Treasury Secretary Henry Paulson said Monday that covered bonds are an answer to financial market's request for clarity. He said covered bonds, a $3 trillion market used widely in Europe for mortgage funding, can develop without legislation in the U.S., and four of the largest U.S. banks are already prepared to set up the market.
Covered bonds are a debt instrument secured by a cover pool of mortgage loans or public-sector debt to which investors have a preferential claim in the event of default. The nature of this preferential claim depends on the specific framework under which a covered bond is issued; it is the safety aspect that is common to all covered bonds.
"I believe covered bonds have the potential to increase mortgage financing, improve underwriting standards, and strengthen U.S. financial institutions by providing a new funding source that will diversify their overall portfolio," Paulson said.
The Treasury also published a Best Practices guide for U.S. residential covered bonds. The document is "intended to outline practices that will promote covered bond market simplicity and homogeneity, using high quality mortgages as collateral."
The four banks willing to kick-start the program are the Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo.
Joining him at the press conference, Federal Reserve Governor Kevin Warsh said high quality bonds would be eligible to borrow from the discount window. Warsh added that the bonds will bring investors and create better access to credit.
"High-quality assets might be financed if banks are allowed to manage pools of loans, substituting new loans into the pool as others become delinquent," Warsh said. "Newly issued covered bonds backed by high quality mortgage loans and issued by strong financial institutions may find a growing investor base in the United States."
Paulson also said the GSEs Fannie Mae and Freddie Mac, which are funding more than 70% of residential mortgages, "must continue to be active."
By Patrick McGee and edited by Cristina Markham