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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 [email protected]
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A fast growing marketOutstanding amounts- Chile, Korea not included (millions Euros – Source: ECBC)
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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:
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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
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
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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
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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
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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)
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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)
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Challenges
1. Depositors’ subordination and asset encumbrance
2. Withstanding financial crises
3. Fitting in national contexts
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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
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The robustness of Covered Bonds
Has it been tested in the recent financial turmoil?
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A Global Resilience to the Financial Crisis2008-2009 New issues in Europe remained strong Source: ECBC
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… but with shorter maturities
Source: Euromoney:
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CB spreads parallel sovereign bonds Why?
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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)
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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
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