European Mortgage Bonds and MBS.

Issuing mortgage bonds into the capital market is a major specialized method to fund mortgage loans in Europe. However, the development of this capital market instrument has not been even throughout Europe and the importance of the mortgage bonds as funding instrument varies widely among countries.

MBS is not yet a widely spread funding instrument in Europe as it is in the United States. However, when we take a closer look on the country level, we notice many differences in terms of its importance as a funding instrument. United Kingdom is the largest MBS market in the EU.

I. EUROPEAN MORTGAGE BONDS: OVERVIEW

A. Market Development

1. European importance

Mortgage bonds were first issued over 200 years ago in Germany and have subsequently developed in other parts of Europe most notably in Denmark, Sweden Austria, France and Spain. Today, the mortgage bond has established itself as one of the dominant components of the European bond market. The volume of mortgage bonds outstanding in the EU exceeded EUR 1.3 tn--18% of total domestic debt securities outstanding in the EU--at the end of 1999.

2. Concentration

The mortgage bond market in Europe is highly concentrated. As mentioned earlier, three countries share more than 85% of the overall mortgage bond market. Germany leads with 44% of the volume outstanding, followed by Denmark with 29% and Sweden with 15%. The remainder of the market is shared between Spain, France, Austria, Netherlands, Portugal, Finland and Norway.

In Denmark, mortgage lending by mortgage banks is fully funded through the issue of mortgage bonds. For Sweden, mortgage bonds, representing about 70% of total funding for the housing credit institutions, constitute the leading source of financing. The system is further strongly established in Germany and Austria. The German "Hypotheken-Pfandbrief" market, amounting to EUR 232 bn (mid-1999), is one of the largest fixed-income market in Europe. Mortgage bonds constitute the second source of financing in France and Spain, but represent only 17% and 6% respectively of the total mortgage funding well behind deposits. In the Netherlands and Norway, mortgage bonds are issued but fund a relatively small part of the loans (7% and 1% respectively).

Of all the newly established systems, those of Spain and more specifically France are felt to have the greatest potential of becoming a liquid market segment. On the one hand, the new French system, like that in Luxembourg, sticks relatively closely to the German system in many aspects and defines safety, features for its bonds that are comparable to those of the German Pfandbrief. On the other hand, Spanish Cedulas Hipotecarias, which can only be issued as mortgage-secured bonds, differ much more from the German version in terms of the legal framework.

3. Public mortgage bonds

In a number of European countries, mortgage bonds are also used to fund loans to the public sector. The bonds are referred to as "public mortgage bonds" and are as well subject to restrictive laws. Public mortgage bonds are widely used in Germany and Austria where public sector loans constitute nowadays the dominant collateral for mortgage bonds. Public mortgage bonds are also issued in France and Luxembourg.

4. Drivers for growth

The introduction of the Euro has created a strong incentive for the development of mortgage bond markets in Europe. Historically, low nominal interest rates have given rise to an environment that pushes mortgage lenders to adjust their methods of funding. The high demand for mortgages, coupled with low interest rates on deposits, raises questions over the continued ability of lenders to finance mortgages primarily through retail funds. At the same time, the elimination of exchange rate risk in the Euro area and the initiative undertaken by the European Commission to create a deep and liquid European capital market are encouraging many lenders to put greater emphasis on the wholesale markets as an alternative method for funding mortgage loans.

The strong growth ha the European mortgage bond markets in the last few years has been accompanied by massive changes in the rules governing the issue of those bonds. Some countries "re-activated" the use of mortgage bonds (France and Spain) while some others introduced a mortgage bond law (Luxembourg and Finland).

B. Legal Framework

1. At the International level

The Basel Accord is spearheading the banking reforms, notably stricter and more evenly applied capital adequacy requirements, which, in turn, will make it much more expensive for banks in several countries to hold loans on their balance sheets.

2. At the European level

a. Article 22(4) UCITS: a European standard

Despite its long European tradition there is today no common definition of the mortgage bond. Plans for common legislation were abandoned by the European Commission in 1989, following the publication of the White Paper on the Internal Market which put forward the principle of mutual recognition as an alternative to harmonization.

Nevertheless, the special character of mortgage bonds has since then been established in the 1988 Directive on Undertakings for Collective Investments in Transferable Securities (UCITS).

The UCITS directive contains rules, limitations on and opportunities for investing into mortgage bonds. The elements of the so-called "preferential treatment" are incorporated therein. Criteria have been set to decide on the inclusion of a certain security in the group to be treated on a preferential basis, with the possibility of applying exemptions for determining the limitations on the investment into securities of one or a group of issuers. Article 22(4) (1) sets the minimum requisites for a bond to be recognized as a mortgage bond.

* The bonds must have been issued on the basis of legal provisions to protect the holders of these bonds

* They must be subject to special supervision by the public authorities

* The sums deriving from the issue of these bonds must, according to the legal provisions, be placed in assets which provide sufficient cover for the liabilities deriving from the bonds for their entire duration

Mortgage credit institutions must cover mortgage bonds at all times by an asset cover (cover principle) and observe strict rules regarding the relationship between their assets and liabilities (congruence principle).

b. Cover principle:

The asset pool covering mortgage bonds include mortgage loans (residential and non-residential), loans to the public sector, and, in some countries, loans of an equivalent safety. The value of the cover pools has to be at least as high as the liabilities from outstanding issues and their interest payments. In a number of countries, mortgage credit institutions must create separate asset pools for each type of cover. For instance, in Germany, the public-sector loan pool consists of loans to public-sector funded by offentliche Pfandbriefe, and, similarly, the mortgage asset pool consists of residential and non-residential mortgage loans funded by Hypothekenpfandbriefe.

Moreover, mortgage loans covering mortgage bonds cannot exceed a certain percentage of the conservatively calculated mortgageable value of the residential or nonresidential property. This percentage differs according to national requirements. For instance, in Germany and Austria this percentage is 60% whereas in Denmark it is up to 80% for residential property and 60% for nonresidential property.

c. Congruence principle:

The congruence principle ensures that mortgage banks match the maturity of their assets and liabilities. A mortgage bank may not lend money with fixed conditions for a longer time period than these funds are available with fixed conditions. Borrowers when taking out a loan from a mortgage bank can choose the term. In order to hedge interest rate risk, the mortgage bank then matches the maturity of the loans with the maturity of the mortgage bonds, which are issued to fund the loans. In addition, in a number of countries, there exists a clause which excludes the borrowers' right to prepay their loans thus protecting mortgage banks from prepayment risk and reducing the likelihood of future mismatches concerning the banks' assets and liabilities structure.

* In the event of the bankruptcy of the issuer, the sums deriving from the issue of the bond are intended as a priority to repay the capital and interest becoming due.

These criteria ensure a sufficient homogeneity, of the issues and a minimum standard of transparency which makes these bonds a particularly safe financial instrument.

According to Article 20, mortgage bonds that fulfill these common characteristics must be notified by EU Member States to the European Commission. This has been done by Germany, Denmark, Austria, France, Spain and Luxembourg. Mortgage bonds issued in Portugal, the Netherlands, Sweden and Norway do not follow these common characteristics.

A mortgage bond law exists in Germany, Denmark, Austria, France, Spain, Luxembourg and Finland and is still under discussion in Ireland and Belgium.

For a credit institution, the holding of mortgage bonds costs capital. Government bonds, on the other hand, are not subject to any capital cost. If the UCITS Directive criteria are met, then it means a risk weighting of 10% for the security, and the investment ceiling per issuer is 20% instead of 10%. This weighting compares with 20% for financial bonds other than mortgage bonds, 0% for government bonds and 100% for corporate bonds.

In Denmark, Germany, Spain, Greece, France, Austria and Luxembourg, the 10% weighting of mortgage bonds has been granted. This is not the case in Sweden, where credit institutions must weigh bostadsobligationer at 20%.

Even if there are signs of a general convergence in the regulatory framework governing mortgage bonds in Europe, there might not be a standard European mortgage bond legal framework in the end. The respective credit cultures are too different. Other criteria will have to be found, to enable an integration of the different mortgage bond systems into a common "European Pfandbriefe" asset class, and to impose strict and transparent minimum requirements in terms of rating.

3. Other EU directives 

Specific provisions on mortgages are also found in other EU directives. Under the directive on solvency ratios for credit institutions (89/647/EEC), bank bonds are assigned the risk weight of 20%. At the same time it is possible to rate the bonds mentioned in Article 22(4) of the UCITS directive at 10%. Although this only applies to the bonds issued prior to January 1, 1998, the lower risk weight may also be retained after 1998 if member countries deem it necessary. Under Article 4(1) of the Directive 92/121/ EEC relating to large credit exposures, a limit on credit exposure to a client or a group of connected clients is set and this exposure may not exceed 25% of a credit institution's own funds. What is important for mortgage banks is that the

Directive makes it possible for member states to exclude, either in full or in part, specific loans (mortgage and municipal loans) and bonds as per Article 22(4) of the Investment Directive, when calculating the maximum limit. Directives relating to life and property insurance contain provisions under which insurance companies may invest a higher percentage of their assets into certain bonds. Mortgage bonds enjoy a special position under article 22(4) of these directives. Insurance companies may invest as much as 40% of their reserves into specified bonds where the credit institution is seated in an EU member country; holders of bonds issued by it are protected; funds raised through the issue of bonds may only be applied to assets determined by law; claims for the assets cover obligations due from the bonds over the whole maturity period in the event of the bank going bankrupt, holders of these bonds are satisfied on a priority basis. In this context, securities issued or guaranteed by the state are not the only securities offering maximum security (payoff of yields and principal redemption). Also other bonds, such as mortgage bonds can be classified into this group.

4. At the National level

The legal and regulatory, framework impacts the quality of the collateral (asset cover) and the priority treatment in case of the originator's bankruptcy. We will discuss the various national legislations in the country analysis.

Impact of the legal framework on the securitisation process

The legal framework is a fundamental factor in the development of the securitisation process. Laws and regulations, through their impact on the collateral value (asset cover), on the guarantees provided to the investor (e.g. bankruptcy privilege) and on the refinancing possibility among other things, will have strong impact on the risks (credit risk and prepayment risk) beard by a security's investor.

C. Issuers

In most member countries, mortgage bonds issuers are credit institutions and are subject to special public supervision. Beyond these common characteristics mentioned in the article 22(4) of the UCITS directive, there are considerable differences between issuers in the different countries.

The right to issue mortgage bonds is confined, in nearly all countries to specialized credit institutions whose activities are subject to restrictions. These restrictions relate to the nature of their activities, both on the lending and on the liabilities side. This is the case notably in Germany, Denmark, Sweden, France, Finland and Luxembourg. In several other European countries, including Austria, Spain, Portugal and Greece, the issuance of mortgage bonds is not restricted to specialized credit institutions.

D. Return

The development of the mortgage bond in Europe has been supported by its ability to combine relatively low risk with attractive returns.

Between January 1998 and December 1999, the 10-year mortgage bond spreads expressing the yield differential between mortgage bonds and benchmark government bonds in Austria, Denmark and Germany ranged between 15 and 50 basis points. In Sweden (5-year yield differential) and Norway, the spreads were much higher at respectively 67 and 85 basis points. The factor giving rise to a spread however differs from one country to another. European MBS: Overview

II. EUROPEAN MBS: OVERVIEW

A. Market Development

MBS is not yet a widely spread funding instrument in Europe as it is in the United States. However, when we take a closer look on the country level, we notice many differences in terms of its importance as a funding instrument. United Kingdom is the largest MBS market in the EU. Ireland follows its neighbor but the development of an MBS market in this country is slowed down by the lack of expertise and systems required to issue this type of instrument.

Both UK and Ireland are experimenting an increasing competition on their mortgage market. The volume of new mortgages lending is higher every year and mortgage lenders are using MBS as a way to remove existing loans off the balance sheet, reducing the amount of capital which has to be retained and thus freeing up capital for additional new lending. Elsewhere in Europe, MBS have been issued primarily in Spain (3.2% of mortgage lending in March 1999) and France but also in the Netherlands, Belgium and Germany. MBS have not been issued in Denmark, Greece and Austria. As for the other Scandinavian countries, some UK-style MBS have been issued in the beginning of the 1990s. In June 2000, a EUR 1 bn issue was made by a Swedish issuer using UK-style techniques.

In 1998, Spain issued EUR 3.9 bn of MBS, UK EUR 3.3 bn, and France EUR 2.5 bn. Belgium, Ireland and Holland issued together about EUR 1 bn of MBS.

MBS are in general originated by universal banks. In Ireland and UK they can be originated by building societies. In Spain, MBS used to be originated primarily by "specialized financial institutions" (EFC) but now the situation has changed and universal banks and savings banks are becoming predominant.

Apart from the above mentioned countries, securitisation of residential mortgage loans has remained inactive in most of the European Union. The value of MBS outstanding in the EU and Norway is estimated at EUR 16 bn which represents less than 1% of total residential mortgage loans outstanding (end 1998). However, many reasons stemming from the regulatory and economic environment indicate that securitisation will grow in the future.

B. Influence of the Legal, Regulatory, Fiscal & Accounting Framework

1. On the existence of the securitisation transaction

In certain common law jurisdictions, such as the United Kingdom, different types of securitisation structures have been able to evolve relatively free of legal restrictions, as long as they are not expressly prohibited by existing statutes. In other jurisdictions characterized by civil legal codes (for example, France, Italy and Spain), specific laws must be adopted in order for the securitisation market to develop.

2. On the structure of the securitisation transaction

Legal, regulatory and tax rules may affect the sale, assignment or other conveyance of assets by originators to securitisation vehicles (SPVs). A central legal issue deals with the legal isolation of transferred assets from the financial fortunes of the related originator. Another important issue relates to the legal framework governing the creation, maintenance and operation of SPVs. Furthermore, some national regulations limit the number of MBS structures admissible.

On the investment side, legal investment laws applicable to pension funds, insurance companies, banks, financial institutions and other institutional investors may restrict their participation in the ABS markets.

Finally, the balance sheet effects and accounting treatment are considered carefully when structuring a securitisation transaction. The most important issue to be confronted in this regard includes structuring asset sales in a manner that achieves non-recourse sale treatment, and asset derecognition for balance sheet purposes.

C. Rating

Rating is a crucial element in all ABS transactions. It provides information on the likelihood of an issuer being in a position to meet all payments relating to an issue (interest and repayment) in full and on time. In the case of MBS, the analysis concentrates on three areas:

* The credit quality/credit risk of the mortgage-backed claims

* The mechanism for transmitting and allocating the payment flows

* The transaction's legal framework

FitchIBCA has set up a Mortgage Default Model where the mortgage-backed claims pools are submitted to a stress test, in which the repayment of the loan must be guaranteed. The better the rating is supposed to be, the worse the scenarios are applied in the simulation. Two major variables are the likelihood of defaulting and the loss severity. The first variable--likelihood of defaulting--is determined by the loan-to-value (LTV) ratio and by the debtor's solvency measured on the basis of loan commitments to income (DTI, debt to income ratio). Lower LTV and DTI ratios lead to the assumption of a smaller likelihood of defaulting on the mortgage loan. The second variable--loss severity--is the difference between the loan balance and the recovery value of the property, divided by the loan balance (expressed as a percentage). This variable takes into account all costs in the event of borrower's default.

END NOTES

(1) Article 22(4) states: Member States may raise the 5% limit (proportion of an investor's assets invested in the securities issued by one issuer) to a maximum 25% in the case of certain bonds when these are issued by a credit institution which has its registered office in an EU Member State and under the statutes related to the protection of holders of such bonds is subject to special public supervision; sums deriving from the issue of these bonds must be invested in assets specified by law, which, during the whole period of validity of the bonds, are capable of covering claims attaching to the bonds and which, in the event of failure of the issuer, would be used on a priority basis for the satisfaction of investors' claims.

MATHILDE FRANSCINI Graduated from HEC Lausanne, Switzerland in 2001. She is a titular of a Licence en Sciences Economiques, a Master in Banking and Finance (MBF) and a Certificate FAME (Financial Asset Management and Engineering). She currently works at ABB Financial Services.

TAMARA SCHILLINGER obtained a Licence en Sciences Economiques from University of Lausanne, Switzerland in 2000; a Master of Science in Banking and Finance from University of Lausanne, Switzerland in 2001-2002. Tamara is currently working for ABB Financial Services.