Covered Bonds: What the Paulson Plan Means for You

JPMorgan, BofA, Wells Fargo, and Citi will issue the new bonds. Will they help the markets? Should investors bite? Here's what you need to know

by Avi Salzman

Treasury Secretary Henry Paulson announced a plan on Monday to encourage banks to issue a new form of debt known as a covered bond. Paulson said that if investors buy enough of these bonds, which are generally considered safer than many of the risky mortgage-backed securities that proliferated during the housing boom, banks will feel more comfortable financing mortgages again. That, along with various other measures, could restart the stalled housing market, Paulson said. Four banks—JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C)—have agreed to begin issuing covered bonds to "kick-start this market in the U.S."

What are covered bonds?

A covered bond is a kind of bond that is backed by mortgages. That might sound suspiciously similar to the mortgage-backed securities that got us into this mess in the first place, but there are several important distinctions. Whereas asset-backed securities generally take the mortgages out of a bank's hands and put the investor holding the security at risk when the home buyer defaults, covered bonds stay on the bank's balance sheet. They work like this: Banks make mortgage loans to customers. They use those mortgages as collateral to issue covered bonds, which, like other bonds, offer specified yields and maturities and trade on a public market. The banks hold onto the mortgages, however, and pay bondholders out of their own cash flow, not from the proceeds on the mortgages.

Covered bonds are considered safe investments because they must meet numerous standards. The loan-to-value ratio of the mortgages cannot exceed 80%, and borrowers must have documented income, according to the Treasury Dept.'s guidelines. In addition, no more than 20% of the underlying loans can be from one metropolitan area.

These types of bonds are popular in Europe, so why haven't they gained a foothold in the U.S. yet?

The European covered bond market is booming; it was valued at $3.3 trillion last year. Until Secretary Paulson's announcement, only two U.S. institutions—Bank of America and Washington Mutual (WM)—issued covered bonds, and the total value of the bonds in the U.S. was less than 1% of the European market.

Europeans were issuing covered bonds long before Americans were even officially American. As far back as 1770, Prussians issued covered bonds to finance agriculture. In the 1990s covered bonds took off with a vengeance in Europe as investors pushed for more liquidity in the mortgage market. Most European countries have legislation dictating what can and cannot be used as collateral, so the regulatory framework was firmly in place.