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A Mortgage Fix That Won't Come Soon

NEW YORK ( TheStreet) -- Covered bonds have been heralded, time and again, as a cure for what ails the U.S. mortgage system, but a few things are standing in the way: Fannie Mae (FNMA.OB), Freddie Mac (FMCC.OB) and Sheila Bair.

In a different environment, covered bonds could be a viable alternative to mortgage securitization - whose flaws have been made even more evident of late. But cheap funding alternatives and regulatory pushback have relegated them to the sideline, once again. >>>Earlier Coverage: Once Favored Housing Fix Put on Back Burner

The Treasury Department first began hyping covered bonds in the summer of 2008, just before Fannie and Freddie were taken over. Despite its best attempts to "kickstart" the market , Congress' effort to pass covered-bond legislation, strong investor appetite, cooperation from the financial industry, and a joint pledge from the country's four largest lenders - Bank of America, Wells Fargo (WFC - Get Report), JPMorgan Chase (JPM - Get Report) and Citigroup (C - Get Report) - to become "leading issuers as the U.S. covered bond market develops," there have only been two issues from U.S. banks to-date. They occurred in 2006 and 2007 and one of the issuers no longer exists.

"People thought, 'Gee, this is the start of a new market' and then it never went anywhere," says Sean Davy, who specializes in covered bonds at the Securities Industry and Financial Markets Association (SIFMA).

The reason covered bonds have appeal - particularly now - is that they're quite different from the "originate to sell" model U.S. banks have embraced via mortgage securitization.

Covered-bond investors lend them money at a specified rate, with the assurance that a pool of top-quality mortgages have been "ring fenced" for them in case of insolvency. But the loans haven't been packaged, sold, chopped up and sold; they're kept on the bank's balance sheet. To maintain credit quality, lenders are usually able to swap out loans or change mortgage terms.

Total issuance in the covered bond market for 2010 is $338.5 billion, according to Dealogic.

It's a situation - unusual in this day and age - where mortgages represent piece of mind.

"It would lead to a sounder, safer housing finance system," says longtime banking consultant Bert Ely. "What we're seeing how seriously flawed the securitization process is."

Ely was alluding to the backlash plaguing major mortgage servicers today. Investors are demanding they buyback billions of dollars' worth of souring loans that were originated improperly. There's also the threat of litigation over sloppy foreclosure processes, which has led to confusion over who owns defaulted loans or the underlying property. As central clearinghouses of mortgage debt - originators, wholesale purchasers, sellers, packagers and servicers - big banks are feeling the heat.

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