While a covered bonds market in the US could create a new asset class, attract private liquidity and aid in the origination of new loans, the system would require a sound legal framework to give investors certainty, expert witnesses told lawmakers Tuesday at a House Financial Services Committee Hearing. The discussion comes as the House considers legislation establishing a groundwork for legal treatment of covered bonds — debt instruments covered by a pool of loans that remains on the issuer’s balance sheet. An attempt was made in mid-2008 to get a US covered bonds market off the ground, but the worsening liquidity crisis in following months prevented any substantial efforts to facilitate the market. Pioneered as Europe’s pfandbriefe in the 1700s, covered bonds offer investors dual recourse in both the assets used as collateral and the underlying institution. This dual recourse system where the issuer maintains all the risk, along with the high underwriting standards of the loans in the covered bond pool, give investors confidence and can provide for liquidity in the US mortgage market, according to Rep. Scott Garrett (R-NJ), who recently introduced an amendment to establish a legal framework for a US covered bonds market. Garrett added to comments he made in a teleconference Monday by noting the prospect for modifications under a covered bonds structure are favorable to the securitization process, where loans are not held by the issuer. Modification of loans within securitizations is complicated by conflicts of interest held by multiple note holders. With covered bonds, the loans remain with the issuer, who has an interest in keeping the loans performing. Garret’s previously introduced amendment would create a detailed statutory framework to facilitate the use of covered bonds in the US. This would give investors surety in recourse, he said in the hearing Tuesay. His amendment defines asset classes that could participate in covered bonds — not only residential mortgages but others like commercial mortgages and auto loans. The Treasury Department would act as covered bond regulator. Witnesses at the hearing indicated a legal framework for the facilitation and oversight of US covered bonds would return Fannie Mae (FNM) and Freddie Mac (FRE) to a competitive market by creating a new channel for private liquidity. Alan Boyce, CEO of Absalon, George Soros’ joint venture with the Danish financial system to organize a standard mortgage-backed securities (MBS) market in Mexico, recommended that any US covered bonds market keep the interest of the issuing institution better aligned with those of the borrowers and investors. He said in cases where the institutions must pull nonperforming loans from covered pools, cash should be the only substitute. Bert Ely, a principal at financial institutions and monetary policy consulting firm Ely & Co., said covered bonds offer better credit risk management through 100 risk retention, since firms keep loans on their balance sheets. He said covered bonds offer borrower protection, as lenders keep the loans they make. He added lower interest rates are attainable through covered bonds, as transaction costs are lower to lenders. Finally, a substantial new supply of high-quality debt attracts international investors. Wesley Phoa, senior vice president of Capital International Research, agreed that covered bonds are an attractive investment. Asset management firms currently investing mainly in Government bonds sacrifice diversity and make investments more sensitive to policy changes, he said. Investing in covered bonds would provide a private sector alternative, as “safety comes from good collateral, not government support,” Phoa said. “Investors can live with economic uncertainty,” he said. “That’s our job. But uncertainty about institutions and policies is problematic. Sound investment analysis relies on a clearly defined framework of rights and duties. That’s a critical element of investor confidence.” He called for fundamental soundness and liquidity in a US covered bond market. He also noted the importance of adequate returns for investors, good oversight of the system and legal and policy certainty to secure a broad investor base. Scott Stengel, partner at Orrick, Herrington & Sutcliffe on behalf of the US Covered Bond Council, noted that institutions participating in covered bonds keep 100 percent “skin in the game” by keeping loans on their balance sheets. He recommended any legislation on covered bonds in the US define eligible asset classes to include not only residential mortgages, but home equity loans, commercial and multi-family loans, public sector, auto and student loans, credit or charge cards and small business loans. Christopher Hoeffel, managing director at Investcorp International Inc. on behalf of the Commercial Mortgage Securities Association (CMSA), said covered bonds could aid in the tightening of credit felt in commercial real estate (CRE) and commercial mortgage-backed securities (CMBS). “While covered bonds should not and cannot replace CMBS as a capital source for the CRE mortgage market, facilitating a commercial covered bond market will be additive,” Hoeffel said. Write to Diana Golobay.