"Paulsonbriefs", or covered bonds, seek Fannie/Freddie status

By Al Yoon

NEW YORK (Reuters) - The global credit crunch of the past year that shut down trading in many kinds of mortgage bonds is giving a second chance to a type of security many U.S. investors shunned.

"Covered bonds", a main source of mortgage funding in Europe, are back on the radar screen for U.S. banks and investors, aiming high for the coveted "rates product" trading status on Wall Street that currently applies to the trillions of dollars in debt issued by the U.S. Treasury, Fannie Mae and Freddie Mac.

Leading the charge is U.S. Treasury Secretary Henry Paulson, heralding the securities as a path of renewal for mortgage funding and market confidence.

He has convened some of the biggest banks and investors, including BlackRock Inc. and Western Asset Management, to lay a better foundation for U.S. covered bond trading after a shaky start in 2006.

Covered bonds are commonplace in European markets, modeled on the German "pfandbrief" that date back as far as 1769. The bonds are seen as a safer than many other mortgage-related securities since the pool of assets covering payments is backed by the issuer. Mortgages whose cash flows are earmarked to covered bonds stay on issuers' balance sheets, so they retain the risk.

Washington Mutual Inc., WM.N which pioneered covered bonds in the U.S., was heralded by Euromoney for a deal that "changed the market" in its bid to turn the Euro-centric securities global. Bank of America Corp (BAC.N) also issued covered bonds, but saw the market sputter as the bonds got tainted by the credit crisis, despite the extra layer of bank protection.

This time around, support from regulators and the U.S. Treasury could provide a second wind for the bonds, or "Paulsonbriefs," as one economist quipped.

With U.S. mortgage market confidence at stake, the U.S. Treasury and dealers hope to gain the confidence of investors who were skeptical of their protections and doubtful of Wall Street support in the secondary market.

"We all acknowledged the product had not been positioned optimally," said Tim Skeet, managing director and head of covered bonds for Merrill Lynch & Co. in London.

"There were a number of things, if we could have redesigned that market, we might have done differently. Now we have that opportunity."

The U.S. Treasury's "best practices" standard set in late July restricts the pool of collateral to low-risk mortgages, limits the debt to 4.0 percent of an issuer's liabilities and requires the market value of the loan pool to be 105 percent of the covered bond principal.

That document followed guidance from the Federal Deposit Insurance Corp. that removed a key hurdle by determining how investors can get their collateral if an issuer fails.

The quality of banks that pledged to sell covered bonds -- Bank of America, JPMorgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. -- will help dispel credit concern, Skeet said.

The goal of trading the bonds as pure "rates" products -- the most-actively traded bonds priced at low yield spreads -- may be a challenge at the outset, analysts said.

In addition to credit quality, rates products are bought and sold in the tens-of-millions of dollars by money managers and hedge funds for making adjustments to portfolios with the knowledge they can unwind the bet quickly, if needed.