UPDATE 4-U.S. senators eye Fed as home for watchdog-sources
* No agreement yet on financial reform - Dodd spokeswoman
* White House official reaffirms agency independence is key
* Dodd, Corker discuss Fed as watchdog compromise - sources
* Shelby and Dodd have proposed other possibilities
* Watchdog's rule-writing power still a key to dispute (Adds Dodd aide, White House official comments, background)
WASHINGTON, March 1 (Reuters) - Two key senators were discussing making the Federal Reserve the home of a proposed U.S. government watchdog office for consumers that has been the main obstacle to bipartisan agreement on financial reform, said sources familiar with Senate discussions on Monday.
The Fed option, as unlikely as it may seem given recently sharp criticism of the central bank's past performance as a consumer protection regulator, could constitute a breakthrough in a stubborn dispute that has frustrated lawmakers.
But a spokeswoman for Senate Banking Committee Chairman Christopher Dodd, who is leading financial reform negotiations for the Democrats, cautioned that no deal is at hand yet.
"Senator Dodd is keeping members informed on how things are progressing as he has throughout this process," said Dodd spokeswoman Kirstin Brost. "We do not have an agreement yet. He hopes to have a consensus bill in the coming days."
President Barack Obama first proposed in mid-2009 that an independent Consumer Financial Protection Agency (CFPA) be created as part of a sweeping package of financial reforms.
But Republicans and bank lobbyists have resisted that proposal and Dodd has been seeking a compromise that will win enough Republican support to move a financial reform bill out of the banking committee and onto the Senate floor.
Dodd and Republican Senator Bob Corker, a first-term committee member, were talking about the Fed option, said sources close to the committee's ongoing negotiations.
Responding to reports about a Fed option being eyed, an administration official who asked not to be named said:
"The president is strongly committed to an effective and independent consumer agency, with real accountability for setting and enforcing clear rules of the road in the financial services marketplace."
Other options on the table in the Senate in recent days have included putting a consumer watchdog in the Federal Deposit Insurance Corp. or in the Treasury Department.
Senator Richard Shelby, the committee's top Republican, has proposed making the watchdog a division of the FDIC, with some rule-writing power and a director who is appointed by the president and confirmed by the Senate, documents showed.
DODD PROPOSED TREASURY OPTION
Dodd himself has proposed putting the watchdog in the Treasury Department, but Republicans have rejected that idea.
If Dodd were to settle on the Fed option, it would mark a dramatic turnaround for him.
In November he released a draft financial reform proposal that called for stripping the Fed of its consumer protection and bank supervision duties, leaving it focused on its core responsibility of managing the nation's monetary policy.
When he released the draft, Dodd said, "We saw over the last number of years when (the Fed) took on consumer protection responsibilities and the regulation of bank holding companies, it was an abysmal failure."
The urgent discussions swirling around the issue showed that negotiations among Shelby, Dodd and Corker are in full swing, but still have some ground to cover.
After marathon talks over the weekend, lawmakers remained snagged on how much rule-writing power the new watchdog should have, no matter where it is located within the government.
"We are at the start of a political dance between Dodd and Shelby. We expect more draft language -- and more headlines -- throughout the week," said financial services policy analyst Jaret Seiberg at investment advisory firm Concept Capital.
Tightening bank and capital market oversight is one of Obama's top priorities. Nearly a year and a half since a severe financial crisis tipped the U.S. economy into its worst recession in decades, financial regulation has changed little in the face of stiff resistance from banks and Wall Street.
But lawmakers in both parties generally concur that reforms are needed and analysts expect legislation this year.
CFPA THREATENS PROFITS
Obama's proposed CFPA would threaten the profits of banks, mortgage lenders, credit card companies and other businesses.
Republicans have said it would also unwisely divorce consumer protection laws from bank supervision.
But the CFPA is backed by many Democrats who see it as needed to shield Americans from deceptive financial products such as the subprime mortgages that played such a key role in inflating the real estate bubble behind the crisis.
The U.S. House of Representatives approved a sweeping financial reform bill in December that included Obama's CFPA.
Consumer activists were dismayed by the Senate debate, which they saw as leading to a watering down of reforms.
"We're holding out hope, but the White House seems to be losing the high ground as Congress waters down their proposal day by day," said John Taylor, president of the National Community Reinvestment Coalition, a public interest group.
(Reporting by Kevin Drawbaugh and Rachelle Younglai; Editing by Richard Chang)
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