by Rachelle Horn

NEW YORK, March 11 (IFR) - Covered bond advocates descended on Capitol Hill on Friday to testify before the House Financial Services Committee as the cause for establishing a market in the United States looks to be gaining traction.

Covered bonds are debt instruments issued by banks and secured by a cover pool such as residential mortgages or public-sector debt to which investors have a preferential claim in the event of default.

Unlike mortgage-backed securities, covered bonds remain on the issuer's balance sheet and are therefore seen as a safer alternative to the originate to sell model of existing mortgage-backed securities.

There have been several attempts to establish a market in the U.S., but they have been stymied by a lack of legislation, competition from other sources of mortgage financing such as mortgage giants Fannie Mae and Freddie Mac , as well as uncertainty surrounding the FDIC's role in the event of bankruptcy.

But some believe the tide is turning following the introduction of the United States Covered Bond Act of 2011 to Congress on Tuesday, and the clear intention of the government to wind down the government-sponsored enterprises (GSEs). Just how far and how quickly a market can develop remains a matter of debate.

Ed Fitzpatrick, a fixed income fund manager at Schroders, said U.S. banks are flushed with deposits which could stifle issuer demand for covered bonds.

Why would you spend the money setting up a covered bond programme, especially while you still have competition from the GSEs? he said.

I think it would be very difficult. There will not be any U.S. covered bonds unless the legislation passes and the issue with the FDIC is resolved. And that is before you even get into the issue of pricing, he said.


Foreign banks are expected to issue $50 billion dollars in covered bonds to U.S. investors in 2011, according to Bank of America , one of just two U.S. banks to have an established covered bond programme.

But U.S. banks may have to wait until 2012 before they can tap this funding source.

Brad Brown, a managing director in Bank of America's corporate treasury group, said the bank remains very supportive of the development of a covered bond market in the United States.

As a potential issuer, our view is that covered bonds provide an attractive, private, stable and diversified funding source for issuers that promotes transparency, underwriting discipline and quality liquidity to the credit markets, he said.

However, a funding official at a competing U.S. bank who wished to remain anonymous said there is still little enthusiasm for covered bonds.

This lack of support also translated to our organization, he said, adding that this will continue to be the case for as long as GSEs remain a part of its revenue-generating business.

Our view is that without an acceptable legislation in place, covered bonds, from a credit perspective, would be too expensive.

Key to the success of the covered bond legislation is the FDIC's concern that legislation would impair its ability to recover losses from its deposit insurance fund when it winds down a failed bank by allowing covered bond holders to be treated differently than other creditors.

The bill introduced on Tuesday made it clearer that the FDIC is unlikely to get access to the cover pool in terms of receivership, said Patrick Dolan, a partner at Dechert LLP.

If an institution goes into receivership, the cover pool will be set aside, he said.

The FDIC will have 180 days to transfer the cover pool to another institution and during that period it must cause servicing obligations regarding the cover pool to be met. Alternatively, the FDIC may send a notice indicating that it has elected to cease performance with respect to the applicable covered bond program.

Some comfort can be gleaned from a comment made by FDIC chairwomen Sheila Bair at the Reuters Future Face of Finance Summit earlier this month.

There are advantages to having covered bonds in terms of the bank, the loans staying on balance sheet, and capital held against them. We support the covered bond market, she said.


In testimony to be delivered later on Friday, Industry veteran Tim Skeet, a consultant at Amias Berman & Co and former head of covered bonds at Bank of America Merrill Lynch, will argue that covered bonds did not help inflate the mortgage bubble.

The instrument has consistently been viewed as part of the solution to resolving market imbalances, not a cause, he said.

The U.S. mortgage market is $11 trillion in size, with Fannie Mae and Freddie Mac accounting for $4 trillion of that total.

Analysts at Bank of America Merrill Lynch project that a U.S. covered bond market could grow to $475 billion.

Scott Stengel, a partner at King & Spalding in Washington and a member of the U.S. covered bond council, will testify on behalf of the Securities Industry and Financial Markets Association.

Stengel will say that U.S. covered bonds are an untapped but proven resource that could be invaluable in meeting this need.

We believe that the time for U.S. covered bonds is now, said Stengel.

While the balance sheets of financial institutions cannot replace the multi-trillion dollar securitization market, covered bonds can bridge funding gaps in the short term and can supply a much needed source of complementary liquidity in the long term, he said.

Similarly, while covered bonds are no panacea for the difficult policy issues that have been raised in the context of GSE reform, a robust covered bond market would immediately attract private capital without need of a federal subsidy and would ultimately contribute to a more stable system of mortgage finance.

With the success of a fragile economic recovery hanging in the balance, we simply cannot afford to wait any longer, he said.

(Reporting by Rachelle Horn; Additional reporting by Timothy Sifert in New York and Aimee Donnellan in London)