Covered Mortgage Bonds -

A Funding Tool for Sub-Saharan Africa?

Dr. Friedemann Roy

November 4, 2008

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Objectives of session

• Gain a general understanding of the funding instrument,

including prerequisites and risks

• Get an overview of covered mortgage bond (CMB) systems in

developed countries and developing countries

• Learn which are the criteria for the establishment of a CMB

system you need to look at

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Equity

Bonds

Mortgage loans

Bank A

Cover pool

Capital market

Collateral

What is a covered mortgage bond (CMB)?

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Definition Covered Mortgage Bond

A covered mortgage bond is a debt instrument which is secured against a dynamic pool of specifically identified, eligible mortgages

• Reliance on collateral (mortgage) as primary source of credit quality

• Loans usually remain on balance sheet of issuing banks

• Bondholders have dual claim

– Issuer

– Assets and cash flows of underlying (dynamic) cover pool

• Credit quality of bonds is assured through

– Conservative underwriting standards

– Strict regulation of loans and lending institutions

– Rigorous valuation rules of property offered as collateral

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CMBs – characteristics (I)

• Framework

– Specific CMB legislation (nearly all countries in Europe)

– EU-level: UCITS Directive, Article 22 (4) and Capital Requirements Directive

– Contractual arrangements (e.g. Canada)

• Cover assets

– Residential and commercial mortgages

– Exposures to public sector entities

– Ship loans

• Asset-liability management guidelines: e.g. cover principle

• Valuation of mortgage cover pool and LTV criteria

– Principles for property valuation

– LTV ratios: 60 to 80%

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• Cover pool monitor and banking supervision

– External cover pool monitor

– Special supervision of CMBs within regulator (often central bank)

• Segregation of assets and bankruptcy remoteness

– Bondholders have preferential claims in comparison to other creditors

– Segregation from cover pool and CMBs from general insolvency estate

– Recourse to issuer’s insolvency estate upon cover pool default

• Typically no implicit or explicit state guarantee

CMBs – characteristics (II)

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Why were these instruments developed?

• Historical dimension

– Right to own and pledge property, establishment of land registries

– Development of monetary system (bond as replacement for metal)

• Mobilize long-term funding

– Base for provision of agricultural credit (Germany, 1770)

– Reconstruction of capital after great fire (Denmark, 1797)

– Issuance of real estate and public sector bonds to ensure capital supply in the provinces (France, 1852)

→ Use of property for finance has been matter of security of instrument and public confidence

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Why CMBs could be an advantageous funding tool?

• Improved liquidity and interest rate management

– CMBs are liquid papers

– Opportunity to lengthen maturity profiles

– Cover principle limits interest rate risk

• Opportunity to lower funding cost

– High credit rating

– Basle II framework leads to lower risk-weight

– Diversify funding sources

• Enhance reputation in the market

– Demonstrate discipline in management of strong asset quality

– Benefits from established reputation of instrument

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Which could have negative effects on CMBs?

• Risk management

– Risk concentration could be harmful if financial sector

tumbles

– Large bullet maturity profiles are vulnerable to liquidity

mismatches (including pre-payment risk management)

– Overcollateralisation can be expensive in case property

values decline

• Assessment by ratings agencies, investors

– How far will other debt holders be redeemed in case of

bankruptcy (e.g. FDIC statement, US)?

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Experiences of other regions - Europe

• Second largest bond market after government bond market

• Total CB volume outstanding: EUR 2.1 trillion (thereof CMBs 1.1trillion)

• 17 % of mortgages in Europe are funded by CMBs

• Germany, Denmark, Spain and France largest issuing countries

Source: EMF/ECBC

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Types of CMB systems – specialized financial institutions

with dynamic loan portfolio or pass-through series

Assets Liabilities

Issued

mortgage

bonds

(fungible)

Loans

against

mortgages

Other

assetsEquity

Assets Liabilities

Series A

Bonds

Series A

mortgages

Other assets Equity

Series B

Bonds

Series B

mortgages

Series C

Bonds

Series C

mortgages

Issuer with dynamic loan portfolio

• Quality of issuer important

• Less diversification opportunities

• Few creditors with lower ranking

Issuer with pass-through series

• Amount of loan = amount of bond

• Issuer bears no financial risks

• Callable bonds allow for better

pricing of pre-payment option

• Sophisticated, well reputed

infrastructure required

Source: Jeppe

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Types of CMB systems – club funding (e.g. Spain)

CH CH

Investors

CH CH CH CHCH

AyT Cedulas Fund

Portfolio of individual issues

AyT Cedulas Cajas

Issuer

Joint Cedula Bonds

Cedulas Issuers

(a number of savings banks)

Liquidity

reserve

&

Protection

deposit

Source: AyT, HVB

• Every credit institution is entitled

to issue cedulas (CMBs)

• No cover register

• Structural subordination of non-

cedula creditors and

overcollateralisation (25%)

• Supervision by Banco de Espana

• Pooled cedulas = cash flow

securitizations of cedulas

• Allows smaller institutions to tap

capital market

• But higher spreads possible, risk

weights in other countries may

differ

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Risk assessment of CMBs: through swap spreads

• No common European model:

o Risk perception of CMBs from countries differs

o Difference due to structure and legal framework (NL ↔ D)

• Breakthrough with Jumbo issue to develop benchmark

Source: Jeppe, VDP

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Risk assessment of CMBs: higher CMB ratings than issuers

Name of issuer

(country)

CMB rating

Moody’s S&P

Rating of senior

unsecured debt

Moody’s S&P

Financial

strength

(Moody’s)

Eurohypo

(Germany)

Aaa AAA A1 A C

Banco Espirito

Santo (Spain)

Aaa AAA A2 AA B+

Abbey (UK) Aaa AAA Aa3 AA C+

ABN Amro

(Netherlands)

Aaa AAA Aa2 AA- B-

OTB Mortgage

Bank (Hungary)

Aa1 Aa3 BBB+ C+

Source: Moody’s, S&P, Merrill Lynch, Bloomberg

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CMBs – Emerging Europe

CMBs outstanding as percentage of total residential lending

(2006)

16.2%

1.4%

1.4%

2.0%

58.0%

68.8%

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0%

EU-average

Latvia

Lithuania

Poland

Hungary

Czech Republic

• Most central and eastern European countries adopted CMB

legislation

• Different variants: Specialized institutions (Poland), license

required (Latvia, Russia), no license (Czech Republic, Bulgaria)

• Proximity to western Europe facilitated adoption

Sources: EMF Hypostat

2006 (Nov. 2007)

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How have CMBs in Europe performed during credit

crunch (since August 08)?

• Until mid-2008, CMBs were less affected although spreads have

risen (e.g. UK +57, Spain + 57, Germany +6)

• Near bankruptcy of Hypo Real Estate brought market to a near

standstill. What has happened?

– Investors perceive CMBs more as credit product than rate

product

– Universal banks as issuers are considered less risky than

specialized institutions

– Issuers have been running considerable short-term liquidity

gaps (“riding on the yield curve”), misusing funding

advantage of Pfandbriefe

– Role of regulator in Germany?

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CMBs – Latin America: characteristics

• Danish/German model served as example

• Laws adopted in Chile, Uruguay, Guatemala, Colombia,

Argentina, Paraguay

• No large bond markets, but many laws (often mixture of CMB

and MBS elements)

– Columbian law not specific on ring fencing of mortgage pool

– Argentinean law would fulfill requirements of EU-law

– Guatemalan law lacks regulations on duration matching

• In Mexico, discussion on CMB framework is on-going process

– One issue of USD 900k

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CMBs in Latin America: an alternative funding tool?

Source: Chiquier

• Deposits cheaper and more flexible funding tool (e.g. Chile)

• Small bond markets: confidence in new funding tools needs to be

developed

• Investors strong orientation towards issuer and preference for triple

A-rated investment instruments

• Confidence in legislation to protect investors?

Role of CMBs as funding instrument in Chile

39%

10%

51%

69%

20%

11%

0% 10% 20% 30% 40% 50% 60% 70% 80%

CMBs

Direct sales and MBS

Deposits

2005 1999

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How could we develop CMB systems in Sub-

Saharan Africa (SSA)?

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• Urbanisation requires huge investments

• Promotion of housing supply

• Create synergies with the development of financial markets

– Tap long-term income sources for lenders

– Diversification of investment opportunities (alternative to

government bonds)

SSA offer a host of opportunities

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But a number of risks prevail …

• Enabling environment

– Inadequate legal systems for collateralised lending, land

ownership and titling

– Weak institutional framework (e.g. lack of credit bureau, poor

housing evaluation standards, etc.)

– Poorly functioning property markets to ensure housing supply

– Ineffective housing policy to support mortgage market

development

• Primary market development

– Inadequate capacities of lenders in HF (products, processes

and procedures, service culture)

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Considerations for establishing CMB systems in Africa (I)

• Framework is key - sound regulation and supervision

– Credit quality of pledged assets

– Collateralization mechanism

– Asset-liability management rules

– Supervisory framework

– Definition of priority rights over other creditors

• Institutional set-up

– Specialized institutions vs. universal banks

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Considerations for establishing CMB systems in Africa (II)

• Market requirements

– Confidence in real estate as collateral necessary

– CMBs do not require market for credit risk

– How to deal with pre-payment risk

– Appetite of investors for new instrument (depends on size,

return, liquidity, etc.)

– Lending standards

• Take care of asset-liability practices at lenders

– Any financial mismatches should be taken on up-front

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Considerations for establishing CMB systems in Africa (III)

• Structuring of bond issuances

– Investors may thoroughly scrutinize structures and

underlying legal framework

– “Pure” CMBs (D, DK) or mixed CMBs/MBS structures (ES,

USA)

– If too complex, investors may not buy it (Korea)

– Issue should lead to lower funding cost

• Time

– Investor must learn about instruments and safety features

– Issuers must learn to deal with new instrument

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Dr. Friedemann Roy

Program Manager, Housing Finance

Private Enterprise Partnership for Africa

Tel. +27 11 731 3000

E-mail: Froy@ifc.org