The main difference with the now infamous mortgaged-backed securities (which are backed by pools of mortgages) is the first point: ie the entity launching the bonds is still liable for them, so it has a direct interest in ensuring that the pool of assets backing the bonds have real value, otherwise it will be on the hook (as opposed to the creators of MBSs, which did not care what happened to their products once they had sold them, and thus took less than perfect care in building up their pools of assets).

The other difference is that the requirements with respect to the quality of the underlying assets tend to be much more stringent and specific, thus ensuring that they won't collaspe like the mortgages used in MBSs did.

Covered bonds are seen as a way for weakened financial players to extract liquidity from their otherwise illiquid long term assets, and therefore to free up balance sheet capacity to extend new mortgages. The Us Treasury has thus issued new guidelines to help develop that asset class, to help support the mortage market and beleaguered US banks.

So far, so good.

But in an intriguing twist noted by London Banker, the FDIC (the public entity in charge of protecting depositors from failing banks, and dealing with the aftermath of such bankruptcies) has provided a new policy statement with respect to covered bonds, which provides for an "expedited access to collateral pledged for certain covered bonds."

What this means is that lenders under covered bonds to banks that go bankrupt will have priority access to the underlying assets even during the bankrupcy process (whereas ordinary creditors will ony have access on a collective basis to the remaining unsecured assets, the quality of which is likely to be relatively poor, given that the bank went under).

This makes sense as a way to ensure that covered bonds are genuinely safer than the alternatives, an incentive that is probably required in today's markets to ensure that more liquidity becomes available.

But here's how that can go awry, as per London Banker:

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets.

They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.

When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

In other words, unscrupulous investment bankers might see an opportunity in helping weaker banks launching covered bonds; given their circumstances, these banks will have to provide top notch collateral, ie their best remaining assets, and will probably not get a great price for them (ie the bonds will be both overcollateralised and expensive). If that cash is stll not enough to solve these banks' problems - and give nthe scale of the crisis, it's likely not to be in many cases - then these banks will indeed go bankrupt, a little later than expected, but at that point they will have been sucked dry of their best assets, leaving only the junk behind - and leaving the cost of protecting depositors to FDIC, ie ultimately taxpayers, once the existing reserves of FDIC are drained.

And the investment banks will have (i) made fat fees on the covered bonds and (ii) grabbed good quality assets from the balance sheet of these banks in "expedited" fashion.

As ARGeezer duly noted, they are likely to get away with it because:

One: Very few people will pay close enough attention to notice what is happening.  It sounds wonky.

Two: If they speak out, they are endangering the contributions from these banks to their re-election campaigns.

Three: They can always say that they didn't expect THIS to happen.

Just a scenario at this point, but who would be willing to bet against the greed of the investment bankers and the cluelessness of the smaller banks when relief (even of the temporary kind) comes knocking at their door in desperate times?

But just for the record: the US Treasury will have been fully complicit.