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Covered Bonds Seen as Ripe for U.S. Role

Hoping to revive the private label MBS market, the Treasury Department last week issued a best practices guide aimed at underwriters that are interested in issuing "covered bonds" backed by nonconforming loans.

"The private label market is severely constrained," said Treasury secretary Henry Paulson at a press conference. "Fannie Mae and Freddie Mac are funding more than 70% of all mortgages today," he said.

A covered bond is a debt instrument backed by a specific pool of mortgages. The underlying collateral is held on the balance sheet of the institution issuing the security.

At the Treasury Department press conference last week, four major banking companies - Bank of America, Citigroup, JPMorgan Chase and Wells Fargo - expressed interest in issuing covered bonds in the next few months.

These four hope to issue the bonds directly through their banks without having to go through the expense of forming a special purpose vehicle or registering them with the Securities and Exchange Committee.

Mr. Paulson called covered bonds a "new funding source" for non-agency loans. Initially, the effort likely will entail jumbo mortgages and not necessarily subprime loans.

Mr. Paulson is hoping that Treasury's guidance will create "greater risk awareness and investor discipline." He said his agency is looking to support this nascent market.

Capital Research and Management of Los Angeles, an investment adviser, said, "We expect the covered-bond initiative will provide an important new source of long-term funding in the mortgage market. We also believe that the Treasury Department's best practices guide, especially its requirement for high-quality collateral, will provide the structure needed for the covered-bond market to develop over time."

Treasury's best practices guide opens the door for depository institutions to issue covered bonds without a special purpose vehicle. The next step for bank issuers will be to obtain clarification from the SEC that they do not need to register the covered bonds.

The combination of Treasury's best practices guide and the Federal Deposit Insurance Corp.'s July 15 policy statement on covered bonds has created a "good framework" for issuing covered bonds and more legal certainty for investors, said one industry source.

But some legislators believe investors need more assurance that the FDIC will not repudiate a covered bond if an issuing bank fails.

Rep. Scott Garrett, R-N.J., has introduced a bill (H.R. 6659) that treats covered bonds as "qualified financial contracts," so the FDIC cannot refuse to pay the investors.

The House Financial Services Committee member also calls for joint rulemaking authority so the FDIC has to reach a consensus with other banking regulators and Treasury on covered bond issues. Some critics have complained that the FDIC policy statement on covered bonds is too conservative in limiting a bank's issuance to 4% of total liabilities.

"FDIC is being excessively parochial," according to financial consultant Bert Ely. "FDIC is too narrowly focused on the potential impact to the deposit insurance fund without considering the benefits of covered bonds," he said. His firm, Ely & Co., is based in Alexandria, Va.

Brian Collins contributed to this report. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/

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