WASHINGTON — How to ensure the Federal Deposit Insurance Corp. has the flexibility it seeks while giving investors and issuers the certainty they need emerged Wednesday as the central sticking point confronting lawmakers interested in developing a covered bond market in the U.S.

At a Senate Banking Committee hearing, supporters of the plan argued that covered bonds are an untapped channel that could supply additional liquidity to the sluggish mortgage markets. But their drive remained beset by doubts from the FDIC, which is concerned that covered bonds could potentially make bank failures more expensive.

"The issue is the rub between the rights that the FDIC understandably wants to have and the clarity that the investors in covered bonds want to have in the event there is a problem with the institution," Sen. Bob Corker, R-Tenn., who asked for the hearing, said in an interview. "To me, that's the essence of what's standing in our way of having a real covered bond market, and I hope over the period of the next several months we figure out a way to resolve that."

Rep. Scott Garrett, R-N.J., who testified before the Senate panel, has written legislation designed to expand the covered bond market.

"As our nation continues to recover from the recent financial crisis and certain credit markets remain locked, Congress must examine new and innovative ways to encourage the return of private investment to our capital markets," he said.

"I believe covered bond legislation offers a way for the government to provide additional certainty to private enterprise and generate increased liquidity through the innovation of a new marketplace without putting taxpayers on the hook … The reason why I have been so active in pushing covered bonds this year is because they could help now."

Lenders would keep covered bonds on their balance sheets — instead of selling loans to be packaged into securities as in securitizations — and they could require the collateral behind the bonds to be refreshed with new loans if the original assets stop performing.

Garrett's bill passed the House Financial Services Committee unanimously in July, but its prospects in the Senate are unclear.

Banking Committee Chairman Chris Dodd raised several questions related to covered bonds on Wednesday, including which entities should be eligible to issue covered bonds, which agencies should regulate them, what assets should be eligible and what standards should apply to issuance.

But much of the hearing focused on the gulf between the broad leeway the FDIC wants when it handles an issuer failure, which it argues is needed to prevent the creation of a special class of protected investors, and the certainty sought by investors that the agency will not rob them of the value of a bond at full maturity by requiring an investor to accept a forced acceleration of the bond.

"Obviously, from their [the FDIC's] standpoint, they want to have access to every piece of collateral they can have access to, and I can understand something being walled off would be of concern to them," Corker said.

"But I would think there would probably be a rational way of solving that."

Michael Krimminger, the FDIC's deputy to the chairman, argued that the agency supports creating a covered bond market but needs more flexibility to handle an issuer failure than the Garrett bill would allow.

The agency is specifically seeking the right to repudiate contracts, which is currently an option for the FDIC when putting a failed bank into receivership.

"We should not transfer investment risk of covered bond investors to the public or to the Deposit Insurance Fund," Krimminger said. "In short, covered bond investors should not be given extra protections that are unavailable to any other investors."

Krimminger said that the FDIC supports the intent of the bill but emphasized that it must have more power over covered bond receiverships.

The Garrett bill "transfers the risk of loss to the Deposit Insurance Fund if, as is usually the case, the cover pool is worth far more than the total" remaining assets, Krimminger said.

But Scott A. Stengel, who testified on behalf of the Securities Industry and Financial Markets Association's U.S. Covered Bond Council, argued that the kinds of power the FDIC is seeking could spook investors and undercut the legislation's intent.

"The message that we want to convey is that, if we are talking about covered bonds that have been accelerated, we are not talking about covered bonds, and we can put our pencils down and there will be no market," Stengel said.

The kinds of freedom the FDIC wants run counter to how covered bonds work in Europe and elsewhere, he argued.

"In these circumstances, investors face a number of uncertainties," he said. "Equally troubling to investors and other market participants is the fact that these options reside with the FDIC, which has a rather clear conflict of interest because of its fiduciary duty to depositors and the Deposit Insurance Fund."

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