Treasury Secretary Henry Paulson on Tuesday afternoon set off a late afternoon rally on Wall Street as he said the Treasury Department and other federal financial agencies were looking at "covered bonds" as a potential solution to the shortage of money for mortgage lending.

Wall Street shot up on his comments, with the Dow Industrial average rising 1.34% , the Nasdaq up 2.19% and the S&P 500 up 1.7%. The home builder group soared, led by Hovnanian Enterprises (NYSE:HOV), which shot up 22.6% to $5.69 at market close before backing down a bit more than 6% in after-hours trading. The S&P home builder ETF (AMEX: XHB) closed up 7.7% at $16.43 as many of its holdings, including Lennar, Meritage, M/I, Pulte and KB Home posted double digit percentage gains.

Paulson, speaking at an FDIC forum on mortgage lending to low and moderate income households, said the Treasury Department was working with FDIC, the Federal Reserve, the Comptroller of the Currency and the Office of Thrift Supervision "to explore the potential of covered bonds." Used widely in Europe, covered bonds are a better securitized version of the mortgage-backed securities used in the U.S. in recent years to spread the risk associated with lending to sub-par borrowers.

As described by Paulson, covered bonds provide funding to an issuer, generally a depository institution such as a commercial bank or thrift, through a secured debt instrument collateralized by a pool of residential mortgage loans that remain on the issuer's balance sheet. Interest is paid to investors from the issuer's cash flow. In the event of a default, covered bond investors' primary recourse is the pool of mortgage loans, and secondary recourse is an unsecured claim on the issuer.

"In the simplest of terms, the housing market is being negatively impacted by excess inventory and a reduction in the number of homebuyers," said Paulson. "These two factors are working in tandem; we cannot reduce the inventory unless we have committed homebuyers. And the availability and price of mortgage financing will affect how many buyers come into the market and when."

He also called on Congress to pass comprehensive GSE reform, which will provide additional capital to Fannie Mae and Freddie Mac and the Federal Home Loan Banks so they can lend more mortgage money. The House has passed such a measure; a companion in the Senate is now under consideration.

"Completing this legislation is the single most powerful step Congress can take this year to help our nation get through this housing correction,"Paulson said.

Earlier in the day, speaking to the same group, Federal Reserve Chairman Ben Bernanke suggested a greater role for the Fed in policing financial markets, including direct examination of financial institutions. Such authority would have to be given to the Fed by Congress.