U.S. covered bond appetite still suppressed

WASHINGTON Thu Mar 3, 2011 1:22pm EST

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WASHINGTON (Reuters) - Covered bond sales could boost the struggling U.S. mortgage bond market and give investors more options for highly rated securities, a top lawmaker and a senior regulator told Reuters this week.

But building a U.S. market is still in the theoretical stage, until housing finance reform scales back massive government support in the mortgage market.

"There are advantages to having covered bonds in terms of the bank, the loans staying on balance sheet, and capital held against them," Federal Deposit Insurance Corp Chairman Sheila Bair told the Reuters Future Face of Finance Summit.

"We support the covered bond market," she said.

Covered bonds offer banks a way to raise money for new mortgages without selling the loans. They are favored by European institutions where they play an important role in real estate funding.

Prior to the financial crisis, the Bush administration urged major banks to issue covered bonds as a way to promote U.S. mortgage financing, but the effort fizzled when credit froze and most domestic lenders held back from selling the debt without a legislative roadmap.

Bank of America (BAC.N) and Washington Mutual came on board with the administration and heralded the bonds as a way for banks to retain control of mortgages, but investors stuck with cheaper funding and relied on loans backed by government-supported Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB), often referred to as the GSEs.

ECONOMIC SENSE

Without guidance from lawmakers, and until Fannie and Freddie are shrunk, it will take time for investors to feel confident in how the loans are structured and sold in U.S. markets.

"Nothing actually prohibits the existence of a covered bond market right now. It's just that the market is so dominated by the GSEs that -- economically -- it doesn't make sense as an alternative to the market," Republican Representative Scott Garrett told the Reuters summit.

The Obama administration, Republicans and some Democrats have said they want to cut back the government's role in housing finance.

A bill sponsored by Garrett, that aimed to pave the way for covered bond issuance, failed last year when Democrats had a majority in the U.S. House of Representatives.

Garrett, who chairs the House panel overseeing mortgage finance giants Fannie and Freddie, said the House is on track to approve legislation revamping housing finance by year's end, yet did not specify a timeline for a bill dealing specifically with covered bonds.

He favors a backstop for the securities "within the framework of a regulatory institution."

But Bair said Congress needs to consider a bill that establishes "good market discipline," and does not rely on her agency to cover losses if covered bonds default.

She is concerned the FDIC's deposit insurance fund would be burdened when it winds down a failed bank by allowing covered bond holders to be treated differently than other creditors.

"I think it is important to get it right and we don't want the FDIC as the implied government guarantor of covered bonds," she said. "A true covered bond market, where covered bond investors are doing their own due diligence about the credit worthiness of the underlying bank, as well as the assets that have been set aside to back the covered bond issuance."

Bair stressed that finding ways to spur the sale of the alternatively structured products in U.S. financial markets could potentially "be another argument for phasing out the GSEs.

(Reporting by Margaret Chadbourn; Editing by Tim Dobbyn)

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