Asia Pacific Union for Housing Finance

International Conference on Housing April 10-13, 2013 New Delhi, India

MORTGAGE COVERED BONDS:

ECONOMICS, BENEFITS, CHALLENGES

Olivier Hassler ohhfinance@gmail.com

1

A fast growing marketOutstanding amounts- Chile, Korea not included (millions Euros – Source: ECBC)

2

A clear geographic expansion, but still a mostly European market - Only 4 countries in Asia currently: Japan, Korea, Russia, Turkey

India, Brazil, Mexico, Morocco: frameworks under way

Source: Euromoney:

3

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

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

4

The 7 Pillars of a CB system

1. Types of assets

2. Quality standards

3. Additional components of the cover pool

4. Segregation of assets

5. Coverage mechanism

6. Supervision

7. Management of insolvency situations

5

Assets

1. Main types Traditional: well secured , low risk profile loans

Residential mortgage loans Secured Commercial real estate loans Public sector loans Ship loans, used only Germany and Denmark

Trend towards diversification : consistent with the concept? Special Commercial real estate CBs (Ireland) SME loans (Korea, Turkey – Asset Backed Bonds distinct from Mortgage CBs-, draft US

legislation, Germany – recent transactions, but with a public sector guarantee ) Aircraft finance (Germany) Export finance CBs (Spain) Consumer loans (draft US legislation)

2. Quality standardsBasic standards (legal, contractual ) to eliminate risk factors - LTV, valuation: key elements

3. Other components of the cover pool Substitute assets, to allow flexibility in the management of the pool : e.g. prepayments, large

issues preceding the extension of new loans Hedging instruments

6

Coverage

4.Segregation of assets Objective: avoid mingling the cover pool with the general bankruptcy estate Methods: depend on the national legal system

Ring-fencing on balance sheet loans (typically recorded in a public register) Specialized subsidiaries set out by dedicated legislation - ex.: France Separation issuer /guarantor holding the cover pool: structured CB model, transposed in

legal frameworks of countries where it was prevailing (Austr., NZ, Netherland, UK)

5. Mechanics Coverage in terms of

principal balance outstanding (repayment perspective) Net Present Value (liquidation perspective) interest cash flows (continuity of servicing the bonds)

Overcollateralization “structural”: to face temporary mismatches (delinquencies, cash flows gaps)- legal miinimum

“dynamic” : to face changes of situations (e.g. issuer’s downgrade, periodic asset coverage

tests, fall of real estate prices )

Asset coverage tests to check the coverage on an on-going basis 7

6 - Supervision Cover pool monitor

Compliance with requirements, legal checks

Checks of withdrawals from / entries in the cover pool

Verification of calculations (e.g. valuations, tests)

Independently organized function

Supervision by the banking Authority Licensing

Registration of programs

Special on-going oversight

Market information on cover pool Initial disclosure

On-going disclosure

Transparency: a new emphasis of statutory & market practices (ECBC

label, CBIC template, some national regulatory frameworks - ex. Norway)

8

7 - Management of Insolvency Situations

Ring fencing legally binding

No automatic acceleration of maturity: central feature

Specific insolvency administrator

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

extension, typically 1 year), conversion into a pass trough structure

If portfolio liquidation unavoidable: Legal validity of voluntary OC: critical In case of shortfall: recourse to the general insolvency estate

(pari passu typically)

9

Challenges

1. Depositors’ subordination and asset encumbrance

2. Withstanding financial crises

3. Fitting in national contexts

10

Depositors’ subordination / Asset Encumbrance

CBs by commercial banks the protection of depositors, primary goal of prudential frameworks, implies a

priority over other creditors, competing with secured claim holders Some banking laws had to be changed to accommodate CB frameworks :

Australia, New Zealand

CB Overcollateralization (OC): the critical aspect A wider issue:

CBs not the only driver of unsecured creditors’ subordination “The real question: the ratio unencumbered assets /unsecured debt”* and its

capital adequacy implication A strong need: measuring the degree of encumbrance

Protection of depositors Ability for the issuer to manage funding crisis by offering collateral Assessment of assets available in a resolution situation

Another frequent claim ranking issue: salaries and tax privileges

*Ralf Grossman, EMF Mortgage Info February 2013 11

Asset Encumbrance – Selected Regulatory answers

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%

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

Capital requirement to OC Denmark (capital center), Netherlands

Contribution to Deposit Insurance Schemes Not a tested solution

12

The robustness of Covered Bonds

Has it been tested in the recent financial turmoil?

13

A Global Resilience to the Financial Crisis2008-2009 New issues in Europe remained strong Source: ECBC

14

… but with shorter maturities

Source: Euromoney:

15

CB spreads parallel sovereign bonds Why?

16

Governments step in before the CB mechanism is enforced in stress situations Spain: Cedulas Hipotecarias

Most CH downgraded to [A-, BBB] –fall of the housing market, risk of lower OC, insufficient transparency (i.e.no indexation of LTVs),high commercial RE components.

Strong government measures (MOU) for financial system restructuring / orderly resolution –bad bank, resolution entity- : up-stream strengthening, before reliance on cover pools

Bankia’s partial nationalization (SIFI), 2012

Other State bail-outs : Hypo Real Estate / Depfa Group(Ger), 2008 : nationalized Anglo Irish Bank 2008-2010: nationalization, creation of a new bank, winding down entity with CBs -

downgraded to BB-, then redeemed Dexia (Fr/Belgium), SNS Reaal (NL): nationalized + senior unsecured bondholders bail-in (SNS) 3CIF (Fr), 2012,: Government guarantee

Cyprus (Bank of Cyprus, Cyprus Popular (Laiki) Bank) Before the crisis: rating uplift (1 notch) limited by the marketability of assets , inefficient foreclosure

process. Covered bonds = BBB- February-March 2013 crisis:

Severe downgrade of the country rating (B) BC& CPB in default, but BC to be bail-out by the government and CPB merged into it Cov Bonds excluded from the bail-in measures, contrarily to large depositors CPB Cov Bonds downgraded to Caa But all the Cypriot CBs were retained by the 2 issuers (to access ECB liquidity support), several

were cancelled, hence not a significant test 17

Efficiency of Covered bonds in insolvency situation- Lessons for recent experiences

Despite the lack of full security enforcement, recent experiences show some key conditions for the actual efficiency of CB mechanisms in insolvency scenarios:

No or remote bail-in risk, a major status in the recent bank failures, to be confirmed by regulation

Dynamic overcollateralization capacity Market maturity and size (potential buyers / alternative servicers for the cover

pool) Sovereign rating –even for domestic investors (government's capacity to

provide support if other solutions fail)

18

Conclusion: Introducing CBs- Some Key Conditions Lenders:

Standing Critical mass Shortage of stable liquidity (Loan-to-Deposit Ratios, ALM constraints)

Investors: Critical mass Need of long term investment instruments Adjusted investment rules

Market structure: Strong supervision capacities Availability of credible alternate servicers / mortgage business buyers –

pass through option: a way around the lack thereof

Legal framework: Exemption to basic bankruptcy law, Bail-in of CB holders excluded from bank resolution/restructuring Legal validity of OC above statutory minimum

19