, the cash flow off a pool of loans "covers" a covered bond. But since the underlying loans stay on the issuer's balance sheet, lenders may reduce the kind of risk-taking that led to the the mortgage meltdown, Federal Deposit Insurance Corp. Chairman Sheila Bair told the Reuters Regulation Summit on Tuesday.

Issuers use the $1.8 trillion euro market, which dates back to 1769 in Germany, to diversify funding, ASF panelists said. When Washington Mutual Inc (WM.N) issued the United States' first such bond in September 2006, it was seen as a cheaper source of money than its loans from the Federal Home Loan Bank system.

But it may take the involvement of more banks to get investors comfortable, panelists said.

Further, rising yields on the debt in recent months may have surprised investors that hoped the debt would be seen relatively free of credit risk, such as other "rates products" like the corporate debt obligations and mortgage-backed securities issued by Fannie Mae and Freddie Mac, they said.

As the credit crunch set in last year, "people thinking covered bonds were a rates product said 'wait a minute, it doesn't trade as liquid as a rates product'" said Ben Colice, an associate director at Barclays Capital, which managed WaMu's foray into covered bonds.

The bonds are often pitched to investors as alternatives to the debt of Fannie Mae FNM.N and Freddie Mac FRE.N, known as "federal agency" bonds. Agency debt is not guaranteed by the government but they have charters from Congress to fund U.S. home loans, and investors perceive this as implied backing.

And while Freddie Mac once eyed the covered bond market as competition, that fear has eased, said Mark Hanson, a Freddie Mac vice president for mortgage funding.

Meanwhile, there are holes in the argument that covered bonds would lead lenders to make more responsible loans. Credit derivatives, such as credit default swaps, could be used to hedge away any risks, Kathryn Dick, deputy comptroller in the Office of the Comptroller of the Currency told Reuters after another ASF panel.

"The reality is getting those risks disbursed more widely is the most desirable (route) for banks" versus on-balance sheet transactions, Dick said.