NEW YORK (MarketWatch) -- Investors and banks are looking to jumpstart a new form of mortgage debt to help the housing market just when it needs it most.
Analysts say the market for covered bonds, a form of debt used extensively in Europe and promoted by Treasury Secretary Henry Paulson last week, could grow to more than a quarter of a trillion dollars, giving a big boost to banks willingness to hand out more mortgages.
"If it catches on and works for the market, it will be a way of opening up the spigots for mortgage financing," said Jerry Webman, chief economist and director of fixed income at Oppenheimer Funds Inc., which manages about $225 billion.
Investors' hunger for mortgages has stalled since the credit crisis began last year, cutting off crucial financing for lenders and making it harder for would-be home owners to obtain mortgages.
"There will still be a lower volume than we saw in the first two-thirds of this decade," Webman said.
Paulson said Bank of America
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, Citigroup
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, J.P. Morgan
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and Wells Fargo
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intend to establish covered bond programs to kick-start the market.
"The investor is taking on the risk of the banks" and the mortgages, said Rob Corner, portfolio manager of the $400 million RidgeWorth Short-Term Bond Fund. "We're going to be looking hard at the banks, that they are industry leaders and have superior access to capital markets."
The banks that pledged to help fit that description, Corner said.
How we got here
Mortgage defaults have soared as falling home prices have made it impossible for many borrowers to refinance loans there were unable to afford. That's deterred many investors from buying mortgage-backed securities. In order to make bond yields attractive enough to investors, enabling banks to originate more loans, mortgage rates have had to rise.
The rate on 30-year fixed mortgages averages 6.41%, according to the Mortgage Bankers Association. That's barely budged from 6.50% a year earlier despite more than 3 percentage points in interest rate cuts from the Federal Reserve.
Further crimping the market for mortgage bonds, many financial institutions that used to package mortgages no longer do, or are out of business, leaving the whole job to government-sponsored mortgage buyers Fannie Mae
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and Freddie Mac
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That means far fewer loans are being offered to borrowers or packaged for investors. Issuance of mortgage-backed debt this year through July has dropped 83% from last year to about $119.6 billion, including offerings packaged by Fannie Mae and Freddie Mac, according to data tracker Dealogic. About $635 billion was sold in the first seven months of 2006.
With investors in those two government-sponsored agencies also shying away, the government and investment banks are looking to open a new avenue to draw investors, reversing the whole domino effect in order to get mortgage rates down.
The idea is to encourage banks to issue covered bonds: a secured debt instrument that provides mortgage loan interest and payments to an issuer, like a bank or depository institution.
Issuers hold it
Under the system that contributed to the current credit mess, banks were able to pass on the actual risks of mortgage loans to outside investors. But when issuing covered bonds, banks would be required to hold the mortgage assets on its books.
Having to hold the debt gives the issuer a very big incentive to only issue traditional, safer loans to borrowers with a down payment, income and credit history. The rules laid out by the Treasury effectively prohibit the kinds of subprime loans that precipitated the current credit crunch being allowed as collateral for covered bonds.
"With covered bonds, an originator who has to fund mortgages by keeping them on balance sheet has an immediate incentive to originate the highest quality mortgages," said Morgan Stanley analysts led by Michelle Bradley. "The originate-to-distribute model has been severely criticized in the wake of the subprime crisis, as it invokes moral hazard issues."
However, it limits the banks' ability to do what they've done in recent years: leverage the loans - sell off part of the amount, which enabled them to use that money to make more home loans to a wide range of borrowers.