The nation's top financial regulators and four of its largest banks announced plans yesterday to expand a method for financing mortgages, called "covered bonds," in an effort to reinvigorate the frozen housing market.
Covered bonds are securities that a bank can sell to raise money for home loans. In return, the bank receives monthly payments from homeowners and pays back the bonds.
Unlike the complex securities that backed most subprime mortgages over the past few years, covered bonds are kept in plain view on the financial statements of banks. These securities get their name because the banks issuing them must "cover" any losses if a borrower defaults on a loan, bank executives said.
Treasury Secretary Henry M. Paulson Jr. said the use of covered bonds should lead to better underwriting standards on Wall Street because banks would retain the risk of the bonds.
"The availability of affordable mortgage financing is essential to turning the corner on the current housing correction," Paulson said at a news conference at Treasury yesterday. "We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing."
The stock markets yesterday underscored the troubles facing banks and mortgage lenders even as Paulson was making his announcement in the afternoon.
Major stock indicators tumbled about 2 percent, dragged down by concerns over the health of the real estate market and banking system. Two community banks failed over the weekend, sparked by troubled commercial real estate and home loans, and Merrill Lynch announced that it would sell off $11.1 billion worth of mortgage assets at a discount and raise $8.5 billion in stock.
For months, Paulson has been seeking to import the practice of covered bonds from Europe, where they are a major way of backing loans and have grown into a $3.3 trillion business. The first covered bond was issued in Germany in 1769.
Executives from four banks -- Bank of America, J.P. Morgan Chase, Citigroup and Wells Fargo -- stood shoulder to shoulder with Paulson at the news conference and issued a joint statement saying they would consider issuing covered bonds, although they were not specific about their plans.
Two banks, Bank of America and Washington Mutual, have issued covered bonds in the United States. But they have yet to be widely embraced by debt investors, who have had concerns about their profitability, analysts said.
"It remains to be seen whether the current restrictions and inherent execution costs on covered bonds will allow the vehicle to become a viable substitute for alternatives," three analysts at Paul Hastings wrote in a July research report.
Regulators have announced a series of initiatives to help the fledgling market get off the ground.
Yesterday, the Treasury published guidelines for covered bonds, requiring banks to disclose details about the mortgage pools that are backed by the bonds and scrutinize the assets monthly to ensure the quality of the bonds.
Earlier this month, the Federal Deposit Insurance Corp. clarified several rules for covered bonds, stating that investors in covered bonds would have the right to get their money back within days if the bank issuing them were to fail.
"We must ensure that market mechanisms return to incentives that encourage sound underwriting and strong capital," FDIC Chairman Sheila C. Bair said. "I think that covered bonds can help achieve these goals, while bringing positive innovation to the U.S. market."
Federal Reserve Governor Kevin Warsh added that the Fed would consider accepting high-quality covered bonds as collateral if banks requested emergency funds.
Brad Brown and Chip Salter, both senior vice presidents at Bank of America, said in a joint telephone interview that covered bonds hold multiple benefits for everyone involved in issuing and financing mortgages.
Cash-strapped banks can use covered bonds to quickly raise money or to diversify the way they finance mortgages. "It's another arrow in the quiver that gives us options on funding," Salter said.
Debt investors are doubly protected if a borrower defaults on a mortgage, Brown said. Their first recourse is the bank issuing the covered bond. If that bank cannot make up for the losses, the investors still have a claim on the underlying collateral of the mortgage, which is the home.
Homebuyers looking for a mortgage will have an easier time because the moribund debt markets could be sparked by the development of a rigorous covered bond market, Salter and Brown said.
