FACTBOX: What is a covered bond?

(Reuters) - The U.S. Treasury Department and bank regulators on Monday unveiled guidelines for the development of a covered bond market in the United States as an alternative source of funding for mortgages to securitization.

Covered bonds are widely used by European banks to raise money to finance home loans, but their use has been scarce in the United States. Bank of America and Washington Mutual are the only U.S. banks that have issued covered bonds.

Federal Reserve Governor Kevin Warsh said banks can exchange highly rated covered bonds for cash at its discount window lending facility.

On Monday, Citigroup, JPMorgan Chase and Wells Fargo Corp said they plan to sell covered bonds to help kickstart the new U.S. market.

Roughly half of the $14.7 trillion in outstanding U.S. mortgages are in held in securitizations including those guaranteed by Fannie Mae and Freddie Mac.

Meanwhile, the Securities Industry and Financial Markets Association, a Wall Street trade group, said it had established a committee for traders for this type of bonds.

Following are some key facts about covered bonds:

** WHAT IS A COVERED BOND?

Covered bonds are securities issued by banks and backed by mortgage or public-sector loans.

Unlike the loans behind existing mortgage- and asset-backed securities, covered bond loans remain on the balance sheet of the bank issuing the bond, making the bonds obligations of the bank. The issuer keeps control of the assets and can change the make-up of the loan pool as well as alter the terms of the loans.

Covered bonds offer long-term funding to borrowers for long-term and relatively low-credit risk investments, such as acquisition or construction of residential, commercial or agricultural property, public investment and ships.

** HISTORY

Covered bonds make up one of the oldest and largest sectors of the European bond market.

In 1770, Germany introduced covered bonds, known as Pfandbriefe, to finance public works projects. Since then, 24 other European countries have adopted the covered bond system, each operating under a set of unique laws. Spanish covered bonds backed by mortgages are known as Cedulas Hipotecarias, while in France they are known as obligations foncieres.

** HOW BIG IS THE COVERED BOND MARKET?

According to the Bank for International Settlements, there were 1.7 trillion euros worth of covered bonds outstanding in mid-2007.

Total new issuance has averaged 220 billion euros annually in recent years, or roughly 15 percent of the euro-denominated bond market, according to the European Central Bank.

Germany leads the market in terms of outstanding bonds, with nearly 950 billion euros outstanding in 2006, according to the ECBC.

** RATINGS

Based on the quality of the loans, the legal framework for the bonds, and the strength of the issuing banks, most covered bonds receive high credit ratings of double-A or triple-A, which helps reduce funding costs for the borrower. This, in conjunction with their size and market-making commitments, has also led them to be regarded as similar to government bonds.

** HOW COVERED BONDS TRADE

Large covered bonds contain a market marking agreement, which guarantees liquidity, as banks are required to quote fixed bid-offer spreads on qualifying issues.

Recent market volatility, however, has led to questions over this commitment, as it can lead to distortions in spreads as a relatively small amount of paper ricochets around the market.

This led European regulators to propose a suspension of inter-bank market-making obligations.

** IMPLICATIONS FOR U.S. MARKET

Covered bonds offer banks another source of financing for mortgages to consumers, rather than selling their assets in the secondary market dominated by Fannie Mae, Freddie Mac and the Federal Home Loan Bank System.

Banks will likely pay higher interest payments on covered bonds than those on mortgage-backed securities but lower rates than their corporate debt.

Banks will also likely hold less capital against the pools of assets that back covered bonds compared to other assets but more capital than is currently required for mortgage-backed securities.

At the end of the first quarter, savings institutions held $5.1 trillion in mortgages on their books, according to Federal Reserve. Some of that could be used to create covered bonds.

(Reporting by Richard Leong)