Regulators and politicians alike believe covered bonds could help fill the void created when and if Fannie Mae and Freddie Mac are dismantled, but right now one of the biggest stumbling blocks to the market moving forward is the Federal Deposit Insurance Corp. (FDIC).

Among other things, the agency is concerned that a bill introduced by Reps. Scott Garrett, R-N.J., and Carolyn Maloney, D-N.Y., in the House would give covered bond investors superior rights over secured creditors and increase the cost of bank failures. But Treasury secretary Timothy Geithner believes those concerns can be resolved, though it will take some work.

“The FDIC has legitimate concerns,” the secretary told the Senate Banking Committee recently. For a covered bond market to work, “we would be putting the taxpayer, in some sense, behind private investors,” he said.“That has it own consequences. But it’s something we can work through.”

The Garrett-Maloney bill (H.R. 940) would create a regulatory framework for federally insured banks to issue covered bonds that are collateralized by mortgages (residential and commercial) as well as other assets.

Geithner said the Obama administration would “support legislation that would help create better conditions for a covered bond market.”

Last year large European banks issued $175 billion in covered bonds, and have already issued $70 billion so far this year.

U.S. issuers have only experimented with covered bonds, but foreign banks on a somewhat more regular basis have been selling dollar-denominated covered bonds to American investors.

Garrett believes covered bonds could become an alternative to issuing MBS, but cautions that these “new” instruments will not necessarily replace the MBS market.

Among other things, the Garrett-Maloney bill has a provision that allows small institutions to participate by issuing individual covered bonds into a pooling entity that aggregates the bonds into a single issuance.

But many community banks that make up a bulk of the Federal Home Loan Bank System (FHLB) are not buying into the covered bond story.

They remain concerned that large banks will turn to covered bonds and reduce their advance borrowing and stock in the FHLBs.

“Without large bank participation, the Federal Home Loan Bank System would not be as strong as it is and able to provide reasonably priced advances,” said Steve Andrews, president and chief executive of the Bank of Alameda (Calif.), which is a member of the San Francisco FHLB.

In issuing covered bonds, banks keep and service the underlying mortgages on their balance sheets.

They also must pledge additional mortgages so the bonds are overcollateralized. In addition, the issuing bank has to replace all mortgages as they default with new mortgages or cash.

The FDIC contends this structure shields investors from “all risks,” increases incentives for overcollateralization and reduces the loans available for the FDIC to sell if the issuing bank fails.

In the event of a failure, the FDIC should be allowed to “pay the outstanding principal and interest on the bonds and recover the overcollateralization,” the agency said in a statement.

But some elected officials and supporters of covered bonds warn that a market will never take hold in the United States if the FDIC approach is adopted.

Bank consultant Bert Ely pointed out that banks continue to hold the mortgages on their balance sheets and the FDIC will be well protected under its new bank assessment structure, which is based on assets, not deposits.

“Covered bonds would generate additional income for the FDIC that will far exceed the additional losses it might suffer from covered bonds,” he testified before Congress. Ely & Co. is based in Alexandria, Va.

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