We heard about covered calls, but covered bonds? Portfolio.com have an article explaining briefly how this works:

Banks have assets and liabilities. If the bank borrows money from individuals, the liabilities are called “deposits”. Alternatively, the bank can borrow money from other banks, in the interbank market, or from the Federal Reserve. All of those borrowings are unsecured, and more creditworthy banks pay lower interest rates than less creditworthy banks in the interbank market. Banks can also issue bonds, if they want, which are also unsecured, and which can have much longer tenors – sometimes they’re even perpetual.

Recently, the market has been having a lot of concerns about the creditworthiness of banks in general. Interbank borrowing costs have gone up, while the prices of banks’ bonds have gone down. In such a situation, one way of bringing down borrowing costs is to borrow against collateral – secure the debt, rather than issuing unsecured debt.

Now historically, banks haven’t done this. If they have a pool of assets they want to secure, they’ll securitize it – basically, sell the assets outright to an off-balance-sheet special purpose entity for which they have no legal responsibility. In return for the assets they get cash on the barrelhead – they’re not borrowing money they’ll have to pay back in future.

But the securitization market, too, is broken right now. Investors have very little trust in the banks’ assets, which are things like mortgage loans. If the banks try to sell the loans outright, they won’t get much money for them.

Enter covered bonds.

With a covered bond, the bank doesn’t sell its assets (in this case, its mortgages); rather, it continues to own them, and it borrows money against them. If the bank ends up going bust, the lender can take possession of the underlying assets – the mortgages. But until then, the lender doesn’t own the mortgages, it just has a debt obligation of a bank.

There are two good things about covered bonds. The first is that because they’re secured rather than unsecured, they’re less risky than plain vanilla bank debt, which means that they constitute low-cost funding for the bank in question. And the second is that because the mortgages remain on the bank’s balance sheet rather than being securitized and sold off into the market, no one’s trying to sell mortgages in an environment in which the very concept is borderline toxic.

Now it’s true that covered bonds are, technically, mortgage-backed. But all the mortgages could default and go into foreclosure tomorrow, and so long as the bank remains in operation, the covered bond will pay out as normal. Similarly, if the bank blows up for some non-mortgage-related reason, investors in the bond will still get paid back in full. Their main risk is that the bank blows up because the mortgages blow up, and they’ll be left holding a bag of damaged loans – but because two things have to happen rather than just one, that risk is relatively low.

Could covered bonds be part of the solution to the current credit crisis? Paulson thinks so, and so do I. They’re not a panacea, by any means. But they certainly can’t do any harm, and they might be able to do some good.