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), JPMorgan Chase ( JPM) and Citigroup ( C) - 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.

The covered-bond model would seem like a win-win situation in certain respects: It offers additional protection for bond investors; it allows banks to issue debt at a lower rate; and it protects the broader economy because banks tend to enforce tighter underwriting standards for loans kept on-balance-sheet.

Nonetheless, U.S. banks have little interest in issuing covered bonds right now.

First and foremost, they don't need to. Unlike the E.U., America has a few giant, government-run, taxpayer-financed institutions buying up hoards of high-quality MBS. And while investors are hungry for high-quality debt with a little extra yield, banks have no reason to tap the market for financing. Depositors and the federal government are throwing cash at banks for next-to-nothing.

"Money is very cheap and plentiful," says Ken Marin, a partner at Chapman & Cutler who specializes in securitization, "and the government has been a huge buyer of mortgage debt."

Of course, that situation isn't permanent. The current funding environment will dry up eventually and the current housing-finance system is about to be overhauled. But even if U.S. banks wanted to issue covered bonds right now, today, they'd find it difficult to woo investors at attractive rates.

"Investors are looking for legislation that would give really iron-clad certainty as to how they would be treated in the event a bank were to go insolvent," says Marin. "That hasn't happened to date."

Congress came close last summer.

Rep. Scott Garrett (R., N.J.), a leading proponent of covered bonds on Capitol Hill, nearly succeeded in getting a statutory framework tucked into the Dodd-Frank reform legislation. But, to the lament of covered-bond advocates, the provision was pulled from the broader bill at 3 a.m. on July 15, just hours before its passage.

"The problem is the FDIC," says Ely. "They deny being the problem but, in fact, they are."

Indeed, the Federal Deposit Insurance Corp. has represented a huge stumbling block in getting covered-bond market off the ground, from a regulatory and legislative perspective. The agency is responsible for handling bank failures at the lowest possible cost to its insurance fund. As a result, Bair, its chairman, isn't thrilled with the idea of letting some creditors run off with the best-quality assets while the FDIC cleans up the rest of the mess.

"This would result in decreased market discipline from investors who know that their risks are essentially back-stopped by the FDIC," Bair said earlier this week at symposium on the future of housing finance.

Since the start of 2008, the agency has handled more than 300 bank failures or assisted transactions; it considers another 775 or so entities to be at risk of failure. Problem banks have so far cost the fund more than $50 million - without the existence of generous credit protections that covered bonds offer.

The FDIC has taken issue with various aspects of Garrett's proposal. In a 2008 policy statement, the agency outlined its own terms and conditions for covered-bond issuance. Last month, Bair's deputy, Michael Kimminger, went as far as to say "it is unclear that legislation is necessary." He asserted that, if lawmakers insist on writing up some rules for covered bonds, they ought to base it on the FDIC's policy statement.

Through a spokesman, Garrett pledged to keep pushing the legislation forward next year - assuming, of course, that he gets re-elected. His proposal had broad support among lawmakers on both sides of the aisle, among other regulators and among market participants. But it's unclear how or when the legislation could pass without Bair's concerns being addressed.

Says Ely, one of the foremost advocates of covered bonds: "I think it's inexcusable the position that Sheila & Co. are taking at the FDIC. But, ultimately, there are going to have to be rules."

SIFMA is hoping Garrett's proposal can move forward "on its own merits," says Davy - apart from broader negotiations on housing finance, which may take quite awhile to resolve.

"Why would you not put it on the table?" says Davy. "And especially why would you not put it on the table for people to use when there's so much question about the other tools and how they're going to exist in the future. Don't you want to put more tools on the table when you think some of the existing tools are broken?"

Bair's argument about risk to the FDIC's insurance fund also loses a little steam after examining Europe's covered-bond market.

Germany, the crown jewel of European financial strength, has been using the funding mechanism since the 1770s. In fact, the few German banks that got in trouble did so largely by looking abroad for yield - including purchases of toxic, repackaged U.S. mortgage debt. But the Pfandbriefe and other European covered bond markets have continued to thrive throughout the crisis.

An aggregate index of weighted returns on one-to-10-year Pfandbriefe since the end of 2007 shows a steady trend upward, apart from a few months in 2008 when the credit crisis reached its peak. Over that time, the index has returned 12%, according to Bloomberg data.

Recent covered bond issuance proves that point: Just because there aren't any U.S. issuers of covered bonds doesn't mean the U.S. covered-bond market is sitting idle.

In fact, a record $26 billion in covered bonds have been gobbled up by U.S. investors. But while the country's four largest lenders - none of the recent issues came from U.S. banks. Competitors in Canada, France, Norway, Sweden, the U.K. and South Korea seized upon investor appetite instead.

"It's kind of a quirky situation," says Davy. "It's wonderful for international markets that these banks can come and tap that U.S. investor base. But at the same time, from a competitive standpoint in the U.S., you have money that could be funding U.S. financial system entities that is flowing overseas."

Covered-bond supporters haven't given up hope, even if their patience is being tried.

Marin, the securitization attorney, worked on both the only two issues from U.S. banks to-date - Washington Mutual in 2006 and Bank of America ( BAC) in 2007. He predicts "there will be a tremendous amount of demand over the next U.S.-issued covered bond" - whenever that may be.

"When a new financial product comes out, you have to create a market and there has to be some track record," he notes. "But once a couple of banks come out with some product, that's what will get the market going."

Ely doesn't expect the market to overtake MBS in the U.S. any time soon, but argues that it's an invaluable component of housing finance.

"I've never been a big fan of securitization, never thought it was particularly efficient," he says. "But now, I think we're seeing more broadly what its problems are. Covered bonds represent an alternative."

-- Written by Lauren Tara LaCapra in New York.

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