Asia Pacific Union for Housing FinanceDelhi Conference January 2012

The Expansion of Mortgage Covered Bonds:

Market Drivers, Policy Options

Olivier Hassler ohassler@worldbank.org

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Foreword: The World Bank Support to Housing Finance Development

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A Critical component of Social and Economic Development…

World needs c 4,000 houses an hour to keep up with demand (UN-Habitat, 2005)

Urbanization requires huge investments – or slums prevail Individual and social impact of immediate decent housing Possible wealth ladder Impact on the economy

Construction multiplier effect Link home owner ownership /micro or small business

Limits of government finance Promotion of savings and development of capital market

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…But faces challenges

Among others, HF : Can have an adverse effect on banking stability

(linkage with real estate market cycles or bubbles, risky lending practices)

Imply long term finance to make large investments affordable, a feature often hard to match

The World Bank’s 4 Pillar Strategy: Build sound foundations of HF systems Expand access of LI households to HF Promote affordable housing supply Develop adequate funding for housing

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What are Covered Bonds

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CB Essence : to Provide Security to Investors

1. A Double Recourse Mechanism: Mortgage portfolios are pledged to bondholders (Cover Pool) Bondholders’ privilege on the CP in case of insolvency CP segregated from other assets The CP must be sufficient to service the bonds at any time

Quintessential principle: insolvency not an Event of Default no automatic acceleration of the maturity of the CB

2. Quality Requirements for the AssetsStrict eligibility criteria: first mortgage, Max LTVs (80% for residential

typically, insurance /guarantees if more), valuation rules, limits on CRE

3. On going supervision by specific controllers/trustees

However, not a totally Bankruptcy Remote Instrument6

The Expansion of Covered Bonds

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A Fast Growing MarketAmounts outstanding - Billion Euros - Chile , Korea not included

Source: ECBC

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The Benefits of Covered Bonds For lenders

Long term funding, fixed rates available

But ALM mismatches generally (bullet repayment vs amortizable loans) Rating enhancement can be significant (several notches possible) Cost effective, cheaper than securitization

But spreads widened in Europe (AAA: 150 bp +) – largely sovereign effect

For investors High level of security , with yield pick up Market liquidity: no valuation problem, large volumes, market making

achievable under certain conditions, repos

From a macro perspective: financial stability factor Long term investments stimulated by security conditions

But government supported CB issuers during crises (France, UK, Germany) No moral hazard (credit risk retained) Access to Central Banks’ repos with small haircuts 9

A Greater Resilience to the Financial CrisisNew issues in Europe remained strong - Source: ECBC-

(But with shorter maturities)

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Changing Funding Patterns

Importance of short term liquidity risk re-discovered

Wholesale short term funding for mortgage portfolios out

Stable core deposit bases revalued

Securitization affected by the crisis (image, new regulations)

Geographic expansion of covered bonds, including in jurisdictions that up to now prevented commercial banks from issuing secured debt

New legal frameworks Legal frameworks considered/prepared - Australia - India

- Korea - Belgium

- New Zealand - Brazil

- Canada

- Japan

- Mexico

- Morocco

- USA11

Options for Key Features

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Structural Options

Specialized lenders ( initially) vs commercial banks (general case now)

Asset mix (residential, CRE, public entities), or specific cover pools by asset types?

Ring fencing options: CP register (fungible assets, dynamic pool) Special subsidiary fungible assets, (dynamic pool) –

France, Australia

bond specific CP (static pool, pass through structure) Denmark / Chile models

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Management of Insolvency Situations

Ring fencing legally binding

Specific insolvency administrator

CP becomes static. Risks to address for continuation: Lower recovery Back-up loan servicer Liquidity shortage possibility to borrow, soft bullet

arrangement

If portfolio liquidation unavoidable: Legal value of voluntary OC In case of shortfall: recourse to the general insolvency estate (pari passu typically)

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Assets/Liabilities Matching

Cash flow coverage: a not precise enough principle Liquidity risk:

Substitute assets Pre-maturity test and liquidity reserve (Germany,

France: 6 months in advance) Market risks:

NPV coverage Derivatives included in the CP

Better matching = lesser OC requirement

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Depositors’ SubordinationDepositors ranking behind secured creditors: a concern of many prudential Authorities. Ways to address it:

1.Link CBs issuance to soundness criteria Licensing criteria Minimum solvency ratios

Italy : limits for cover pool size: None if Capital ratio > 11% 60% if Capital ratio = 10%-11% & tier 1 capital > 6.5% 25% if Capital ratio = 9%-10% & tier 1 capital > 6%

2.Hard limits - from 4% to 20% in various jurisdictions Regulation Cases by case approach (UK, Netherlands)

3.Impose capital requirement to OC Denmark (capital center), Netherlands

4.Contribution to Deposit Insurance Schemes 16

Conditions of Success beyond Legal Frameworks

Institutional Investors: investment guidelinesSpecific asset class, adjusted risk concentration rules, etc.

Investing banks: Lower risk weight Repo-ability

Reporting and market information Transparency (dynamic pool composition, on going LTVs,

NPL, etc.) allows less OC Loan by loan information (UK) maybe excessive (no asset

transfer)

Support to market liquidity market making ideally, but hard to hold commitments in

stressed contexts 17