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Paulson unveils new mortgage plan

Four big banks sign onto the 'covered bond' concept in a new bid to ease the strains in U.S. mortgage markets.

By Colin Barr, senior writer
Last Updated: July 28, 2008: 5:22 PM EDT

Treasury Secretary Hank Paulson

NEW YORK(Fortune) -- The government is reaching across the Atlantic in its latest bid to revive the U.S. housing market.

On Monday, Treasury Secretary Henry Paulson laid out guidelines for banks seeking to issue so-called covered bonds as a way to finance home mortgages. Four big U.S. lenders - Citi (C, Fortune 500), Bank of America (BAC, Fortune 500), JPMorgan Chase (JPM, Fortune 500) and Wells Fargo (WFC, Fortune 500) - said they support the venture, though none said they have plans to issue the bonds right now.

By issuing covered bonds, a bank borrows money from investors, using assets on its balance sheet - such as home mortgage loans - as collateral. The investor gets a claim on those specific assets in the event the bank that issued the bonds fails, rather than having to line up with other creditors. Until now, covered bonds haven't been issued in the U.S., though the concept has long been in use in Europe.

But with the housing bust threatening to push the economy into recession - the International Monetary Fund warned Monday that "a bottom for the housing market is not visible" - policymakers and financial institutions have been trying out new ideas in hopes of making mortgages more available, while breaking the cycle of falling house prices and rising foreclosures.

"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 efforts of the big banks would "kick-start" the market's development, he added.

The move comes as shares of banks and brokerage stocks posted their latest sharp decline and investors fret over the fallout of falling house prices on the health of financial institutions. While the Federal Reserve has slashed short-term interest rates over the past year, partly in response to the sharp decline of house prices, mortgage rates recently soared to highs last seen at the turn of the century.

Banks in Europe have used covered bonds as a primary source of mortgage finance for many years, and the market is worth more than $3 trillion.

An alternative way to lend

Until recently, American lenders have preferred to sell their mortgage loans to investors as securities, in the process known as securitization. But when loans to borrowers with poor credit histories started souring at unusually rapid rates last summer, investors fled the market - a trend that marked the beginning of a credit crisis that has choked off lending in the housing market and, increasingly, elsewhere in the economy.

Monday's move comes on the heels of the Senate's approval of a bill that gives the Treasury the authority to buy shares in two struggling U.S. mortgage firms: Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500). Fannie and Freddie are the biggest providers of mortgage finance in the nation, through their guarantee of mortgage-backed securities and the purchase of mortgages for their own portfolios. Together, the firms hold or guarantee some $5 trillion of mortgages and mortgage securities.

With U.S. house prices having plunged at a double-digit rate over the past year, fears have arisen on Wall Street that Fannie and Freddie will face losses that will eat through their thin capital cushions.

Thus, with the securitization market in disarray and the government potentially on the hook for a bailout, Paulson is looking for ways to shore up the mortgage market.

For investors, one potentially appealing aspect of covered bonds lies in their structure. Because the bonds are backed by a specific pool of mortgages or other loans, investors in the bonds issued by a failed bank wouldn't find themselves in line with other general creditors. For banks, covered bonds could offer a new way to raise funds for mortgage finance, now that the securitization model is faltering.

Needed: more capital

Still, while the market can always use a new financing vehicle, covered bonds have drawbacks. One reason banks flocked to the securitization model was that selling their loans to a third party generated lucrative fees and eliminated the need to hold capital against the loans.

Covered bonds, being on the balance sheet, will create new capital requirements for banks that have spent much of the past year raising cash at a hefty cost to existing shareholders.

And while Europe's covered bond market is certainly large, it's no stranger to the fears that have shaken other debt markets. In fact, the U.K. covered bond market went into a tailspin late last year. And the yield on covered bonds sold in Europe by the two U.S. banks that have sold the bonds - Washington Mutual (WM, Fortune 500) and Bank of America - have soared since those offerings were made in 2006, Bloomberg reports.

Moreover, Monday's moves didn't change the fundamentals of the U.S. housing market. House prices remain above long-term norms, based on income and rental rates, and banks have gotten much stingier about who's eligible for a loan. Until demand for housing stops declining, changes in mortgage finance aren't likely to make much of a dent in the big picture.  To top of page

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