On Tuesday, the conference committee for financial reform moved the most important amendment forward that you'll probably hear almost nothing about. The House side passed a provision which would create the legal framework for a covered bond market in the U.S. Covered bonds have been popular in Europe for a long time, and some believe that they could be part of the answer to the housing policy problem in the U.S. The Senate is expected to approve the amendment, perhaps with a few tweaks.

The legislation (.pdf) was offered by Rep. Scott Garrett (R-NJ). According to his spokesperson, here's some of what it would do:

  • Create a covered bond regulator within the Department of Treasury
  • Define the eligible asset classes to be included in the "cover pool"
  • Establish eligibility criteria for issuers interested in offering covered bonds
  • Detail the process of transferring the covered assets to a separate estate in the event of an issuer insolvency
  • Appoint an administrator to oversee and manage the separate estate

Credit markets in the U.S. have been clamoring for covered bonds for several years now. The market was on the verge of being established in mid-2007. Then, well, we all know what happened to the financial industry and mortgage market. This amendment could get it back on track.

A full description of how a covered bond works can be found here. Put simply, a covered bond looks like unsecured bank debt, but is secured by mortgages. In a sense, it's sort of a hybrid between an unsecured corporate bank bond and a mortgage-backed security. Covered bonds serve as a way for banks to obtain funding for more credit with mortgages still on-balance sheet, while still providing investors with a very attractive, ultra-safe security.

There are a few reasons why covered bonds are so desirable. First, you know how Washington is obsessed with banks having "skin in the game" when it comes to mortgage- and asset-backed securities? Covered bonds result in banks having all their skin in the game with regard to mortgages that back the associated debt banks issue. If theory is right, then bank underwriting standards will improve.

A covered bond market is also very desirable, because it's a way to enhance liquidity in the credit markets. Debt can be issued based on a pool of mortgages that can appeal to a variety of different investors. If banks can obtain financing for mortgages more easily, then they'll have to rely less on government-sponsored entities like Fannie Mae. While covered bonds might not be the only answer to the housing finance problem, they could very well be part of the solution.

As you might expect, the securitization industry is very pleased at the prospect of this amendment passing. The Asset Securitization Forum's Executive Director Tom Deutsche is positive about this development, saying that covered bonds would be very helpful to credit markets. He added that, while this legislation is a great start, there needs to be quite a bit of follow-up with bank regulators. But he thinks the bedrock legal framework this provision creates will help to provide stability to covered bond programs in the U.S.

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