In Washington on Monday, Treasury Secretary Henry Paulson outlined a proposal for financial institutions to issue covered bonds to create broader choices for mortgage financing, and applauded the support of the nation’s four largest banks to spur the initiative.

 
In his statement, Paulson reiterated the importance of affordable mortgage financing in turning the corner on the current housing correction. He explained that he and other industry leaders have been examining alternative ways to increase availability and lower the cost of mortgage financing. Their solution – covered bonds.

Paulson said, “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.”

The U.S. mortgage market relies heavily on Fannie Mae and Freddie Mac and other government-linked institutions, such as the Federal Home Loan Banks and the Federal Housing Authority (FHA) for residential mortgage funding. These organizations currently provide more than 70 percent of the financing. Under Paulson’s plan, covered bonds would complement these traditional funding methods.

Paulson said the U.S. Treasury consulted with its European counterparts in examining ways to support the emergence of a covered bond market in the United States. He stated that European covered bonds are widely used for mortgage financing and represent a $3 trillion market.

While no legislation has been enacted regarding the covered bond issue, Paulson said the Treasury has published a Best Practices guide for U.S. residential covered bonds. Paulson said the document is intended to outline practices that will promote covered bond market simplicity and homogeneity, using high quality mortgages as collateral, and he urged banks to proceed without formal legislation.

Paulson added that the covered bond initiative would only be successful if the country’s leading banks paved the way. Alongside Paulson during his statement in Washington were representatives from America’s four largest bank – Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo – each of which has pledged to throw their hat into the covered bond ring and kick-start this market in the United States.

Paulson commended these institutions for their pioneering efforts. He said, “We applaud these banks for their leadership and for recognizing an opportunity to help increase mortgage funding availability and strengthen our financial system.”

According to a report on Bloomberg.com, all of the four banks were reluctant to announce any specific plans for bond issuance, illustrating how the market may be slow to take off in the United States following the recent mortgage meltdown.

Nevertheless, Paulson said, “We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing.”