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

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.

The certainty that the bonds can be easily bought and sold reduces costs to the issuer, making them a more attractive source of mortgage funding.

The U.S. housing market has traditionally been supported by mortgage-backed securities, which involve bundling loans into securities for sale to investors.

But financing for much of the market has dried up since the wave of mortgage defaults and foreclosures turned investors away from all but the guaranteed MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae.

"Recent events demonstrated (a covered bond) is not a rates product ... it's a hybrid," Skeet said. "We want to make it a rates product, to bring it back as much as we can."

To do that, Skeet and other dealers must win over U.S. investors who were surprised that covered bonds did not trade as easily as expected when the credit crunch set in last year.

Regular issues with minimum sizes of $2 billion to $3 billion will be required to foster the liquidity, similar to the programs started by housing finance giants Fannie Mae and Freddie Mac, which since 1997 have helped triple the "federal agency" market to $3 trillion, analysts said.

"The dealer community will need to continue to cultivate the buyer base," said Craig Leonard, co-head of U.S. syndicate at Barclays Capital in New York. "Pricing at the outset will probably be a bit wider than where it is likely to be 6-12 months down the road."

Despite statements of support from well-placed money managers like TIAA-CREF, dealers must convince investors they can feel as comfortable with the bonds as they do with the debt of Fannie Mae (FNM.N) and Freddie Mac (FRE.N), whose credit was underpinned last month by a sweeping funding backstops from the Treasury and Federal Reserve.

"Our country's banks tried for years to try to get investors in the U.S. for pfandbrief, and they found very few of them because your investors know Fannie Mae and Freddie Mac product," said Bodo Winkler, a division manager of capital markets at the Association of German Mortgage Banks in Berlin.

One manager at a large endowment said bonds that are dependent on the senior unsecured credit of a bank and securitization of mortgage assets, appear "gimicky."

"If I do not want to buy either in current form, why would a less liquid blend interest me?" the manager said.

But to Jason Brady, a portfolio manager at Thornburg Investment Management, it "all depends on the spread."